Computation of AMT ACE Adjustment and FSC Changes -- Final and Temporary Regulations Under Sections 56 and 926

 [4830-01]

 ACTION: Final and temporary regulations.

 SUMMARY: This document contains final regulations relating to the alternative minimum tax for corporations. The Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the Revenue Reconciliation Act of 1989, and the Omnibus Budget Reconciliation Act of 1990 all made changes to the applicable law. These regulations affect corporate taxpayers and provide them with guidance necessary to determine their alternative minimum tax.

 EFFECTIVE DATES: These regulations are effective for taxable years beginning after December 31, 1989.

 FOR FURTHER INFORMATION CONTACT: Nicholas G. Bogos of the Office of the Assistant Chief Counsel, Income Tax and Accounting, (202) 566-4104 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

This document contains final regulations amending the Income Tax Regulations (26 CFR Part 1) under section 56 of the Internal Revenue Code of 1986. This Treasury Decision would conform the regulations to section 701 of the Tax Reform Act of 1986 (Public L. 99-514; 100 Stat. 2320), sections 1007 and 6079 of the Technical and Miscellaneous Revenue Act of 1988 (Public L. 100-647, 102 Stat. 3342), sections 7205 and 7611 of the Revenue Reconciliation Act of 1989 (Public L. 101-239, 103 Stat. 2106), and section 11301(b) of the Omnibus Budget Reconciliation Act of 1990 (Public L. 101-508).

 On May 3, 1990, the Federal Register published a Notice of Proposed Rulemaking (55 F.R. 18626). A number of public comments were received and a public hearing was held on October 16, 1990. After consideration of the written comments and those presented at the hearing, the proposed regulations are adopted as revised in this Treasury Decision.

PUBLIC COMMENTS

I. SECTION 1.56(g)-1(a).

 Section 1.56(g)-1(a)(5) of the regulations provides that except as otherwise provided by regulations or other guidance issued by the Internal Revenue Service, all Internal Revenue Code provisions that apply in determining the regular taxable income of a taxpayer also apply in determining adjusted current earnings (ACE). The regulations finalize section 1.56(g)-1(a)(5) without change because the Internal Revenue Service believes Congress intended that ACE (and the alternative minimum tax (AMT) in general) be a separate tax system.

 The Service specifically requested comments when it published the Notice of Proposed Rulemaking on whether the statute and the legislative history required ACE to be a separate tax system, and if so, whether there were ways in which the Service could mitigate the resulting complexity without deviating from the substantive results Congress intended. The Service received no comments on these issues.

 As stated above, section 1.56(g)-1(a)(5) provides that ACE is a separate tax system except to the extent the Service provides otherwise. The Service has not expanded section 1.56(g)-1(a)(5) to include any exceptions because the Service is currently studying this and related matters. The Service again requests comments and suggestions on ways in which the Service might simplify ACE and the AMT without deviating from the results Congress intended. See, e.g., proposed section 1.56(g)-1(r) in the Notice of Proposed Rulemaking published this day in the Federal Register.

II. SECTION 1.56(g)-1(c).

A. INCOME FROM THE DISCHARGE OF INDEBTEDNESS.

 Section 56(g)(4)(B) and section 1.56(g)-1(c) of the regulations provide that ACE includes amounts taken into account in determining earnings and profits but that are excluded from pre-adjustment alternative minimum taxable income (pre-adjustment AMTI). Section 56(g)(4)(B), as amended by section 7611(f)(2) of the Revenue Reconciliation Act of 1989, Pub. L. 101-239, provides that ACE does not include income from the discharge of indebtedness which is excluded from gross income under section 108 (or the corresponding provisions of prior law). Section 1.56(g)-1(c)(4) of the proposed regulations provided that "[a]mounts excluded from gross income under section 108 . . . or any corresponding provisions of law repealed by the Bankruptcy Tax Act of 1980 are not included in adjusted current earnings." Commenters pointed out that the proposed regulations did not address the treatment of income from the discharge of indebtedness which is excluded under a prior law that was NOT repealed by the Bankruptcy Tax Act of 1980.

 The final regulations under section 1.56(g)-1(c)(4)(i) are clarified to also exclude from ACE income from the discharge of indebtedness that is excluded from gross income under law that was not repealed by the 1980 Act.

B. FEDERAL INCOME TAX REFUNDS.

 In response to comments received, section 1.56(g)-1(c)(4)(ii) of the final regulations is added to provide that refunds of federal income taxes are not included in ACE.

C. INCOME ACCRUED ON BEHALF OF STATES AND MUNICIPALITIES.

 Section 115 provides that gross income does not include the income derived from any public utility or the exercise of any essential governmental function and accruing to a state or one of its political subdivisions. Income earned by a state generally is not SUBJECT to Federal income tax. See Rev. Rul. 71-131, 1971-1 C.B. 28; Rev. Rul. 71-132, 1971-1 C.B. 29; Rev. Rul. 87-2, 1987-1 C.B. 18. Because income clearly would not be subject to Federal income tax (including the AMT and ACE) if earned directly by a state or its political subdivisions, the fact that it accrues to a state or local government through an intermediary corporation does not change the result. Thus, section 1.56(g)-1(c)(4)(iii) of the final regulations provides that income that accrues to a state or local government through a corporation and that is not included in the gross income of the corporation under section 115 is not included in ACE.

D. DISTRIBUTIONS OF APPRECIATED PROPERTY.

 Several commenters were concerned that a distribution of appreciated property could result in an increase in earnings and profits that is not included in pre-adjustment AMTI, thus causing an increase in ACE. In most cases, this does not occur because there is no increase in earnings and profits that is permanently excluded from pre-adjustment AMTI.

 The final regulations clarify that if a distribution of property gives rise to more than one adjustment to earnings and profits under section 312, all of the adjustments with respect to the distribution of that item of property are combined for purposes of determining the net effect of the distribution on the corporation's ACE for the taxable year. No ACE adjustment is required unless the net increase in earnings and profits exceeds the amount included in pre-adjustment AMTI.

 In the case of a corporation's distribution of appreciated property with respect to its stock, section 312 provides that the earnings and profits of the distributing corporation is increased by the excess of the fair market value over the adjusted basis of the property (section 312(b)(1)) and decreased by the fair market value of the property (sections 312(a)(3) and (b)(2)). In addition, section 311(b)(1) provides that if a corporation distributes appreciated property to a shareholder in a distribution to which subpart A, part 1 of subchapter C applies, gain is recognized to the distributing corporation as if the property were sold to the shareholder at its fair market value. Thus, the excess of the distributed property's fair market value over its adjusted basis generally is included as gain under section 311(b)(1) in computing the distributing corporation's taxable income and pre-adjustment AMTI. Because the gain that is included in pre-adjustment AMTI will usually equal or exceed the net increase in earnings and profits, no ACE adjustment is needed in most cases.

E.DISTRIBUTION OF ENCUMBERED PROPERTY OR A SHAREHOLDER'S ASSUMPTION OF LIABILITIES IN CONNECTION WITH A DISTRIBUTION.

 Several commenters were concerned that a distribution of encumbered property or a shareholder's assumption of a liability in connection with a distribution of property could result in an increase in earnings and profits that is not included in pre- adjustment AMTI, thus causing an increase in ACE. In most cases, this does not occur because there is no increase in earnings and profits that is permanently excluded from pre-adjustment AMTI.

 The final regulations clarify that if a distribution of encumbered property or the assumption by a shareholder of a liability to which the property is subject in connection with a distribution of property gives rise to more than one adjustment to earnings and profits under section 312, all of the adjustments with respect to the distribution of that item of property are combined for purposes of determining the net effect of the distribution on the corporation's ACE for the taxable year.

 In the case of a distribution by a corporation with respect to its stock, section 312(a)(3) provides that the earnings and profits of the corporation is decreased by the adjusted basis of distributed property. Section 312(b) provides that in the case of a distribution with respect to stock of appreciated property, earnings and profits is increased by the excess of the fair market value over the adjusted basis of the property and decreased by the fair market value of the property. Section 312(c) provides that in making the adjustments to earnings and profits under section 312(a) and (b) for distributions with respect to stock, proper adjustment shall be made for the amount of any liability to which the distributed property is subject, and the amount of any liability of the corporation assumed by the shareholder in connection with the distribution. Thus, the amount of any decrease in earnings and profits as a result of a distribution with respect to stock is adjusted by the amount of any liability described in section 312(c)(1) or (2).

 Section 311(b)(2) provides that if property is distributed subject to a liability or the shareholder assumes a liability in connection with the distribution, the fair market value of the property distributed shall be treated as not less than the amount of the liability. The excess of the distributed property's fair market value (determined in accordance with section 311(b)(2)) over its adjusted basis is included as gain under section 311(b)(1) in computing taxable income and pre-adjustment AMTI.

 In many cases, the amount included in pre-adjustment AMTI (after applying the provisions of section 311, 336, or 356) will equal or exceed the net earnings and profits effect of the distribution. In such cases, no additional adjustment will be made in computing the distributing corporation's ACE.

F. OTHER EARNINGS AND PROFITS ITEMS.

 Commenters were concerned that the regulations did not specify that two particular items that are excluded from pre-adjustment AMTI do not increase earnings and profits and thus do not increase ACE. These two items are lessee improvements to leasehold property that are excluded from the lessor's gross income under section 109, and non-shareholder contributions to the capital of a corporation that are excluded from the corporation's income under section 118. Because these items do not generate earnings and profits when they are received by a corporation, the final regulations specify that these items are excluded from both pre-adjustment AMTI and ACE.

G. SURRENDER OF LIFE INSURANCE CONTRACTS.

 Section 1.56(g)-1(c)(5)(i) of the final regulations clarifies that if the ACE basis in a life insurance contract exceeds the amount of death benefits received or the amount received when the contract is surrendered, then the resulting loss is allowed as a deduction in computing ACE.

H. PARTIAL LISTS OF EARNINGS AND PROFITS ITEMS.

 The proposed regulations contain two non-exclusive lists of items that increase ACE. See sections 1.56(g)-1(c)(6) and 1.56(g)- 1(d)(3). Several commenters requested that new items added to these lists have prospective effect only.

 Guidance on the proper treatment of an earnings and profits item for purposes of ACE may be effective retroactively. The Service is aware, however, of the difficulties that may arise in computing ACE if the proper treatment of an item in computing earnings and profits is uncertain. Therefore, when specifying new items to be included in ACE, the Service will consider making the treatment of the new item effective prospectively if substantial uncertainty as to treatment of the item in computing earnings and profits justifies this prospective effect for purposes of ACE. For example, section 1.56(g)-1(c)(6)(x) is added to the final regulations to provide that amounts that are excluded from pre-adjustment AMTI as a result of an election under section 831(b) (allowing certain insurance companies to compute their taxable income using only their investment income) are included in ACE for all taxable years beginning after December 31, 1989. Retroactivity is warranted in this case because the ACE treatment of section 831(b) elections was mentioned in the Conference Report to the Tax Reform Act of 1986. The final regulations also provide that additional items that increase ACE may be identified by the Commissioner in published guidance other than regulations.

III. SECTIONS 1.56(g)-1(d).

A. DIVIDENDS PAID TO AN ESOP.

 Many commenters questioned the disallowance of the deduction for dividends paid to an employee stock ownership plan (ESOP) in computing ACE. The Conference Report to the Tax Reform Act of 1986 states that "[a]djusted current earnings measures pre-tax income without diminution by reason of any dividend paid. . . . [N]o deduction is allowed with respect to a dividend paid." H.R. Rep. No. 841, 99th Cong., 2d Sess. II-276 (1986). Thus, section 1.56(g)- 1(d)(3)(iii)(E) provides that ACE is determined without any section 404(k) deduction for dividends paid to an ESOP.

B. NONPATRONAGE DIVIDENDS OF COOPERATIVES.

 Several commenters questioned the disallowance of the deduction under section 1382(c)(2) for nonpatronage dividends that are not paid with respect to stock. Section 1.56(g)-1(d)(3)(iii)(F) of the final regulations clarifies that the deduction under section 1382(c)(1) is disallowed in computing ACE, while the deduction under section 1382(c)(2) is allowed.

IV. SECTION 1.56(g)-1(f).

 Commenters noted that section 1.56(g)-1(f)(2) merely states that section 173 does not apply in computing ACE. Commenters were concerned that in the absence of section 173, taxpayers would be required to determine which circulation costs are related to increasing circulation, which costs are related to maintaining circulation, and whether any of their circulation costs have a determinable useful life. The final regulations note that section 59(e) allows taxpayers to elect to capitalize all circulation costs and amortize them over three years. This election applies for purposes of ACE, as well as regular taxable income and pre-adjustment AMTI. Thus, taxpayers have a means to avoid the complexities of pre- section 173 law.

V. SECTION 1.56(g)-1(k).

 Section 56(g)(4)(G) and section 1.56(g)-1(k) require certain corporations that have ownership changes (as defined in section 382) to restate the adjusted basis of their assets. A corporation has an ownership change if first, the corporation is a loss corporation, and second, there is an increase of more than 50 percentage points in stock ownership by 5-percent shareholders during the testing period (usually the three-year period ending on the date on which a transaction is tested for an ownership change). See generally section 382(g). A corporation is a loss corporation under section 1.382-2T(f)(1) if it has certain net operating or capital losses, excess credits as defined in section 383, or a net unrealized built-in loss.

 In order to simplify the determination of whether a corporation is a loss corporation, section 1.56(g)-1(k)(2) of the proposed regulations provided that in determining whether a corporation is a loss corporation, its net unrealized built-in loss is calculated using the regular tax basis of its assets. This relieves all corporations of the burden of making ACE, as well as regular tax, determinations of their status as loss corporations. Section 1.56(g)- 1(k)(3) required that once a loss corporation has an ownership change, the determination of whether the corporation has a net unrealized built-in loss to be eliminated is made using the ACE basis of its assets.

 Commenters suggested that the calculation of any net unrealized built-in loss under section 1.56(g)-1(k)(3), as well as the corporation's status as a loss corporation under section 1.56(g)- 1(k)(2), be determined by reference to the regular tax basis of the assets. The recommended approach, however, would narrow the scope of section 56(g)(4)(G) by allowing taxpayers that have a net unrealized built-in loss for ACE purposes but not for regular tax purposes to avoid restating the basis of their assets for ACE. Thus, the final regulations under section 1.56(g)-1(k) are unchanged from the proposed regulations. In response to comments received, section 1.56(g)-1(k)(1) clarifies that the rules of section 1.338(b)-2T(b), if otherwise applicable to the transaction, are applied in making the allocation of basis for purposes of ACE.

VI. CLARIFYING CHANGES.

 The final regulations contain a number of clarifying and technical changes. For example, the regulations clarify that in determining ACE, to the extent an amount is included (or deducted) in computing pre-adjustment AMTI for the taxable year (whether because an adjustment is made under section 56 or 58, because of a tax preference item under section 57, or because the item is reflected in taxable income), that amount is not again included (or deducted) in computing ACE.

OTHER MATTERS

 When the proposed regulations were published, the Service invited public comments on the proposed regulations and any other issues arising under section 56(g). Although this preamble does not discuss all of the comments received, the Service did consider all comments in drafting these final regulations. The Service appreciates the submission of these comments. The final regulations do not expand the provisions of the proposed regulations dealing with the determination of ACE by corporations filing a consolidated return. The Service intends to address consolidated return issues in more detail in future regulations.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. Chapter 5) and the Regulatory Flexibility Act (5 U.S.C. Chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Impact Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Nicholas G. Bogos of the Office of Assistant Chief Counsel, Income Tax and Accounting, Internal Revenue Service. Personnel from other offices of the Service and the Treasury, however, assisted in developing these regulations, on matters of both substance and style.

LIST OF SUBJECTS

26 CFR sections 6 1.1 - 1-1.58-8

 Credits, Income taxes, Tax liability, Tax rates

26 CFR sections 1.861-1 through 1.999-1

 Aliens, DISC, Exports, Foreign investment in U.S., Foreign tax credit, Income taxes, Sources of income, United States investments abroad.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows: PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 is amended by adding the following citation.:

Authority: 26 U.S.C. 7805 * * * Section 1.56(g)-1 is also issued under section 7611(g)(3) of the Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239, 103 Stat. 2373).

Par. 2. The following center heading is added before section 1.56A-1:

REGULATIONS APPLICABLE TO TAXABLE YEARS BEGINNING IN 1969 AND ENDING IN 1970

Par. 3. The following center heading is added before section 1.57:

TAX PREFERENCE REGULATIONS

Par. 4. New section 1.56(g)-0 is added to read as follows:

SECTION 1.56(g)-0 TABLE OF CONTENTS.

This section lists the paragraphs contained in section 1.56(g)- 1.

 SECTION 1.56(g)-1 ADJUSTED CURRENT EARNINGS.

SECTION 1.56(g)-1 ADJUSTED CURRENT EARNINGS.

(a) ADJUSTMENT FOR ADJUSTED CURRENT EARNINGS -- (1) POSITIVE ADJUSTMENT. For taxable years beginning after December 31, 1989, the alternative minimum taxable income of any taxpayer described in paragraph (a)(4) of this section is increased by the adjustment for adjusted current earnings. The adjustment for adjusted current earnings is 75 percent of the excess, if any, of --

(i) The adjusted current earnings (as defined in paragraph (a)(6)(ii) of this section) of the taxpayer for the taxable year over

(ii) The pre-adjustment alternative minimum taxable income (as defined in paragraph (a)(6)(i) of this section) of the taxpayer for the taxable year.

(2) NEGATIVE ADJUSTMENT -- (i) IN GENERAL. For taxable years beginning after December 31, 1989, the alternative minimum taxable income of any taxpayer is decreased, subject to the limitation of paragraph (a)(2)(ii) of this section, by 75 percent of the excess, if any, of pre-adjustment alternative minimum taxable income (as defined in paragraph (a)(6)(i) of this section), over adjusted current earnings (as defined in paragraph (a)(6)(ii) of this section).

(ii) LIMITATION ON NEGATIVE ADJUSTMENTS. The amount of the negative adjustment for any taxable year is limited to the excess, if any, of --

(A) the aggregate increases in alternative minimum taxable income in prior years under paragraph (a)(1) of this section over

(B) the aggregate decreases in alternative minimum taxable income in prior years under this paragraph (a)(2).

Any excess of pre-adjustment alternative minimum taxable income over adjusted current earnings that is not allowed as a negative adjustment for the taxable year because of the limitation in this paragraph (a)(2)(ii) is not applied to reduce any positive adjustment in any other taxable year.

(iii) EXAMPLE. the following example illustrates the provisions of this paragraph (a)(2):

(A) Corporation P is a calendar-year taxpayer and has pre- adjustment alternative minimum taxable income and adjusted current earnings in the following amounts for 1990 through 1993:

 Pre-adjustment            alternative        Adjusted

                   Negative                 Positive

(D) In 1991, P has a positive adjustment of $225,000 (75 percent of the $300,000 excess of adjusted current earnings over pre-adjustment alternative minimum taxable income). P is not allowed to use the prior year's excess of pre-adjustment alternative minimum taxable income over adjusted current earnings to reduce its 1991 positive adjustment.

(E) In 1992, P is permitted a negative adjustment of $75,000, the full amount of 75 percent of the $100,000 excess of pre-adjustment alternative minimum taxable income over adjusted current earnings for the taxable year. This is because P's prior cumulative increases in alternative minimum taxable income due to the positive adjustments for adjusted current earnings exceed the negative adjustment for the year.

(f) In 1993, P has a potential negative adjustment (before the cumulative limitation) of $300,000 (75 percent of the $400,000 excess of pre-adjustment alternative minimum taxable income over adjusted current earnings). P's net cumulative increases in alternative minimum taxable income due to the adjustment for adjusted current earnings are $150,000 ($225,000 increase in 1991, less $75,000 decrease in 1992). Thus, P's negative adjustment in 1993 is limited to $150,000. P may not use the remaining portion ($150,000) of the negative adjustment for 1993 to reduce positive adjustments in other taxable years.

(3) NEGATIVE AMOUNTS. In determining whether an excess exists under paragraph (a)(1) or (a)(2) of this section, a positive amount exceeds a negative amount by the sum of the absolute numbers, and a smaller negative amount exceeds a larger negative amount by the difference between the absolute numbers. Thus, for example, a positive amount of adjusted current earnings of $30 exceeds a negative amount (or loss) of pre-adjustment AMTI of $10 by the sum of the absolute numbers, or $40 (30+10). Accordingly, the adjustment for adjusted current earnings would be 75 percent of $40, or $30. In contrast, a negative amount of adjusted current earnings of $10 exceeds a negative amount (or loss) of pre-adjustment alternative minimum taxable income of $30 by the difference between the absolute numbers, or $20 (30 - 10). Accordingly, the adjustment for adjusted current earnings would be 75 percent of $20, or $15.

(4) TAXPAYERS SUBJECT TO ADJUSTMENT FOR ADJUSTED CURRENT EARNINGS. The adjustment for adjusted current earnings applies to any corporation other than --

(i) An S corporation as defined in section 1361,

(ii) A regulated investment company as defined in section 851,

(iii) A real estate investment trust as defined in section 856, or

(iv) A real estate mortgage investment conduit as defined in section 860A.

(5) GENERAL RULE FOR APPLYING INTERNAL REVENUE CODE PROVISIONS IN DETERMINING ADJUSTED CURRENT EARNINGS -- (i) IN GENERAL. Except as otherwise provided by regulations or other guidance issued by the Internal Revenue Service, all Internal Revenue Code provisions that apply in determining the regular taxable income of a taxpayer also apply in determining adjusted current earnings. For example, the rules of part V of subchapter P (relating to original issue discount and similar matters) of the Code apply in determining the amount (and the timing) of any interest income included in adjusted current earnings under this section. In applying Code provisions, however, the adjustments of section 56(g) and this section are also taken into account. For example, in applying the capitalization provisions of section 263A, the amount of depreciation to be capitalized is based on the amount of depreciation allowed in computing adjusted current earnings.

(ii) EXAMPLE. The following example illustrates the provisions of this paragraph (a)(5):

(A) Corporation N is a calendar year manufacturer of golf clubs. N places new manufacturing equipment in service in 1990. The regular tax depreciation allowable for this equipment is $80,000; the pre-adjustment alternative minimum taxable income depreciation is $60,000; and the adjusted current earnings depreciation is $40,000. All of the golf clubs N produces in 1990 are unsold and are in ending inventory.

(B) Pursuant to section 263A and section 1.263A- 1T(b)(2)(iii)(J), N must capitalize the depreciation allowed for the year for the new manufacturing equipment in the ending inventory of golf clubs. Thus, when N sells the golf clubs (or is deemed to have sold them under its normal method of accounting), the cost of goods sold attributable to the capitalized depreciation will be $80,000 in computing regular taxable income; $60,000 in computing pre-adjustment alternative minimum taxable income; and $40,000 in computing adjusted current earnings.

(6) DEFINITIONS. The following terms have the following meanings for purposes of this section.

(i) PRE-ADJUSTMENT ALTERNATIVE MINIMUM TAXABLE INCOME. Pre- adjustment alternative minimum taxable income is the alternative minimum taxable income of the taxpayer for the taxable year, determined under section 55(b)(2), but without the adjustment for adjusted current earnings and without the alternative tax net operating loss deduction under section 56(a)(4).

(ii) ADJUSTED CURRENT EARNINGS. Adjusted current earnings is the pre-adjustment alternative minimum taxable income of the taxpayer for the taxable year, adjusted as provided in section 56(g) and this section. To the extent an amount is included (or deducted) in computing pre-adjustment alternative minimum taxable income for the taxable year (whether because an adjustment is made under section 56 or 58, because of a tax preference item under section 57, or because the item is reflected in taxable income), that amount is not again included (or deducted) in computing adjusted current earnings for the taxable year.

(iii) EARNINGS AND PROFITS. Earnings and profits means current earnings and profits within the meaning of section 316(a)(2), that is, earnings and profits for the taxable year computed as of the close of the taxable year of the corporation without diminution by reason of any distributions made during the taxable year.

(b) DEPRECIATION ALLOWED. The depreciation deduction allowed in computing adjusted current earnings is determined under the rules of this paragraph (b). Generally, the rules for computing the adjusted current earnings depreciation deduction differ depending on the taxable year in which the property is placed in service and the method used in computing the depreciation deduction for taxable income purposes.

(1) PROPERTY PLACED IN SERVICE AFTER 1989. The depreciation deduction for property placed in service in a taxable year beginning after December 31, 1989, is the amount determined by using the alternative depreciation system of section 168(g). This paragraph (b)(1) does not apply to property to which paragraph (b)(4) of this section applies (relating to certain property described in sections 168(f)(1) through (f)(4)).

(2) PROPERTY SUBJECT TO NEW ACRS -- (i) IN GENERAL. This paragraph (b)(2) provides the rules for computing the depreciation deduction for property to which the amendments made by section 201 of the Tax Reform Act of 1986 (new ACRS) apply (generally property placed in service after December 31, 1986), and that is placed in service in a taxable year beginning before January 1, 1990. This paragraph (b)(2) does not apply to property described in paragraph (b)(4) of this section (relating to certain property described in sections 168(f)(1) through (f) (4)) or to property described in paragraph (b)(5)(i) of this section (relating to certain churning transactions described in section 168(f)(5)).

(ii) RULES FOR COMPUTING THE DEPRECIATION DEDUCTION. The depreciation deduction for property described in this paragraph (b)(2) is the amount determined by using --

(A) The adjusted basis of the property as determined in computing alternative minimum taxable income as of the close of the last taxable year beginning before January 1, 1990,

(B) The straight-line method, and

(C) The recovery period that consists of the remainder of the recovery period applicable to the property under the alternative depreciation system of section 168(g).

Thus, the recovery period begins on the first day of the first taxable year beginning after December 31, 1989, and ends on the last day of the recovery period that would have applied had the recovery period for the property originally been determined under section 168(g). In determining the recovery period that would have applied, the property is deemed placed in service on the date it was considered placed in service under the depreciation convention that would have applied to the property under section 168(d).

(iii) EXAMPLE. The following example illustrates the provisions of this paragraph (b)(2).

EXAMPLE. Corporation X, a calendar-year taxpayer, purchases and places in service on August 1, 1987, computer-based telephone central office switching equipment. This is the only item of depreciable property X places in service during 1987. Thus, the applicable convention under section 168(d) is the half-year convention. As of December 31, 1989, the adjusted basis of the property used in computing alternative minimum taxable income is $42,000. The recovery period that would have applied to the property under section 168(g)(2) is 9.5 years (from July 1, 1987 to December 31, 1996). Thus, the recovery period for computing adjusted current earnings under section 56(g)(4)(A)(ii) and this paragraph (b)(2) begins on January 1, 1990, and ends on December 31, 1996. X's 1990 depreciation deduction for computing adjusted current earnings is $6,000, determined under the straight-line method by dividing $42,000 (adjusted basis) by 7 (recovery period).

(3) PROPERTY SUBJECT TO ORIGINAL ACRS -- (i) IN GENERAL. This paragraph (b)(3) provides the rules for computing the depreciation deduction for property to which section 168 as in effect on the day before the date of enactment of the Tax Reform Act of 1986 (original ACRS) applies and that is placed in service in a taxable year beginning before January 1, 1990 (generally property that was placed in service after December 31, 1980 and before January 1, 1987). In determining whether original ACRS applies to property, the fact that the unadjusted basis of the property is reduced or eliminated under section 168(d)(4)(A)(i) of original ACRS is not taken into account. This paragraph (b)(3) does not apply to property described in paragraph (b)(4) or (b)(5)(i) of this section (relating to certain section 168(f) property).

(ii) RULES FOR COMPUTING THE DEPRECIATION DEDUCTION. The depreciation deduction for property described in this paragraph (b)(3) is the amount determined by using --

(A) The adjusted basis of the property as determined in computing taxable income as of the close of the last taxable year beginning before January 1, 1990,

(B) The straight-line method, and

(C) The recovery period that consists of the remainder of the recovery period applicable to the property under the alternative depreciation system of section 168(g).

Thus, the recovery period begins on the first day of the first taxable year beginning after December 31, 1989, and ends on the last day of the recovery period that would have applied had the recovery period for the property originally been determined under section 168(g)(2). In determining the recovery period that would have applied, the property is deemed placed in service on the date it was considered placed in service under the depreciation convention that would have applied to the property under section 168(d) (without regard to section 168(d)(3)).

(iii) EXAMPLE. The following example illustrates the provisions of this paragraph (b)(3).

EXAMPLE. Corporation Y, a calendar-year taxpayer, purchases and places in service on December 1, 1986, computer-based telephone central office switching equipment. The depreciation convention that would have applied to this property under section 168(d) (without regard to section 168(d)(3)) is the half-year convention. As of December 31, 1989, the adjusted basis of the property used in computing taxable income is $21,000. The recovery period for the property under section 168(g)(2) is 9.5 years (from July 1, 1986 to December 31, 1995). Thus, the recovery period for computing adjusted current earnings under section 56(g)(4)(A)(iii) and this paragraph (b)(3) begins on January 1, 1990, and ends on December 31, 1995. Y's 1990 depreciation deduction for computing adjusted current earnings is $3,500, determined under the straight-line method by dividing $21,000 (adjusted basis) by 6 (recovery period).

(4) SPECIAL RULE FOR CERTAIN SECTION 168(f) PROPERTY. The depreciation or amortization deduction for property described in section 168(f)(1) through (4) is determined in the same manner as used in computing taxable income, without regard to when the property is placed in service.

(5) CERTAIN PROPERTY NOT SUBJECT TO ACRS. The depreciation or amortization deduction for property not described in paragraphs (b)(1) through (4) of this section is determined in the same manner as used in computing taxable income. Thus, this paragraph (b)(5) applies to --

(i) Property placed in service after December 31, 1980, in a taxable year beginning before January 1, 1990, and that is excluded from the application of original ACRS or new ACRS by section 168(e)(4) of original ACRS or section 168(f)(5)(A)(i) of new ACRS, and

(ii) Property placed in service before January 1, 1981.

(c) INCLUSION IN ADJUSTED CURRENT EARNINGS OF ITEMS INCLUDED IN EARNINGS AND PROFITS -- (1) IN GENERAL. Except as otherwise provided in paragraph (c)(4) of this section, adjusted current earnings includes all income items that are permanently excluded from (i.e., not taken into account in determining) pre-adjustment alternative minimum taxable income but that are taken into account in determining earnings and profits. An income item is considered taken into account in determining pre-adjustment alternative minimum taxable income without regard to the timing of its inclusion. Thus, this paragraph (c)(1) does not apply to any income item that is, has been, or will be included in pre-adjustment alternative minimum taxable income. For example, a taxpayer eligible to use the completed contract method of accounting for long-term construction contracts does not take income (or expenses) into account in determining pre-adjustment alternative minimum taxable income for taxable years before the taxable year the contract is completed. The taxpayer is required under section 312(n)(6) to include income (and expenses) in earnings and profits throughout the term of the contract under the percentage of completion method. This paragraph (c)(1) does not require the income on the contract to be included in adjusted current earnings, however, because the income will be taken into account in the taxable year the contract is completed and therefore is considered to be taken into account in determining pre-adjustment alternative minimum taxable income.

(2) CERTAIN AMOUNTS NOT TAKEN INTO ACCOUNT IN DETERMINING WHETHER AN ITEM IS PERMANENTLY EXCLUDED. The fact that proceeds from an income item may eventually be reflected in pre-adjustment alternative minimum taxable income of another taxpayer on the liquidation or disposal of a business, or similar circumstances, is not taken into account in determining whether the item is permanently excluded from pre-adjustment alternative minimum taxable income. Thus, for example, a corporation's adjusted current earnings include interest excluded from pre-adjustment alternative minimum taxable income under section 103 even though the interest might eventually be reflected in the pre-adjustment alternative minimum taxable income of a corporate shareholder as gain on the liquidation of the corporation.

(3) ALLOWANCE OF OFFSETTING DEDUCTIONS. In determining adjusted current earnings under this paragraph (c), a deduction is allowed for all items that relate to income required to be included in adjusted current earnings under this paragraph (c) and that would be deductible in computing pre-adjustment alternative minimum taxable income if the income items to which the items of deduction relate were included in pre-adjustment alternative minimum taxable income for any taxable year. For example, deductions disallowed under section 265(a)(2) for the costs of carrying tax-exempt obligations, the interest on which is excluded from pre-adjustment alternative minimum taxable income under section 103 but is included in adjusted current earnings under this paragraph (c), are generally allowed as deductions in computing adjusted current earnings. Amounts deductible under this paragraph (c)(3) are taken into account using the taxpayer's method of accounting and are subject to any provisions or limitations of the Code that would have applied if the amounts had been deductible in determining pre-adjustment alternative minimum taxable income. For example, section 267(a)(2) may affect the timing of a deduction otherwise disallowed under section 265(a)(2).

(4) SPECIAL RULES. Adjusted current earnings does not include the following amounts.

(i) INCOME FROM THE DISCHARGE OF INDEBTEDNESS. Amounts that are excluded from gross income under section 108 of the Internal Revenue Code of 1986 or any corresponding provision of prior law (including the Bankruptcy Tax Act of 1980, case law, income tax regulations and administrative pronouncements).

(ii) FEDERAL INCOME TAX REFUNDS. Refunds of federal income taxes.

(iii) INCOME EARNED ON BEHALF OF STATES AND MUNICIPALITIES. Amounts that are excluded from gross income under section 115.

(5) TREATMENT OF LIFE INSURANCE CONTRACTS -- (i) IN GENERAL. This paragraph (c)(5) addresses the treatment of life insurance contracts in determining adjusted current earnings. These rules apply to life insurance contracts as defined in section 7702. Generally, death benefits under a life insurance contract are included in adjusted current earnings, and all other distributions (including surrenders) are taxed in accordance with the principles of section 72(e), taking into account the taxpayer's basis in the contract for purposes of adjusted current earnings. If the adjusted basis in the contract for purposes of adjusted current earnings exceeds the amount of death benefits received or the amount received when the contract is surrendered (increased by the amount of any outstanding policy loan), the resulting loss is allowed as a deduction under paragraph (c)(3) of this section in computing adjusted current earnings for the taxable year. In addition, undistributed income on the contract is included in adjusted current earnings as provided in paragraph (c)(5)(ii) of this section. Paragraph (c)(5)(vi)(A) of this section provides special rules for term insurance that has no net surrender value.

(ii) INCLUSION OF INSIDE BUILDUP. Income on a life insurance contract with respect to a taxable year (or any shorter period either ending or beginning with the date of a distribution from the contract) is included in adjusted current earnings for the taxable year. Thus, income on the contract is calculated from the beginning of a taxable year to the date of any distribution, from immediately after any distribution to the date of the next distribution, and from the last distribution during the taxable year through the end of the taxable year. Income on a life insurance contract is not included in adjusted current earnings for any taxable year in which the insured dies or the contract is completely surrendered for its entire net surrender value. Solely for purposes of computing adjusted current earnings, the taxpayer's adjusted basis in the contract (as determined under section 72(e)(6)) is increased to reflect any positive income on the contract included in adjusted current earnings under this paragraph (c)(5)(ii). The manner in which the income on the contract is determined for adjusted current earnings purposes is prescribed in paragraph (c)(5)(iii) of this section. If the income on the contract determined under paragraph (c)(5)(iii) of this section is a negative amount, income on the contract is not included in adjusted current earnings and no deduction from adjusted current earnings is allowed for the negative amount.

(iii) CALCULATION OF INCOME ON THE CONTRACT. For purposes of determining adjusted current earnings, the income on a life insurance contract for any period, including a taxable year, is the excess, if any, of --

(A) The sum of the contract's net surrender value (as defined in section 7702(f)(2)(B)) at the end of the period, and any distributions under the contract during the period that, in accordance with the principles of section 72(e), are not taxed because they represent recoveries of the taxpayer's basis in the contract for adjusted current earnings, over

(B) The sum of the contract's net surrender value at the end of the preceding period, and any premiums paid under the contract during the period.

(iv) TREATMENT OF DISTRIBUTIONS UNDER THE LIFE INSURANCE CONTRACT. Any distribution under a life insurance contract (whether a partial withdrawal or an amount received on complete surrender of the contract) is included in adjusted current earnings in accordance with the principles of section 72(e), taking into account the taxpayer's basis in the contract for purposes of computing adjusted current earnings. The taxpayer's basis in the contract is equal to the basis at the end of the immediately preceding period, plus any premiums paid before the distribution. The taxpayer's basis in the contract for purposes of adjusted current earnings is reduced, in accordance with the principles of section 72(e), to the extent that the distribution is not included in adjusted current earnings because it represents a recovery of that basis.

(v) TREATMENT OF DEATH BENEFITS. The excess of the contractual death benefit of a life insurance contract over the taxpayer's adjusted basis in the contract for purposes of computing adjusted current earnings at the time of the insured's death is included in adjusted current earnings as provided by paragraph (c)(6)(i) of this section. The amount of the death benefit that is taken into account for adjusted current earnings includes the amount of any outstanding policy loan treated as forgiven or discharged by the insurance company upon the death of the insured.

(vi) OTHER RULES -- (A) TERM LIFE INSURANCE CONTRACTS WITHOUT NET SURRENDER VALUES. Except as provided in this paragraph (c)(5)(vi), the requirements of paragraph (c)(5) of this section do not apply to term life insurance contracts that provide no net surrender value. Adjusted current earnings are reduced by any premiums paid under such a contract that are allocable to the taxable year. Any premiums paid that are not allocable to the taxable year must be included in the basis of the contract. The death benefit under such a term insurance contract is included in adjusted current earnings as provided by paragraph (c)(5)(v) of this section.

(B) Life insurance contracts involving divided ownership. If the ownership of a life insurance contract is divided between different persons (for example, a split-dollar arrangement), the requirements of paragraph (c)(5) of this section apply to the separate ownership interests as though each interest were a separate contract.

(vii) EXAMPLES. The following examples illustrate the provisions of this paragraph (c)(5).

EXAMPLE 1. (i) On January 1, 1987, corporation X, a calendar-year taxpayer, purchased a flexible premium life insurance contract with a death benefit of $100,000 and planned annual gross premiums of $2,200 payable on January 1 of each year. The net surrender value of the contract at the end of 1987 and subsequent years, together with the cumulative premiums for the contract at the end of each year, are set forth in the following table:

                  Cumulative              Year-End Net

(iii) For 1991, the income on the contract included in adjusted current earnings is determined in the same manner as the preceding year, and there is a corresponding increase in X's adjusted basis in the contract. Thus, for 1991, the income on the contract is $1,343, which is determined by subtracting from the net surrender value of the contract at the end of the taxable year ($14,774) the sum of the net surrender value at the end of the preceding taxable year ($11,231) plus the premiums paid during the taxable year ($2,200). At the end of 1991, X's adjusted basis in the contract for adjusted current earnings is $13,364, which reflects the basis of the contract at the beginning of 1991, increased by the premium paid during the year ($2,200) and the income on the contract that has been included in adjusted current earnings for the taxable year ($1,343).

EXAMPLE 2. The facts are the same as in example 1, except that, after the payment of the premium for 1991, the insured dies and X receives the $100,000 death benefit under the contract. Under paragraph (c)(5)(ii) of this section, no amount is included in adjusted current earnings for income on the contract for the taxable year in which the insured dies. Instead, under paragraph (c)(5)(v) of this section, X must include in adjusted current earnings for 1991 the excess of the death benefit ($100,000) over the adjusted basis in the contract for purposes of computing adjusted current earnings at the time of the insured's death ($12,021), which equals X's adjusted basis in the contract at the end of 1990 ($9,821), increased by X's premium payment for 1991 ($2,200).

EXAMPLE 3. (i) The facts are the same as in example 1, except that in addition to making the $2,200 planned premium payment for 1992, X receives a $16,200 distribution under the contract on February 1, 1992, leaving a net surrender value of $915 immediately following the distribution. On March 1, 1992, X pays an additional premium of $5,000 under the contract. The net surrender value of the contract at the end of 1992 is $6,417.

(ii) Treatment of the distribution. Under paragraph (c)(5)(iv) of this section, the $16,200 distribution in 1992 is included in adjusted current earnings as an amount taxable in accordance with the principles of section 72(e) to the extent that the distribution ($16,200) exceeds X's adjusted basis for adjusted current earnings, as determined at the end of the immediately preceding period, and including premiums paid through the period ending on the date of the distribution ($15,564). Thus, X must include $636 in adjusted current earnings for 1992 as an amount taxable in accordance with the principles of section 72(e).

(iii) Determination of the income on the contract. Under paragraph (c)(5)(iii) of this section, for 1992, the income on the contract must be separately determined for the period beginning with the first day of the taxable year to the date of the distribution and for the period beginning immediately after the distribution to the end of the taxable year, using the contract's net surrender values at the beginning and end of each of these periods. The income on the contract for the period beginning on January 1, 1992 and ending on February 1, 1992 (the date of the distribution) is equal to the excess, if any, of (A) the sum of the net surrender value at the end of the period ($915) and the amount of the distribution that is allocable to X's basis in the contract for adjusted current earnings ($15,564), over (B) the sum of the net surrender value at the end of the preceding taxable year ($14,774) plus any premiums paid on the contract during the period ($2,200). Because the net result of this computation is a negative amount (($915 + $15,564) - ($14,774 + $2,200) = - $495), no income on the contract for the period ending with the date of the distribution is included in adjusted current earnings for 1992.

(iv) Under paragraph (c)(5)(ii), X must also determine the income on the contract for the period beginning immediately after the distribution through the end of the taxable year. The income on the contract for this period is $502, which is equal to the excess of the net surrender value at the end of the taxable year ($6,417) over the sum of the net surrender value at the end of the preceding period ($915), plus any premiums paid during the period ($5,000). At the end of 1992, X's adjusted basis in the contract for adjusted current earnings is $5,502, determined by adding the income on the contract ($502) and the premiums paid during the period ($5,000) to the basis at the end of the preceding period ($0).

(v) Thus, X must include a total of $1,138 ($636 + 502) in adjusted current earnings for 1992. This inclusion reflects both the undistributed income on the contract for the taxable year plus the amount of income from distributions under the contract that is taxed in accordance with the principles of section 72(e) using X's adjusted basis in the contract for adjusted current earnings.

(6) PARTIAL LIST OF INCOME ITEMS EXCLUDED FROM GROSS INCOME BUT INCLUDED IN EARNINGS AND PROFITS. The following is a partial list of items that are permanently excluded from pre-adjustment alternative minimum taxable income but that are included in earnings and profits, and are therefore included in adjusted current earnings under this paragraph (c).

(i) Proceeds of life insurance contracts that are excluded under section 101, to the extent provided in paragraph (c)(5)(v) or (c)(5)(vi) of this section.

(ii) Interest that is excluded under section 103.

(iii) Amounts received as compensation for injuries or sickness that are excluded under section 104.

(iv) Income taxes of a lessor of property that are paid by a lessee and are excluded under section 110.

(v) Income attributable to the recovery of an item deducted in computing earnings and profits in a prior year that is excluded under section 111.

(vi) Amounts received as proceeds from sports programs that are excluded under section 114.

(vii) Cost-sharing payments that are excluded under section 126, to the extent section 126(e) does not apply.

(viii) Interest on loans used to acquire employer securities that is excluded under section 133.

(ix) Financial assistance that is excluded under section 597.

(x) Amounts that are excluded from pre-adjustment alternative minimum taxable income as a result of an election under section 831(b) (allowing certain insurance companies to compute their pre- adjustment alternative minimum taxable income using only their investment income).

Items described in paragraph (c)(1) of this section must be included in earnings and profits (and therefore in adjusted current earnings) even if they are not identified in this paragraph (c)(6). The Commissioner may identify additional items described in paragraph (c)(1) in other published guidance.

(7) PARTIAL LIST OF ITEMS EXCLUDED FROM BOTH PRE-ADJUSTMENT ALTERNATIVE MINIMUM TAXABLE INCOME AND ADJUSTED CURRENT EARNINGS. The following is a partial list of items that are excluded from both pre- adjustment alternative minimum taxable income and adjusted current earnings, and for which no adjustment is allowed under this section.

(i) The value of improvements made by a lessee to a lessor's property that is excluded from the lessor's income under section 109.

(ii) Contributions to the capital of a corporation by a non- shareholder that are excluded from the corporation' s income under section 118.

The Commissioner may identify additional items described in this paragraph (c)(7) in other published guidance.

(d) DISALLOWANCE OF ITEMS NOT DEDUCTIBLE IN COMPUTING EARNINGS AND PROFITS -- (1) IN GENERAL. Except as otherwise provided in this paragraph (d), no deduction is allowed in computing adjusted current earnings for any items that are not taken into account in determining earnings and profits for any taxable year, even if the items are taken into account in determining pre-adjustment alternative minimum taxable income. These items therefore increase adjusted current earnings to the extent they are deducted in computing pre-adjustment alternative minimum taxable income. An item of deduction is considered taken into account without regard to the timing of its deductibility in computing earnings and profits. Thus, to the extent an item is, has been, or will be deducted for purposes of determining earnings and profits, it does not increase adjusted current earnings in the taxable year in which it is deducted for purposes of determining pre-adjustment alternative minimum taxable income. For example, a deduction allowed (in determining pre-adjustment alternative minimum taxable income) under section 196 for unused research credits allowable under section 41 is taken into account in computing earnings and profits because the costs that gave rise to the credit were deductible in computing earnings and profits when incurred. Therefore, the deduction does not increase adjusted current earnings. As a further example, payments by a United States parent corporation with respect to employees of certain foreign subsidiaries, which are deductible under section 176, are considered contributions to the capital of the foreign subsidiary for purposes of computing earnings and profits. Although the payments are not deductible in computing the earnings and profits of the United States parent corporation in the year incurred, the payments do increase the parent's basis in its stock in the foreign subsidiary. This basis increase will reduce any gain the parent may later realize for purposes of computing earnings and profits on the disposition of the stock of the foreign subsidiary. Therefore, the amount of the payment by the parent is considered taken into account in computing the earnings and profits of the parent and does not increase adjusted current earnings. Thus, only deduction items that are never taken into account in computing earnings and profits are disallowed in computing adjusted current earnings under this paragraph (d).

(2) DEDUCTIONS FOR CERTAIN DIVIDENDS RECEIVED -- (i) CERTAIN AMOUNTS DEDUCTED UNDER SECTIONS 243 AND 245. Paragraph (d)(1) of this section does not apply to, and adjusted current earnings therefore are not increased by, amounts deducted under sections 243 and 245 that qualify as 100-percent deductible dividends under sections 243(a), 245(b) or 245(c), or to any dividend received from a 20-percent owned corporation (as defined in section 243(c)(2)), to the extent that the dividend giving rise to the deductions is attributable to earnings of the paying corporation that are subject to federal income tax. Earnings are considered subject to federal income tax if the earnings are included on the federal income tax return (that is filed or, if not, that should be filed) of an entity subject to United States taxation, even if there is no resulting United States tax liability (e.g., because of net operating losses or tax credits, other than the credit provided for in section 936).

(ii) SPECIAL RULES -- (A) DIVIDENDS RECEIVED FROM A FOREIGN SALES CORPORATION. The portion of a dividend received from a foreign sales corporation (FSC) that is classified as a 100-percent deductible dividend attributable to earnings of the FSC subject to federal income tax is that portion of the dividend distributed out of earnings and profits of the FSC attributable to non-exempt foreign trade income determined under either of the administrative pricing methods of section 925(a)(1) or (2), and to non-exempt foreign trade income determined under section 925(a)(3) that is effectively connected with the conduct of a trade or business in the United States (determined without regard to section 921). If the FSC is a 20-percent owned corporation (as defined in section 243 (c)(2)), an additional portion of that dividend is classified as being attributable to earnings of the FSC subject to federal income tax to the extent that the dividend is distributed out of earnings and profits of the FSC attributable to effectively connected income (as defined in section 245(c)(4)(B)). A FSC is defined in section 922 and, for purposes of this paragraph, includes a small FSC and a former FSC. The ordering rules for distributions from a FSC set forth in section 1.926(a)-1T(b)(1) apply to determine the classification of earnings and profits out of which a distribution has been made.

(B) DIVIDENDS RECEIVED FROM A SECTION 936 CORPORATION. In the case of a dividend received from a corporation eligible for the credit provided by section 936, only that part of the dividend that is attributable to income that is not eligible for the credit is attributable to earnings of the paying corporation that are subject to federal income tax. Dividends are deemed to be distributed first out of earnings and profits for the current taxable year of the section 936 corporation, to the extent thereof, and then out of the most recently accumulated earnings and profits, under the principles of section 316. With respect to a distribution of less than all of the earnings and profits for the current or any prior taxable year, the amount of the distribution attributable to income not eligible for the section 936 credit is determined on a pro rata basis. For example, assume that a section 936 corporation earns $100 of taxable income in its current taxable year, $10 of which is not eligible for the credit under section 936. If the section 936 corporation makes a distribution of $50 during that year, $5 of that distribution ($10 of income not eligible for the section 936 credit divided by $100 of taxable income, times $50 distributed) is deemed to be attributable to earnings of the paying corporation that are subject to federal income tax.

(iii) SPECIAL RULE FOR CERTAIN DIVIDENDS RECEIVED BY CERTAIN COOPERATIVES. Paragraph (d)(1) of this section does not apply to, and adjusted current earnings do not include, any dividend received by any organization to which part I of subchaper T of the Code applies and that is engaged in the marketing of agricultural or horticultural products, if the dividend is paid by a FSC and is allowable as a deduction under section 245(c).

(3) PARTIAL LIST OF ITEMS NOT DEDUCTIBLE IN COMPUTING EARNINGS AND PROFITS. The following is a partial list of items that are not taken into account in computing earnings and profits and thus are not deductible in computing adjusted current earnings.

(i) Unrecovered losses attributable to certain damages that are deductible under section 186, to the extent those damages were previously deducted in computing earnings and profits.

(ii) The deduction for small life insurance companies allowed under section 806.

(iii) Dividends deductible under the following sections of the Code:

(A) Dividends received by corporations that are deductible under section 243, to the extent paragraph (d)(2)(i) of this section does not apply.

(B) Dividends received on certain preferred stock that are deductible under section 244.

(C) Dividends received from certain foreign corporations that are deductible under section 245, to the extent neither paragraph (d)(2)(i) nor (d)(2)(iii) of this section applies.

(D) Dividends paid on certain preferred stock of public utilities that are deductible under section 247.

(E) Dividends paid to an employee stock ownership plan that are deductible under section 404(k).

(F) Non-patronage dividends that are paid and deductible under section 1382(c)(1).

Items described in paragraph (d)(1) of this section are not taken into account in computing earnings and profits (and thus are not deductible in computing adjusted current earnings) even if they are not identified in this paragraph (d)(3). The Commissioner may identify additional items described in paragraph (d)(1) of this section in other published guidance.

(4) PARTIAL LIST OF ITEMS DEDUCTIBLE FOR PURPOSES OF COMPUTING BOTH PRE-ADJUSTMENT ALTERNATIVE MINIMUM TAXABLE INCOME AND ADJUSTED CURRENT EARNINGS. The following is a partial list of items that are deductible for purposes of computing both pre-adjustment alternative minimum taxable income and adjusted current earnings, and for which no adjustment is allowed under this section.

(i) Payments by a United States corporation with respect to employees of certain foreign corporations that are deductible under section 176.

(ii) Dividends paid on deposits by thrift institutions that are deductible under section 591.

(iii) Life insurance policyholder dividends that are deductible under section 808.

(iv) Dividends paid by cooperatives that are deductible under sections 1382(b) or 1382(c)(2) and that are not paid with respect to stock.

The Commissioner may identify additional items described in this paragraph (d)(4) in other published guidance.

(e) TREATMENT OF INCOME ITEMS INCLUDED, AND DEDUCTION ITEMS NOT ALLOWED. IN COMPUTING PRE-ADJUSTMENT ALTERNATIVE MINIMUM TAXABLE INCOME. Adjusted current earnings includes any income item that is included in pre-adjustment alternative minimum taxable income, even if that income item is not included in earnings and profits for the taxable year. Except as specifically provided in paragraph (c)(3) or (c)(5) of this section, no deduction is allowed for an item in computing adjusted current earnings if the item is not deductible in computing pre-adjustment alternative minimum taxable income for the taxable year, even if the item is deductible in computing earnings and profits for the year. Thus, for example, capital losses in excess of capital gains for the taxable year are not deductible in computing adjusted current earnings for the taxable year.

(f) CERTAIN OTHER EARNINGS AND PROFITS ADJUSTMENTS -- (1) INTANGIBLE DRILLING COSTS. For purposes of computing adjusted current earnings, the amount allowable as a deduction for intangible drilling costs (as defined in section 263(c)) for amounts paid or incurred in taxable years beginning after December 31, 1989, is determined as provided in section 312(n)(2)(A). See section 56(h) for an additional adjustment to alternative minimum taxable income based on energy preferences for taxable years beginning after 1990.

(2) CERTAIN AMORTIZATION PROVISIONS DO NOT APPLY. For purposes of computing adjusted current earnings, sections 173 (relating to circulation expenditures) and 248 (relating to organizational expenditures) do not apply to amounts paid or incurred in taxable years beginning after December 31, 1989. If an election is made under section 59(e) to amortize circulation expenditures described in section 173 over a three-year period, the expenditures to which the election applies are deducted ratably over the three-year period for purposes of computing taxable income, pre-adjustment alternative minimum taxable income, and adjusted current earnings.

(3) LIFO INVENTORY ADJUSTMENTS. [RESERVED]

(4) INSTALLMENT SALES -- (i) IN GENERAL. Adjusted current earnings are computed without regard to the installment method, except as provided in this paragraph (f)(4).

(ii) EXCEPTION FOR PRIOR DISPOSITIONS. Paragraph (f)(4)(i) of this section does not apply to any disposition in a taxable year beginning before January 1, 1990, that is taken into account under the installment method for purposes of computing pre-adjustment alternative minimum taxable income. Thus, for any disposition in a taxable year beginning before January 1, 1990, the installment method applies in computing adjusted current earnings for taxable years beginning after December 31, 1989, to the same extent it applies in determining pre-adjustment alternative minimum taxable income for the taxable year.

(iii) SPECIAL RULES FOR OBLIGATIONS TO WHICH SECTION 453A APPLIES -- (A) IN GENERAL. The following special rules apply to any installment sale occurring in a taxable year beginning after December 31, 1989, that results in an installment obligation to which section 453A(a)(1) applies and with respect to which pre-adjustment alternative minimum taxable income is determined under the installment method. As explained in paragraph (f)(4)(iii)(B) of this section, for purposes of computing adjusted current earnings, a portion of the contract price is eligible for the installment method, and the remainder of the contract price is not eligible for the installment method. Payments under the obligation are allocated pro- rata between the two accounting methods.

(B) LIMITATION ON APPLICATION OF INSTALLMENT METHOD. Only a portion of the contract price of an installment sale described in paragraph (f)(4)(iii)(A) of this section is eligible to be accounted for under the installment method for purposes of computing adjusted current earnings. The portion eligible for the installment method is equal to the total contract price of the sale multiplied by the applicable percentage (as determined under section 453A(c)(4)) for the taxable year of the sale. The remainder of the contract price is not eligible to be accounted for under the installment method for purposes of computing adjusted current earnings. The gross profit ratio is determined without regard to this bifurcated treatment of the sale.

(C) TREATMENT OF THE INELIGIBLE PORTION. The gain on the sale that is taken into account in the taxable year of the sale for purposes of computing adjusted current earnings is equal to the gross profit ratio multiplied by the entire portion of the contract price that is ineligible for the installment method.

(D) TREATMENT OF THE ELIGIBLE PORTION. For purposes of calculating adjusted current earnings, the amount of gain recognized in a taxable year on the portion of the contract price that is eligible for the installment method is equal to --

(1) The amount of payments received during the taxable year, multiplied by

(2) The applicable percentage for the taxable year of the sale, multiplied by

(3) The gross profit ratio.

(E) COORDINATION WITH THE PLEDGE RULE. For purposes of determining the amount of payments received during the taxable year under paragraph (f)(4)(iii)(D), the rules of section 453A(d) (relating to the treatment of certain pledge proceeds as payments) apply. This includes the rules under section 453A(d)(3) that relate to treating later payments as receipts of amounts on which tax has already been paid.

(F) EXAMPLE. The following example illustrates the provisions of this paragraph (f)(4)(iii):

(1) On January 1, 1990, corporation A, a calendar-year taxpayer, sells a building with an adjusted basis for purposes of computing adjusted current earnings of $10 million, for $5 million and an installment obligation bearing adequate stated interest with a principal amount of $20 million. The installment obligation calls for 4 annual payments of $5 million on January 1 of 1991, 1992, 1993 and 1994. A does not elect out of the installment method, and disposes of no other property under the installment method during 1990. No gain with respect to the sale is recaptured pursuant to section 1250.

(2) The gross profit percentage for purposes of computing adjusted current earnings on the sale is 60 percent, computed as follows: gross profit of $15 million ($25 million contract price less $10 million adjusted basis) divided by $25 million contract price. The applicable percentage on the sale is 75 percent, computed as follows: $15 million ($20 million of installment obligations arising during and outstanding at the end of 1990 less $5 million) divided by $20 million of installment obligations arising during and outstanding at the end of 1990. See section 453A(c)(4). The portion of the contract price eligible for accounting under the installment method for purposes of computing adjusted current earnings is $18.75 million, or $25 million total contract price times applicable percentage of 75 percent. The portion of the contract price ineligible for the installment method is $6.25 million, or $25 million less $18.75 million.

(3) In computing adjusted current earnings for 1990, A must include $3.75 million of the gain on the sale. This amount is equal to the portion of the contract price that is ineligible for the installment method times the gross profit ratio, or $6.25 million times 60 percent. A must also include $2.25 million of gain from the $5 million payment received in 1990. This amount is computed as follows: the eligible portion of the payment, $3.75 million ($5 million payment times the applicable percentage of 75 percent), times the gross profit ratio of 60 percent. Thus, the total amount of gain from the sale that A must include in adjusted current earnings for 1990 is $6 million ($3.75 million of gain from the portion of the contract price that is not eligible for the installment method, plus $2.25 million of gain from the 1990 payment).

(4) A does not pledge or otherwise accelerate payments on the note in any other taxable year. In computing adjusted current earnings for 1991, 1992, 1993 and 1994, A therefore includes $2.25 million of gain on the installment sale, computed as follows: $5 million payment times the applicable percentage of 75 percent, times the gross profit ratio of 60 percent.

(g) DISALLOWANCE OF LOSS ON EXCHANGE OF DEBT POOLS. [RESERVED]

(h) POLICY ACQUISITION EXPENSES OF LIFE INSURANCE COMPANIES -- (1) IN GENERAL. This paragraph (h) addresses the treatment of policy acquisition expenses of life insurance companies in determining adjusted current earnings. Policy acquisition expenses are those expenses that, under generally accepted accounting principles in effect at the time the expenses are incurred, are considered to vary with and to be primarily related to the acquisition of new and renewal insurance policies. Generally, these acquisition expenses must be capitalized and amortized for purposes of adjusted current earnings over the reasonably estimated life of the acquired policy, using a method that provides a reasonable allowance for amortization. This method of amortization is treated as if it applied to all taxable years in determining the amount of policy acquisition expenses deducted for adjusted current earnings. The rules in this paragraph (h) apply to any life insurance company, as defined in section 816(a).

(2) REASONABLY ESTIMATED LIFE. The reasonably estimated life of an acquired policy is determined based on the facts with respect to each policy (such as the age, sex and health of the insured), and the company's experience (such as mortality, lapse rate and renewals) with similar policies. A company may treat as the reasonably estimated life of an acquired policy the period for amortizing expenses of the acquired policy that would be required by the Financial Accounting Standards Board (FASB) at the time the acquisition expenses are incurred. If the FASB has not established such a period, the period for amortizing acquisition expense of an acquired policy under guidelines issued by the American Institute of Certified Public Accountants in effect at the time the acquisition expenses are incurred may be treated as the reasonably estimated life of the acquired policy.

(3) REASONABLE ALLOWANCE FOR AMORTIZATION. For purposes of determining a reasonable allowance for amortization, a company may use a method that amortizes acquisition expenses in the same proportion that gross premiums and gross investment income for the taxable year bear to total anticipated receipts of gross premiums (including anticipated renewal premiums) and gross investment income to be realized over the reasonably estimated life of the policy.

(4) SAFE HARBOR FOR PUBLIC FINANCIAL STATEMENTS. Any company that is required to file with the Securities and Exchange Commission (SEC) a financial statement with respect to the taxable year will be treated as having complied with paragraph (h)(1) of this section if it accounts for acquisition expenses for adjusted current earnings purposes in the same manner as it accounts for those expenses on its financial statements filed with the SEC.

(1) [RESERVED]

(j) DEPLETION. For purposes of computing adjusted current earnings, the allowance for depletion with respect to any property placed in service in a taxable year beginning after December 31, 1989 is determined under the cost depletion method of section 611.

(k) TREATMENT OF CERTAIN OWNERSHIP CHANGES -- (1) IN GENERAL. In the case of any corporation that has an ownership change as defined in paragraph (k)(2) of this section in a taxable year beginning after December 31, 1989, and that also has a net unrealized built-in loss (as defined in paragraph (k)(3) of this section) immediately before the ownership change, the adjusted basis of each asset of the corporation for purposes of computing adjusted current earnings following the ownership change shall be its proportionate share (determined on the basis of the respective fair market values of each asset) of the fair market value of the assets of the corporation immediately before the ownership change. The rules of section 1.338(b)-2T(b), if otherwise applicable to the transaction, are applied in making this allocation of basis. If such rules apply, the limitations of sections 1.338(b)-2T(c)(1) and (2) also apply in allocating basis under this paragraph (k)(1).

(2) DEFINITION OF OWNERSHIP CHANGE. A corporation has an ownership change for purposes of section 56(g)(4)(G)(i) and this paragraph (k) if there is an ownership change under section 382(g) for purposes of computing the corporation's amount of taxable income that may be offset by pre-change losses or the regular tax liability that may be offset by pre-change credits. See section 1.382-2T for rules to determine whether a corporation has an ownership change. Accordingly, in order for an ownership change to occur for purposes of this paragraph (k), a corporation must be a loss corporation as defined in section 1.382-2T(f)(1). In determining whether the corporation is a loss corporation, the determination of whether there is a net unrealized built-in loss is made by using the aggregate adjusted basis of the assets of the corporation used in computing taxable income. The aggregate adjusted basis of the corporation's assets for purposes of computing adjusted current earnings is not relevant in determining whether the corporation is a loss corporation. See part (iv) of the example in paragraph (k)(4) of this section.

(3) DETERMINATION OF NET UNREALIZED BUILT-IN LOSS IMMEDIATELY BEFORE AN OWNERSHIP CHANGE. In order to determine whether it has a net unrealized built-in loss for purposes of section 56(g)(4)(G)(ii) and paragraph (k)(1) of this section, a corporation that has an ownership change as defined in paragraph (k)(2) of this section must use the aggregate adjusted basis of its assets that it uses in computing its adjusted current earnings. The rules of section 382 (including sections 382(h)(3)(B)(i) and 382(h)(8)) otherwise apply in determining whether the corporation has a net unrealized built-in loss.

(4) EXAMPLE. The following example illustrates the provisions of this paragraph (k):

(i) Individual A has owned all the issued and outstanding stock of corporation L for the past 5 years. A sells all of his stock in L to unrelated individual B. On the date of the sale, L owns the following assets (all numbers are in millions):

 Adjusted basis         Adjusted basis          Fair

(ii) L has no net unrealized built-in loss for purposes of computing taxable income because the amount by which the aggregate adjusted basis of its assets for that purpose exceeds their fair market value is $10 million, which is less than 15 percent of their fair market value and is not greater than $10 million. See section 382(h)(3)(B)(i). L, however, does have a net unrealized built-in loss for purposes of computing adjusted current earnings because the aggregate adjusted basis of its assets for that purpose exceeds their fair market value by $20 million, and that amount is greater than $10 million.

(iii) Under paragraph (k)(1) of this section, L must restate the adjusted basis of its assets for purposes of computing adjusted current earnings to their fair market values, as follows (all numbers are in millions):

 Asset          New adjusted basis

(iv) If L did not have the net operating loss carryforward, and had no other loss or credit carryovers or other attributes described in section 1.382-2T(f)(1) for purposes of computing the amount of its taxable income that may be offset by pre- change losses or its regular tax liability that may be offset by pre-change credits, it would not have been a loss corporation on the date of the sale and therefore would not be treated as having had an ownership change for purposes of computing adjusted current earnings. This would be true even though L had a net unrealized built-in loss for purposes of computing adjusted current earnings. Therefore, this paragraph (k) would not have applied.

(l) [RESERVED]

(m) ADJUSTED CURRENT EARNINGS OF FOREIGN CORPORATIONS. [RESERVED]

(n) ADJUSTMENT FOR ADJUSTED CURRENT EARNINGS OF CONSOLIDATED GROUPS -- (1) POSITIVE ADJUSTMENTS. For taxable years beginning after December 31, 1989, the alternative minimum taxable income of a consolidated group (as defined in section 1.1502-1T) is increased by 75 percent of the excess, if any, of --

(i) The consolidated adjusted current earnings for the taxable year, over

(ii) The consolidated pre-adjustment alternative minimum taxable income for the taxable year.

(2) NEGATIVE ADJUSTMENTS -- (i) IN GENERAL. The alternative minimum taxable income of a consolidated group is decreased, subject to the limitation of paragraph (n)(2)(ii) of this section, by 75 percent of the excess, if any, of the consolidated pre-adjustment alternative minimum taxable income over consolidated adjusted current earnings.

(ii) LIMITATION ON NEGATIVE ADJUSTMENTS. The amount of the negative adjustment for any taxable year shall be limited to the excess, if any, of --

(A) The aggregate increases in the alternative minimum taxable income of the group in prior years under this section, over

(B) The aggregate decreases in the alternative minimum taxable income of the group in prior years under this section.

(3) DEFINITIONS -- (i) CONSOLIDATED PRE-ADJUSTMENT ALTERNATIVE MINIMUM TAXABLE INCOME. Consolidated pre-adjustment alternative minimum taxable income is the consolidated taxable income (as defined in section 1.1502-11) of a consolidated group for the taxable year, determined with the adjustments provided in sections 56 and 58 (except for the adjustment for adjusted current earnings and the alternative tax net operating loss determined under section 56(a)(4)) and increased by the preference items described in section 57.

(ii) CONSOLIDATED ADJUSTED CURRENT EARNINGS. The consolidated adjusted current earnings of a consolidated group is the consolidated pre-adjustment alternative minimum taxable income of the consolidated group for the taxable year, adjusted as provided in section 56(g) and this section.

(4) EXAMPLE. The following example illustrates the provisions of this paragraph (n):

(i) P is the common parent of a consolidated group. In 1990, the group has consolidated pre-adjustment alternative minimum taxable income of $1,400,000 and consolidated adjusted current earnings of $1,600,000. Thus, the group has a consolidated adjustment for adjusted current earnings for 1990 of $150,000 (75 percent of the $200,000 excess of consolidated adjusted current earnings over consolidated pre-adjustment alternative minimum taxable income), and alternative minimum taxable income of $1,550,000 ($1,400,000 plus $150,000).

(ii) In 1991, the group has consolidated pre-adjustment alternative minimum taxable income of $1,500,000 and consolidated adjusted current earnings of $1,100,000. Thus, the group can reduce its alternative minimum taxable income by $150,000. The potential negative adjustment of $300,000 (75 percent of the $400,000 excess of consolidated pre-adjustment alternative minimum taxable income over consolidated adjusted current earnings) is limited to the $150,000 consolidated adjustment for adjusted current earnings taken into account in 1990.

(o) [RESERVED]

(p) EFFECTIVE DATES FOR CORPORATE PARTNERS IN PARTNERSHIPS -- (1) IN GENERAL. The provisions of this section apply to a corporate partner's distributive share of items of income and expense from a partnership for any taxable year of the partnership ending within or with any taxable year of the corporate partner beginning after December 31, 1989.

(2) APPLICATION OF EFFECTIVE DATES. Solely for purposes of the effective date provisions of this section, a partnership event (such as placing property in service, paying or incurring a cost, or closing an installment sale) is deemed to occur on the last day of the partnership's taxable year.

(3) EXAMPLE. The following example illustrates the provisions of this paragraph (p):

(i) X is a calendar-year corporation that is a partner in P, an accrual-basis partnership with a taxable year ending March 31. During P's taxable year ending March 31, 1990, P earned ratably throughout the year interest income on tax-exempt obligations. In addition, P incurred intangible drilling costs in November 1989 and in February 1990.

(ii) X's adjusted current earnings for 1990 includes X's distributive share of the interest on the tax-exempt obligations earned by P for its taxable year ending March 31, 1990. This is true even though P earned a portion of the interest prior to January 1, 1990.

(iii) For purposes of computing X's adjusted current earnings for 1990, the adjustment provided in paragraph (f)(1) of this section applies to X's distributive share of P's November 1989 and February 1990 intangible drilling costs.

(q) TREATMENT OF DISTRIBUTIONS OF PROPERTY TO SHAREHOLDERS -- (1) IN GENERAL. If a distribution of an item of property by a corporation with respect to its stock gives rise to more than one adjustment to earnings and profits under section 312, all of the adjustments with respect to that item of property (including the adjustment described in section 312(c) with respect to liabilities to which the item is subject or which are assumed in connection with the distribution) are combined for purposes of determining the corporation's adjusted current earnings for the taxable year. If the amount included in pre-adjustment alternative minimum taxable income with respect to a distribution of an item of property exceeds the net increase in earnings and profits caused by the distribution, pre- adjustment alternative minimum taxable income is not reduced in computing adjusted current earnings. If the net increase in earnings and profits caused by a distribution of an item of property exceeds the amount included in pre-adjustment alternative minimum taxable income with respect to the distribution, that excess is added to pre- adjustment alternative minimum taxable income in computing adjusted current earnings.

(2) EXAMPLES. The following examples illustrate the provisions of this paragraph (q).

(i) EXAMPLE 1. K corporation distributes property with a fair market value of $150 and an adjusted basis of $100. The adjusted basis is the same for purposes of computing taxable income, pre-adjustment alternative minimum taxable income, adjusted current earnings, and earnings and profits. Under of section 312(a)(3), as modified by section 312(b)(2), K decreases its earnings and profits by the fair market value of the property, or $150. Under section 312(b)(1), K increases its earnings and profits by the excess of the fair market value of the property over its adjusted basis, or $50. As a result of the distribution, there is a net decrease in K's earnings and profits of $100. K recognizes $50 of gain under section 311(b) as a result of the distribution as if K sold the property for $150. K thus has no amount permanently excluded from pre- adjustment alternative minimum taxable income that is taken into account in determining current earnings and profits, and thus has no adjustment under paragraph (c)(1) of this section.

(ii) EXAMPLE 2. The facts are the same as in example 1, except that the distributee shareholder assumes a $190 liability in connection with the distribution. Under section 312(c)(1), K must adjust the adjustments to its earnings and profits under section 312(a) and (b) to account for the liability the shareholder assumes. K adjusts the $100 net decrease in its earnings and profits to reflect the $190 liability, resulting in an increase in its earnings and profits of $90. Because section 311(b)(2) makes the rules of section 336(b) apply, the fair market value of the property is not less than the amount of the liability, or $190. K therefore is treated as if it sold the property for $190, recognizing $90 of gain. K thus has no amount permanently excluded from pre-adjustment alternative minimum taxable income that is taken into account in determining current earnings and profits, and thus has no adjustment under paragraph (c)(1) of this section.

Par. 6. Section 1.926(a)-1T(b)(1) is revised to read as follows:

SECTION 1.926(a)-1T TEMPORARY REGULATIONS: DISTRIBUTIONS TO SHAREHOLDERS.

* * * * *

(b) ORDER OF DISTRIBUTIONS -- (1) IN GENERAL. For guidance, see section 1.926(a)-1(b)(1).

Par. 7. Section 1.926(a)-1 is added to read as follows:

* * * * *

SECTION 1.926(a)-1 DISTRIBUTIONS TO SHAREHOLDERS.

(a) TREATMENT OF DISTRIBUTIONS. [Reserved] For guidance, see section 1.926(a)-1T(a).

(b) ORDER OF DISTRIBUTION -- (1) IN GENERAL -- (i) DISTRIBUTIONS BY A FSC RECEIVED BY A SHAREHOLDER IN A TAXABLE YEAR OF THE SHAREHOLDER BEGINNING BEFORE JANUARY 1, 1990. Any actual distribution to a shareholder by a FSC (all references to a FSC in this section shall include a small FSC and a former FSC) that is received by the shareholder in a taxable year of the shareholder beginning before January 1, 1990, and made out of earnings and profits shall be treated as made in the following order, to the extent thereof --

(A) Out of earnings and profits attributable to exempt foreign trade income determined solely because of operation of section 923(a)(4),

(B) Out of earnings and profits attributable to other exempt foreign trade income,

(C) Out of earnings and profits attributable to non-exempt foreign trade income determined under either of the administrative pricing methods of section 925(a)(1) or (2),

(D) Out of earnings and profits attributable to section 92(a)(2) non-exempt income, and

(E) Out of other earnings and profits.

(ii) DISTRIBUTIONS BY A FSC RECEIVED BY A SHAREHOLDER IN A TAXABLE YEAR OF THE SHAREHOLDER BEGINNING AFTER DECEMBER 31, 1989. Any actual distribution to a shareholder by a FSC that is received by the shareholder in a taxable year beginning after December 31, 1989, and that is made out of earnings and profits shall be treated as made in the following order, to the extent thereof --

(A) Out of earnings and profits attributable to exempt foreign trade income determined solely because of the operation of section 923(a)(4),

(B) Out of earnings and profits attributable to foreign trade income (other than exempt foreign trade income determined solely because of the operation of section 923(a)(4)) allocable to the marketing of agricultural or horticultural products (or the providing of related services) by a qualified cooperative which is a shareholder of the FSC,

(C) Out of earnings and profits attributable to non-exempt foreign trade income and other exempt foreign trade income determined under either of the administrative pricing methods of section 925(a)(1) or (2). Distributions out of this classification will be made on a pro rata basis so that 15/23 (16/23 with regard to distributions to a non-corporate shareholder) of each distribution will be out of earnings and profits attributable to exempt foreign trade income and the remainder will be out of earnings and profits attributable to non-exempt foreign trade income. To the extent the distributions are out of earnings and profits attributable to the disposition of, or services related to, military property, 7.5/23 (8/23 with regard to distributions to a non-corporate shareholder) of each distribution will be out of earnings and profits attributable to exempt foreign trade income and the remainder will be out of earnings and profits attributable to non-exempt foreign trade income,

(D) Out of earnings and profits attributable to other exempt foreign trade income determined under the transfer pricing method of section 925(a)(3),

(E) Out of earnings and profits attributable to section 923(a)(2) non-exempt income,

(F) Out of earnings and profits attributable to effectively connected income, as defined in section 245(c)(4)(B), and

(G) Out of other earnings and profits.

(2) DETERMINATION OF EARNINGS AND PROFITS. [Reserved] For guidance, see section 1.926(a)-1T(b)(1).

(c) DEFINITION OF "FORMER FSC". [Reserved] For guidance, see section 1.926(a)-1T(c).

(d) PERSONAL HOLDING COMPANY INCOME. [Reserved] For guidance, see section 1.926(a)-1T(d).

(e) SALE OF STOCK IF SECTION 1248 APPLIES. [Reserved] For guidance, see section 1.926(a)-1T(e).

* * * * *