Final Regs on Foreign Tax Credit Limitations

 4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final Income Tax Regulations relating to the application of section 904 with respect to income received or accrued by a taxpayer consisting of income described in section 904(d). Amendments to the final regulations are necessary because of the changes made to the applicable law by the Technical and Miscellaneous Revenue Act of 1988. The regulations provide taxpayers with guidance needed to comply with that Act and with the Tax Reform Act of 1986 and affect individuals and entities claiming the foreign tax credit. In addition, these regulations remove an obsolete provision from the regulations under section 905 of the Internal Revenue Code of 1986.

 EFFECTIVE DATE: The amendments to the regulation are effective for taxable years beginning after December 31, 1986.

 FOR FURTHER INFORMATION CONTACT: Caren Silver Shein of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224 (Attention: CC:CORP:T:R (INTL-0790-88)) (202-566-3452, not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

On August 26, 1987, the Internal Revenue Service published in the Federal Register proposed amendments to the Income Tax Regulations (26 CFR part 1) under section 904 of the Internal Revenue Code of 1954 (52 FR 32242). On July 18, 1988, the Internal Revenue Service published in the Federal Register final regulations under section 904 of the Internal Revenue Code of 1986 (53 FR 27006). The regulations provided rules for determining a taxpayer's foreign tax credit limitations under section 904(d) and conformed the regulations to the Tax Reform Act of 1986 (Pub. L. 99-514, 100 Stat. 2085). The proposed regulations reflected proposed technical corrections. Because the technical corrections bill had not yet been enacted, portions of the final regulations were reserved. The reserved portions have now been added to conform the regulations to section 1012 of the Technical and Miscellaneous Revenue Act of 1988 (Pub. L. 100-647, 102 Stat. 3342). Other amendments and corrections also have been made. Written comments were received with respect to the final regulations. No public hearing was requested or held with respect to those comments. The significant points raised by the comments and the changes made to the final regulations are discussed in the remainder of the preamble. After consideration of the comments received, the amendments are adopted as modified by this Treasury Decision.

EXPLANATION OF PROVISIONS

 In addition to numerous clarifying and correcting amendments, the following revisions are made to the regulations.

SECTION 1.904-4

 Section 1.904-4(c)(1) is amended to clarify that for purposes of allocating taxes to groups of income, foreign taxes imposed on both United States source and foreign source income are included. In making the determination whether income is high-taxed under the rules of paragraph (c) (the high-tax exception to the passive income category), however, only foreign source income is relevant.

 Pursuant to comments, section 1.904-4(c)(5)(ii) is amended to clarify that United States QBUs of United States entities are subject to the grouping rules of paragraph (c)(3), as is a distributive share of income from a United States partnership earned by a United States QBU.

 Section 1.904-4(c)(5)(iv) is added to provide a rule for certain dividends that are not taxable under subpart F by reason of section 954(b)(4) (the subpart F high-tax exclusion) but are passive income for foreign tax credit purposes. As an example, such dividends may be passive because of a reduction in the effective rate of tax imposed by a foreign country on the dividend and consequent redetermination of United States income tax liability pursuant to section 905(c). Paragraph (c)(5)(iv) provides that a dividend from a controlled foreign corporation that is treated as passive income under the look through rules shall be grouped, for purposes of determining whether the income is high-taxed, according to the rules of paragraph (c)(4).

 Section 1.904-4(c)(7)(ii) is amended to clarify that foreign law controls the year to which a reduction in foreign tax relates, and to provide that the LIFO ordering rules are to apply only when foreign law is not clear. These amendments conform the regulations to section 905(c) and the regulations under that section, which generally look to foreign law to determine the year to which a reduction in tax relates.

 Section 1.904-4(c)(6)(ii) has been revised and section 1.904-4(c)(8) has been deleted to be consistent with the regulations under section 905(c). The Service suspended section 1.905-3T(d)(2)(ii)(A), which provided that redeterminations more than 90 days before the due date of a return for the prior taxable year must be reflected on that return. Notice 90-26, 1990-1 C.B. 336. Thus, paragraph (c)(8), which provided that if there is a redetermination of foreign tax within the meaning of section 905(c) more than 90 days before the due date of its income tax return, a taxpayer is required to reflect the income as redetermined on its return for that taxable year, has been deleted. Paragraph (c)(6)(ii) provided two exceptions to the general rule of paragraph (c)(6)(i) that the determination whether a subpart F inclusion is high-taxed is to be made in the year of the inclusion, notwithstanding that the taxpayer is required to pay an additional tax when the previously taxed income is distributed in a later year. The second exception, providing that additional taxes paid on previously taxed income will be taken into account for purposes of applying the high-tax kick out if a distribution is received more than 90 days before the due date of the tax return for the taxable year of the subpart F inclusion, has been deleted.

 Section 1.904-4(d) is revised, pursuant to technical corrections, to provide that interest income that is not high withholding tax interest because it is export financing interest shall be treated as general limitation income unless it is received by a financial services entity, in which case it will be financial services income.

 Paragraphs (e)(1) and (5)(i) and (ii) of section 1.904-4, which had been reserved, are added. Paragraph (e)(1) defines the term "financial services income" and paragraphs (e)(5)(i) and (ii) describe income that is excluded from the definition of financial services income.

 The Service has clarified section 1.904-4(e)(2)(i)(V) by defining a finance lease based on generally accepted accounting standards used to distinguish a finance lease from an operating lease. A finance lease, for purposes of section 904(d), is defined by these regulations to be a direct financing lease or a leveraged lease for accounting purposes that is also a lease for tax purposes. A lease that produces active rental income excludible from subpart F pursuant to section 954(c)(2)(A) is not a finance lease and the rental income earned from that lease would not be active financing income. As a result of this change, the rule in section 1.904-4(e)(3)(ii) providing that leasing income of any member of the group will not be considered active financing income if any member of the recipient's group satisfies the active trade or business requirements of section 954(c)(2)(A) with respect to that income is unnecessary and, therefore, is deleted.

 Section 1.904-4(f) is revised to correct an oversight in the final regulations. Income that falls into both the shipping and foreign trade income categories will be treated as foreign trade income.

 Formerly reserved section 1.904-4(g)(2)(iv) is added to provide that an inclusion in gross income under section 1293 with respect to a noncontrolled section 902 corporation shall be treated as a dividend from a noncontrolled section 902 corporation.

 Section 1.904-4(h)(2) and (3) is revised and the reserved paragraphs of section 1.904-4(h)(3) are added. Paragraph (h)(3) provides exceptions to the general rule for the treatment of export financing interest provided in paragraph (h)(2).

 The Federal Register published proposed revised regulations under sections 1.904-4(j), 1.954-2T(g) and 1.985-3(d) on July 10, 1991 (56 FR 31362). Those regulations are proposed to be effective prospectively. The Service, therefore, is leaving section 1.904-4(j) in place until the proposed regulations are effective.

 A new section 1.904-4(k) is added to provide a rule for characterizing income for purposes of computing the alternative minimum tax ("AMT") foreign tax credit under section 59(a). For taxable years beginning after 1989, alternative minimum taxable income ("AMTI") is increased by 75 percent of the excess of AMTI computed without the adjustment based on adjusted current earnings (the "ACE adjustment") and AMTI computed with the ACE adjustment. Section 56(g). In computing the AMT foreign tax credit, the rules of section 904 apply except that AMTI is substituted for taxable income. Section 59(a)(1)(B). Commenters have suggested that for purposes of determining the character of income under section 904(d), the ACE adjustment should be viewed as an item of income. Because the ACE adjustment is not described in any other category, it would be included in the residual or general limitation basket. The Service does not adopt such a rule. Congress did not intend that all ACE adjustments be made to the general limitation basket. The legislative history indicates that items included in AMTI by reason of the ACE adjustment are to be sourced for section 904 purposes on an item-by- item basis. See H.R. Rep. (Conf.) 841, 99th Cong., 2d Sess. II-282 (1986). Once the ACE adjustment has been divided into its component parts for sourcing purposes, the character or basket of each foreign source component also should be determined on an item-by-item basis under section 904(d). Thus, paragraph (k) has been added to provide that an item included in AMTI by reason of the ACE adjustment is to be characterized for purposes of section 904(d) based on the character of the underlying item of income.

 Formerly reserved section 1.904-4(k) is added as new paragraph (1) to provide priority rules in the case of income that meets the definitions of more than one category of separate limitation income.

SECTION 1.904-5

 A commenter suggested that the Service amend section 1.904-5 (a)(3) to change the definition of an affiliated group to include foreign corporations. This would allow look-through treatment for foreign source payments between related United States entities who are not part of the same affiliated group because a nonincludible corporation such as a foreign corporation has been inserted between them in the chain of ownership. Such corporations in most cases are disaffiliated for tax planning reasons. There is no indication that Congress intended to provide look-through treatment in such cases.

 Formerly reserved section 1.904-5(d)(1) is added to provide that if a controlled foreign corporation satisfies the de minimis rule of section 954(b)(5), all of the controlled foreign corporation's gross foreign base company income and gross insurance income, other than income that would be financial services income, shall be treated as general limitation income.

 Several commenters requested that section 1.904-5(g) be expanded to provide look-through treatment for foreign source dividends paid by a U.S. corporation to a related U.S. corporation. Section 1.904-5(g) currently provides look-through treatment only for foreign source interest, rents and royalties paid by a U.S. corporation to a related U.S. corporation. The problem concerns section 936 corporations and the alternative minimum tax ("AMT") foreign tax credit. For regular tax purposes, dividends received from a section 936 corporation by a related U.S. corporation are entitled to a 100% dividends received deduction and taxes paid on that income are not treated as foreign income taxes. Section 243(a)(3). For AMT purposes after 1989, however, there is no deduction and the dividend is added back in calculating the taxpayers adjusted current earnings. Section 56(g)(4)(C)(ii).

 Dividends paid by a section 936 corporation are foreign source under section 861(a)(2)(A) and are characterized as passive income under section 904(d)(2)(A). Commenters argue that because a section 936 corporation must derive 75 percent of its income from an active trade or business (section 936(a)(2)(B)), it is inappropriate to retain dividends received from a section 936 corporation in the passive basket. Dividends from a section 936 corporation, however, are virtually always subject to a low rate of tax. Providing look- through would permit averaging of high and low-taxed income. Where low-taxed foreign source income such as a dividend from a section 936 corporation is already separately identified for other Code purposes, permitting averaging of such income with high-taxed foreign source income is inappropriate. The comment, therefore, is rejected.

 The temporary and proposed regulations under section 864(e)(5) and (6) currently provide that a section 936 corporation is a member of the affiliated group for purposes of allocating and apportioning interest and certain other expenses. See sections 1.861-11T(d) and 1.861-14T(d). The proposed regulations (but not the temporary regulations) are proposed to be amended (in a separate document (INTL-0001-92)) to exclude section 936 corporations from the affiliated group solely for purposes of determining foreign source alternative minimum taxable income and the AMT foreign tax credit. The intended result of the proposed amendments is to increase the proportion of interest and certain other expenses apportioned to foreign source passive income, and to reduce the proportion of those expenses apportioned to foreign source general limitation income, in each case solely for AMT purposes. For taxpayers subject to the AMT, these adjustments are intended to provide expense allocation rules consistent with the treatment of dividends paid by a section 936 corporation as foreign source passive income. For further discussion of the proposed amendments to the interest and other expense allocation and apportionment rules under section 864(e)(5) and (6), see INTL-0001-92.

 Section 1.904-5(h)(3), which had been reserved, is added to provide that if a partner recognizes gain on the sale of a partnership interest, that income shall be treated as passive income to the partner, unless the income is high taxed.

 A commenter suggested that an active trade or business exception be added to the rule of section 1.904-5(h)(3) that gain on the sale of a partnership interest is passive. Specifically, the commenter suggested that if a partner holds an interest in an oil and gas joint venture or partnership and the partner is regularly, actively and substantially engaged in the exploration for and extraction of minerals either directly or through the joint venture or partnership, then the partner should be entitled to look-through treatment on the disposition of the interest. The commenter noted that moat foreign countries in which oil and gas exploration occurs require foreign investors to operate through a partnership or joint venture. Such investors thus do not have the option of operating in corporate form in order to obtain look-through treatment on disposition of their interests.

 There is no statutory authority to add the suggested exception. Section 954(c)(1) defines foreign personal holding company income as, among other things, royalties, rents, and gain on the sale of a partnership interest. Section 954(c)(2) provides an active trade or business exception for rents and royalties derived from the active conduct of a trade or business. No exception is provided for gain on the sale of a partnership interest in which the partner was an active participant.

 In the final regulations published in 1988, paragraph (i)(3) was reserved on the issue whether to extend look-through to payments from foreign parents to United States subsidiaries. The Service has decided not to allow look-through on payments from a foreign parent to a United States subsidiary. To apply the look-through rules, the Service needs complete information concerning the foreign corporation's income and expenses. The Service may not be able to obtain all of the necessary information from a foreign parent corporation and to audit it. In addition, the payments generally would be deductible from taxable income of the payor that is entirely outside the jurisdiction of the United States (including subpart F) and, therefore, do not give rise to the same concerns involved in other look-through cases.

 Section 1.904-5(j), which had been reserved, is added to provide that the look-through rules apply to amounts included in the gross income of a United States shareholder of a passive foreign investment company under section 1293 if that company is also a controlled foreign corporation.

 Formerly reserved section 1.904-5(m)(7) is added to provide a special rule for income that would be United States source income under section 904(g), but is treated as foreign source income under an income tax convention with the United States and the taxpayer elects the benefits of the treaty pursuant to section 904(g)(10). Paragraph (m)(7) provides that if the taxpayer elects the benefits of the treaty, the income shall be treated as foreign source but the foreign tax credit rules shall be applied separately with respect to income treated as foreign source pursuant to each treaty under which the taxpayer has claimed benefits. Thus, the taxpayer must segregate income treated as foreign source under each treaty and then allocate the income within each treaty to a separate group of section 904(d) categories. For example, a taxpayer may not average general limitation income treated as foreign source under one treaty with general limitation income treated as foreign source under another treaty. A taxpayer also may not average general limitation income treated as foreign source under a treaty with passive income treated as foreign source under the same treaty.

SECTION 1.904-6

 Section 1.904-6(a)(1)(iv) is added to provide special rules for items that are taxed under foreign law but are not income for United States purposes, and for items that are income for United States purposes, but are subject to a foreign tax in a year other than the year in which they would be income under United States tax principles. Paragraph (a)(1)(iv) provides two rules. First, if a foreign country imposes a tax on income that would not be income for United States purposes, the tax shall be treated as imposed with respect to general limitation income. Second, if the foreign country imposes a tax on an item in one year that would be recognized under United States tax principles in another year, the tax must be allocated among the separate categories as if the income were recognized under United States principles in the year in which the tax was imposed.

 Section 1.904-6(a)(2) is revised to provide that if a taxpayer receives or accrues a dividend from a noncontrolled section 902 corporation, and there is an express or implied agreement that the dividend is to be paid out of earnings that would be subject to the separate limitation for passive income or high withholding tax interest, then only foreign income taxes imposed on passive or high withholding tax interest income will be considered taxes relating to the dividend.

 Section 1.904-6(b)(2)(i) is amended in response to a comment to provide that the rule shall be applicable to individual as well as corporate shareholders.

SECTION 1.904-7

 Section 1.904-7(a) is revised pursuant to comments to provide that the transition rules for characterizing income derived by a controlled foreign corporation in taxable years beginning before January 1, 1987, and distributed to or included in the gross income of a United States shareholder in a taxable year beginning after December 31, 1986, apply to distributions and section 951(a)(1)(A)(ii) and (iii) and (B) inclusions.

 Paragraph (a) is revised further, in response to comments, to clarify that the transition rules of section 1.904-7 apply only if the controlled foreign corporation was a controlled foreign corporation at the time the income to be distributed to or included by the United States shareholder was accumulated by the controlled foreign corporation. Section 1.904-7(a) provides transition rules for applying the section 1.904-5 look-through rules when earnings accumulated in a pre-1987 year are distributed or included in a post- 1986 year. The look-through rules apply only to controlled foreign corporations. Thus, the transition rules also apply only if a corporation was a controlled foreign corporation in the year in which the income distributed or included was earned.

SECTION 1.905-2

 Paragraph (c) of section 1.905-2 has been removed because it interprets a provision that is no longer in the Internal Revenue Code.

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 also has 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 Flexibility Analysis is not required by the Regulatory Flexibility Act.

DRAFTING INFORMATION

 The principal author of these regulations is Caren Silver Shein of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. Other personnel from the Internal Revenue Service and Treasury Department participated in developing the regulations.

LIST OF SUBJECTS IN 26 CFR 1.901-1 THROUGH 1.905-5T

 Income taxes, Reporting and recordkeeping requirements, United States investments abroad.

Treasury Decision 8412

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 citation for part 1 continues to read in part:

Authority: 26 U.S.C. 7805 * * * Sections 1.904-4 through 1.904-7 also issued under 26 U.S.C. 904(d)(5). * * *

Par. 2. Section 1.904-0 is revised to read as follows:

SECTION 1.904-0 OUTLINE OF REGULATION PROVISIONS FOR SECTION 904.

This section lists the revised paragraphs contained in sections 1.904-1 through 1.904-7, 1.904(b)-1 through 1.904(b)-4, 1.904(f)-1 through 1.904(f)-6 and 1.904(f)-12.

 SECTION 1.904-1 LIMITATION ON CREDIT FOR FOREIGN TAXES.

(a) Characterization of distributions and section 951

(a)(1)(A)(ii) and (iii) and (B) inclusions of earnings of a controlled foreign corporation accumulated in taxable years beginning before January 1, 1987, during taxable years of both the payor controlled foreign corporation and the recipient which begin after December 31, 1986.

(1) Distributions and section 951(a)(1)(A)(ii) and (iii) and (B) inclusions.

(2) Limitation on establishing the character of earnings and profits.

(b) Application of look-through rules to distributions (including deemed distributions) and payments by an entityto a recipient when one's taxable year begins before January 1, 1987 and the other's taxable year begins after December 31, 1986.

(1) In general.

(2) Payor of interest, rents, or royalties is subject to the Act and recipient is not subject to the Act.

(3) Recipient of interest, rents, or royalties is subject to the Act and payor is not subject to the Act.

(4) Recipient of dividends and subpart F inclusions is subject to the Act and payor is not subject to the Act.

(5) Examples.

(c) Installment sales.

(d) Special effective date for high withholding tax interest earned by persons with respect to qualified loans described in section 1201(e)(2) of the Act.

(e) Treatment of certain recapture income.

 SECTION 1.904(b)-1 TREATMENT OF CAPITAL GAINS FOR CORPORATIONS.

1. Paragraph (b)(1)(i) concluding text is amended by removing the last sentence and adding three sentences in its place.

2. Paragraph (b)(2)(i) is amended by removing "section 1.954-2(d)(1)" and adding in its place "section 954(c)(2)(A) and the regulations under that section".

3. Paragraph (b)(2)(iv) is amended by removing "section 1.954-2(d)(1)" in the EXAMPLE and adding in its place "section 954(c)(2)(A) and the regulations under that section".

4. Paragraph (c)(1) is amended by removing the last sentence and adding four sentences in its place.

5. Paragraph (c)(2)(ii) is amended by removing "section 1.861-8" and adding in its place "sections 1.861-8 through 1.861-14T".

6. The heading and introductory text to paragraph (c)(4) are revised.

7. Paragraphs (c)(5)(ii) and (iii) are revised, and a new paragraph (c)(5)(iv) is added.

8. Paragraph (c)(6)(ii) is revised.

9. Paragraph (c)(7)(ii) is amended by removing the second sentence and adding two sentences in its place, and paragraph (c)(7)(iii) is amended by adding a new sentence at the end of the paragraph.

10. Paragraph (c)(8) is removed, paragraph (c)(9) is redesignated paragraph (c)(8), and newly designated paragraph (c)(8) is amended by:

a. Revising Example (4);

b. Amending Example (5) by inserting "(not including the section 78 amount)" after "$80" in the second sentence, and by removing the language "after P has filed its return for its 1988 tax year," in the eighth sentence;

c. Removing Example (6), Example (7) and Example (12);

d. Redesignating Example (8) through Example (11) as Example (6) through EXAMPLE (9), respectively;

e. Amending newly designated Example (7) and Example (8) by removing the references "Example (8)" and adding in their place "Example (6)";

f. Amending newly designated Example (9)(ii) by adding "(the reduction in tax rates from 50 percent to 30 percent is a 40 percent reduction in tax)" after "40 percent" in the seventh sentence; and

g. Adding a new Example (10).

11. Paragraph (e)(1) is revised.

12. Paragraph (e)(2)(i)(V) is revised.

13. Paragraph (e)(3)(i) is amended by:

a. Adding "at least" before "80 percent" in the third sentence;

b. Adding after the sixth sentence "See paragraph (e)(3)(iv) Example (5) of this section."; and

c. Adding a sentence at the end of the paragraph.

14. Paragraph (e)(3)(ii) is amended by removing the fourth sentence.

15. Paragraph (e)(3)(iii) is amended by:

a. Removing the designation (A) and removing the heading "RULE.";

b. Redesignating paragraph (e)(3)(iii)(B) as paragraph (e)(3)(iv);

c. Removing the reference "paragraph (e)(3)(iii)" in the introductory paragraph of newly designated paragraph (e)(3)(iv) and adding "paragraph (e)(3)" in its place;

d. In newly designated paragraph (e)(3)(iv), redesignating Examples (1) and (2) as Examples (3) and (4), respectively, and adding new Examples (1), (2) and (5).

16. Paragraphs (e)(5)(i) and (ii) are added.

17. Paragraph (f) is amended by removing the last sentence and adding a new sentence in its place.

18. Paragraph (g)(1) is amended by adding "Except as provided in section 902 and the regulations under that section and paragraph (g)(3) of this section, a controlled" in place of "A controlled" at the beginning of the second sentence.

19. Paragraph (g)(2)(ii)(A) is amended by adding "that is not a controlled foreign corporation" after "foreign corporation" and before "is", and by adding at the end of paragraph (g)(2)(ii)(A) the language "see paragraph (g)(4) Example (1),"

20. Paragraph (g)(2)(iv) is revised.

21. Paragraph (g)(3) is amended by:

a. Adding the language " -- (i) GENERAL RULE." at the end of the heading; and

b. Adding and reserving paragraphs (g)(3)(ii), (iii) and (iv).

22. Paragraph (g)(4) is amended by:

a. Amending Example (2) by adding "section 904(d)(2)(E)(i) and" before "paragraph (g)(3)" in the last sentence; and

b. Amending Example (3) by removing the reference "paragraph (g)(3)" in the ninth sentence and adding in its place "paragraph (g)(2)(iii)".

23. Paragraph (h)(2) is revised.

24. Paragraph (h)(3) is amended by:

a. Revising the heading and paragraphs (h)(3)(i) through (iii);

b. Redesignating paragraphs (iv) and (v) as paragraphs (h)(4) and (h)(5), respectively; and

c. Adding a new paragraph (iv).

25. Newly designated paragraph (h)(4) is amended by:

a. Revising the introductory text;

b. Adding "is not a financial services entity and" in the second sentence of Example (1) after "S" and before "has";

c. Adding text to Example (2); and

d. Adding "is not a financial services entity and" in the second sentence of Example (3) after "S" and before "has".

26. Newly designated paragraph (h)(5) is amended by:

a. Redesignating paragraphs (h)(5)(A), (B) and (C) as paragraphs (h)(5)(i), (ii) and (iii), respectively;

b. Adding a sentence at the end of newly designated paragraph (h)(5)(i);

c. Adding a sentence at the end of newly designated paragraph (h)(5)(ii); and

d. Revising the introductory text and Example (1), and adding text to Examples (2) and (4) of newly designated paragraph (h)(5)(iii).

27. Paragraph (k) is revised.

28. Paragraph (1) is added.

29. The revised, redesignated, reserved and added provisions read as follows:

SECTION 1.904-4 SEPARATE APPLICATION OF SECTION 904 WITH RESPECT TO CERTAIN CATEGORIES OF INCOME.

* * * * *

(b) * * *

(1) * * *

(i) * * *

* * * In addition, passive income does not include any incomethat would otherwise be passive but is characterized as income in another separate category under the look-through rules. Indetermining whether any income is of a kind that would be foreign personal holding company income, the rules of section 864(d)(5)(A)(i) and (6) (treating related person factoring income of a controlled foreign corporation as foreign personal holding company income that is not eligible for the export financing income exception to the separate limitation for passive income) shall apply only in the case of income of a controlled foreign corporation (as defined in section 957). Thus, income earned directly by a United States person that is related person factoring income may be eligible for the exception for export financing interest.

* * * * *

(c) * * *

(1) * * * Income and taxes shall be translated at the appropriate rates, as determined under sections 986, 987 and 989 and the regulations under those sections, before application of this paragraph. For purposes of allocating taxes to groups of income, United States source passive income is treated as any other passive income. In making the determination whether income is high-taxed, however, only foreign source income, as determined under United States tax principles, is relevant. See paragraph (c)(8) Example (10) of this section for an example illustrating the application of this paragraph (c)(1).

* * * * *

(4) INCOME OF CONTROLLED FOREIGN CORPORATIONS AND FOREIGN QBUS.

Except as provided in paragraph (c)(5) of this section, all amounts included in gross income of a United States shareholder under section 951(a)(1) for a particular year that (after application of the look-through rules of section 904(d)(3) and section 1.904-5) are attributable to passive income received or accrued by a controlled foreign corporation and all amounts of passive income received or accrued by a United States person through a foreign QBU shall be subject to the rules of this paragraph (c)(4). This paragraph (c)(4) shall be applied separately to inclusions with respect to each controlled foreign corporation of which the taxpayer is a United States shareholder. This paragraph (c)(4) also shall be applied separately to income attributable to each QBU of a controlled foreign corporation or any other look-through entity as defined in section 1.904-5(i), except that if the entity subject to the look-through rules is a United States person, then this paragraph (c)(4) shall be applied separately only to each foreign QBU of that United States person.

* * * * *

(5) * * *

(ii) TREATMENT OF PARTNERSHIP INCOME. A partner's distributive share of income from a foreign or United States partnership that is not subject to the look-through rules and that is treated as passive income under section 1.904-5(h)(2)(i) (generally providing that a less than 10 percent partner's distributive share of partnership income is passive income) shall be treated as a single item of income and shall not be grouped with other amounts. A distributive share of income from a foreign partnership that is treated as passive income under the look-through rules shall be grouped according to the rulesin paragraph (c)(4) of this section. A distributive share of incomefrom a United States partnership that is treated as passive income under the look-through rules shall be grouped according to the rulesin paragraph (c)(3) of this section, except that the portion, if any, of the distributive share of income attributable to income earned by a United States partnership through a foreign QBU shall be grouped under the rules of paragraph (c)(4) of this section.

(iii) CURRENCY GAIN OR LOSS -- (A) SECTION 986(c). Any currency gain or loss with respect to a distribution received by a United States shareholder (other than a foreign QBU of that shareholder) of previously taxed earnings and profits that is recognized under section 986(c) and that is treated as an item of passive income shallbe subject to the rules provided in paragraph (c)(3)(iii) of this section. If that item, however, is received or accrued by a foreign QBU of the United States shareholder, it shall be treated as an item of passive income from sources within the QBU's country of operation for purposes of paragraph (c)(4)(i) of this section. This paragraph (c)(5)(iii)(A) shall be applied separately for each foreign QBU of a United States shareholder.

(B) SECTION 987(3). Any currency gain or loss with respect to remittances or transfers of property between QBUs of a United States shareholder that is recognized under section 987(3)(B) and that is treated as an item of passive income shall be subject to the rules provided in paragraph (c)(3)(iii) of this section. If that item, however, is received or accrued by a foreign QBU of the United States shareholder, it shall be treated as an item of passive income from sources within the QBU's country of operation for purposes of paragraph (c)(4)(i) of this section. This paragraph (c)(5)(iii)(B) shall be applied separately for each foreign QBU of a United States shareholder.

(C) EXAMPLE. The following example illustrates the provisions of this paragraph (c)(5)(iii).

EXAMPLE. P, a domestic corporation, owns all of the stock of S, a controlled foreign corporation that uses X as its functional currency. In 1993, S earns 100x of passive foreign personal holding company income. When included in P's income under subpart F, the exchange rate is 1x equals $1. Therefore, P's subpart F inclusion is $100. At the end of 1993, S has previously taxed earnings and profits of 100x and P's basis in those earnings is $100. In 1994, S has no earnings and distributes 100x to P. The value of the earnings when distributed is $150. Assume that under section 986(c), P must recognize $50 of passive income attributable to the appreciation of the previously taxed income. Country X does not recognize any gain or loss on the distribution. Therefore, the section 986(c) gain is not subject to any foreign withholding tax or other foreign tax. Thus, under paragraph (c)(3)(iii) of this section, the section 986(c) gain shall be grouped with other items of P's income that are subject to no withholding tax or other foreign tax.

(iv) CERTAIN PASSIVE DIVIDENDS. A dividend from a controlled foreign corporation that is treated as passive income under the look-through rules shall be grouped according to the rules of paragraph (c)(4) of this section.

(6) * * *

(ii) EXCEPTION. Paragraph (c)(6)(i) of this section shall not apply to an increase in tax in a case in which the taxpayer is required to adjust its foreign taxes in the year of inclusion under section 905(c).

* * * * *

(7) * * *

(ii) * * * Thus, for purposes of determining to which year's taxes the reduction in taxes relates, foreign law shall apply. If, however, foreign law does not attribute a reduction in taxes to a particular year or years, then the reduction in taxes shall be attributable, on an annual last in-first out (LIFO) basis, to foreign taxes potentially subject to reduction that are associated with previously taxed income, then on a LIFO basis to foreign taxes associated with income that under paragraph (c)(7)(iii) of this section remains as passive income but that was excluded from subpart F income under section 954(b)(4), and finally on a LIFO basis to foreign taxes associated with other earnings and profits. * * *

(iii) * * * For an example illustrating the operation of this paragraph (c)(7)(iii), see paragraph (c)(8) Example (7) of this section.

(8) EXAMPLES. * * *

* * * * *

EXAMPLE (4). Domestic corporation M operates in branch form in foreign countries X and Y. The branches are qualified business units (QBUs), within the meaning of section 989(a). In 1988, QBU X earns passive royalty income, interest income and rental income. All of the QBU X passive income is from Country Z sources. The royalty income is not subject to a withholding tax, and is not taxed by Country X, and the interest and the rental income are subject to a 5 percent and 10 percent withholding tax, respectively. QBU Y earns interest income in Country Y that is not subject to foreign tax. For purposes of determining whether M's foreign source passive income is high-taxed income, the rental income and the interest income earned in QBU X are treated as one item of income pursuant to paragraphs (c)(4)(ii)and (3)(ii) of this section. The interest income earned in QBU Yand the royalty income earned in QBU X are each treated as a separate item of income under paragraphs (c)(4)(i) (with respectto QBU Y's interest income) and (c)(4)(ii) and (3)(iii) (withrespect to QBU X's royalty income) of this section.

* * * * *

EXAMPLE (10). P, a domestic corporation, earns $100 of passive royalty income from sources within the United States. Under the laws of Country X, however, that royalty is considered to be from sources within Country X and Country X imposes a 10 percent withholding tax on the payment of the royalty. P also earns $100 of passive foreign source dividend income subject to a 10 percent withholding tax to which $15 of expenses are allocated. In determining whether P's passive income is high- taxed, the $10 withholding tax on P's royalty income is allocated to passive income, and within the passive category to the group of income described in paragraph (c)(3)(ii) of this section (passive income subject to a withholding tax of less than 15 percent (but greater than zero)). For purposes of determining whether the income is high-taxed, however, only the foreign source dividend income is taken into account. The foreign source dividend income will still be treated as passive income because the foreign taxes paid on the passive income in the group ($20) do not exceed the highest United States tax rate multiplied by the $85 of net foreign source income in the group ($20 is less than $28.90 ($100 - $15) x .34).

* * * * *

(e) FINANCIAL SERVICES INCOME -- (1) IN GENERAL. The term "financial services income" means income derived by a financial services entity, as defined in paragraph (e)(3) of this section, that is:

(i) Income derived in the active conduct of a banking, insurance, financing, or similar business (active financing income as defined in paragraph (e)(2) of this section), except income described in paragraph (e)(2)(i)(W) of this section (high withholding tax interest);

(ii) Passive income as defined in section 904(d)(2)(A) and paragraph (b) of this section as determined before the application of the exception for high-taxed income;

(iii) Export financing interest as defined in section 904(d)(2)(G) and paragraph (h) of this section that, but for section 904(d)(2)(B)(ii), would also meet the definition of high withholding tax interest; or

(iv) Incidental income as defined in paragraph (e)(4) of this section.

(2) * * *

(i) * * *

(V) Income from a finance lease. For this purpose, a finance lease is any lease that is a direct financing lease or a leveraged lease for accounting purposes and is also a lease for tax purposes. * * * * *

(3) * * *

(i) * * * For purposes of this paragraph, related person is defined in section 1.904-5 (i)(1). * * * * *

(iv) EXAMPLES. * * *

EXAMPLE (1). P is a domestic corporation that owns 100 percent of the stock of S, a controlled foreign corporation incorporated in Country X. For the 1990 taxable year, 60 percent of S's income is active financing income that consists of income that will be considered general limitation or passive income if S is not a financial services entity. The other 40 percent of S's income is passive non-active financing income. S is not a financial services entity and its active financing income thus retains its character as general limitation and passive income. S makes an interest payment to P in 1990 that is characterized under the look-through rules. Although the interest is not financial services income to S under the look-through rules, it retains its character as active financing income when paid to P and P must take that income into account in determining whether it is a financial services entity under paragraph (e)(3)(i) of this section. If P is determined to be a financial services entity, both the portion of the interest payment characterized as active financing income (whether general limitation or passive income in S's hands) and the portion characterized as passive non-active financing income received from S will be recharacterized as financial services income.

EXAMPLE (2). [Reserved]

* * * * *

EXAMPLE (5). P is a United States corporation that is not a financial services entity. P owns 100 percent of the stock of S, a controlled foreign corporation that is not a financial services entity. S owns 100 percent of the stock of T, a controlled foreign corporation that is a financial services entity. In 1991, T pays a dividend to S. The dividend from T is characterized under the look-through rules of section 904(d)(3). Pursuant to paragraph (e)(3)(i) of this section, the dividend from T is excluded in determining whether S is a financial services entity. S is determined not to be a financial services entity but the dividend retains its character as financial services income in S's hands. Any subpart F inclusion or dividend to P out of earnings and profits attributable to the dividend from T will be excluded in determining whether P is a financial services entity but the inclusion or dividend will retain its character as financial services income.

* * * * *

(5) * * *

(i) Export financing interest as defined in section 904(d)(2)(G) and paragraph (h) of this section unless that income would be high withholding tax interest as defined in section 904(d)(2)(B) but for paragraph (d)(2)(B)(ii) of that section;

(ii) High withholding tax interest as defined in section 904(d)(2)(B) unless that income also meets the definition of export financing interest; and

* * * * *

(f) * * * Shipping income does not include any dividends received or accrued from a noncontrolled section 902 corporation, any income that is financial services income, or any income described in section 904(d)(1)(G) (foreign trade income within the meaning of section 923(b)).

(g) * * *

(2) * * *

(iv) TREATMENT OF INCLUSIONS UNDER SECTION 1293. If a foreign corporation is a noncontrolled section 902 corporation with respect to a taxpayer, any inclusion in the taxpayer's gross income under section 1293 with respect to that corporation shall be treated as a dividend from a noncontrolled section 902 corporation and thus shall be subject to a separate limitation.

(3) * * *

(ii) DIVIDEND DISTRIBUTIONS OUT OF EARNINGS AND PROFITS FOR A YEAR DURING WHICH A SHAREHOLDER THAT IS CURRENTLY A MORE-THAN-90- PERCENT UNITED STATES SHAREHOLDER WAS NOT A UNITED STATES SHAREHOLDER. [Reserved]

(iii) ORDERING RULE. [Reserved]

(iv) EXAMPLES. [Reserved] * * * * *

(h) * * * (2) TREATMENT OF EXPORT FINANCING INTEREST. Except as provided in paragraph (h)(3) of this section, if a taxpayer (including a financial services entity) receives or accrues export financing interest from an unrelated person, then that interest shall be treated as general limitation income.

(3) EXCEPTIONS -- (i) EXPORT FINANCING INTEREST THAT IS HIGH WITHHOLDING TAX INTEREST. If a financial services entity receives or accrues export financing interest that would also be high withholding tax interest but for section 904(d)(2)(B)(ii), that income shall be treated as financial services income.

(ii) EXPORT FINANCING INTEREST THAT IS ALSO RELATED PERSON FACTORING INCOME. Export financing interest shall be treated as passive income if that income is also related person factoring income. For this purpose, related person factoring income is --

(A) Income received or accrued by a controlled foreign corporation that is income described in section 864(d)(6) (income of a controlled foreign corporation from a loan for the purpose of financing the purchase of inventory property of a related person); or

(B) Income received or accrued by any person that is income described in section 864(d)(1) (income from a trade receivable acquired from a related person).

(iii) EXPORT FINANCING INTEREST THAT IS RELATED PERSON FACTORING INCOME AND IS RECEIVED OR ACCRUED BY A FINANCIAL SERVICES ENTITY. If a financial services entity receives or accrues export financing interest that is also related person factoring income, then the income shall be treated as financial services income. See section 864(d)(5)(A)(i).

(iv) EXPORT FINANCING INTEREST THAT IS RELATED PERSON FACTORING INCOME AND HIGH WITHHOLDING TAX INTEREST. If any taxpayer (including a financial services entity) receives or accrues export financing interest that is also related person factoring income and high withholding tax interest, then that income shall be treated as high withholding tax interest. See section 864(d)(5)(A)(i).

(4) EXAMPLES. The following examples illustrate the operation of paragraph (h)(3) of this section:

* * * * *

EXAMPLE (2). The facts are the same as in Example (1) except that S is a financial services entity and derives the income in an active financing business. The income derived by S on the receivables is related person factoring income and is also export financing interest. Therefore, pursuant to paragraph (h)(3)(iii) of this section, the income is financial services income to S.

* * * * *

(5) INCOME ELIGIBLE FOR SECTION 864(d)(7) EXCEPTION (SAME COUNTRY EXCEPTION) FROM RELATED PERSON FACTORING TREATMENT -- (i) INCOME OTHER THAN INTEREST. * * * If a financial services entity receives or accrues that income, the income shall not be considered to be export financing interest and, therefore, shall be treated as financial services income.

(ii) INTEREST INCOME. * * * If that interest is received or accrued by a financial services entity, section 904(d)(2)(C)(iii)(III) shall apply and the interest shall be treated as general limitation income. If that interest also would be high withholding tax interest but for section 904(d)(2)(B)(ii), then the interest shall be treated as financial services income.

(iii) EXAMPLES. The following examples illustrate the operation of this paragraph (h)(5):

EXAMPLE (1). Controlled foreign corporation S is a wholly- owned subsidiary of domestic corporation P. Controlled foreign corporation T is a wholly-owned subsidiary of controlled foreign corporation S. S and T are incorporated in Country M. In 1987, P sells tractors to T, which T sells to X, an unrelated foreign corporation organized in country M. The tractors are to be used in country M. T uses a substantial part of its assets in its trade or business located in Country M. T has uncollected trade receivables from X that it factors to S. S derived more than 20 percent of its gross income for 1987 other than from an active financing business and the income derived by S from the receivables is not derived in an active financing business.

Thus, pursuant to paragraph (e)(3)(i) of this section, S is not a financial services entity. The income is not related person factoring income because it is described in section 864(d)(7) (income eligible for the same country exception). If section 864(d)(1) applied, the income S derived from the receivables would meet the definition of export financing interest. The income, therefore, is considered to be export financing interest and is general limitation income to S.

EXAMPLE (2). The facts are the same as in Example (1) except that S is a financial services entity and derives the income on the receivables from the conduct of an active financing business. The income S derives from the receivables is not related person factoring income because it is described in section 864(d)(7). If the income would be high withholding tax interest but for section 904(d)(2)(B)(ii), then the income will not be considered to be export financing interest and will be financial services income to S. Otherwise, the income will considered to be export financing interest and will be general limitation income to S.

* * * * *

EXAMPLE (4). The facts are the same as in Example (3) except that S is a financial services entity and derives the interest on the loan to X in an active financing business. The interest S earns is export financing interest that is not described in section 864(d)(1) because it is described in section 864(d)(7). Because the interest is described in section 864(d)(7) and is export financing interest, section 904(d)(2)(C)(iii)(III) shall apply and the income shall be general limitation income to S, unless it would also be high withholding tax interest but for section 904(d)(2)(B)(ii), in which case it will be financial services income to S.

* * * * *

(k) SPECIAL RULE FOR ALTERNATIVE MINIMUM TAX FOREIGN TAX CREDIT.

For purposes of computing the alternative minimum tax foreign tax credit under section 59(a), items included in alternative minimum taxable income by reason of section 56(g) (adjustments based on adjusted current earnings) shall be characterized as income described in a separate category under section 904(d) and this section based on the character of the underlying items of income.

(1) PRIORITY RULES -- (1) IN GENERAL. In the case of income that meets the definitions of more than one category of separate limitation income, the following priority rules apply:

(i) Income that meets the definitions of passive income and of any other separate limitation income described in section 904(d)(1)(B) through (H) will be subject to the other separatelimitation;

(ii) Income that meets the definitions of financial services income and of either shipping income or passive income will be subject to the separate limitation for financial services income;

(iii) Income that meets the definitions of financial services income and of any separate limitation income other than shipping or passive income will be subject to the other separate limitation;

(iv) Income that meets the definitions of dividends from a noncontrolled section 902 corporation and of any other separate limitation income will be subject to the separate limitation for dividends from a noncontrolled section 902 corporation unless that income is foreign oil and gas extraction income defined in section 907(c), in which case it will be treated as general limitation income pursuant to section 1.907(a)-1(f);

(v) Income that meets the definitions of high withholding tax interest and of any other separate limitation income will be high withholding tax interest; and (vi) Income that meets the definitions of shipping income and of foreign trade income will be subject to the separate limitation for foreign trade income.

(2) EXAMPLES. The provisions of this paragraph (1) are illustrated by the following examples:

EXAMPLE (1). Controlled foreign corporation S is a wholly- owned subsidiary of domestic corporation P. S owns 20 percent of the voting stock of T, a foreign corporation that is not a controlled foreign corporation. In 1987, T pays S a dividend that qualifies as foreign base company shipping income to S under section 1.954-6(f)(1). The dividend from T is also a dividend from a noncontrolled section 902 corporation.

Therefore, pursuant to section 904(d)(2)(D) and paragraph (1)(1)(iv) of this section, the dividend from T is treated as a dividend from a noncontrolled section 902 corporation.

EXAMPLE (2). In 1987, domestic corporation P received a dividend from R, a foreign corporation that is not a controlled foreign corporation. P owns 30 percent of the voting stock of R. P is a financial services entity and the dividend from R qualifies as financial services income under paragraph (e)(4)(i)(A) of this section. The dividend from R is also a dividend from a noncontrolled section 902 corporation. Therefore, pursuant to section 904(d)(2)(C)(iii)(II) and paragraphs (1)(1)(iii) and (iv) of this section, the dividend from R is treated as a dividend from a noncontrolled section 902 corporation.

EXAMPLE (3). P, a domestic corporation, owns 10 percent of foreign corporation S. S is a noncontrolled section 902 corporation. In 1990, S earns foreign oil and gas extraction income which is general limitation income. S pays a dividend to

P out of its earnings and profits for 1990. The dividend from S is a dividend from a noncontrolled section 902 corporation that is also foreign oil and gas extraction income. Pursuant to section 907(c)(3)(A), section 1.907(a)-1(f) and paragraph (1)(1)(iv) of this section, P will include the dividend in income as general limitation income.

Par. 4. Section 1.904-5 is amended as follows:

1. Paragraph (a) is amended by:

a. Removing the language "this section" in the introductory text and adding in its place "the regulations under section 904"; and

b. Removing the language "section 1504(a)(2)" the first time it appears in the last sentence of paragraph (a)(3) and adding in its place "section 1504(a)(1)".

2. Paragraph (b) is amended by removing the language "section 904(d)(3)" and adding in its place "section 904(d)(2)(E) and (3)".

3. Paragraph (c)(1)(i) is amended by removing the last sentence and adding two new sentences in its place.

4. In paragraph (c)(1)(ii), text is added to Example (2) and Example (3), Example (4) is redesignated Example (5), and a new Example (4) is added.

5. Paragraph (c)(2)(i) is revised. 6. Paragraph (c)(2)(ii) is amended by:

a. Revising the heading;

b. Revising the introductory text;

c. Revising paragraph (c)(2)(ii)(B); d. Revising paragraphs (c)(2)(ii)(D) and (E).

7. Paragraph (c)(2)(iii)(A) is amended by removing "section 1.861-8" in the first sentence and adding in its place "section 1.861-9T(g)"; by removing "section 1.861-8" in the second sentence and adding in its place "section 1.861-10T(d)(2)"; and by removing "section 1.861-8" in the last sentence and adding in its place "section 1.861-9T(g)(2)".

8. Paragraph (c)(2)(iv) Example (1) is amended by:

a. Removing the language "allocate" in the last sentence of Example (1)(i) and adding "apportion" in its place; and

b. Removing the language "allocable" in the third sentence of Example (1)(ii) and adding "apportioned" in its place, and removing the language "allocated" in the fifth and sixth sentences and adding "apportioned" in its place.

9. Paragraph (c)(2)(iv) Example (2) is amended by removing the language "for allocating" in the first sentence and adding "to apportion" in its place, and by removing the language "allocated" each place it appears in the second and third sentences and adding "apportioned" in its place.

10. Paragraph (c)(2)(iv) Example (3) is amended by:

a. Removing the language "allocated" in the last sentence of Example (3)(i) and adding "apportioned" in its place; and

b. Revising Example (3)(iii) and (iv).

11. Paragraph (c)(2)(iv) Example (4) is amended by:

a. Removing in Example (4)(i) the language "section 1.861-8" and adding in its place "sections 1.861-8 through 1.861-14T", and removing the language "allocate" in the last two sentences and adding in its place "apportion";

b. Removing in Example (4)(ii) the language "(c)(2)(ii)(B)" and adding "(c)(2)(ii)(C)", and by removing the language "allocated" in the second sentence and adding "apportioned" in its place; and

c. Removing in Example (4)(iii) the language "allocated" each place it appears and adding "apportioned" in its place and by removing the language "allocable" in the last sentence and adding "apportioned" in its place.

12. Paragraph (c)(2)(iv) Example (5) is amended by removing the language "allocate" in the first sentence and adding "apportion" in its place, and by removing the language "allocated" in the third and fourth sentences and adding "apportioned" in its place.

13. Paragraph (c)(3) is amended by removing "section 1.861-8" and adding in its place "sections 1.861-8 through 1.861-14T".

14. Paragraph (c)(4)(ii) is amended by removing the reference "paragraph (i) of this section" in the first sentence and adding in its place "section 1.904-5(i)".

15. Paragraph (c)(4)(iii) Example (1) is revised.

16. Paragraph (d) is amended by:

a. Revising paragraph (d)(1);

b. Removing in paragraph (d)(2) the reference "section 1.904-4(k)" and adding "section 1.904-4(1)"; and

c. In paragraph (d)(3), adding text to Example (1) and Example (2).

17. Paragraph (e)(1) is amended by inserting "or gross insurance income (whichever is appropriate)" in the first sentence after "foreign base company income" the second time it appears.

18. Paragraph (f)(1) is amended by adding after the first sentence "See section 904(d)(3)(H).".

19. Paragraph (f)(2) is amended by designating the text after the heading as paragraph (f)(2)(i); by adding a heading to newly designated paragraph (f)(2)(i); and adding a new paragraph (f)(2)(ii).

20. Paragraph (f)(3) is revised.

21. Paragraph (g) is revised.

22. Paragraph (h)(3) is revised.

23. Paragraph (i)(1) is amended by removing the first sentence and adding a new sentence in its place.

24. Paragraph (i)(3), the heading is revised and the paragraph is reserved.

25. Paragraph (i)(4) is added.

26. Paragraph (j) is revised.

27. Paragraph (k)(1) is revised.

28. Paragraph (l) is amended by:

a. Adding in Example (1), the eighth sentence, after the word "because" the language "S and T are related look-through entities within the meaning of paragraph (i)(1) of this section and, therefore,";

b. Adding text to Example (2) and Example (5);

c. Amending Example (8)(i), in the second sentence, by adding the word "company" after the word "holding";

d. Amending Example (10)(iii), in the second sentence, by removing the language "(g)" and adding in its place "(c)(1)(i)"; and

e. Adding Example (11).

29. Paragraph (m)(2) is amended by removing the last two sentences and adding two new sentences in their place.

30. Paragraph (m)(3) Example (4), the third paragraph, is amended by removing "$16" each place it appears and adding "$19" in its place.

31. Paragraph (m)(7) is revised.

32. The revised, reserved and added provisions read as follows:

SECTION 1.904-5 LOOK-THROUGH RULES AS APPLIED TO CONTROLLED FOREIGN CORPORATIONS AND OTHER ENTITIES.

* * * * *

(c) * * *

(1) * * * (i) * * * For purposes of this section 1.904-5, income shall be characterized under the rules of section 1.904-4 prior to the application of the rules of paragraph (c) of this section. For rules concerning inclusions under section 951(a)(1)(B), see paragraph (c)(4)(i) of this section.

(ii) * * *

EXAMPLE (2). Controlled foreign corporation S is a wholly- owned subsidiary of domestic corporation P. S is a financial services entity. P manufactures cars and is not a financial services entity. In 1987, S earns $200 of interest income unrelated to its banking business and $900 of interest income related to its banking business. Assume that S pays no foreign taxes and has no expenses. All of S's income is included in P's gross income as foreign personal holding company income. Because S is a financial services entity, income that would otherwise be passive income is considered to be financial services income. P, therefore, treats the entire subpart F inclusion as financial services income.

EXAMPLE (3). Controlled foreign corporation S is a wholly- owned subsidiary of domestic corporation P. P is a financial services entity. S manufactures cars and is not a financial services entity. In 1987, S earns $200 of passive income that is subpart F income and $900 of general limitation non-subpart F income. Assume that S pays no foreign taxes on its passive earnings and has no expenses. P includes the $200 of subpart F income in gross income. Because P is a financial services entity, the inclusion will be financial services income to P.

EXAMPLE (4). Controlled foreign corporation S is a wholly- owned subsidiary of domestic corporation P. Neither P nor S is a financial services entity. Controlled foreign corporation T is a wholly-owned subsidiary of controlled foreign corporation S. T is a financial services entity. In 1991, T pays a dividend to S. For purposes of determining whether S is a financial services entity under section 1.904-4(e)(3)(i), the dividend from T is ignored. For purposes of characterizing the dividend in S's hands under the look-through rules of paragraph (c)(4) of this section, however, the dividend retains its character as financial services income. Similarly, any subpart F inclusion or dividend to P out of the earnings and profits attributable to the dividend from S is excluded in determining whether P is a financial services entity under section 1.904-4(e)(3)(i), but retains its character in P's hands as financial services income under paragraph (c)(4) of this section.

* * * * *

(2) INTEREST -- (i) IN GENERAL. For purposes of this paragraph, related person interest is any interest paid or accrued by a controlled foreign corporation to any United States shareholder in that corporation (or to any other related person) to which the look- through rules of section 904(d)(3) and this section apply. Unrelated person interest is all interest other than related person interest.

Related person interest shall be treated as income in a separate category to the extent it is allocable to income of the controlled foreign corporation in that category. If related person interest is received or accrued from a controlled foreign corporation by two or more persons, the amount of interest received or accrued by each person that is allocable to any separate category of income shall be determined by multiplying the amount of related person interest allocable to that separate category of income by a fraction. The numerator of the fraction is the amount of related person interest received or accrued by that person and the denominator is the total amount of related person interest paid or accrued by the controlled foreign corporation.

(ii) ALLOCATING AND APPORTIONING EXPENSES INCLUDING INTEREST PAID TO A RELATED PERSON. Related person interest and other expenses of a controlled foreign corporation shall be allocated and apportioned in the following manner:

* * * * *

(B) Any expenses that are definitely related to less than all of gross income as a class, including unrelated person interest that is directly allocated to income from a specific property, shall be allocated and apportioned under the principles of sections 1.861-8 or 1.861-10T, as applicable, to income in each separate category;

* * * * *

(D) To the extent that related person interest exceeds passive foreign personal holding company income as determined after the application of paragraphs (c)(2)(ii)(B) and (C) of this section, the related person interest shall be apportioned under the rules of this paragraph to separate categories other than passive income.

(1) If under section 1.861-9T, the modified gross income method of apportioning interest expense is elected, related person interest shall be apportioned as follows:

 Related                                 Related person interest

 Related                                  Related person interest

(1) If under section 1.861-9T, the modified gross income method of apportioning interest expense is elected, the interest expense shall be apportioned as follows: Expense apportionable to a separate category =

 Gross income in a separate category

 Expense apportionable to a separate category =

* * * * *

(iv) * * *

EXAMPLE (3). * * *

(iii) Under paragraph (c)(2)(ii)(E) of this section, the non-interest expenses that are not definitely related are apportioned on the basis of the asset values reduced by the allocated related person debt. Therefore, $10 of these expenses are apportioned to the passive category ($50 X ($2000 - $1500)/($4000 - $1500)) and $40 are apportioned to the general limitation category ($50 X $2000/($4000-$1500)).

(iv) In order to apportion third person interest between the categories of assets, the value of assets in a separate category must also be reduced under the principles of section 1.861-8 by the indebtedness relating to the specifically allocated interest. Therefore, under paragraph (c)(2)(iii)(B) of this section, the value of assets in the passive category for purposes of apportioning the additional third person interest = O ($2000 minus $500 (the principal amount of the debt, the interest payment on which is directly allocated to specific interest producing properties) minus $1500 (the related person debt allocated to passive assets)). Under paragraph (c)(2)(ii)(E) of this section, all $100 of the non-definitely related third person interest is apportioned to the general limitation category ($100 = $100 X $2000/($4000 - $500 - $1500)).

* * * * *

(4) * * *

(iii) * * *

EXAMPLE (1). Controlled foreign corporation S is a wholly- owned subsidiary of P, a domestic corporation. In 1987, S has earnings and profits of $1,000, $600 of which is attributable to general limitation income and $400 of which is attributable to dividends received by S from its wholly-owned subsidiary, T. T is a controlled foreign corporation and is incorporated and operates in the same country as S. All of T's income is financial services income. Neither S's general limitation income nor the dividend from T is subpart F income. In December 1987, S pays a dividend to P of $200, all of which is attributable to earnings and profits earned in 1987. Six-tenths of the dividend ($120) is treated as general limitation income because six- tenths of S's earnings and profits are attributable to general limitation income. Four-tenths of the dividend ($80) is treated as financial services income because four-tenths of S's earnings and profits are attributable to dividends from T, and all of T's earnings are financial services income.

* * * * *

(d) EFFECT OF EXCLUSIONS FROM SUBPART F INCOME -- (1) DE MINIMIS AMOUNT OF SUBPART F INCOME. If the sum of a controlled foreign corporation's gross foreign base company income (determined under section 954(a) without regard to section 954(b)(5)) and gross insurance income (determined under section 953(a)) for the taxable year is less than the lesser of 5 percent of gross income or $1,000,000, then all of that income (other than income that would be financial services income without regard to this paragraph (d)(1)) shall be treated as general limitation income. In addition, if the test in the preceding sentence is satisfied, for purposes of paragraphs (c)(2)(ii)(D) and (E) of this section (apportionment of interest expense to passive income using the asset method), any passive limitation assets shall be treated as general limitation assets. The determination in the first sentence shall be made prior to the application of the exception for certain income subject to a high rate of foreign tax described in paragraph (d)(2) of this section.

* * * * *

(3) * * *

EXAMPLE (1). Controlled foreign corporation S is a wholly- owned subsidiary of P, a domestic corporation. In 1987, S earns $100 of gross income, $4 of which is interest that is subpart F foreign personal holding company income and $96 of which is gross manufacturing income that is not subpart F income. S has no other earnings for 1987. S has no expenses and pays no foreign taxes. S pays P a $100 dividend. Under the de minimis rule of section 954(b)(3), none of S's income is treated as foreign base company income. All of S's income, therefore, is treated as general limitation income. The entire $100 dividend is general limitation income to P.

EXAMPLE (2). (i) Controlled foreign corporation S is a wholly-owned subsidiary of P, a domestic corporation. In 1987, S earns $50 of shipping income of a type that is foreign base company shipping income. S also earns $50 of dividends from T, a foreign corporation in which S owns 45 percent of the voting stock, and receives $50 of dividends from U, a foreign corporation in which S owns 5% of the voting stock. Foreign persons hold the remaining voting stock of both T and U. S, T, and U are all incorporated in different foreign countries. The dividends S receives from T and U are of a type that normally would be subpart F foreign personal holding company income that is passive income. Under section 1.904-4(l)(1)(iv), however, the dividends from T are dividends from a noncontrolled section 902 corporation rather than passive income. S has no expenses. The earnings and profits of S are equal to the net income after taxes of S. The dividends and the shipping income are taxed abroad by S's country of incorporation at an effective rate of 40 percent. P establishes to the satisfaction of the Secretary that the effective rate of tax on both the dividends and the shipping income exceeds 90 percent of the maximum United States tax rate. Thus, under section 954(b)(4), neither the shipping income nor the dividends are taxed currently to P under subpart F. S's earnings attributable to shipping income and dividends from a noncontrolled section 902 corporation retain their character as such. Under paragraph (d)(2) of this section, S's earnings attributable to the dividends from U are treated as earnings attributable to general limitation income. See sections 1.905-3T and 1.905-4T, however, for rules concerning adjustments to the pools of earnings and profits and foreign taxes and redeterminations of United States tax liability when foreign taxes are refunded in a later year.

(ii) In 1988, S has no earnings and pays a $150 dividend (including gross-up) to P. The dividend is paid out of S's post- 1986 pool of earnings and profits. One-third of the dividend ($50) is attributable to S's shipping earnings, one-third ($50) is attributable to the dividend from T, and one-third ($50) is attributable to the dividend from U. Pursuant to section 904(d)(3)(E) and paragraph (c)(4) of this section, one-third of the dividend is shipping income, one-third is a dividend from a noncontrolled section 902 corporation, T, and one-third is general limitation income to P.

* * * * *

(f) * * *

(2) * * * -- (i) RULE. * * *

(ii) EXAMPLE. The following example illustrates the provisions of this paragraph (f)(2).

EXAMPLE. P, a domestic corporation, owns 40 percent of S, a controlled foreign corporation. U, an unrelated domestic corporation, owns the remaining 60 percent of S. S owns 10 percent of T, a noncontrolled section 902 corporation. In 1990, T pays S a dividend, which S includes in its gross income as a dividend from a noncontrolled section 902 corporation. S has no other income during 1990. P and U must include S's dividend income from T in their gross income under subpart F. Pursuant to section 1.904-4(g)(2)(ii)(C), the subpart F inclusion to U is characterized as a dividend from a noncontrolled section 902 corporation because U meets the 5 percent ownership requirement of section 902(b) (60% x 10% = 6%). The subpart F inclusion to P is characterized as passive income because P does not meet the 5 percent ownership requirement of section 902(b) (40% x 10% = 4%).

(3) DISTRIBUTIONS FROM A FSC. Income received or accrued by a taxpayer that, under the rules of paragraph (c)(4) of this section (look-through rules for dividends), would be treated as foreign trade income or as passive income that is interest and carrying charges (as defined in section 927(d)(1)), and that is also a distribution from a FSC (or a former FSC), shall be treated as a distribution from a FSC (or a former FSC).

* * * * *

(g) APPLICATION OF LOOK-THROUGH RULES TO CERTAIN DOMESTIC CORPORATIONS. The principles of section 904(d)(3) and this section shall apply to any foreign source interest, rents and royalties paid by a United States corporation to a related corporation. For this purpose, a United States corporation and another corporation are considered to be related if one owns, directly or indirectly, stock possessing 50 percent or more of the total voting power of all classes of stock of the other corporation or 50 percent or more of the total value of the other corporation. In addition, a United States corporation and another corporation shall be considered to be related if the same United States shareholders own, directly or indirectly, stock possessing 50 percent or more of the total voting power of all classes of stock or 50 percent of the total value of each corporation. For purposes of this paragraph, the constructive stock ownership rules of section 318 and the regulations under that section apply.

(h) * * *

(3) INCOME FROM THE SALE OF A PARTNERSHIP INTEREST. To the extent a partner recognizes gain on the sale of a partnership interest, that income shall be treated as passive income to the partner, unless the income is considered to be high-taxed under section 904(d)(2)(A)(iii)(III) and section 1.904-4 (c).

* * * * *

(i) * * * (1) * * * Except as provided in paragraphs (i)(2) and (3) of this section, the principles of this section shall apply to distributions and payments that are subject to the look-through rules of section 904(d)(3) and this section from a controlled foreign corporation or other entity otherwise entitled to look-through treatment (a "look-through entity") under this section to a related look-through entity. * * *

* * * * *

(3) SPECIAL RULE FOR DIVIDENDS. [Reserved]

(4) EXAMPLES. The following examples illustrate the provisions of this paragraph (i):

EXAMPLE (1). P, a domestic corporation, owns all of the stock of S, a controlled foreign corporation. S owns 40 percent of the stock of T, a controlled foreign corporation. The remaining 60 percent of the stock of T is owned by V, a domestic corporation. The percentages of value of T owned by S and V correspond to their percentages of stock ownership. T owns all of the stock of U, a controlled foreign corporation. U earns exclusively general limitation non-subpart F income. In 1992, U makes an interest payment of $100 to T, which is subpart F income to P and V. Vand T are related look-through entities, but P and T are not related look-through entities. V, therefore, is entitled to look-through treatment on the interest payment to T and the payment will be treated as general limitation income. P is not entitled to look-through treatment (because P, through S, owns only 40 percent of T) and the interest payment, therefore, is passive income to P.

EXAMPLE (2). [Reserved]

(j) LOOK-THROUGH RULES APPLIED TO PASSIVE FOREIGN INVESTMENT COMPANY INCLUSIONS. If a passive foreign investment company is a controlled foreign corporation and the taxpayer is a United States shareholder in that passive foreign investment company, any amount included in gross income under section 1293 shall be treated as income in a separate category to the extent the amount so included is attributable to income received or accrued by that controlled foreign corporation that is described as income in the separate category. For purposes of this paragraph (j), the priority rules of section 1.904-4(1) shall apply prior to the application of the rules of this paragraph.

(k) * * * (1) IN GENERAL. Income received or accrued by a related person to which the look-through rules apply is characterized before amounts included from, or paid or distributed by that person and received or accrued by a related person. For purposes of determining the character of income received or accrued by a person from a related person if the payor or another related person also receives or accrues income from the recipient and the look-through rules apply to the income in all cases, the rules of paragraph (k)(2) of this section apply.

* * * * *

(1) * * *

EXAMPLE (2). The facts are the same as in Example (1) except that instead of earning $100 of general limitation foreign base company sales income, S earns $100 of foreign personal holding company income that is passive income. Although the interest payment to T would otherwise be passive income, T is a financial services entity and, under section 1.904-4(e)(1), the income is treated as financial services income in T's hands. Thus, P's entire $350 section 951 inclusion consists of financial services income.

* * * * *

EXAMPLE (5). P has a 25 percent interest in partnership PS that he sells to X for $110. P's basis in his partnership interest is $35. P recognizes $75 of gain on the sale of its partnership interest and is subject to no foreign tax. Under paragraph (h)(3) of this section, the gain is treated as passive income.

* * * * *

EXAMPLE (11). P, a domestic corporation, owns 100 percent of the stock of S, a controlled foreign corporation, and S owns 100 percent of the stock of T, a controlled foreign corporation. P also owns 100 percent of the stock of U, a controlled foreign corporation. In 1991, T earns $100 of general limitation income that is not subpart F income and distributes the entire amount to S as a dividend. S earns $100 of passive foreign personal holding company income and the $100 dividend from T. S pays $100 of interest to U. U earns $200 of general limitation income that is foreign base company income and $100 of interest income from S. This transaction does not involve circular payments and, therefore, the ordering rules of paragraph (k)(2) of this section do not apply. Instead, pursuant to paragraph (k)(1) of this section, income received is characterized first. T's earnings and, thus, the dividend from T to S are characterized first. S includes the $100 dividend from T in gross income as general limitation income because all of T's earnings are general limitation income. S thus has $100 of passive foreign personal holding company income and $100 of general limitation income. The interest payment to U is then characterized as $100 passive income under paragraph (c)(2)(ii)(C) of this section (allocation of related person interest to passive foreign personal holding company income). For 1991, U thus has $200 of general limitation income that is subpart F income, and $100 of passive foreign personal holding company income. For 1991, P includes in its gross income $200 of general limitation subpart F income from U, $100 of passive subpart F income from U (relating to the interest payment from S to U), and $100 of general limitation subpart F income from S (relating to the dividend from T to S).

(m) * * *

(2) * * *

For purposes of this paragraph, the value of assets in a separate category is the value of assets as determined under the principles of section 1.861-9T(g). See section 1.861-10T(d)(2) for purposes of determining the value of assets and gross income in a separate category as reduced for indebtedness the interest on which is directly allocated.

* * * * *

(7) COORDINATION WITH TREATIES -- (i) RULE. If any amount of income derived from a United States-owned foreign corporation, as defined in section 904(g)(6), would be treated as derived from sources within the United States under section 904(g) and this paragraph (m) and, pursuant to an income tax convention with the United States, the taxpayer chooses to avail itself of benefits of the convention that treat that amount as arising from sources outside the United States under a rule explicitly treating the income as foreign source, then that amount will be treated as foreign source income. However, sections 904 (a), (b), (c), (d) and (f), 902, 907, and 960 shall be applied separately to amounts described in the preceding sentence with respect to each treaty under which the taxpayer has claimed benefits and, within each treaty, to each separate category of income.

(ii) EXAMPLE. The following example illustrates the application of this paragraph (m)(7).

EXAMPLE. Controlled foreign corporation S is incorporated in Country A and is a wholly-owned subsidiary of P, a domestic corporation. In 1990, S earns $80 of foreign base company sales income in Country A which is general limitation income and $40 of U.S. source interest income. S incurs $20 of expenses attributable to its sales business. S pays P $40 of interest that is allocated to U.S. source passive income under paragraphs (c)(2)(ii)(C) and (m)(2) of this section. Assume that earnings and profits equal net income. All of S's net income of $60 is includible in P's gross income under subpart F (section 951(a)(1)). For 1990, P also has $100 of passive income derived from investments in Country B. Pursuant to section 904(g)(3) and paragraph (m)(2) of this section, the $40 interest payment from S is United States source income to P because it is attributable to United States source interest income of S. The United States- Country A income tax treaty, however, treats all interest payments by residents of Country A as Country A sourced and P elects to apply the treaty. Pursuant to section 904(g)(10) and this paragraph (m)(7), the entire interest payment will be treated as foreign source income to P. P thus has $60 of foreign source general limitation income, $40 of foreign source passive income from S, and $100 of other foreign source passive income. In determining P's foreign tax credit limitation on passive income, the passive income from Country A shall be treated separately from any other passive income.

* * * * *

Par. 5. Section 1.904-6 is amended as follows:

1. The section heading for section 1.904-6 is revised.

2. The heading for paragraph (a) is revised.

3. Paragraph (a)(1)(ii) is amended by removing the reference "section 1.861-8" in the three places it now appears and adding in its place "sections 1.861-8 through 1.861-14T", and by adding the language "and apportioning" after "allocating" and before "such" in the seventh sentence.

4. Paragraph (a)(1)(iv) is added.

5. Paragraph (a)(2) is revised.

6. Paragraph (b)(1), in the last sentence, is amended by removing "of" after "foreign taxes deemed paid" and adding "by".

7. Paragraph (b)(2)(i) is revised.

8. Paragraph (c) is amended by:

a. Removing in Example (1), in the fourth sentence, the reference "section 1.861-8" and adding in its place sections 1.861-8 through 1.861-14T";

b. Removing in Example (1), in the fifth sentence, the language "allocates" and adding "apportions" in its place;

c. Removing the last two sentences in Example (5) and adding two new sentences in their place;

d. Removing the language "$25" in the first parenthetical in Example (6) and adding "$50" in its place; and

e. Revising the introductory text of Example (8).

9. The added and revised provisions read as follows:

SECTION 1.904-6 ALLOCATION AND APPORTIONMENT OF TAXES.

(a) ALLOCATION AND APPORTIONMENT OF TAXES TO A SEPARATE CATEGORY OR CATEGORIES OF INCOME -- (1) * * *

(iv) SPECIAL RULE FOR BASE AND TIMING DIFFERENCES. If, under the law of a foreign country or possession of the United States, a tax is imposed on an item of income that does not constitute income under United States tax principles, that tax shall be treated as imposed with respect to general limitation income. If, under the law of a foreign country or possession of the United States, a tax is imposed on an item that would be income under United States tax principles in another year, that tax will be allocated to the appropriate separate category or categories as if the income were recognized under United States tax principles in the year in which the tax was imposed.

(2) TREATMENT OF CERTAIN DIVIDENDS FROM NONCONTROLLED SECTION 902 CORPORATIONS. If a taxpayer receives or accrues a dividend from a noncontrolled section 902 corporation, and if the Commissioner establishes that there is an agreement, express or implied, that such dividend is paid out of the passive earnings or high withholding tax interest income of the foreign corporation, then only the foreign taxes imposed on passive income or high withholding tax interest income of the noncontrolled section 902 corporation will be considered to be taxes related to the dividend. For an illustration of this rule, see paragraph (c) Example (7) of this section.

(b) * * *

(2) * * *

(i) Any portion of a distribution received from a first-tier corporation by a domestic corporation or individual that is excluded from the domestic corporation's or individual's income under section 959(a) and section 1.959-1; and

* * * * *

(c) * * *

EXAMPLE (5). * * * For U.S. purposes, the income is not characterized as a dividend but as a repayment of a bona fide debt and, therefore, the $50 of income is not required to be recognized by R in 1988. The $10 of tax is treated as a tax paid in 1988 on the $50 of passive income included by R in 1987 pursuant to the section 482 adjustment rather than as a tax associated with a dividend from a noncontrolled section 902 corporation. The $10 tax is a tax imposed on passive income under paragraph (a)(1)(iv) of this section.

* * * * *

EXAMPLE (8). Domestic corporation P owns all of the stock of controlled foreign corporation S, which owns all of the stock of controlled foreign corporation T. All such corporations use the calendar year as the taxable year. Assume that earnings and profits are equal to net income and that the income amounts are identical under United States and foreign law principles. In 1987, T earns (before foreign taxes) $187.50 of net passive income and $62.50 of net general limitation income and pays $50 of foreign taxes. S earns no income in 1987 and pays no foreign taxes. For 1987, P is required under section 951 to include in gross income $175 attributable to the earnings and profits of T for that year. One hundred and fifty dollars ($150) of the subpart F inclusion is attributable to passive income earned by T, and $25 of the subpart F inclusion is attributable to general limitation income earned by T. In 1988, T earns no income and pays no foreign taxes. T pays a $200 dividend to S, consisting of $175 from its earnings and profits attributable to amounts required to be included in P's gross income with respect to T and $25 from its other earnings and profits. Assume that no withholding tax is imposed with respect to the distribution from T to S. In 1988, S earns $100 of net general limitation income and receives a $200 dividend from T. S pays $30 in foreign taxes. For 1988, P is required under section 951 to include in gross income $22.50 attributable to the earnings and profits of S for such year. The entire subpart F inclusion is attributable to general limitation income earned by S. In 1988, S pays P a dividend of $247.50, consisting of $157.50 from its earnings and profits attributable to the amount required under section 951 to be included in P's gross income with respect to T, $22.50 from its earnings and profits attributable to the amount required under section 951 to be included in P's gross income with respect to S, and $67.50 from its other earnings and profits. Assume the de minimis rule of section 954(b)(3)(A) and the full inclusion rule of section 954(b)(3)(B) do not apply to the gross amounts of income earned by S and T. The foreign income taxes deemed paid by P for 1987 and 1988 under section 960(a)(1) and section 902(a) are determined as follows on the basis of the following facts and computations.

* * * * *

Par. 6. Section 1.904-7 is amended as follows:

1. Paragraph (a) is revised as set forth below.

2. Paragraph (c) is amended by removing the reference "453(A)" and adding in its place "453A".

3. Paragraph (d) is amended by removing the reference "section 1.904-6(d)" and adding in its place "section 1.904-4(d)".

SECTION 1.904-7 TRANSITION RULES.

(a) CHARACTERIZATION OF DISTRIBUTIONS AND SECTION 951 (a)(1)(A)(ii) AND (iii) AND (B) INCLUSIONS OF EARNINGS OF A CONTROLLED FOREIGN CORPORATION ACCUMULATED IN TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1987, DURING TAXABLE YEARS OF BOTH THE PAYOR CONTROLLED FOREIGN CORPORATION AND THE RECIPIENT WHICH BEGIN AFTER DECEMBER 31, 1986 -- (1) DISTRIBUTIONS AND SECTION 951(a)(1)(A)(ii) AND (iii) AND (B) INCLUSIONS. Earnings accumulated in taxable years beginning before January 1, 1987, by a foreign corporation that was a controlled foreign corporation when such earnings were accumulated are characterized in that foreign corporation's hands under section 904(d)(1)(A) (separate limitation interest income) or section 904(d)(1)(E) (general limitation income) (prior to their amendment by the Tax Reform Act of 1986 (the Act)) after application of the de minimis rule of former section 904(d)(3)(C) (prior to its amendment by the Act). When, in a taxable year after the effective date of the Act, earnings and profits attributable to such income are distributed to, or included in the gross income of, a United States shareholder under section 951(a)(1)(A)(ii) or (iii) or (B) (hereinafter in this section "inclusions"), the ordering rules of section 904(d)(3)(D) and section 1.904-5(c)(4) shall be applied in determining initially the character of the income of the distributee or United States shareholder. Thus, a proportionate amount of a distribution described in this paragraph initially will be characterized as separate limitation interest income in the hands of the distributee based on the ratio of the separate limitation interest earnings and profits out of which the dividend was paid to the total earnings and profits out of which the dividend was paid. The distribution or inclusions must then be recharacterized in the hands of the distributee or United States shareholder on the basis of the following principles:

(i) Distributions and inclusions that initially are characterized as separate limitation interest income shall be treated as passive income;

(ii) Distributions and inclusions that initially are characterized as old general limitation income shall be treated as general limitation income, unless the taxpayer establishes to the satisfaction of the Commissioner that the distribution or inclusion is attributable to:

(A) Earnings and profits accumulated with respect to shipping income, as defined in section 904(d)(2)(D) and section 1.904-4(f); or

(B) In the case of a financial services entity, earnings and profits accumulated with respect to financial services income, as defined in section 904(d)(2)(C)(ii) and section 1.904-4(e)(1); or

(C) Earnings and profits accumulated with respect to high withholding tax interest, as defined in section 904(d)(2)(B) and section 1.904-4(d).

(2) LIMITATION ON ESTABLISHING THE CHARACTER OF EARNINGS AND PROFITS. In order for a taxpayer to establish that distributions or inclusions that are attributable to general limitation earnings and profits of a particular taxable year beginning before January 1, 1987, are attributable to shipping, financial services or high withholding tax interest earnings and profits, the taxpayer must establish the amounts of foreign taxes paid or accrued with respect to income attributable to those earnings and profits that are to be treated as taxes paid or accrued with respect to shipping, financial services or high withholding tax interest income, as the case may be, under section 904(d)(2)(I). Conversely, in order for a taxpayer to establish the amounts of general limitation taxes paid or accrued in a taxable year beginning before January 1, 1987, that are to be treated as taxes paid or accrued with respect to shipping, financial services or high withholding tax interest income, as the case may be, the taxpayer must establish the amount of any distributions or inclusions that are attributable to shipping, financial services or high withholding tax interest earnings and profits. For purposes of establishing the amounts of general limitation taxes that are to be treated as taxes paid or accrued with respect to shipping, financial services or high withholding tax interest income, the principles of section 1.904-6 shall be applied.

* * * * *

Par. 7. Section 1.905-2 is amended as follows:

1. Paragraph (c) is removed.

2. Paragraph (d) is redesignated as paragraph (c).