Sec. 1.865-2 Loss with respect to stock.

Example 1. (i) P, a domestic corporation, is a United States shareholder of N, a controlled foreign corporation. N has never had any subpart F income and all of its earnings and profits are described in section 959(c)(3). On May 5, 1998, N distributes a dividend to P in the amount of $100. The dividend gives rise to a $5 foreign withholding tax, and P is deemed to have paid an additional $45 of foreign income tax with respect to the dividend under section 902. Under the look-through rules of section 904(d)(3) the dividend is general limitation income described in section 904(d)(1)(I).

(ii) On February 6, 2000, P sells its shares of N and recognizes a $110 loss. In 2000, P has the following taxable income, excluding the loss on the sale of N:

(A) $1,000 of foreign source income that is general limitation income described in section 904(d)(1)(I);

(B) $1,000 of foreign source capital gain from the sale of stock in a foreign affiliate that is sourced under section 865(f) and is passive income described in section 904(d)(1)(A); and

(C) $1,000 of U.S. source income.

(iii) The $100 dividend paid in 1998 is a dividend recapture amount that was included in P's income within the recapture period preceding the disposition of the N stock. The de minimis exception of paragraph (b)(1)(ii) of this section does not apply because the $100 dividend recapture amount exceeds 10 percent of the $110 loss. Therefore, to the extent of the $100 dividend recapture amount, the loss must be allocated under paragraph (b)(1)(i) of this section to the separate limitation category to which the dividend was assigned (general limitation income).

(iv) P's remaining $10 loss on the disposition of the N stock is allocated to U.S. source income under paragraph (a)(1) of this section.

(v) After allocation of the stock loss, P's foreign source taxable income in 2000 consists of $900 of foreign source general limitation income and $1,000 of foreign source passive income.

Example 2. (i) P, a domestic corporation, owns all of the stock of N1, which owns all of the stock of N2, which owns all of the stock of N3. N1, N2, and N3 are controlled foreign corporations. All of the corporations use the calendar year as their taxable year. On February 5, 1997, N3 distributes a dividend to N2. The dividend is foreign personal holding company income of N2 under section 954(c)(1)(A) that results in an inclusion of $100 in P's income under section 951(a)(1)(A)(i) as of December 31, 1997. Under section 904(d)(3)(B) the inclusion is general limitation income described in section 904(d)(1)(I). The income inclusion to P results in a corresponding increase in P's basis in the stock of N1 under section 961(a).

(ii) On March 5, 1999, P sells its shares of N1 and recognizes a $110 loss. The $100 1997 subpart F inclusion is a dividend recapture amount that was included in P's income within the recapture period preceding the disposition of the N1 stock. The de minimis exception of paragraph (b)(1)(ii) of this section does not apply because the $100 dividend recapture amount exceeds 10 percent of the $110 loss. Therefore, to the extent of the $100 dividend recapture amount, the loss must be allocated under paragraph (b)(1)(i) of this section to the separate limitation category to which the dividend recapture amount was assigned (general limitation income). The remaining $10 loss is allocated to U.S. source income under paragraph (a)(1) of this section.

Example 3. (i) P, a domestic corporation, owns all of the stock of N1, which owns all of the stock of N2. N1 and N2 are controlled foreign corporations. All the corporations use the calendar year as their taxable year and the U.S. dollar as their functional currency. On May 5, 1998, N2 pays a dividend of $100 to N1 out of general limitation earnings and profits.

(ii) On February 5, 2000, N1 sells its N2 stock to an unrelated purchaser. The sale results in a loss to N1 of $110 for U.S. tax purposes. In 2000, N1 has the following current earnings and profits, excluding the loss on the sale of N2:

(A) $1,000 of non-subpart F foreign source general limitation earnings and profits described in section 904(d)(1)(I);

(B) $1,000 of foreign source gain from the sale of stock that is taken into account in determining foreign personal holding company income under section 954(c)(1)(B)(i) and which is passive limitation earnings and profits described in section 904(d)(1)(A);

(C) $1,000 of foreign source interest income received from an unrelated person that is foreign personal holding company income under section 954(c)(1)(A) and which is passive limitation earnings and profits described in section 904(d)(1)(A).

(iii) The $100 dividend paid in 1998 is a dividend recapture amount that was included in N1's income within the recapture period preceding the disposition of the N2 stock. The de minimis exception of paragraph (b)(1)(ii) of this section does not apply because the $100 dividend recapture amount exceeds 10 percent of the $110 loss. Therefore, to the extent of the $100 dividend recapture amount, the loss must be allocated under paragraph (b)(1)(i) of this section to the separate limitation category to which the dividend was assigned (general limitation earnings and profits).

(iv) N1's remaining $10 loss on the disposition of the N2 stock is allocated to foreign source passive limitation earnings and profits under paragraph (a)(1) of this section.

(v) After allocation of the stock loss, N1's current earnings and profits for 1998 consist of $900 of foreign source general limitation earnings and profits and $1,990 of foreign source passive limitation earnings and profits.

(vi) After allocation of the stock loss, N1's subpart F income for 2000 consists of $1,000 of foreign source interest income that is foreign personal holding company income under section 954(c)(1)(A) and $890 of foreign source net gain that is foreign personal holding company income under section 954(c)(1)(B)(i). P includes $1,890 in income under section 951(a)(1)(A)(i) as passive income under sections 904(d)(1)(A) and 904(d)(3)(B).

Example 4. P, a foreign corporation, has two wholly-owned subsidiaries, S, a domestic corporation, and B, a foreign corporation. On January 1, 2000, S purchases a one-percent interest in N, a foreign corporation, for $100. On January 2, 2000, N distributes a $20 dividend to S. The $20 dividend is foreign source financial services income. On January 3, 2000, S sells its N stock to B for $80 and recognizes a $20 loss that is deferred under section 267(f). On June 10, 2008, B sells its N stock to an unrelated person for $55. Under section 267(f) and section 1.267(f)-1(c)(1), S's $20 loss is deferred until 2008. Under this paragraph (b)(1), the $20 loss is allocated to reduce foreign source financial services income in 2008 because the loss was recognized (albeit deferred) within the 24-month recapture period following the receipt of the dividend. See sections 1.267(f)-1(a)(2)(i)(B) and 1.267(f)-1(c)(2).

Example 5. The facts are the same as in Example 4, except P, S, and B are domestic corporations and members of the P consolidated group. Under the matching rule of section 1.1502-13(c)(1), the separate entity attributes of S's intercompany items and B's corresponding items are redetermined to the extent necessary to produce the same effect on consolidated taxable income as if S and B were divisions of a single corporation and the intercompany transaction was a transaction between divisions. If S and B were divisions of a single corporation, the transfer of N stock on January 3, 2000 would be ignored for tax purposes, and the corporation would be treated as selling that stock only in 2008. Thus, the corporation's entire $45 loss would have been allocated against U.S. source income under paragraph (a)(1) of this section because a dividend recapture amount was not received during the corporation's recapture period. Accordingly, S's $20 loss and B's $25 loss are allocated to reduce U.S. source income.

Example 6. (i) On January 1, 1998, P, a domestic corporation, purchases N, a foreign corporation, for $1,000. On March 1, 1998, P causes N to sell its operating assets, distribute a $400 general limitation dividend to P, and invest its remaining $600 in short-term government securities. P converted the N assets into low-risk investments with a principal purpose of holding the N stock without significant risk of loss until the recapture period expired. N earns interest income from the securities. The income constitutes subpart F income that is included in P's income under section 951, increasing P's basis in the N stock under section 961(a). On March 1, 2002, P sells N and recognizes a $400 loss.

(ii) Pursuant to paragraph (d)(3) of this section, the recapture period is increased by the period in which N's assets were held as low-risk investments because P caused N's assets to be converted into and held as low-risk investments with a principal purpose of enabling P to hold the N stock without significant risk of loss. Accordingly, under paragraph (b)(1)(i) of this section the $400 loss is allocated against foreign source general limitation income.

Example 1. (i) Facts. On January 1, 2000, P, a domestic corporation, owns all of the stock of N1, a controlled foreign corporation, which owns all of the stock of N2, a controlled foreign corporation. N1's basis in the stock of N2 exceeds its fair market value, and any loss recognized by N1 on the sale of N2 would be allocated under paragraph (a)(1) of this section to reduce foreign source passive limitation earnings and profits of N1. In contemplation of the sale of N2 to an unrelated purchaser, P causes N1 to liquidate with principal purposes of recognizing the loss on the N2 stock and allocating the loss against U.S. source income. P sells the N2 stock and P recognizes a loss.

(ii) Loss allocation. Because one of the principal purposes of the liquidation was to transfer the stock to P in order to change the allocation of the built-in loss on the N2 stock, under paragraph (b)(4)(i) of this section the loss is allocated against P's foreign source passive limitation income.

Example 2. (i) Facts. On January 1, 2000, P, a domestic corporation, forms N and F, foreign corporations, and contributes $1,000 to the capital of each. N and F enter into offsetting positions in financial instruments that produce financial services income. Holding the N stock substantially diminishes P's risk of loss with respect to the F stock (and vice versa). P holds N and F with a principal purpose of recognizing foreign source income and U.S. source loss. On March 31, 2000, when the financial instrument held by N is worth $1,200 and the financial instrument held by F is worth $800, P sells its F stock and recognizes a $200 loss.

(ii) Loss allocation. Because P held an offsetting position with respect to the F stock with a principal purpose of recognizing foreign source income and U.S. source loss, the $200 loss is allocated against foreign source financial services income under paragraph (b)(4)(ii) of this section.

Example 3. (i) Facts. On January 1, 2002, P and Q domestic corporations, form R, a domestic partnership. The corporations and partnership use the calendar year as their taxable year. P contributes $900 to R in exchange for a 90-percent partnership interest and Q contributes $100 to R in exchange for a 10-percent partnership interest. R purchases a dance studio in Country X for $1,000. On January 2, 2002, R enters into contracts to provide dance lessons in Country X for a 5-year period beginning January 1, 2003. These contracts are prepaid by the dance studio customers on December 31, 2002, and R recognizes foreign source taxable income of $500 from the prepayments (R's only income in 2002). P takes into income its $450 distributive share of partnership taxable income. On January 1, 2003, P's basis in its partnership interest is $1,350 ($900 from its contribution under section 722, increased by its $450 distributive share of partnership income under section 705). On September 22, 2003, P contributes its R partnership interest to S, a newly-formed domestic corporation, in exchange for all the stock of S. Under section 358, P's basis in S is $1,350. On December 1, 2003, P sells S to an unrelated party for $1050 and recognizes a $300 loss.

(ii) Loss allocation. P recognized foreign source income for tax purposes before the income had economically accrued, and the accelerated recognition of income increased P's basis in R without increasing its value by a corresponding amount, which resulted in the creation of a built-in loss with respect to the S stock. Under paragraph (b)(4)(iii) of this section the $300 loss is allocated against foreign source income if P had a principal purpose of recognizing foreign source income and corresponding loss.