Guidance Under Section 951 for Determining Pro Rata Share, 49864-49869 [05-16611]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 70, Number 164 (Thursday, August 25, 2005)]
[Rules and Regulations]
[Pages 49864-49869]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-16611]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9222]
RIN 1545-BD49


Guidance Under Section 951 for Determining Pro Rata Share

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations under section 951(a) 
of the Internal Revenue Code (Code) that provide guidance for 
determining a United States shareholder's pro rata share of a 
controlled foreign corporation's (CFC's) subpart F income, previously 
excluded subpart F income withdrawn from investment in less developed 
countries, and previously excluded subpart F income withdrawn from 
foreign base company shipping operations.

DATES: Effective Date: These regulations are effective August 25, 2005.
    Applicability Date: For dates of applicability, see Sec.  1.951-
1(e)(7).

FOR FURTHER INFORMATION CONTACT: Jeffrey L. Vinnik, (202) 622-3840 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On August 6, 2004, the IRS published in the Federal Register a 
notice of proposed rulemaking (REG-129771-04, 2004-36 I.R.B. 453) under 
section 951 of the Code. Written comments were received in response to 
the notice of proposed rulemaking. No public hearing was requested or 
held on the notice of proposed rulemaking. After consideration of the 
comments received, the proposed regulations are adopted as final 
regulations with the modifications discussed below. This issue of the 
Federal Register also includes a notice of proposed rulemaking (REG-
129782-05) setting forth special pro rata share rules that apply to (1) 
a CFC with more than one class of stock which has earnings and profits 
and subpart F income for the taxable year that are attributable to one 
or more deemed dividends arising from one or more transactions 
described in section 304 that are part of a plan a principal purpose of 
which is the avoidance of Federal income taxation, and (2) a CFC with 
certain cumulative preferred stock outstanding that is held by one or 
more persons who are not U.S. taxpayers.

Summary of Public Comments and Explanation of Changes

A. Amounts Determined Under Section 956 of the Code

    Section 951(a)(1) requires a United States shareholder of a CFC to 
include in income the amount determined under section 956 with respect 
to such shareholder. The proposed regulations include a conforming 
change to replace increase in earnings invested in United States 
property with amount determined under section 956 to reflect statutory 
changes made to section 956 of the Code by the Omnibus Budget 
Reconciliation Act of 1993, Public Law 103-66 (107 Stat. 312). 
Commentators recommended that the pro rata rules for section 956 be 
addressed in a separate regulatory project because, after the statutory 
change to section 956, the section 951 pro rata rules are no longer 
relevant to a United States shareholder's inclusion of the amount 
determined under section 956.
    The IRS and Treasury Department agree with this recommendation and 
accordingly have deleted all references to section 956 under Sec.  
1.951-(1)(e). Provisions of Sec.  1.951-1(a) and (d) that concerned a 
United States shareholder's pro rata share of the CFC's increase in 
earnings invested in United States property have been revised and 
removed, respectively, to conform the regulations to the relevant post-
1993 Code provisions. The IRS and Treasury Department are considering a 
separate regulations project regarding the amount determined under 
section 956.

B. One Class of Stock--Proposed Sec.  1.951-1(e)(2)

    The proposed regulations state that if a CFC for a taxable year has 
only one class of stock outstanding, each United States shareholder's 
pro rata share of such corporation's subpart F income for the taxable 
year is determined by allocating the CFC's earnings and profits for 
such year on a per-share basis. A commentator asked that this rule be 
modified to clarify that the relevant earnings and profits are earnings 
and profits for such year unreduced by distributions during the year.
    The IRS and Treasury Department agree with the comment and have 
clarified Sec.  1.951-1(e)(2) accordingly.

C. More Than One Class of Stock--Proposed Sec.  1.951-1(e)(3)(i)

    In general, the proposed regulations allocate subpart F income 
among multiple classes of stock by reference to the distributions that 
would be made with respect to each class if the CFC's earnings and 
profits for the year were distributed on the last day of the CFC's 
taxable year (the hypothetical distribution). A commentator expressed 
concern that the hypothetical-distribution rule under the proposed 
regulations could allocate earnings and profits to preferred stock 
(including, e.g., preferred stock with a noncumulative dividend 
preference) without regard to whether or when dividends are or will be 
paid. The commentator recommended that the proposed regulations be 
amended to provide that dividend rights should not be taken into 
account if, as of an appropriate date, the dividends have not been 
paid.
    The IRS and Treasury Department have considered this comment and 
have concluded that, if the terms of a class of preferred stock are 
such that an obligation to pay a dividend with respect to the stock may 
or may not arise during the CFC's taxable year, depending on an 
exercise of discretion by the CFC's board of directors or a similar 
governing body, then the stock should be considered to have 
discretionary distribution rights. In such case, the rule of Sec.  
1.951-1(e)(3)(ii) would apply. Therefore, the suggested amendment was 
not adopted.
    A commentator recommended that, in the case of mandatorily 
redeemable preferred stock with cumulative dividend rights, the 
regulation should include an anti-abuse rule to be applied where the 
amount of earnings and profits required to be allocated to such stock 
differs substantially on a present-value basis from the amount expected 
to be distributed on such stock. Additionally, a commentator 
recommended that an anti-abuse rule could target shareholder-level 
agreements that are inconsistent with the economic terms of the 
underlying stock.
    The IRS and Treasury Department agree that it is appropriate to 
provide a special rule for the allocation of earnings and profits to 
certain mandatorily redeemable cumulative preferred stock held by 
persons who are not U.S. taxpayers. This special rule is set forth in a 
notice of proposed rulemaking published in this issue of the Federal 
Register (REG-129782-05).
    With respect to the comments regarding shareholder-level 
agreements,

[[Page 49865]]

while the proposed regulations are finalized without modification in 
respect of that comment, the IRS and Treasury Department may issue 
regulations in the future if needed to address those issues based on 
experience following the publication of these regulations.

D. Discretionary Power To Allocate Earnings to Different Classes of 
Stock--Proposed Sec.  1.951-1(e)(3)(ii)(A)

    The proposed regulations provide that, where the allocation of the 
amount of a CFC's earnings and profits for the taxable year between two 
or more classes of stock depends upon the exercise of discretion by the 
board of directors or a similar governing body of the CFC, earnings and 
profits shall be allocated to classes of shares with discretionary 
distribution rights by reference to the relative values of those 
classes at the time of the hypothetical distribution. Commentators 
suggested that the use of a value test could be complex, costly, and 
time consuming. They proposed an alternative facts-and-circumstances 
test, with the valuation approach being used as a fall back only in 
limited situations. At the same time, the commentators noted that stock 
with discretionary distribution rights generally does not appear to 
exist in the marketplace (apart from ordinary common stock).
    The IRS and Treasury Department have considered these comments and 
in light of the latter comment do not believe that a value-based 
allocation is likely to be required in many cases. The IRS and Treasury 
Department are aware that valuation is a sophisticated process but 
believe that the interests of sound tax policy and administration are 
served by requiring the value-based allocation in those instances 
covered by these regulations.
    Under the proposed regulations, in cases where the value of each of 
two or more classes of stock with discretionary distribution rights is 
substantially the same, the allocation of earnings and profits to each 
such class is made as if such classes constituted one class of stock. A 
commentator suggested that values should be treated as substantially 
the same for this purpose if they are within a specified percentage of 
one another.
    The IRS and Treasury Department have considered the comment and 
have concluded that the existing language is sufficient for the 
purposes of the regulations without the need to adopt a specified 
percentage range. However, Example 3 in the regulations dealing with 
this issue has been revised to indicate that values may be considered 
substantially the same even if the difference between them is more than 
de minimis.

E. Redemptions and Scope of Deemed Distributions--Proposed Sec. Sec.  
1.951-1(e)(3)(ii)(B) and 1.951-1(e)(4)

    The proposed regulations contain a special rule that provides that 
no amount shall be considered to be distributed with respect to a 
particular class of stock to the extent that such a distribution would 
constitute a distribution in redemption of stock, a distribution in 
liquidation, or a return of capital. Commentators suggested that this 
rule was too broad and that stock rights resulting in deemed dividends 
under sections 302 or 305 of the Code should not be disregarded in 
situations that are unlikely to be abusive.
    The IRS and Treasury Department have considered the comments and 
have concluded that no change is required. The hypothetical 
distribution mandated by section 951(a) of the Code contemplates a pro 
rata distribution to shareholders with respect to stock owned on the 
relevant date, with no disposition of the stock or change in stock 
rights being made at the same time. Disregarding redemptions, 
liquidations, or return of capital distributions for this purpose 
serves the objectives of these regulations without creating undue 
potential for unfairness or traps for the unwary. A rule that provided 
that some deemed dividends under sections 302 and 305 of the Code are 
disregarded and some are regarded could be overly complex and difficult 
to administer.
    The term deemed distributions in proposed Sec.  1.951-1(e)(4) has 
been changed to hypothetical distribution in order to conform to the 
language used in Sec.  1.951-1(e)(3).

F. Dividend Arrearages--Proposed Sec.  1.951-1(e)(3)(iv)

    The proposed regulations retained the rule in existing regulations 
with respect to arrearages in dividends with respect to classes of 
preferred stock of a CFC. Specifically, the earnings and profits of the 
CFC for the taxable year are attributable to such arrearage only to the 
extent the arrearage exceeds the earnings and profits remaining from 
prior taxable years beginning after December 31, 1962. Commentators 
suggested that this rule can lead to anomalous results, particularly 
where cumulative preferred stock is issued when a CFC has accumulated 
earnings and profits. In such a case, a failure to pay dividends for 
some number of periods could cause the preferred stock to attract 
earnings and profits (and thus subpart F income) accumulated prior to 
the issuance of the preferred stock and thus fail to attract an 
appropriate share of the CFC's subpart F income. Commentators suggested 
that this could be addressed by allocating to dividend arrearages only 
earnings and profits that arise after the issuance of the preferred 
stock.
    The IRS and Treasury Department have considered these comments and 
believe that such a rule is appropriate. The final regulations adopt 
such a rule.

G. Section 958 of the Code

    Commentators suggested that a separate project was needed to 
address the relationship between the indirect stock ownership rules and 
the pro rata share inclusion rules.
    The IRS and Treasury Department have considered the comment. The 
need for a separate regulations project of the kind suggested may be 
considered at a later date.

H. Effective Date

    The proposed regulations were proposed to apply for taxable years 
of a CFC beginning on or after January 1, 2005. Commentators 
recommended that the regulations provide transitional effective-date 
guidance to taxpayers that may need to take into account backward-
looking provisions of the Code or regulations regarding the allocation 
of earnings and profits to stock of a CFC.
    The IRS and Treasury Department have considered the comment and 
have provided a transitional effective date rule for cases in which the 
application of these pro rata rules for purposes of applying a related 
Code section, such as section 1248 of the Code, would result in an 
allocation to the stock of the CFC of earnings and profits that have 
already been allocated to the stock for an earlier year under the prior 
rules of Sec.  1.951-1(e). In that case, the prior rules will continue 
to apply for purposes of applying the related Code section.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking preceding these

[[Page 49866]]

regulations was submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Drafting Information

    The principal author of these regulations is Jeffrey Vinnik, Office 
of Associate Chief Counsel (International). However, other personnel 
from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

    Authority: 26 U.S.C. 7805 * * *

0
Par. 2. Section 1.951-1 is amended as follows:
0
1. Revising paragraphs (a)(2)(i) and (a)(2)(iv).
0
2. Removing and reserving paragraph (d).
0
3. Revising paragraph (e), and reserving paragraphs (e)(3)(v), 
(e)(4)(ii) and (e)(6) Example 9.
    The revisions read as follows:


Sec.  1.951-1  Amounts included in gross income of United States 
shareholders.

    (a) * * *
    (2) * * *
    (i) Such shareholder's pro rata share (determined under paragraph 
(b) of this section) of the corporation's subpart F income (as defined 
in section 952) for such taxable year of the corporation,
* * * * *
    (iv) The amount determined under section 956 with respect to such 
shareholder for such taxable year of the corporation (but only to the 
extent not excluded from gross income under section 959(a)(2)).
* * * * *
    (d) [Reserved].
    (e) Pro rata share defined--(1) In general. For purposes of 
paragraphs (b) and (c) of this section, a United States shareholder's 
pro rata share of the controlled foreign corporation's subpart F 
income, previously excluded subpart F income withdrawn from investment 
in less developed countries, or previously excluded subpart F income 
withdrawn from investment in foreign base company shipping operations, 
respectively, for any taxable year is his pro rata share determined 
under Sec.  1.952-1(a), Sec.  1.955-1(c), or Sec.  1.955A-1(c), 
respectively.
    (2) One class of stock. If a controlled foreign corporation for a 
taxable year has only one class of stock outstanding, each United 
States shareholder's pro rata share of such corporation's subpart F 
income or withdrawal for the taxable year under paragraph (e)(1) of 
this section shall be determined by allocating the controlled foreign 
corporation's earnings and profits on a per share basis.
    (3) More than one class of stock--(i) In general. Subject to 
paragraphs (e)(3)(ii) through (e)(3)(v) of this section, if a 
controlled foreign corporation for a taxable year has more than one 
class of stock outstanding, the amount of such corporation's subpart F 
income or withdrawal for the taxable year taken into account with 
respect to any one class of stock for purposes of paragraph (e)(1) of 
this section shall be that amount which bears the same ratio to the 
total of such subpart F income or withdrawal for such year as the 
earnings and profits which would be distributed with respect to such 
class of stock if all earnings and profits of such corporation for such 
year (not reduced by actual distributions during the year) were 
distributed on the last day of such corporation's taxable year on which 
such corporation is a controlled foreign corporation (the hypothetical 
distribution date), bear to the total earnings and profits of such 
corporation for such taxable year.
    (ii) Discretionary power to allocate earnings to different classes 
of stock--(A) In general. Subject to paragraph (e)(3)(iii) of this 
section, the rules of this paragraph apply for purposes of paragraph 
(e)(1) of this section if the allocation of a controlled foreign 
corporation's earnings and profits for the taxable year between two or 
more classes of stock depends upon the exercise of discretion by that 
body of persons which exercises with respect to such corporation the 
powers ordinarily exercised by the board of directors of a domestic 
corporation (discretionary distribution rights). First, the earnings 
and profits of the corporation are allocated under paragraph (e)(3)(i) 
of this section to any class or classes of stock with non-discretionary 
distribution rights (e.g., preferred stock entitled to a fixed return). 
Second, the amount of earnings and profits allocated to a class of 
stock with discretionary distribution rights shall be that amount which 
bears the same ratio to the remaining earnings and profits of such 
corporation for such taxable year as the value of all shares of such 
class of stock, determined on the hypothetical distribution date, bears 
to the total value of all shares of all classes of stock with 
discretionary distribution rights of such corporation, determined on 
the hypothetical distribution date. For purposes of the preceding 
sentence, in the case where the value of each share of two or more 
classes of stock with discretionary distribution rights is 
substantially the same on the hypothetical distribution date, the 
allocation of earnings and profits to such classes shall be made as if 
such classes constituted one class of stock in which each share has the 
same rights to dividends as any other share.
    (B) Special rule for redemption rights. For purposes of paragraph 
(e)(3)(ii)(A) of this section, discretionary distribution rights do not 
include rights to redeem shares of a class of stock (even if such 
redemption would be treated as a distribution of property to which 
section 301 applies pursuant to section 302(d)).
    (iii) Special allocation rule for stock with mixed distribution 
rights. For purposes of paragraphs (e)(3)(i) and (e)(3)(ii) of this 
section, in the case of a class of stock with both discretionary and 
non-discretionary distribution rights, earnings and profits shall be 
allocated to the non-discretionary distribution rights under paragraph 
(e)(3)(i) of this section and to the discretionary distribution rights 
under paragraph (e)(3)(ii) of this section. In such a case, paragraph 
(e)(3)(ii) of this section will be applied such that the value used in 
the ratio will be the value of such class of stock solely attributable 
to the discretionary distribution rights of such class of stock.
    (iv) Dividend arrearages. For purposes of paragraph (e)(3)(i) of 
this section, if an arrearage in dividends for prior taxable years 
exists with respect to a class of preferred stock of such corporation, 
the earnings and profits for the taxable year shall be attributed to 
such arrearage only to the extent such arrearage exceeds the earnings 
and profits of such corporation remaining from prior taxable years 
beginning after December 31, 1962, or the date on which such stock was 
issued, whichever is later.
    (v) Earnings and profits attributable to certain section 304 
transactions. [Reserved].
    (4) Scope of hypothetical distribution--(i) Redemption rights. 
Notwithstanding the terms of any class of stock of the controlled 
foreign corporation or any agreement or arrangement with respect 
thereto, no amount shall be considered to be distributed as part of the 
hypothetical

[[Page 49867]]

distribution with respect to a particular class of stock for purposes 
of paragraph (e)(3) of this section to the extent that a distribution 
of such amount would constitute a distribution in redemption of stock 
(even if such redemption would be treated as a distribution of property 
to which section 301 applies pursuant to section 302(d)), a 
distribution in liquidation, or a return of capital.
    (ii) Certain cumulative preferred stock. [Reserved].
    (5) Restrictions or other limitations on distributions--(i) In 
general. A restriction or other limitation on distributions of earnings 
and profits by a controlled foreign corporation will not be taken into 
account, for purposes of this section, in determining the amount of 
earnings and profits that shall be allocated to a class of stock of the 
controlled foreign corporation or the amount of the United States 
shareholder's pro rata share of the controlled foreign corporation's 
subpart F income or withdrawal for the taxable year.
    (ii) Definition. For purposes of this section, a restriction or 
other limitation on distributions includes any limitation that has the 
effect of limiting the allocation or distribution of earnings and 
profits by a controlled foreign corporation to a United States 
shareholder, other than currency or other restrictions or limitations 
imposed under the laws of any foreign country as provided in section 
964(b).
    (iii) Exception for certain preferred distributions. The right to 
receive periodically a fixed amount (whether determined by a percentage 
of par value, a reference to a floating coupon rate, a stated return 
expressed in terms of a certain amount of dollars or foreign currency, 
or otherwise) with respect to a class of stock the distribution of 
which is a condition precedent to a further distribution of earnings or 
profits that year with respect to any class of stock (not including a 
distribution in partial or complete liquidation) is not a restriction 
or other limitation on the distribution of earnings and profits by a 
controlled foreign corporation under paragraph (e)(5) of this section.
    (iv) Illustrative list of restrictions and limitations. Except as 
provided in paragraph (e)(5)(iii) of this section, restrictions or 
other limitations on distributions include, but are not limited to--
    (A) An arrangement that restricts the ability of the controlled 
foreign corporation to pay dividends on a class of shares of the 
corporation owned by United States shareholders until a condition or 
conditions are satisfied (e.g., until another class of stock is 
redeemed);
    (B) A loan agreement entered into by a controlled foreign 
corporation that restricts or otherwise affects the ability to make 
distributions on its stock until certain requirements are satisfied; or
    (C) An arrangement that conditions the ability of the controlled 
foreign corporation to pay dividends to its shareholders on the 
financial condition of the controlled foreign corporation.
    (6) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. (i) Facts. FC1, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 100 shares of 
one class of stock. Corp E, a domestic corporation and a United 
States shareholder of FC1, within the meaning of section 951(b), 
owns 60 shares. Corp H, a domestic corporation and a United States 
shareholder of FC1, within the meaning of section 951(b), owns 40 
shares. FC1, Corp E, and Corp H each use the calendar year as a 
taxable year. Corp E and Corp H are shareholders of FC1 for its 
entire 2005 taxable year. For 2005, FC1 has $100x of earnings and 
profits, and income of $100x with respect to which amounts are 
required to be included in gross income of United States 
shareholders under section 951(a). FC1 makes no distributions during 
that year.
    (ii) Analysis. FC1 has one class of stock. Therefore, under 
paragraph (e)(2) of this section, FC1's earnings and profits are 
allocated on a per share basis. Accordingly, for the taxable year 
2005, Corp E's pro rata share of FC1's subpart F income is $60x (60/
100 x $100x) and Corp H's pro rata share of FC1's subpart F income 
is $40x (40/100 x $100x).
    Example 2. (i) Facts. FC2, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 70 shares of 
common stock and 30 shares of 4-percent, nonparticipating, voting, 
preferred stock with a par value of $10x per share. The common 
shareholders are entitled to dividends when declared by the board of 
directors of FC2. Corp A, a domestic corporation and a United States 
shareholder of FC2, within the meaning of section 951(b), owns all 
of the common shares. Individual B, a foreign individual, owns all 
of the preferred shares. FC2 and Corp A each use the calendar year 
as a taxable year. Corp A and Individual B are shareholders of FC2 
for its entire 2005 taxable year. For 2005, FC2 has $50x of earnings 
and profits, and income of $50x with respect to which amounts are 
required to be included in gross income of United States 
shareholders under section 951(a). In 2005, FC2 distributes as a 
dividend $12x to Individual B with respect to Individual B's 
preferred shares. FC2 makes no other distributions during that year.
    (ii) Analysis. FC2 has two classes of stock, and there are no 
restrictions or other limitations on distributions within the 
meaning of paragraph (e)(5) of this section. If the total $50x of 
earnings were distributed on December 31, 2005, $12x would be 
distributed with respect to Individual B's preferred shares and the 
remainder, $38x, would be distributed with respect to Corp A's 
common shares. Accordingly, under paragraph (e)(3)(i) of this 
section, Corp A's pro rata share of FC1's subpart F income is $38x 
for taxable year 2005.
    Example 3. (i) Facts. The facts are the same as in Example 2, 
except that the shares owned by Individual B are Class B common 
shares and the shares owned by Corp A are Class A common shares and 
the board of directors of FC2 may declare dividends with respect to 
one class of stock without declaring dividends with respect to the 
other class of stock. The value of the Class A common shares on the 
last day of FC2's 2005 taxable year is $680x and the value of the 
Class B common shares on that date is $300x. The board of directors 
of FC2 determines that FC2 will not make any distributions in 2005 
with respect to the Class A and B common shares of FC2.
    (ii) Analysis. The allocation of FC2's earnings and profits 
between its Class A and Class B common shares depends solely on the 
exercise of discretion by the board of directors of FC2. Therefore, 
under paragraph (e)(3)(ii)(A) of this section, the allocation of 
earnings and profits between the Class A and Class B common shares 
will depend on the value of each class of stock on the last day of 
the controlled foreign corporation's taxable year. On the last day 
of FC2's taxable year 2005, the Class A common shares had a value of 
$9.30x/share and the Class B common shares had a value of $10x/
share. Because each share of the Class A and Class B common stock of 
FC2 has substantially the same value on the last day of FC2's 
taxable year, under paragraph (e)(3)(ii)(A) of this section, for 
purposes of allocating the earnings and profits of FC2, the Class A 
and Class B common shares will be treated as one class of stock. 
Accordingly, for FC2's taxable year 2005, the earnings and profits 
of FC2 are allocated $35x (70/100 x $50x) to the Class A common 
shares and $15x (30/100 x $50x) to the Class B common shares. For 
its taxable year 2005, Corp A's pro rata share of FC2's subpart F 
income will be $35x.
    Example 4. (i) Facts. FC3, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 100 shares of 
Class A common stock, 100 shares of Class B common stock and 10 
shares of 5-percent nonparticipating, voting preferred stock with a 
par value of $50x per share. The value of the Class A shares on the 
last day of FC3's 2005 taxable year is $800x. The value of the Class 
B shares on that date is $200x. The Class A and Class B shareholders 
each are entitled to dividends when declared by the board of 
directors of FC3, and the board of directors of FC3 may declare 
dividends with respect to one class of stock without declaring 
dividends with respect to the other class of stock. Corp D, a 
domestic corporation and a United States shareholder of FC3, within 
the meaning of section 951(b), owns all of the Class A shares. Corp 
N, a domestic corporation and a United States shareholder of FC3, 
within the meaning of section 951(b), owns all of the Class B 
shares. Corp S, a domestic corporation and a United States 
shareholder of FC3, within the meaning of

[[Page 49868]]

section 951(b), owns all of the preferred shares. FC3, Corp D, Corp 
N, and Corp S each use the calendar year as a taxable year. Corp D, 
Corp N, and Corp S are shareholders of FC3 for all of 2005. For 
2005, FC3 has $100x of earnings and profits, and income of $100x 
with respect to which amounts are required to be included in gross 
income of United States shareholders under section 951(a). In 2005, 
FC3 distributes as a dividend $25x to Corp S with respect to the 
preferred shares. The board of directors of FC3 determines that FC3 
will make no other distributions during that year.
    (ii) Analysis. The distribution rights of the preferred shares 
are not a restriction or other limitation within the meaning of 
paragraph (e)(5) of this section. Pursuant to paragraph (e)(3)(i) of 
this section, if the total $100x of earnings were distributed on 
December 31, 2005, $25x would be distributed with respect to Corp 
S's preferred shares and the remainder, $75x would be distributed 
with respect to Corp D's Class A shares and Corp N's Class B shares. 
The allocation of that $75x between its Class A and Class B shares 
depends solely on the exercise of discretion by the board of 
directors of FC3. The value of the Class A shares ($8x/share) and 
the value of the Class B shares ($2x/share) are not substantially 
the same on the last day of FC3's taxable year 2005. Therefore for 
FC3's taxable year 2005, under paragraph (e)(3)(ii)(A) of this 
section, the earnings and profits of FC3 are allocated $60x ($800/
$1,000 x $75x) to the Class A shares and $15x ($200/$1,000 x $75x) 
to the Class B shares. For the 2005 taxable year, Corp D's pro rata 
share of FC3's subpart F income will be $60x, Corp N's pro rata 
share of FC3's subpart F income will be $15x and Corp S's pro rata 
share of FC3's subpart F income will be $25x.
    Example 5. (i) Facts. FC4, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 40 shares of 
participating, voting, preferred stock and 200 shares of common 
stock. The owner of a share of preferred stock is entitled to an 
annual dividend equal to 0.5-percent of FC4's retained earnings for 
the taxable year and also is entitled to additional dividends when 
declared by the board of directors of FC4. The common shareholders 
are entitled to dividends when declared by the board of directors of 
FC4. The board of directors of FC4 has discretion to pay dividends 
to the participating portion of the preferred shares (after the 
payment of the preference) and the common shares. The value of the 
preferred shares on the last day of FC4's 2005 taxable year is $600x 
($100x of this value is attributable to the discretionary 
distribution rights of these shares) and the value of the common 
shares on that date is $400x. Corp E, a domestic corporation and 
United States shareholder of FC4, within the meaning of section 
951(b), owns all of the preferred shares. FC5, a foreign corporation 
that is not a controlled foreign corporation within the meaning of 
section 957(a), owns all of the common shares. FC 4 and Corp E each 
use the calendar year as a taxable year. Corp E and FC5 are 
shareholders of FC4 for all of 2005. For 2005, FC4 has $100x of 
earnings and profits, and income of $100x with respect to which 
amounts are required to be included in gross income of United States 
shareholders under section 951(a). In 2005, FC4's retained earnings 
are equal to its earnings and profits. FC4 distributes as a dividend 
$20x to Corp E that year with respect to Corp E's preferred shares. 
The board of directors of FC4 determines that FC4 will not make any 
other distributions during that year.
    (ii) Analysis. The non-discretionary distribution rights of the 
preferred shares are not a restriction or other limitation within 
the meaning of paragraph (e)(5) of this section. The allocation of 
FC4's earnings and profits between its preferred shares and common 
shares depends, in part, on the exercise of discretion by the board 
of directors of FC4 because the preferred shares are shares with 
both discretionary distribution rights and non-discretionary 
distribution rights. Paragraph (e)(3)(i) of this section is applied 
first to determine the allocation of earnings and profits of FC4 to 
the non-discretionary distribution rights of the preferred shares. 
If the total $100x of earnings were distributed on December 31, 
2005, $20x would be distributed with respect to the non-
discretionary distribution rights of Corp E's preferred shares. 
Accordingly, $20x would be allocated to such shares under paragraphs 
(e)(3)(i) and (iii) of this section. The remainder, $80x, would be 
allocated under paragraph (e)(3)(ii)(A) and (e)(3)(iii) of this 
section between the preferred and common shareholders by reference 
to the value of the discretionary distribution rights of the 
preferred shares and the value of the common shares. Therefore, the 
remaining $80x of earnings and profits of FC4 are allocated $16x 
($100x/$500x x $80x) to the preferred shares and $64x ($400x/$500x x 
$80) to the common shares. For its taxable year 2005, Corp E's pro 
rata share of FC4's subpart F income will be $36x ($20x + $16x).
    Example 6. (i) Facts. FC6, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 10 shares of 
common stock and 400 shares of 2-percent nonparticipating, voting, 
preferred stock with a par value of $1x per share. The common 
shareholders are entitled to dividends when declared by the board of 
directors of FC6. Corp M, a domestic corporation and a United States 
shareholder of FC6, within the meaning of section 951(b), owns all 
of the common shares. FC7, a foreign corporation that is not a 
controlled foreign corporation within the meaning of section 957(a), 
owns all of the preferred shares. Corp M and FC7 cause the governing 
documents of FC6 to provide that no dividends may be paid to the 
common shareholders until FC6 cumulatively earns $100,000x of 
income. FC6 and Corp M each use the calendar year as a taxable year. 
Corp M and FC7 are shareholders of FC6 for all of 2005. For 2005, 
FC6 has $50x of earnings and profits, and income of $50x with 
respect to which amounts are required to be included in gross income 
of United States shareholders under section 951(a). In 2005, FC6 
distributes as a dividend $8x to FC7 with respect to FC7's preferred 
shares. FC6 makes no other distributions during that year.
    (ii) Analysis. The agreement restricting FC6's ability to pay 
dividends to common shareholders until FC6 cumulatively earns 
$100,000x of income is a restriction or other limitation, within the 
meaning of paragraph (e)(5) of this section, and will be disregarded 
for purposes of calculating Corp M's pro rata share of subpart F 
income. The non-discretionary distribution rights of the preferred 
shares are not a restriction or other limitation within the meaning 
of paragraph (e)(5) of this section. If the total $50x of earnings 
were distributed on December 31, 2005, $8x would be distributed with 
respect to FC7's preferred shares and the remainder, $42x, would be 
distributed with respect to Corp M's common shares. Accordingly, 
under paragraph (e)(3)(i) of this section, Corp M's pro rata share 
of FC6's subpart F income is $42x for taxable year 2005.
    Example 7. (i) Facts. FC8, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 40 shares of 
common stock and 10 shares of 4-percent voting preferred stock with 
a par value of $50x per share. Pursuant to the terms of the 
preferred stock, FC8 has the right to redeem at any time, in whole 
or in part, the preferred stock. FP, a foreign corporation, owns all 
of the preferred shares. Corp G, a domestic corporation wholly owned 
by FP and a United States shareholder of FC8, within the meaning of 
section 951(b), owns all of the common shares. FC8 and Corp G each 
use the calendar year as a taxable year. FP and Corp G are 
shareholders of FC8 for all of 2005. For 2005, FC8 has $100x of 
earnings and profits, and income of $100x with respect to which 
amounts are required to be included in gross income of United States 
shareholder under section 951(a). In 2005, FC8 distributes as a 
dividend $20x to FP with respect to FP's preferred shares. FC8 makes 
no other distributions during that year.
    (ii) Analysis. Pursuant to paragraph (e)(3)(ii)(B) of this 
section, the redemption rights of the preferred shares will not be 
treated as a discretionary distribution right under paragraph 
(e)(3)(ii)(A) of this section. Further, if FC8 were treated as 
having redeemed any preferred shares under paragraph (e)(3)(i) of 
this section, the redemption would be treated as a distribution to 
which section 301 applies under section 302(d) due to FP's 
constructive ownership of the common shares. However, pursuant to 
paragraph (e)(4) of this section, no amount of earnings and profits 
would be allocated to the preferred shareholders on the hypothetical 
distribution date, under paragraph (e)(3)(i) of this section, as a 
result of FC8's right to redeem, in whole or in part, the preferred 
shares. FC8's redemption rights with respect to the preferred shares 
cannot affect the allocation of earnings and profits between FC8's 
shareholders. Therefore, the redemption rights are not restrictions 
or other limitations within the meaning of paragraph (e)(5) of this 
section. Additionally, the non-discretionary distribution rights of 
the preferred shares are not restrictions or other limitations 
within the meaning of paragraph (e)(5) of this section. Therefore, 
if the total $100x of earnings were distributed on December 31, 
2005, $20x would be distributed with respect to FP's preferred 
shares and the remainder, $80x, would be distributed with respect to 
Corp G's common

[[Page 49869]]

shares. Accordingly, under paragraph (e)(3)(i) of this section, Corp 
G's pro rata share of FC8's subpart F income is $80 for taxable year 
2005.
    Example 8. (i) Facts. FC9, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 40 shares of 
common stock and 60 shares of 6-percent, nonparticipating, 
nonvoting, preferred stock with a par value of $100x per share. 
Individual J, a United States shareholder of FC9, within the meaning 
of section 951(b), who uses the calendar year as a taxable year, 
owns 30 shares of the common stock, and 15 shares of the preferred 
stock during tax year 2005. The remaining 10 common shares and 45 
preferred shares of FC9 are owned by Foreign Individual N, a foreign 
individual. Individual J and Individual N are shareholders of FC9 
for all of 2005. For taxable year 2005, FC9 has $1,000x of earnings 
and profits, and income of $500x with respect to which amounts are 
required to be included in gross income of United States 
shareholders under section 951(a).
    (ii) Analysis. The non-discretionary distribution rights of the 
preferred shares are not a restriction or other limitation within 
the meaning of paragraph (e)(5) of this section. If the total 
$1,000x of earnings and profits were distributed on December 31, 
2005, $360x (0.06 x $100x x 60) would be distributed with respect to 
FC9's preferred stock and $640x ($1,000x minus $360x) would be 
distributed with respect to its common stock. Accordingly, of the 
$500x with respect to which amounts are required to be included in 
gross income of United States shareholders under section 951(a), 
$180x ($360x/$1,000x x $500x) is allocated to the outstanding 
preferred stock and $320x ($640x/$1,000x x $500x) is allocated to 
the outstanding common stock. Therefore, under paragraph (e)(3)(i) 
of this section, Individual J's pro rata share of such amounts for 
2005 is $285x [($180x x 15/60)+($320x x 30/40)].
    Example 9.  [Reserved].

    (7) Effective dates. This paragraph (e) applies for taxable years 
of a controlled foreign corporation beginning on or after January 1, 
2005. However, if the application of this paragraph (e) for purposes of 
a related Internal Revenue Code provision, such as section 1248, 
results in an allocation to the stock of such corporation of earnings 
and profits that have already been allocated to the stock for an 
earlier year under the prior rules of Sec.  1.951-1(e), as contained in 
26 CFR part 1 revised April 1, 2005, then the prior rules will continue 
to apply to the extent necessary to avoid such duplicative allocation.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: August 9, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
[FR Doc. 05-16611 Filed 8-24-05; 8:45 am]
BILLING CODE 4830-01-P