Guidance Related to the Allocation and Apportionment of Deductions and Foreign Taxes, Financial Services Income, Foreign Tax Redeterminations, Foreign Tax Credit Disallowance Under Section 965(g), and Consolidated Groups, 69124-69180 [2019-24847]

Download as PDF 69124 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 301 [REG–105495–19] RIN 1545–BP21 Guidance Related to the Allocation and Apportionment of Deductions and Foreign Taxes, Financial Services Income, Foreign Tax Redeterminations, Foreign Tax Credit Disallowance Under Section 965(g), and Consolidated Groups Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking. AGENCY: This document contains proposed regulations that provide guidance relating to the allocation and apportionment of deductions and creditable foreign taxes, the definition of financial services income, foreign tax redeterminations, availability of foreign tax credits under the transition tax, and the application of the foreign tax credit limitation to consolidated groups. DATES: Written or electronic comments and requests for a public hearing must be received by February 18, 2020. ADDRESSES: Send electronic submissions via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG–105495–19) by following the online instructions for submitting comments. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The Department of the Treasury (the ‘‘Treasury Department’’) and the IRS will publish for public availability any comment received to its public docket, whether submitted electronically or in hard copy. Send hard copy submissions to: CC:PA:LPD:PR (REG–105495–19), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–105495– 19), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC 20224. FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations under §§ 1.861–8, 1.861–9(b), 1.861–12, 1.861–14, 1.861–17, and 1.954–2(h), Jeffrey P. Cowan, (202) 317–4924; concerning §§ 1.704–1, 1.861–9(e), 1.904–4(e), 1.904(b)–3, 1.904(g)–3, 1.1502–4, and 1.1502–21, Jeffrey L. Parry, (202) 317–4916; concerning §§ 1.861–20, 1.904–6, 1.960–1, and jbell on DSKJLSW7X2PROD with PROPOSALS2 SUMMARY: VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 1.960–7, Suzanne M. Walsh, (202) 317– 4908; concerning §§ 1.904–4(c), 1.905–3, 1.905–4, 1.905–5, 1.954–1, 301.6227–1, and 301.6689–1, Larry R. Pounders, (202) 317–5465; concerning §§ 1.965–5 and 1.965–9, Karen J. Cate, (202) 317– 4667; concerning submissions of comments and requests for a public hearing, Regina Johnson, (202) 317– 6901 (not toll-free numbers). SUPPLEMENTARY INFORMATION: Background On December 7, 2018, the Treasury Department and the IRS published proposed regulations (REG–105600–18) relating to foreign tax credits in the Federal Register (83 FR 63200) (the ‘‘2018 FTC proposed regulations’’). Those regulations addressed several significant changes that the Tax Cuts and Jobs Act (Pub. L. 115–97, 131 Stat. 2054, 2208 (2017)) (the ‘‘TCJA’’) made with respect to the foreign tax credit rules and related rules for allocating and apportioning deductions in determining the foreign tax credit limitation. The preamble to those proposed regulations requested comments on how to modify the existing approaches for allocating and apportioning deductions, including in particular the rules under § 1.861–17 for allocating and apportioning research and experimentation (‘‘R&E’’) expenditures. The 2018 FTC proposed regulations are finalized in the Rules and Regulations section of this issue of the Federal Register (the ‘‘2019 FTC final regulations’’). On June 25, 2012, the Federal Register published a notice of proposed rulemaking at 77 FR 37837 (the ‘‘2012 OFL proposed regulations’’) proposing rules for the coordination of the rules for determining high-taxed passive income with required adjustments to the foreign tax credit limitation in respect of capital gains and the allocation and recapture of overall foreign losses and overall domestic losses, as well as the coordination of the recapture of overall foreign losses on certain dispositions of property and other rules concerning overall foreign losses and overall domestic losses. The 2012 OFL proposed regulations are finalized in the 2019 FTC final regulations. On November 7, 2007, the Federal Register published temporary regulations (T.D. 9362) at 72 FR 62771 and a notice of proposed rulemaking by cross-reference to the temporary regulations at 72 FR 62805 relating to sections 905(c), 986(a), and 6689. Portions of these temporary regulations are finalized in the 2019 FTC final regulations. This document contains proposed regulations (the ‘‘proposed regulations’’) PO 00000 Frm 00001 Fmt 4701 Sfmt 4702 addressing the following issues: (1) The allocation and apportionment of deductions under sections 861 through 865, including new rules on the allocation and apportionment of R&E expenditures and certain deductions of life insurance companies; (2) the definition of financial services income under section 904(d)(2)(D); (3) the allocation and apportionment of creditable foreign taxes; (4) the interaction of the branch loss and dual consolidated loss recapture rules with sections 904(f) and (g); (5) the effect of foreign tax redeterminations of foreign corporations on the application of the high-tax exception described in section 954(b)(4) (including for purposes of determining tested income under section 951A(c)(2)(A)(i)(III)), and required notifications under section 905(c) to the IRS of foreign tax redeterminations and related penalty provisions; (6) the definition of foreign personal holding company income under section 954; (7) the application of the foreign tax credit disallowance under section 965(g); and (8) the application of the foreign tax credit limitation to consolidated groups. Explanation of Provisions I. Allocation and Apportionment of Deductions and the Calculation of Taxable Income for Purposes of Section 904(a) A. Stewardship Expenses, Litigation Damages Awards and Settlement Payments, Net Operating Losses, and Interest Expense 1. Stewardship Expenses Under § 1.861–8(e)(4)(i), stewardship expenses are definitely related and allocable to dividends received or to be received from related corporations. This reflects a determination that stewardship expenses are, at least in part, intended to protect the shareholder’s capital investment and thus are factually related to the income that arises from the investment. Before the enactment of the TCJA, taxpayers with foreign subsidiaries often included in their income foreign source income only when that income was distributed to the taxpayer. However, as a result of the enactment of sections 951A and 245A, a significant portion of the foreign source income of foreign subsidiaries is included in income on a current basis or not at all. The Treasury Department and the IRS are aware that some taxpayers may be interpreting the ‘‘dividends received, or to be received’’ phrase in § 1.861–8(e)(4)(ii) to exclude the gross up amount treated as a dividend under section 78 (the ‘‘section E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules jbell on DSKJLSW7X2PROD with PROPOSALS2 78 dividend’’), as well as inclusions under section 951(a)(1), section 951A, and similar provisions, even though the stewardship expenses may be factually related to such gross income. With respect to the allocation of stewardship expenses, income arising because of one’s capital investment in a foreign corporation’s stock ordinarily includes not only dividends, but also inclusions under sections 951 and 951A, as well as amounts included under sections 1291, 1293, and 1296 (the ‘‘passive foreign investment company provisions’’). Therefore, the proposed regulations provide that stewardship expenses are allocated to dividends and inclusions received or accrued, or to be received or accrued, from related corporations.1 Thus, stewardship expenses are also allocated to inclusions under sections 951 and 951A, section 78 dividends, and all amounts included under the passive foreign investment company provisions. With respect to apportionment, the current regulations do not provide an explicit rule but instead provide examples of permissible methods. The Treasury Department and the IRS have determined that an explicit rule would provide certainty for taxpayers and the IRS on the appropriate methodology for apportioning stewardship expenses while ensuring that stewardship expenses are apportioned to gross income in a manner that reflects the purpose of the expenses to protect capital investments or to facilitate compliance with reporting, legal, or regulatory requirements. Therefore, the proposed regulations provide that stewardship expenses are apportioned based upon the relative values of a taxpayer’s stock assets, as determined and characterized under § 1.861–9T(g) (and, as relevant, §§ 1.861–12 and 1.861–13) for purposes of allocating and apportioning the taxpayer’s interest expense. Therefore, a taxpayer will be required to use the same method to characterize and value its stock assets for purposes of allocating and apportioning its interest and stewardship expenses, and, in some cases as described in Part 1.A.2 of this Explanation of Provisions, certain 1 Duplicative activities or shareholder activities giving rise to stewardship expenses can only be performed with respect to members of a controlled group as described in § 1.482–9(l)(3)(iii)–(iv). Accordingly, relatedness in the context of stewardship expenses includes taxpayers that are members of the same controlled group as defined in § 1.482–1(i)(6). A taxpayer could incur stewardship expenses with respect to a related foreign corporation that is a passive foreign investment company (in addition to a related foreign corporation that is a controlled foreign corporation). VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 damages payments. Accordingly, since the fair market value method may not be used for interest allocation and apportionment, it may also not be used for stewardship and certain damages payments. Conforming changes are also proposed with respect to § 1.861– 14T(e)(4), which provides rules for the treatment of stewardship expenses with respect to an affiliated group. See also § 1.861–8(g)(18) (Example 18) for an example illustrating the application of the proposed rules for stewardship expenses. The Treasury Department and the IRS are aware that stewardship expenses that are incurred to facilitate compliance with reporting, legal, or regulatory requirements may be more appropriately treated as definitely related to the gross income produced by the particular asset, or assets, whose ownership required the stewardship expenditure. For example, the owner of an entity in a particular jurisdiction might have unique reporting requirements not triggered by the ownership of a similar entity in a different jurisdiction. The Treasury Department and the IRS request comments regarding exceptions to the general rule for the allocation and apportionment of stewardship expenses where it is more appropriate to treat stewardship expenses as definitely related to a more limited class of gross income. Comments are also requested on whether it is more appropriate in certain cases to allocate and apportion stewardship expenses on a separate entity, rather than an affiliated group, basis. The proposed regulations maintain the definition of stewardship expenses as a duplicative activity (as defined in § 1.482–9(l)(3)(iii)) or a shareholder activity (as defined in § 1.482– 9(l)(3)(iv)). See proposed § 1.861– 8(e)(4)(ii)(A). In particular, shareholder activities are those that preserve the shareholder’s capital investment or facilitate compliance with reporting, regulatory, or legal requirements. See § 1.482–9(l)(3)(iv). However, the Treasury Department and the IRS are aware that it may be difficult for taxpayers to distinguish between stewardship expenses that result from oversight functions and expenses that are supportive in nature, as described in § 1.861–8(b)(3), and are concerned that expenses may be misclassified as either stewardship or supportive expenses in certain cases. For example, day-to-day management activities do not give rise to stewardship expenses and are typically more supportive in nature. However, the distinction between dayto-day management and oversight may PO 00000 Frm 00002 Fmt 4701 Sfmt 4702 69125 change over time as a taxpayer’s investments change. Given these concerns, the Treasury Department and the IRS request comments regarding the definition of stewardship expenses and how to readily distinguish such expenses from supportive expenses that are allocated and apportioned under § 1.861–8(b)(3). The proposed regulations extend the treatment of stewardship expenses to cover expenses incurred with respect to a partnership. See proposed § 1.861– 8(e)(4)(ii)(D). Rules similar to those with respect to corporations apply to allocate and apportion stewardship expenses incurred with respect to partnerships. Finally, the Treasury Department and the IRS are considering whether additional changes to the rules for allocating and apportioning stewardship and similar expenses are appropriate in light of the enactment of the TCJA, and in order to better reflect modern business practices that are increasingly global and mobile in nature. Comments are requested on this topic. 2. Litigation Damages Awards, Prejudgment Interest, and Settlement Payments The current rule for the allocation and apportionment of legal and accounting fees and expenses in § 1.861–8(e)(5) does not specifically address damages awards, prejudgment interest, or settlement payments arising from product liability and similar claims. The Treasury Department and the IRS are aware that large, unplanned, and relatively rare expenses can have a significant effect on the calculation of a taxpayer’s taxable income and foreign tax credit limitation, and, in the absence of clear rules, disputes have arisen regarding the proper treatment of such expenses. Proposed § 1.861–8(e)(5) provides that deductions for damages awards, prejudgment interest, and settlement payments arising from product liability and similar or related claims are allocated to the class or classes of gross income produced by the specific sales of products or services that gave rise to the claims for damage or injury. Damages, prejudgment interest, and settlement payments related to events incident to the production of goods or provision of services, such as damages for injuries caused by industrial accidents, are allocated to the class of gross income produced by the assets involved in the event and, if necessary, apportioned between groupings based on the relative value of the assets in such groupings. In the case of claims made by investors that arise from corporate negligence, fraud, or other malfeasance, the E:\FR\FM\17DEP2.SGM 17DEP2 69126 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules proposed regulations provide that damages, prejudgment interest, and settlement payments paid by the corporation are allocated and apportioned based on the value of all the corporation’s assets. In general, the deductions are allocated and apportioned to the statutory or residual groupings to which the related income would be assigned if recognized in the taxable year in which the deductions are allowed. jbell on DSKJLSW7X2PROD with PROPOSALS2 3. Net Operating Loss Deductions Under current rules, a net operating loss deduction is allocated and apportioned in the same manner as the deductions giving rise to the net operating loss deduction. However, the rule does not specify how the statutory and residual grouping components of a net operating loss are determined. See § 1.861–8(e)(8). The proposed regulations provide that a net operating loss is assigned to the statutory and residual groupings by reference to the losses in each statutory or residual grouping (determined without regard to adjustments made under section 904(b)) that are not allocated to reduce income in a different grouping in the taxable year of the loss. See proposed § 1.861– 8(e)(8)(i). Furthermore, the proposed regulations clarify that a net operating loss deduction for a taxable year is allocated and apportioned by reference to the statutory and residual grouping components of the net operating loss that is deducted in the taxable year. See proposed § 1.861–8(e)(8)(ii). Finally, the proposed regulations provide that except as provided in regulations, for example, in § 1.904(g)–3, a partial net operating loss deduction is treated as ratably comprising the components of the net operating loss.2 See id. In connection with the proposed regulations under section 250, comments requested clarification on the application of § 1.861–8(e)(8) with respect to net operating losses arising prior to the enactment of the TCJA when the net operating loss is deducted in a post-TCJA year for purposes of applying section 250 as the operative section. See 84 FR 8188 (March 6, 2019). These comments will be addressed as part of finalizing those proposed regulations. 4. Application of the Exempt Income/ Asset Rule to Insurance Companies in Connection With Certain Dividends and Tax-Exempt Interest As explained in Part II.B.2 of the Summary of Comments and Explanation 2 A partial net operating loss deduction occurs when the full net operating loss is not deductible in the carryover year. VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 of Revisions to the 2019 FTC final regulations, one comment to the 2018 FTC proposed regulations suggested that insurance companies reduce exempt income and assets to reflect prorated amounts of dividends and tax exempt interest. See sections 805(a)(4), 807, 812, and 832(b)(5)(B). The 2019 FTC final regulations do not address this issue, and the proposed regulations do not adopt this comment. Under subchapter L, a nonlife insurance company includes in income its underwriting income, which consists of premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred. The proration rules reduce the company’s losses incurred by the ‘‘applicable percentage’’ of tax exempt interest or deductible dividends received. See section 832(b)(5)(B). For a life insurance company, the proration rules apply in the case of tax exempt interest by reducing the closing balance of reserve items by the ‘‘policyholder’s share’’ (currently a fixed percentage, originally intended to be the portion of tax favored investment income used to fund the company’s obligations to policyholders) of tax exempt interest. See sections 807(b)(1)(B) and 812. Similarly, a life insurance company is allowed a dividends received deduction (DRD) for intercorporate dividends from non-affiliates only in proportion to the ‘‘company’s share’’ of the dividends, but not for the policyholder’s share. See section 805(a)(4)(A). Fully deductible dividends from affiliates are excluded from proration for life insurance companies if the dividends are not themselves distributions from tax exempt interest or from dividend income that would not be fully deductible if received directly by the taxpayer. While the mechanics of the proration rules differ depending on whether a company is a life or nonlife insurance company and whether the amount relates to dividends or tax exempt interest, the purpose of those provisions is the same. That is, the policyholder’s share or applicable percentage of dividends and tax exempt interest should not create a double benefit by reason of a DRD or section 103 tax exemption for interest in the first instance and a reduction to income (via increases in unpaid losses and reserves during the taxable year) in the second. Regardless of the mechanics, however, the policyholder’s share and applicable percentage adjustments do not change the fact that tax exempt interest and (for a nonlife insurance company) the applicable percentage of dividends eligible for DRDs remain exempt from PO 00000 Frm 00003 Fmt 4701 Sfmt 4702 U.S. tax. Including those exempt amounts and the corresponding exempt assets in the apportionment formula in allocating expenses under § 1.861– 8T(d)(2)(i)(B), as the comment suggests, would effectively apportion reserve deductions (which already do not include the disallowed deductions deemed to be attributable to the exempt income, except in the case of the policyholder’s share of life insurance DRDs) to exempt U.S. source income, with the result that those deductions would reduce unrelated U.S. source income, in contravention of the rule in § 1.861–8T(d)(2)(i)(B). See also Travelers Insurance Company v. United States, 303 F.3d 1373 (2002). The current regulations already provide the appropriate rules in this area. Section 1.861–8T(d)(2)(ii)(B) provides that the policyholder’s share of dividends received by a life insurance company is treated as tax exempt income notwithstanding the partial disallowance of the DRD, and § 1.861– 14T(h) provides for the direct allocation to the dividends of an amount of reserve expenses equal to the disallowed portion of the DRDs. The current regulations do not provide a special rule for either tax exempt interest of a life insurance company or DRDs and tax exempt interest of a nonlife insurance company because, when a policyholder’s share or applicable percentage is accounted for as either a reserve adjustment or a reduction to losses incurred, no further modification to the generally applicable rules is required to ensure that the appropriate amount of expenses are apportioned to U.S. source income. Nevertheless, in order to provide greater clarity, the proposed regulations provide in proposed § 1.861– 8(d)(2)(ii)(B), (d)(2)(v), and (e)(16) the effect of certain deduction limitations on the treatment of income and assets generating dividends received deductions and tax exempt interest held by insurance companies. More specifically, the proposed regulations provide that in the case of insurance companies, the term exempt income includes dividends for which a deduction is provided by sections 243(a)(1) and (2) and 245, without regard to the proration rules disallowing a portion of the deduction. Similarly, the term exempt income includes tax exempt interest without regard to the proration rules. These provisions apply on a company wide basis and therefore include each separate account of the company. Two examples are provided in proposed § 1.861–8(d)(2)(v)(B) that illustrate the application of these rules. E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules 5. Other Requests for Comments on Expense Allocation The Treasury Department and the IRS continue to study the rules for allocating and apportioning interest deductions. In addition, the Treasury Department and the IRS expect the implementation of section 864(f) (which is effective for taxable years beginning after December 31, 2020) will have a significant impact on the effect of interest expense apportionment and will necessitate a reexamination of the existing expense allocation rules. Therefore, the Treasury Department and the IRS are studying whether further guidance with respect to allocation and apportionment of interest expense, taking into account the changes made by the TCJA and the future implementation of section 864(f), is required. Comments are requested on this topic. The Treasury Department and the IRS are also considering whether rules providing for the capitalization and amortization of certain expenses solely for purposes of § 1.861–9 may better reflect asset values under the tax book value method. For example, solely for purposes of § 1.861–9, research and experimental expenditures and advertising expenses could be treated as if they were capitalized and amortized. Comments are requested on this topic. As noted in Part III.B.4.iii of the Summary of Comments and Explanation of Revisions to the 2019 FTC final regulations, the Treasury Department and the IRS are studying whether additional rules for allocating and apportioning expenses to foreign branch category income or limiting the amount of the gross income reallocated as a result of certain disregarded payments are appropriate. Comments are requested on whether such special rules would more accurately reflect the business profits of a foreign branch, while maintaining administrability for taxpayers and the IRS. jbell on DSKJLSW7X2PROD with PROPOSALS2 B. Certain Loans Made by Partnerships to Partners The 2018 FTC proposed regulations included rules addressing the source and separate category of interest income and expense related to loans to a partnership by a U.S. person (or a member of its affiliated group) that owns an interest (directly or indirectly) in the partnership. These rules were finalized in the 2019 FTC final regulations. See § 1.861.9(e)(8). As discussed in Part II.C.1 of the Summary of Comments and Explanation of Revisions of the 2019 FTC final regulations, several comments to the 2018 FTC proposed regulations VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 requested that the rules under § 1.861– 9(e)(8) with respect to specified partnership loans be expanded to cover loans made by a partnership to a partner (an ‘‘upstream partnership loan’’). The Treasury Department and the IRS agree with comments that rules addressing upstream partnership loans would reduce distortions that could otherwise affect the foreign tax credit limitation. Therefore, the comments are adopted in proposed § 1.861–9(e)(9)(ii), which generally provides that, to the extent the borrower in an upstream partnership loan transaction takes into account both interest expense and interest income with respect to the same loan, the interest income is assigned to the same statutory and residual groupings as those groupings from which the matching amount of interest expense is deducted, as determined under the allocation and apportionment rules in §§ 1.861–9 through 1.861–13. Additionally, proposed § 1.861– 9(e)(9)(i) provides that, for purposes of applying the allocation and apportionment rules, the borrower does not take into account as an asset its proportionate share of the loan, as otherwise provided under § 1.861– 9(e)(2) and (3). Proposed § 1.861– 9(e)(8)(iv) also applies the upstream partnership loan rules to transactions that are not loans but that give rise to deductions that are allocated and apportioned in the same manner as interest expense under § 1.861–9T(b). An anti-avoidance rule similar to the rule in § 1.861–9(e)(8)(iii) is included to cover back-to-back third-party loans that are intended to circumvent the purposes of the rules. See proposed § 1.861– 9(e)(8)(iii). These rules are being proposed in order to provide taxpayers an additional opportunity to comment on the rule. Additionally, the Treasury Department and the IRS are aware that some taxpayers may be converting existing partnership debt structures that were used to increase a taxpayer’s foreign tax credit limitation before the issuance of § 1.861–9(e)(8) from partnership debt into partnership equity that provides for guaranteed payments for the use of capital. The taxpayer then takes the position that the guaranteed payments are neither allocated and apportioned under the rules in § 1.861– 9 nor included in subpart F income by reason of § 1.954–2(h). Guaranteed payments for the use of capital are similar to a loan from the partner to the partnership because the payment is for the use of money and is generally deductible. See section 707(c). Because these arrangements raise the same policy concerns as ordinary debt PO 00000 Frm 00004 Fmt 4701 Sfmt 4702 69127 instruments, the proposed regulations revise § 1.861–9(b) and § 1.954–2(h)(2)(i) explicitly to provide that guaranteed payments for the use of capital described in section 707(c) are treated similarly to interest deductions for purposes of allocating and apportioning deductions under §§ 1.861–8 through 1.861–14 and are treated as income equivalent to interest under section 954(c)(1)(E). No inference is intended as to whether or not § 1.861–9T(b) or § 1.954–2(h)(2) include guaranteed payments for taxable years before the proposed regulations are applicable. C. Treatment of Assets Connected With Capitalized, Deferred, or Disallowed Interest Section 1.861–12T(f)(1) provides that, in certain circumstances, where interest expense that is capitalized, deferred, or disallowed under a provision of the Code, the adjusted basis or fair market value of the asset to which the interest expense is connected is reduced by the principal amount of the interest that is capitalized, deferred, or disallowed. One comment with respect to the 2018 FTC proposed regulations recommended that the Treasury Department and the IRS consider narrowing the scope of the rule in § 1.861–12T(f)(1) to prevent taxpayers from taking overly expansive views of the rule in order to minimize the value of controlled foreign corporation (‘‘CFC’’) stock that attracts interest expense to reduce the foreign tax credit limitation. In response to the comment, the proposed regulations clarify what it means for an asset to be connected with indebtedness, modify the existing example, and add a new example. See proposed § 1.861–12(f). D. Treatment of Section 818(f) Reserve Expenses for Consolidated Groups Section 818(f)(1) provides that the deduction for life insurance reserves and certain other deductions (‘‘section 818(f) expenses’’) are treated as items which cannot definitely be allocated to an item or class of gross income. Therefore, when a life insurance company computes its foreign tax credit limitation, its section 818(f) expenses generally reduce its U.S. source income and foreign source income ratably. However, issues arise as to how to allocate and apportion section 818(f) expenses if the life insurance company is a member of an affiliated group of corporations (including both life and nonlife members) (the group, ‘‘lifenonlife consolidated group’’) that join in filing a consolidated return. The Treasury Department and the IRS are aware of at least five potential E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69128 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules methods for allocating section 818(f) expenses in a life-nonlife consolidated group. First, the expenses might be allocated solely among items of the life insurance company that has the reserves (‘‘separate entity method’’). Second, to the extent the life insurance company has engaged in a reinsurance arrangement that constitutes an intercompany transaction (as defined in § 1.1502–13(b)(1)), the expenses might be allocated in a manner that achieves single entity treatment between the ceding member and the assuming member (‘‘limited single entity method’’). Third, the expenses might be allocated among items of all life insurance members (‘‘life subgroup method’’). Fourth, the expenses might be allocated among items of all members of the consolidated group (including both life and non-life members) (‘‘single entity method’’). Fifth, the expenses might be allocated based on a facts and circumstances analysis (‘‘facts and circumstances method’’). In response to the request for comments in the 2018 FTC proposed regulations, the Treasury Department and the IRS have received comments advocating for certain of the aforementioned allocation methods. One comment recommended an allocation method similar to the single entity method. The comment proposed that, if all members of a consolidated group were treated as a single corporation, and if that corporation would constitute a life insurance company, then section 818(f) expenses might be allocated and apportioned to all members of the consolidated group, including nonlife members of a lifenonlife consolidated group. Two other comments disagreed with the single entity method. These comments proposed that section 818(f) expenses generally be allocated on the separate entity method. However, if the facts and circumstances demonstrate a sufficient factual relationship between the expense and the income of more than one life insurance company, these comments proposed that such expenses might be allocated based on the facts and circumstances method. The comments did not provide examples of when facts and circumstances would demonstrate a sufficient relationship to qualify for this treatment. The Treasury Department and the IRS decline to adopt the single entity method in the proposed regulations. Section 818(f) only applies to a life insurance company; thus, section 818(f) expenses should not be allocated to nonlife members of a consolidated group. The Treasury Department and the IRS also decline to adopt the facts VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 and circumstances method because a broad facts and circumstances approach would introduce substantial uncertainty into the tax system and would be difficult to administer. The Treasury Department and the IRS considered adopting the life subgroup method in the proposed regulations. This method would reflect a single entity approach for life insurance companies that operate businesses and manage assets and liabilities on a group basis. Under this paradigm, section 818(f) expenses would be treated as not definitely related to an item or class of gross income of the entire life subgroup for purposes of calculating the foreign tax credit limitation, and therefore generally ratably reduce U.S. source income and foreign source income of the life subgroup. The Treasury Department and the IRS also considered adopting the separate entity method. The separate entity method would allocate and apportion section 818(f) expenses on a separate company basis. This method is consistent with the Code because section 818(f) expenses generally are computed on a separate company basis and relate to the liabilities of a specific life insurance company. In addition, this method is consistent with the treatment of reserves when members of a consolidated group engage in an intercompany transaction. Under § 1.1502–13(e)(2)(ii)(A), direct insurance transactions between members of a consolidated group are accounted for by both members on a separate entity basis. For example, if one member provides life insurance coverage for another member with respect to its employees, the premiums, reserve increases and decreases, and death benefit payments are determined and taken into account by both members on a separate entity basis (rather than on a single entity basis under the general rules of § 1.1502–13). See also § 1.1502–13(e)(2)(ii)(B)(2) (providing that reserves resulting from intercompany reinsurance transactions are determined on a separate entity basis). After considering both methods, proposed § 1.861–14(h)(1) adopts the separate entity method. As noted previously, this method generally is consistent with section 818(f) and with the separate entity treatment of reserves under § 1.1502–13(e)(2). Nevertheless, the Treasury Department and the IRS are concerned that this method may create opportunities for consolidated groups to use intercompany transactions to shift their section 818(f) expenses and achieve a more desirable foreign tax credit result. Accordingly, the Treasury Department and the IRS request PO 00000 Frm 00005 Fmt 4701 Sfmt 4702 comments on whether a life subgroup method more accurately reflects the relationship between section 818(f) expenses and the income producing activities of the life subgroup as a whole, and whether the life subgroup method is less susceptible to abuse because it might prevent a consolidated group from inflating its foreign tax credit limitation through intercompany transfers of assets, reinsurance transactions, or transfers of section 818(f) expenses. The Treasury Department and the IRS also request comments on whether an anti-abuse rule may be appropriate to address concerns with the separate entity method, and regarding the appropriate application of § 1.1502–13(c) to neutralize the ancillary effects of separate-entity computation of insurance reserves, such as the computation of limitations under section 904. E. Allocation and Apportionment of R&E Expenditures Part I.G of the Explanation of Provisions of the 2018 FTC proposed regulations discussed the interaction between the current rules for allocating and apportioning R&E expenditures and the changes made to section 904(d) by the TCJA, and requested comments on how the regulations should be revised to account for the new category in section 904(d)(1)(A) (the ‘‘section 951A category’’). The comments received are addressed in this Part I.E. 1. Relevant Class of Gross Income and Application of the Gross Income Method Several comments to the 2018 FTC proposed regulations recommended that the regulations for allocating and apportioning R&E expenditures under § 1.861–17 be revised to preclude allocation and apportionment of R&E expenditures to the section 951A category. The comments stated that R&E expenditures are incurred by a U.S. taxpayer to develop intangible property that cannot generate income in the section 951A category, which is limited to inclusions under section 951A (‘‘GILTI inclusions’’) and the related section 78 dividend in respect of deemed paid taxes. Further, to the extent a GILTI inclusion is attributable to a CFC’s income derived from intangible property developed by the worldwide group, the comments stated that the intangible property must have either been developed by the CFC or a CFC affiliate (in which case the R&E expenditures were not borne by the U.S. taxpayer), or licensed or acquired by the CFC from a U.S. affiliate, which would E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules require that the U.S. affiliate take into account an arm’s length royalty, gain on transfer, or a deemed income amount under section 367(d) to which its R&E expenditures should be allocated. The Treasury Department and the IRS agree with the comments that the rules under § 1.861–17 should be modified to reflect the fact that R&E expenditures that are deductible under section 174 generally give rise to intangible property, and that under the rules in sections 367(d) and 482, the person incurring such R&E expenditures must be compensated properly when such intangible property gives rise to income. Therefore, proposed § 1.861–17(b) provides that the rules in that section are premised on the fact that successful R&E expenditures ultimately result in the creation of intangible property (as defined in section 367(d)(4)) and, therefore, R&E expenditures ordinarily are considered deductions that are definitely related to all gross intangible income reasonably connected with the relevant Standard Industrial Classification Manual code (‘‘SIC code’’) category (or categories) of the taxpayer and so are allocable to all items of gross intangible income related to the SIC code category (or categories) as a class. Gross intangible income is defined as all gross income earned by a taxpayer that is attributable, in whole or in part, to intangible property derived from R&E expenditures and does not include dividends or any amounts included under section 951, 951A, or 1293. See proposed § 1.861–17(b)(2). As a result, when applying § 1.861–17 to section 904 as the operative section, because a U.S. taxpayer’s gross intangible income, as defined in the proposed regulations, does not include income assigned to the section 951A category, none of its R&E expenditures are allocated or apportioned to the section 951A category. Under § 1.861–17(c) and (d), a taxpayer may elect to apportion R&E expenditures, in excess of amounts exclusively apportioned to the place the R&E is performed under § 1.861–17(b), on the basis of either sales or gross income. In contrast to the sales method, the gross income method of apportioning R&E expenditures (1) limits taxpayers to exclusively apportion only 25 percent of R&E expenditures based on the place of research activities (instead of 50 percent under the sales method), and (2) requires the apportionment to or among the statutory groupings to be at least half of what would have been apportioned under the sales method. These limits reflect concerns that the gross income method could produce inappropriate VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 results in cases where the types of gross income recognized by the taxpayer in the statutory and residual groupings in a SIC code category are different. For example, if a taxpayer sells products incorporating its intangible property in the United States but earns royalties from licensing its intangible property used by others to make sales abroad, comparing the gross income from sales, which includes value attributable to other factors in addition to intangible property, to the gross royalty income will generally distort the extent to which the R&E expenditures produce U.S. and foreign source income from intangible property. In such cases, the gross income method is inconsistent with the general principle under § 1.861–8T(c) that the method of apportionment ‘‘reflect to a reasonably close extent the factual relationship between the deduction and the grouping of gross income.’’ In comparison, the sales method requires that taxpayers use a single, consistent measure—gross receipts from sales and services—to attribute R&E expenditures to their various groupings and, therefore, more clearly reflects the anticipated income expected to be derived from successful R&E expenditures. Therefore, the proposed regulations eliminate the optional gross income method and require R&E expenditures in excess of the amount exclusively apportioned under § 1.861–17(b) to be apportioned among the statutory and residual groupings within the class of gross intangible income on the basis of the relative amounts of gross receipts from sales and services in each grouping. See proposed § 1.861–17(d). For this purpose, gross receipts are assigned to the grouping to which the gross intangible income attributable to the sale or service is assigned. For example, where the taxpayer licenses intangible property to a CFC which, in turn, sells products or services incorporating the intangible property, the gross receipts of the CFC are assigned to a grouping based on the source and character of the related royalty included by the taxpayer. Proposed § 1.861–17(d)(1)(iii). This rule addresses concerns that the Treasury Department and the IRS have had since before the TCJA’s enactment that taxpayers would assign the gross receipts from CFC sales to U.S. customers to the residual grouping for U.S. source income while arguing that the related royalty income earned by the U.S. company that owns the intangible property can be treated as foreign source income, with the mismatch resulting in an inflation of R&E expenditures PO 00000 Frm 00006 Fmt 4701 Sfmt 4702 69129 apportioned to U.S. source income. The proposed regulations also clarify that the sales method applies to income from services. Under § 1.861–17(a)(2)(ii), the relevant SIC code categories are determined by reference to the three digit classification of the SIC code. Proposed § 1.861–17(b)(3)(iv) clarifies the rules relating to goods or property that are described in the SIC code category for ‘‘wholesale trade’’ or ‘‘retail trade.’’ The purpose of this rule is to match R&E expenditures with a taxpayer’s core business and minimize the number of a taxpayer’s SIC code categories. This rule provides that vertically integrated taxpayers that perform upstream activities (for example, extraction or manufacturing) before downstream wholesale and retail functions must aggregate their wholesale and retail R&E expenditures and sales with their R&E expenditures and sales in the most closely related three-digit SIC code category. A taxpayer cannot use a SIC code category within the wholesale or retail trade divisions unless its business is generally limited to sales-related activities. Taxpayers engaged in both wholesale and retail trade, but not related upstream activities, are not required to aggregate their wholesale and retail R&E expenditures and sales. Comments are requested on whether a different classification method that takes into account more recent changes in the economy and business practices should be used. For example, comments are requested on whether NAICS codes would be more appropriate. Comments to § 1.861–17 were also received in connection with the proposed regulations under section 250. See 84 FR 8188 (March 6, 2019). Further changes to the rules for allocating and apportioning R&E expenditures will be considered as part of addressing comments in finalizing those regulations. 2. Elimination of Legally Mandated R&E and Increased Exclusive Apportionment of R&E Under § 1.861–17(a)(4), R&E expenditures that are undertaken solely to meet legal requirements (‘‘legally mandated R&E’’) imposed by a political entity and that cannot reasonably be expected to generate amounts of gross income (beyond de minimis amounts) outside a single geographic source are allocated directly to gross income within the geographic source imposing the requirement. A rule similar to the legally mandated R&E rule existed in regulations issued in 1977 that allocated E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69130 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules and apportioned R&E expenditures (‘‘the 1977 regulations’’). Since the adoption of the legally mandated R&E rule in the 1977 regulations, the Treasury Department and the IRS have observed that taxpayers rarely rely on the legally mandated R&E rule. In particular, legal requirements for certain products may significantly overlap between multiple jurisdictions because those jurisdictions have similar legal requirements that relate to areas such as consumer safety, pollution, or pharmaceutical products. In addition, multiple jurisdictions may have similar legal requirements because of multilateral trade and investment agreements or because taxpayers choose to sell their products only in markets with similar requirements. See, for example, IRS Coordinated Issue Biotech and Pharmaceutical Industries Legally Mandated R&E Expense (June 18, 2003) (discussing the International Conference on Harmonization, subsequently the International Council for Harmonization, and its role in rationalizing and harmonizing pharmaceutical regulations in multiple jurisdictions). To reflect the changing international business environment and simplify the regulations with respect to R&E, the proposed regulations eliminate the legally mandated R&E rule. Under § 1.861–17(b), an exclusive apportionment of R&E expenditures is made if activities representing more than 50 percent of the R&E expenditures were performed in a particular geographic location, such as the United States. Under § 1.861–17(b)(1)(ii), for taxpayers electing the gross income method, 25 percent of R&E expenditures is exclusively apportioned to the geographic location where the R&E activities accounting for more than 50 percent of the deductible expenses were incurred. Under § 1.861–17(b)(1)(i), for taxpayers electing the sales method, 50 percent of R&E expenditures are exclusively apportioned to the geographic location where the R&E activities accounting for more than 50 percent of the deductible expenses were incurred. After this initial exclusive apportionment, the remainder of the taxpayer’s R&E expenditures are apportioned under either the sales or gross income methods. The 1977 regulations also included a rule similar to a rule in the current regulations at § 1.861–17(b)(2). Under this rule, taxpayers may demonstrate to the satisfaction of the Commissioner that an even higher amount of R&E expenditures should be exclusively apportioned to a geographic location. According to the current regulations, the exclusive apportionment rules are based VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 on the understanding that R&E may be more valuable where it is undertaken because R&E benefits products all of which may be sold in the nearest market but only some of which may be sold in foreign markets, and R&E is often used in the nearest market first before it is used in other markets. Therefore, under the increased exclusive apportionment rule, a taxpayer may establish to the satisfaction of the Commissioner that one or both of these conditions are satisfied—that is, its research is expected to have a particularly limited or long delayed application outside the geographic area where the research is performed, such that a greater amount of R&E expenditures should be initially exclusively apportioned. Similar to the legally mandated rule, the Treasury Department and the IRS have observed that taxpayers have rarely used the current increased exclusive apportionment rule since the issuance of the 1977 regulations. Moreover, when it has been used, the facts and circumstances nature of the analysis has caused hard-to-resolve disagreements between the Commissioner and taxpayers. Changes in the international business environment have also contributed to the decreased utilization of this rule. Accordingly, the proposed regulations eliminate the increased exclusive apportionment rule. Finally, proposed § 1.861–17(b) clarifies that the exclusive apportionment rule applies only to section 904 as the operative section. See also Part I.E.1 of this Explanation of Provisions (noting that comments were received in connection with proposed regulations under section 250 and that further changes will be considered as part of addressing comments in finalizing those regulations). 3. Sales Made by Other Entities The sales method for apportioning R&E expenditures provides that gross receipts from sales of products or provision of services within a relevant SIC code category by controlled parties of the taxpayer are taken into account in apportioning the taxpayer’s R&E expenditures if the controlled party is reasonably expected to benefit from the taxpayer’s research and experimentation. Under § 1.861– 17(c)(3)(iv), the sales of controlled parties that enter a valid cost sharing arrangement (‘‘CSA’’) with a taxpayer are excluded from the apportionment formula because the controlled party is not expected to benefit from the taxpayer’s remaining R&E expenditures. Proposed § 1.861–17 clarifies the treatment of CSAs in two respects. First, consistent with § 1.482–7, the taxpayer’s PO 00000 Frm 00007 Fmt 4701 Sfmt 4702 R&E expenditures allocated and apportioned under § 1.861–17 do not include any amounts that are not deductible by reason of the second sentence under § 1.482–7(j)(3)(i) (relating to cost sharing transaction payments from a controlled party). Second, the proposed regulations clarify that the exclusion of the controlled party’s gross receipts applies only for purposes of apportioning those R&E expenditures that are intangible development costs with respect to the CSA. If a taxpayer who enters a CSA also incurs R&E expenditures that are not intangible development costs with respect to the CSA, then those expenses would be apportioned under the generally applicable rules, including the rules concerning controlled party sales. See proposed § 1.861–17(d)(4)(v). One comment suggested that § 1.861– 17 be modified to provide that a taxpayer’s R&E expenditures that are funded by a foreign affiliate under a contract research arrangement should be directly allocated to the taxpayer’s income from such arrangements. The terms of the contract research arrangement are not clear from the comment, and it is unclear whether the described expenditures that are reimbursed by a foreign affiliate are paid or incurred by the taxpayer to develop or improve a product in connection with the taxpayer’s trade or business. See §§ 1.174–1 and 1.174–2. If the expenditures are not paid or incurred by the taxpayer to develop or improve a product in connection with its trade or business, the taxpayer may not deduct them under section 174. As a result, § 1.861–17 would not apply to these expenditures. The expenditures would instead be allocated and apportioned under the general rules in § 1.861–8 on the basis of the factual relationship of deductions to gross income. See § 1.861–8(a)(2). The Treasury Department and the IRS request comments on whether contract research arrangements involving expenditures reimbursed by a foreign affiliate are generally paid or incurred by the taxpayer in connection with its trade or business such that a deduction under section 174 is allowable, and whether a special rule for such expenditures should be considered. Another comment suggested a special rule for ‘‘licensor models’’ whereby CFCs pay royalties to compensate for a taxpayer’s R&E expenditures. The comment suggested that in order to avoid allocation and apportionment of R&E expenditures to the section 951A category, the activities of the licensee CFC should be excluded for purposes of apportioning the licensor’s R&E E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules jbell on DSKJLSW7X2PROD with PROPOSALS2 expenditures and should be treated similarly to cost sharing arrangements. The comment suggested in the alternative that if the CFC sales are not excluded entirely, that R&E expenditures should be netted against the royalty income to which the R&E expenditures are apportioned. The Treasury Department and the IRS agree that R&E expenditures should be allocated and apportioned solely with respect to the gross intangible income of the taxpayer rather than the net income of a licensee, and therefore not allocated and apportioned to the section 951A category. See Part I.D.1 of this Explanation of Provisions. Unlike in the case of a CSA, however, a licensor earns royalties or other forms of gross intangible income from the use of its intangible property, and it would not be appropriate to exclude such royalties in allocating R&E expenditures of the licensor. The proposed regulations require the use of the sales method, which would effectively attribute R&E expenditures to the taxpayer’s royalty income based on the proportion of the gross receipts of the licensees over the total gross receipts of the taxpayer and its licensees. This approach is preferable to the comment’s alternative recommendation of netting R&E expenditures against the amount of royalties because taxpayers may earn different types of gross intangible income (for example, from sales of property as well as royalties) and comparing such amounts could lead to distortive results. Finally, under § 1.861–17(c)(3)(ii) and (f)(3), sales made by controlled corporations and partnerships taken into account to apportion R&E expenditures are reduced to reflect the taxpayer’s percentage ownership of such entities. This reduction is inappropriate because the taxpayer’s gross intangible income is not dependent on its percentage ownership of the entity to which it transfers intangible property. The proposed regulations, therefore, eliminate the rule reducing sales of controlled corporations that are taken into account and include partnership sales to the same extent as those made by controlled corporations. F. Application of Section 904(b) to Net Operating Losses The 2018 FTC proposed regulations included a rule in § 1.904(b)–3(d) coordinating the application of section 904(b)(4) with sections 904(f) and 904(g), which apply after section 904(b)(4). This rule is finalized substantially as proposed in the 2019 FTC final regulations. However, the 2018 FTC proposed regulations did not VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 coordinate any of the adjustments required under section 904(b) with the net operating loss provisions. Therefore, the proposed regulations include a coordination rule. Under proposed § 1.904(b)–3(d)(2), for purposes of determining the source and separate category of a net operating loss, the separate limitation loss and overall foreign loss rules of section 904(f) and the overall domestic loss rules of section 904(g) are applied without taking into account the adjustments required under section 904(b). The Treasury Department and the IRS have determined this rule is appropriate because the amount of the net operating loss eligible to be carried to another year under section 172 is not affected by the adjustments required by section 904(b). II. Foreign Tax Credit Limitation Under Section 904 A. Definition of Financial Services Entity Section 904(d)(2)(D) provides that financial services income can only be received by a person ‘‘predominantly engaged in the active conduct of a banking, insurance, financing, or similar business.’’ Under current law, the principal significance of this provision is that under section 904(d)(2)(C), passive income of such a person is not assigned to the passive category. The preamble to the 2018 FTC proposed regulations noted that the Treasury Department and the IRS were considering modifications to the gross income-based test for determining financial services entity (‘‘FSE’’) status and requested comments in this regard. One comment was received requesting that any future modifications not affect the classification of income derived by a substantial (and genuinely active) financial services group. The Treasury Department and IRS agree that a substantial and genuinely active financial services group should be included in the definition of an FSE. However, numerous places in the Code use similar concepts and, at times, the same terms, but provide different definitions (even when largely overlapping in application). The Treasury Department and IRS have determined that interpretive guidance should be simplified and made consistent where possible and appropriate. For example, section 954(h) in the subpart F rules defines ‘‘predominantly engaged in the active conduct of a banking, financing, or similar business’’ (which in the case of a lending or finance business, requires more than 70 percent of the gross income be derived directly from PO 00000 Frm 00008 Fmt 4701 Sfmt 4702 69131 transactions with unrelated customers); section 1297(b)(2)(B) in the passive foreign investment company (‘‘PFIC’’) rules defines ‘‘active conduct of an insurance business by a qualifying insurance corporation’’; and section 953(e)(3) defines the term ‘‘qualifying insurance company’’ in order to determine the amount of passive income excluded from subpart F income as income derived in the active conduct of an insurance business under section 954(i). In order to promote simplification and greater consistency with other Code provisions that have complementary policy objectives, proposed § 1.904– 4(e)(2) modifies the definition of an FSE by adopting a definition of ‘‘predominantly engaged in the active conduct of a banking, insurance, financing, or similar business’’ and ‘‘income derived in the active conduct of a banking, insurance, financing, or similar business’’ that is generally consistent with sections 954(h), 1297(b)(2)(B), and 953(e). Conforming changes are made to the rules for affiliated groups in proposed § 1.904– 4(e)(2)(ii) and partnerships in proposed § 1.904–4(e)(2)(i)(C). Comments are requested on whether additional guidance is needed with respect to section 954(h) (including in particular section 954(h)(2)(B)(ii), which authorizes the Treasury Department to issue regulations regarding corporations not licensed as a bank in the United States) and section 952(c)(1)(B)(vi) (defining a qualified financial institution for purposes of the qualified deficit rules). In addition, when the regulations defining an FSE were originally promulgated in 1988, section 904(d)(1)(C) assigned financial services income to its own separate category. This separate category was repealed in 2004, effective for taxable years beginning after 2006, but the rules in section 904(d)(2)(C) and (D) were retained. The proposed regulations make additional clarifying changes to reflect the repeal of the separate category for financial services income. Finally, in 2004, a definition of financial services group was added in section 904(d)(2)(C)(ii) which was based on the definition of an affiliated group under section 1504(a) but expanded to include insurance companies and foreign corporations. While the current regulations already include foreign corporations as part of an affiliated group, proposed § 1.904–4(e)(2)(ii) conforms the definition of an affiliated group to also include insurance companies referenced in section 1504(b)(2). E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69132 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules B. Allocation and Apportionment of Foreign Income Taxes As explained in Part III.G of the Summary of Comments and Explanation of Revisions to the 2019 FTC final regulations, the Treasury Department and the IRS have determined that additional guidance regarding the allocation and apportionment to separate categories of creditable foreign income taxes in § 1.904–6 is warranted. As a result of changes made by the TCJA, the accurate allocation and apportionment of foreign income taxes to the gross income to which they relate has taken on increased importance. See, for example, sections 245A(d), 960, 965(g), and § 1.861–8(e)(6) (allocating the deduction for foreign income taxes, including at the level of a CFC, to statutory and residual groupings). Therefore, taxpayers will benefit from increased certainty on how to match foreign income taxes with income, particularly in the case of differences in how a U.S. taxable base and foreign taxable base are computed with respect to the same transaction. Furthermore, because these rules are relevant in numerous contexts outside of section 904, the general rules in § 1.904–6 (which address allocating and apportioning taxes to separate categories) have been moved to new proposed § 1.861–20 and generalized to apply for purposes of allocating and apportioning foreign income taxes to statutory and residual groupings. Rules specific to the allocation and apportionment of foreign income taxes to separate categories remain in proposed § 1.904–6. Conforming changes are proposed to §§ 1.704– 1(b)(4)(viii)(d)(1) and 1.960–1(d), which currently rely on the ‘‘principles of’’ § 1.904–6, as well as § 1.965–5(b)(2) (in the case of foreign corporation taxable years beginning after December 31, 2019). Current § 1.904–6 provides that the allocation and apportionment of foreign tax expense to a section 904 separate category is made on the basis of the income as computed under foreign law on which the tax is imposed; foreign tax is allocated to the separate category to which the income included in the foreign tax base would be assigned under Federal income tax principles. See 1.904–6(a)(1). If the foreign tax base includes income in more than one separate category, the tax is apportioned among the separate categories on the basis of the relative amounts of foreign taxable income in each category. In making this determination, foreign law rules apply, with certain modifications, to determine the foreign law deductions VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 that reduce the foreign law gross income to compute the foreign law amount of taxable income in each separate category. See § 1.904–6(a)(1)(ii). Proposed § 1.861–20 adopts the principles of § 1.904–6 but provides more detailed guidance on how to apply those principles, which are illustrated by several examples. Proposed § 1.861– 20(c) provides that foreign tax expense is allocated and apportioned among the statutory and residual groupings by first assigning the items of gross income under foreign law (‘‘foreign gross income’’) on which a foreign tax is imposed to a grouping, then allocating and apportioning deductions under foreign law to that income, and finally allocating and apportioning the foreign tax among the groupings. See proposed § 1.861–20(c). Proposed § 1.861–20(d)(1) provides a general rule for assigning foreign gross income to a statutory or residual grouping. Under this rule, a foreign gross income item is assigned to a grouping by characterizing the item under Federal income tax law. If an item of gross income or loss arises under Federal income tax law from the same transaction or realization event from which the foreign gross income item arose (a ‘‘corresponding U.S. item’’), the foreign gross income item is assigned to the same statutory or residual grouping as the corresponding U.S. item. In the case of a corresponding U.S. item that is an item of loss (or zero), the foreign gross income is assigned to the same grouping to which an item of gain would be assigned had the transaction or realization event given rise to an item of gain under Federal income tax law. See proposed § 1.861–20(d)(1). Proposed § 1.861–20(d)(2) sets forth rules for assigning a foreign gross income item to a grouping if there is no corresponding U.S. item in the U.S. taxable year in which the taxpayer paid or accrued the foreign income tax imposed on foreign taxable income that includes the foreign gross income item. Proposed § 1.861–20(d)(2)(i) generally addresses the circumstance in which there is no corresponding U.S. item either because the event giving rise to the foreign gross income is a nonrecognition event under Federal income tax law or because the recognition event giving rise to the foreign gross income occurred under Federal income tax law in a different U.S. taxable year. In both cases, proposed § 1.861–20(d)(2)(i) assigns the foreign gross income to the grouping to which the corresponding U.S. item would be assigned if the event giving rise to the foreign gross income resulted in the recognition of gross income or PO 00000 Frm 00009 Fmt 4701 Sfmt 4702 loss under Federal income tax law in the same U.S. taxable year in which the foreign income tax is paid or accrued. Proposed § 1.861–20(d)(2)(ii) provides guidance regarding the treatment of foreign gross income items that are either excluded from gross income under Federal income tax law or attributable to base differences. Under § 1.861–20(d)(2)(ii)(A), with the exception of base difference items, foreign gross income that is a type of income expressly excluded from gross income under Federal income tax law is assigned to the grouping to which the gross income would be assigned if it were included in U.S. gross income. Proposed § 1.861–20(d)(2)(ii)(B) provides an exclusive list of items that are excluded from U.S. gross income and that, if taxable under foreign law, are treated as base differences. The items are death benefits described in section 101, gifts and inheritances described in section 102, contributions to capital described in section 118 and the receipt of property in exchange for stock described in section 1032, the receipt of property in exchange for a partnership interest described in section 721, returns of capital described in section 301(c)(2), and distributions to partners described in section 733. The Treasury Department and the IRS have determined that foreign tax on these items, which are excluded from U.S. gross income, is particularly difficult to associate with a particular type of U.S. gross income. Accordingly, foreign tax on base difference items is assigned to the residual grouping, with the result that no credit is allowed if the tax is paid by a CFC, and the tax is assigned to the separate category described in section 904(d)(2)(H)(i) if paid (or treated as paid) by a taxpayer claiming a direct credit under section 901. Comments are requested on whether the list should be expanded to include other items that have no logical analogue to items included in U.S. gross income, or whether a different assignment of any of these types of foreign gross income would be more appropriate. Proposed § 1.861–20(d)(3) sets forth special rules that apply for purposes of assigning certain items of foreign gross income to a grouping, including rules for distributions that both Federal income tax law and foreign law recognize, certain foreign law distributions such as consent dividends, inclusions under foreign law CFC regimes, disregarded payments, inclusions from reverse hybrids, and gain on the sale of a disregarded entity. In the case of a distribution from a non-hybrid corporation that is recognized for both Federal income tax E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules law and foreign tax law purposes, proposed § 1.861–20(d)(3)(i)(B) treats foreign gross income arising from the distribution as a dividend and as capital gain to the extent of the portions of the distribution that are, under Federal income tax law, characterized as a dividend and capital gain, respectively. The foreign gross income is assigned to the same statutory and residual groupings as the corresponding amounts of dividend and capital gain as computed for U.S. tax purposes. Foreign gross income arising from the portion of the distribution that is a return of capital under Federal income tax law is treated as a base difference under proposed § 1.861–20(d)(2)(ii)(B). If foreign law, but not Federal income tax law, recognizes a deemed distribution or consent dividend (a ‘‘foreign law distribution’’), proposed § 1.861–20(d)(3)(i)(C) assigns the resulting foreign gross income to a statutory or residual grouping by applying proposed § 1.861–20(d)(3)(i)(B) as though Federal income tax law recognized the distribution in the U.S. taxable year in which the taxpayer paid or accrued tax with respect to the foreign law distribution. For example, if a taxpayer recognizes foreign gross income arising from a foreign law distribution, and proposed § 1.861– 20(d)(3)(i)(B) (as applied for purposes of section 904 as the operative section) would treat the distribution as made out of general category section 965(a) previously taxed earnings and profits if the distribution had also occurred under Federal income tax law, the foreign gross income is assigned to the general category. If a taxpayer (including an upper-tier CFC) includes an item of foreign gross income by reason of a foreign law regime similar to the subpart F provisions under sections 951 through 959 (a ‘‘foreign law subpart F regime’’), proposed § 1.861–20(d)(3)(i)(D) assigns that item to the same statutory or residual grouping as the gross income (determined under the foreign law subpart F regime) of the foreign law CFC that gave rise to the foreign gross income of the taxpayer. The taxpayer’s gross income included under the foreign law subpart F regime is, in other words, treated as the foreign gross income of the foreign law CFC, and the general rules of proposed §§ 1.861–20(d)(1) and (2) apply to characterize that foreign gross income and assign it to the statutory and residual groupings. For example, in applying proposed § 1.861– 20(d)(3)(i)(D) in applying section 960 as the operative section where an uppertier CFC is the taxpayer, the upper-tier CFC’s foreign law subpart F inclusion is VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 treated as the foreign gross income of the foreign law CFC, which is treated as if it were the taxpayer. If the foreign law CFC has a corresponding U.S. item of subpart F income for which its United States shareholder elects to apply the high tax exception under section 954(b)(4), the foreign gross income and the associated foreign tax paid by the upper-tier CFC are assigned to a residual income group under § 1.960–1(d). In addition, § 1.904–6(f) includes a special rule assigning certain items of foreign gross income recognized by a United States shareholder of a CFC that is also a foreign law CFC to the section 951A category for purposes of applying section 904 as the operative section. Proposed § 1.861–20(d)(3)(ii) addresses the assignment of foreign gross income arising from disregarded payments between a foreign branch (as defined in § 1.904–4(f)(3)) and its owner. If the foreign gross income item arises from a payment made by a foreign branch to its owner, proposed § 1.861– 20(d)(3)(ii)(A) generally assigns the item to the statutory and residual groupings by deeming the payment to be made ratably out of the after-tax income, computed for Federal income tax purposes, of the foreign branch, and deeming the branch income to arise in the statutory and residual groupings in the same ratio as the tax book value of the assets, including stock, owned by the foreign branch. If the item of foreign gross income arises from a disregarded payment to a foreign branch from its owner, proposed § 1.861–20(d)(3)(ii)(B) generally assigns the item to the residual grouping. However, proposed § 1.861–20(d)(3)(ii)(C) assigns an item of foreign gross income attributable to gain recognized under foreign law with respect to the receipt of a disregarded payment in exchange for property under the rule in § 1.861–20(d)(2)(i). In addition, proposed § 1.904–6(b)(2) includes special rules assigning foreign gross income items arising from certain disregarded payments for purposes of applying section 904 as the operative section. Proposed § 1.861–20(d)(3)(iii) addresses the assignment to a statutory or residual grouping of foreign gross income that a taxpayer includes by reason of its ownership of a reverse hybrid. Under this rule, the foreign gross income that a taxpayer recognizes from a reverse hybrid is assigned to the statutory and residual groupings by treating that foreign gross income as the income of the reverse hybrid and applying the general rules of proposed § 1.861–20(d). However, § 1.904–6(f) includes a special rule assigning certain items of foreign gross income PO 00000 Frm 00010 Fmt 4701 Sfmt 4702 69133 recognized by a United States shareholder of a controlled foreign corporation that is a reverse hybrid to the section 951A category for purposes of applying section 904 as the operative section. The Treasury Department and the IRS request comments on whether additional rules are needed to address other fact patterns in which the U.S. and a foreign country tax different persons on the same item of income, for example, in the case of a salerepurchase agreement. Finally, under proposed § 1.861– 20(d)(3)(iv), if a taxpayer recognizes an item of foreign gross income that is gain from the sale of a disregarded entity, and Federal income tax law characterizes the transaction as a sale of the assets of the disregarded entity, the foreign gross income is assigned to the statutory and residual groupings in the same proportion as the gain that the taxpayer would have recognized if foreign law also treated the transaction as a sale of assets. Changes to § 1.904–6 and § 1.960–1 are proposed to clarify and, in certain cases, modify the application of proposed § 1.861–20 for purposes of computing the foreign tax credit limitation under section 904 and foreign income taxes deemed paid under section 960. Proposed § 1.904–6(b)(1) assigns foreign gross income that is attributable to a base difference, and the associated tax, to the separate category described in section 904(d)(2)(H)(i). Proposed § 1.904–6(b)(2)(i) generally provides that if a foreign branch makes a disregarded payment to another foreign branch or to its owner that causes the taxpayer’s gross income under Federal income tax law that is otherwise attributable to the foreign branch to be attributed to another foreign branch or to the foreign branch owner under § 1.904– 4(f)(2)(vi)(A) or § 1.904–4(f)(2)(vi)(D), the foreign gross income that arises by reason of the disregarded payment is assigned to the same category as the reattributed U.S. gross income. Under proposed § 1.904–6(b)(2)(ii), items of foreign gross income that a taxpayer includes solely by reason of the receipt by a foreign branch of a disregarded payment from its foreign branch owner that is a United States person are generally assigned to the foreign branch category (or, in the case of a foreign branch owner that is a partnership, to the partnership’s general category income that is attributable to the foreign branch). However, items of foreign gross income attributable to gain recognized under foreign law with respect to the receipt of a disregarded payment in exchange for property are characterized E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69134 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules and assigned under the rules of § 1.861– 20(d)(2)(i). Under proposed § 1.904– 6(b)(3), if a taxable disposition of property acquired in a disregarded sale results in the recognition of U.S. gross income that is reattributed to or from a foreign branch under § 1.904– 4(f)(2)(vi)(A) or § 1.904–4(f)(2)(vi)(D), any foreign gross income arising from that disposition of property under foreign law is assigned to the same separate category as the corresponding U.S. item of gain under § 1.861–20(d)(1) without regard to the reattribution of U.S. gross income. This rule is intended to better match income and taxes in situations where the foreign country only taxes gain that arises during the period that follows the disregarded sale. Finally, § 1.904–6(f) addresses the circumstance in which a United States shareholder pays or accrues foreign income tax with respect to foreign gross income that it recognizes because it owns a foreign law CFC or a reverse hybrid. The foreign income tax is allocated and apportioned to a category by treating the foreign gross income of the United States shareholder as the foreign gross income of the foreign law CFC or reverse hybrid under proposed §§ 1.861–20(d)(3)(i)(D) or 1.861– 20(d)(3)(ii)(B). Proposed § 1.904–6(f) reassigns to the section 951A category the foreign gross income that, if the foreign law CFC or reverse hybrid recognized the foreign gross income instead of the United States shareholder, would be assigned to the general category tested income group of the foreign law CFC or reverse hybrid to which an inclusion under section 951A is attributable. The amount of the foreign gross income that is reassigned is based upon the inclusion percentage, as defined in § 1.960–2(c)(2), of the United States shareholder. The Treasury Department and the IRS are continuing to study the allocation and apportionment of foreign income tax that is imposed on foreign gross income that is associated with the general category tested income group of a foreign law CFC or reverse hybrid under proposed §§ 1.861–20(d)(3)(i)(D) and 1.861–20(d)(3)(ii)(B), respectively. Comments are requested on the proper treatment of such foreign income tax in the circumstance in which some or all of the tax is not assigned to the section 951A category under proposed § 1.904– 6(f) because no inclusion is attributable to the tested income group, or the inclusion percentage of the United States shareholder is less than 100 percent. In particular, comments are requested on the interaction of proposed § 1.904–6(f) with sections 245A(g) and 909. VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 Proposed § 1.960–1(d)(3)(ii) makes conforming changes and in addition clarifies that, if proposed § 1.861–20 would otherwise apply to assign foreign gross income to a PTEP group that is not increased as a result of a distribution described in section 959(b), the foreign taxable income is assigned to the income group to which the income, computed under Federal income tax law, that gave rise to the PTEP would be assigned if recognized under Federal income tax law in the year in which tax was imposed. The Treasury Department and the IRS are also studying whether additional guidance should be provided on allocating and apportioning foreign taxes described in section 903 (tax in lieu of income tax), and foreign income taxes for which the foreign taxable base is computed formulaically with respect to a unitary business. The Treasury Department and the IRS are also studying whether the rules in § 1.861– 8(e)(6) for allocating and apportioning state income taxes should be revised in light of changes made by the TCJA and changes to state rules for taxing foreign income. Comments are requested on these topics. C. Overall Foreign Loss Recapture on Property Dispositions One comment was received with respect to the 2012 OFL proposed regulations, which recommended addressing dispositions that result in additional income recognition under branch loss recapture and dual consolidated loss recapture rules. The comment pointed out that these additional income recognition amounts are determined after first determining the additional recognition amount under section 904(f)(3) and therefore recommended adding the coordination of these rules as a new Step Nine in the ordering rules of § 1.904(g)–3. The comment recommended that the additional income recognition amounts resulting from branch loss recapture and dual consolidated loss recapture should not be subject to the overall foreign loss (OFL) recapture rules. The branch loss recapture rules under section 367(a) referenced by the comment letter were repealed by the TCJA (subject to a special savings clause that applies with respect to losses incurred before January 1, 2018) and replaced with a new set of branch loss recapture rules in section 91. One of the principal differences between the two regimes is that previously the branch loss recapture amounts were treated as foreign source income, whereas under new section 91(d) they are treated as U.S. source income. Accordingly, PO 00000 Frm 00011 Fmt 4701 Sfmt 4702 although the branch loss recapture amounts for losses incurred after December 31, 2017, are no longer subject to the OFL recapture rules or separate limitation loss (SLL) recapture rules, they are now potentially subject to the overall domestic loss (ODL) recapture rules, and therefore ordering rules are still needed for the application of the branch loss recapture rules, including the rules for losses incurred before January 1, 2018, that are subject to the special savings clause. The Treasury Department and the IRS agree with the recommendation to add a new Step Nine to § 1.904(g)–3 to clarify that additional income amounts recognized by reason of branch loss recapture and dual consolidated loss recapture are not taken into account for purposes of the ordering rules until after the section 904(f)(3) amounts are determined. However, the Treasury Department and the IRS do not agree that those additional income amounts should not be subject to the OFL or ODL recapture rules. The fact that a loss recapture rule may provide that the additional income amount is treated as U.S. source income does not mean it should be treated any differently than any other U.S. source income that is subject to the ODL recapture rules. The same reasoning applies to additional income amounts that are treated as foreign source income and therefore subject to the OFL recapture rules. Accordingly, Step Nine in proposed § 1.904(g)–(3)(j) provides that like section 904(f)(3) recapture amounts addressed in Step Eight, the additional income recognized by reason of branch loss and dual consolidated loss recapture will be subject to the first seven steps of the ordering rules. However, Step Nine applies only to additional income amounts with respect to branch loss and dual consolidated loss recapture that are determined after taking into account an offset for a section 904(f)(3) recapture amount. For example, if a taxpayer has a dual consolidated loss recapture in a year in which there is no section 904(f)(3) recapture, then there is only one application of Steps One through Seven, which takes into account the additional income, and Steps Eight and Nine will not apply. When Step Nine applies, the proposed regulations provide that for purposes of determining how much of the additional income with respect to branch loss and dual consolidated loss recapture will be subject to the ODL, OFL or SLL recapture rules, any increases to an ODL, OFL or SLL account balance in the current year due to the original application of Steps One E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules jbell on DSKJLSW7X2PROD with PROPOSALS2 through Seven (prior to the application of Steps Eight or Nine) are taken into account. In addition, if any additional income with respect to a branch loss or dual consolidated loss recapture is foreign source income in a separate category for which there is a remaining OFL account balance after Steps One through Eight, a special rule applies for purposes of determining the OFL recapture amount under § 1.904(f)–2(c) (the lesser of the maximum potential recapture or 50 percent of total foreign source income). The special rule provides that a taxpayer must first determine a hypothetical OFL recapture amount, which is the OFL recapture amount that would have been determined in the original application of Steps One through Seven (prior to the application of Steps Eight and Nine) if the additional income in Step Nine were also taken into account. From that hypothetical OFL recapture amount, the taxpayer subtracts the actual OFL recapture amount that was determined in the original application of Steps One through Seven (without taking into account the additional income in Step Nine). The remainder is then the OFL recapture amount with respect to the additional income in Step Nine. This special rule is necessary because a simple reapplication of the OFL recapture amount rules in § 1.904(f)–2(c) to just the additional income in Step Nine could result in requiring an excessive amount of recapture, because the same amount of foreign source income in other separate categories may be used twice to increase the OFL recapture amount (once in the original calculation and again in the second calculation with respect to the additional income). III. Foreign Tax Redeterminations Under Section 905(c) As discussed in Part III of the Background section of the 2019 FTC final regulations, portions of the temporary regulations relating to sections 905(c), 986(a), and 6689 (TD 9362) (the ‘‘2007 temporary regulations’’) are being reproposed in order to provide taxpayers an additional opportunity to comment on those rules in light of the changes made by the TCJA. References in this preamble to the 2007 temporary regulations are understood to refer to the corresponding provisions of the accompanying proposed regulations, which were issued by cross-reference to the 2007 temporary regulations at 72 FR 62805. In particular, the rules being reproposed are: (1) § 1.905–3T(d)(2), which addresses foreign tax VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 redeterminations that affect foreign taxes deemed paid under section 960, (2) § 1.905–4T, which in general provides the procedural rules for how to notify the IRS of a foreign tax redetermination, and (3) § 301.6689–1T, which provides rules for the penalty for failure to notify the IRS of a foreign tax redetermination. In addition, the proposed regulations contain a transition rule in proposed §§ 1.905– 3(b)(2)(iv) and 1.905–5 to address foreign tax redeterminations of foreign corporations that relate to taxable years before the amendments made by the TCJA. See Part III.D of this Explanation of Provisions. A. Adjustments to Foreign Taxes Paid by Foreign Corporations Section 1.905–3T(d)(2) of the 2007 temporary regulations reflects the law in effect before the TCJA, which generally required foreign tax redeterminations of foreign corporations to be taken into account by prospectively adjusting the foreign corporations’ pools of post-1986 undistributed earnings and post-1986 foreign income taxes, rather than by adjusting the calculation of deemedpaid taxes and the United States shareholder’s (‘‘U.S. shareholder’’) U.S. tax liability in the prior year or years in which the adjusted foreign tax was included in the calculation of foreign taxes deemed paid. Section 1.905– 3T(d)(3) of the 2007 temporary regulations provides exceptions to the pooling adjustment rules that required redeterminations of the U.S. shareholder’s U.S. tax liability in situations where refunds or other downward adjustments to a foreign corporation’s foreign tax liability would otherwise cause a substantial overstatement of deemed paid taxes. With the repeal of the pooling regime and related amendments to section 905(c) in the TJCA, the statute now requires U.S. tax redeterminations to reflect all foreign tax redeterminations, including those that result in adjustments to foreign taxes deemed paid. Accordingly, proposed § 1.905– 3(b)(2)(i) provides that a U.S. tax redetermination is required in all cases to account for the effect of a foreign corporation’s foreign tax redetermination. Section 1.905–3T(d)(3)(ii), illustrated by an example in § 1.905–3T(d)(3)(iii), provides that the required U.S. tax redetermination is made by taking the foreign tax redetermination into account in the prior year to which the redetermined foreign tax relates, and further provides that a U.S. tax redetermination is also required for any subsequent year in which the domestic PO 00000 Frm 00012 Fmt 4701 Sfmt 4702 69135 corporate shareholder received or accrued a distribution or inclusion from the foreign corporation, which under pre-TCJA law would have resulted in foreign taxes deemed paid. Under these rules, the amount of the adjusted foreign tax was deemed to ‘‘relate back’’ and adjust the foreign corporation’s earnings and profits, as well as its creditable foreign taxes, in the adjusted year. In any case where a U.S. tax redetermination and adjustment to deemed paid taxes is required, an adjustment to the foreign corporation’s taxable income and earnings and profits in the functional currency amount of the adjusted foreign tax (whether upward to reflect a refund or downward to reflect an additional payment of foreign tax) in the relation-back year is necessary in order to coordinate the computation of the U.S. shareholder’s inclusions with the amount of the section 78 dividend in the amount of the adjusted foreign taxes deemed paid. This is because under sections 954(b)(5) and 951A(c)(2)(ii), the creditable foreign tax reduces the foreign corporation’s subpart F income, tested income, and earnings and profits, so that the amount included in the U.S. shareholder’s income under sections 951 and 951A is an after-foreign-tax amount; the section 78 dividend prevents the effective allowance of both a deduction and a credit for an amount of foreign tax that both reduces the inclusion and is allowed as a deemed paid foreign tax credit. If the foreign corporation’s deduction from income and earnings and profits in respect of foreign taxes were adjusted in a different year than the year in which its creditable foreign taxes were adjusted, the amount of foreign tax that reduces the U.S. shareholder’s inclusion and the amount added to income under section 78 in respect of the deemed paid tax would not match, such that the U.S. shareholder’s income would be understated or overstated by the amount of the foreign tax adjustment. Accordingly, proposed § 1.905– 3(b)(2)(ii) clarifies that the required adjustments by reason of a foreign tax redetermination of a foreign corporation include not only adjustments to the amount of foreign taxes deemed paid and related section 78 dividend, but also adjustments to the foreign corporation’s income and earnings and profits and the amount of the U.S. shareholder’s inclusions under sections 951 and 951A in the year to which the redetermined foreign tax relates. The TCJA amendments, by eliminating deemed paid taxes under section 902 with respect to dividends and basing deemed paid taxes under section 960 E:\FR\FM\17DEP2.SGM 17DEP2 69136 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules jbell on DSKJLSW7X2PROD with PROPOSALS2 with respect to subpart F and GILTI inclusions on current year income and taxes rather than multi-year pools, will require more redeterminations of U.S. tax liability to adjust deemed paid credits under section 960, but fewer adjustments to intervening years, since a foreign tax adjustment to one year will generally no longer affect the calculation of deemed paid taxes with respect to inclusions in other years. New examples at proposed § 1.905– 3(b)(2)(v) illustrate these rules. Section 905(c)(1)(B) and (C) require a redetermination of U.S. tax if accrued taxes remain unpaid after two years, or if any tax paid is refunded in whole or in part. These provisions are not limited to cases in which the foreign tax redetermination reduces the amount of the foreign tax credit. Accordingly, proposed §§ 1.905–3(a) and 1.905– 3(b)(2)(ii) also provide that the rules under section 905(c) apply in cases in which foreign tax redeterminations affect U.S. tax liability even though there may be no change to the amount of foreign tax credits originally claimed. For example, under the proposed regulations a redetermination of U.S. tax liability is required when a foreign tax redetermination affects whether or not a taxpayer is eligible for the high-tax exception under section 954(b)(4) (the ‘‘subpart F high-tax exception’’) in the year to which the redetermined foreign tax relates. Similarly, a foreign tax redetermination could affect the subpart F income, tested income, and earnings and profits of a CFC in the year to which the tax relates, see proposed § 1.905– 3(b)(2)(ii), and therefore affect the amount of a U.S. shareholder’s inclusion under section 951 or section 951A with respect to the adjusted year. Corresponding amendments are proposed to the rules in §§ 1.904–4(c)(7) and 1.954–1(d). B. Foreign Tax Redeterminations of Successor Entities The proposed regulations at § 1.905– 3(b)(3) add a rule clarifying that if at the time of a foreign tax redetermination the person with legal liability for the tax (the ‘‘successor’’) is a different person than the person that had legal liability for the tax in the year to which the redetermined tax relates (the ‘‘original taxpayer’’), the required redetermination of U.S. tax liability is made as if the foreign tax redetermination occurred in the hands of the original taxpayer. This could occur, for example, if a disregarded entity is sold to a different taxpayer, or if a CFC liquidates into another CFC that has transferee liability for the liquidated CFC’s foreign tax. The proposed regulations further provide VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 that Federal income tax principles apply to determine the tax consequences if the successor remits, or receives a refund of, a tax that in the year to which the redetermined tax relates was the legal liability of, and thus considered paid by, the original taxpayer. Thus, for example, when the original taxpayer owns the successor which remits a tax that was the legal liability of, and considered paid by, the original taxpayer (for example, if a controlled foreign corporation that was formerly a disregarded entity pays additional tax after a foreign audit), then a distribution can result from the successor to the original taxpayer. See Herbert Enoch, 57 T.C. 781 (1972) (finding constructive dividend when a corporation discharged its shareholder’s personal liability on debt). The Treasury Department and the IRS request comments on whether additional rules are required to address situations involving predecessors or successors. C. Notification to the IRS of Foreign Tax Redeterminations and Related Penalty Provisions Proposed § 1.905–4 contains rules for notifying the IRS of a foreign tax redetermination. Proposed § 301.6689–1 contains rules regarding the penalty for failure to notify the IRS of a foreign tax redetermination. This Part III.C describes changes made to §§ 1.905–4 and 301.6689–1 relative to the rules that were contained in the 2007 temporary regulations. 1. Notification Through Amended Returns Section 1.905–4T(b)(1)(iv) of the 2007 temporary regulations provides that, if more than one foreign tax redetermination requires a redetermination of U.S. tax liability for the same taxable year of the taxpayer (the affected year) and those redeterminations occur within two consecutive taxable years, the taxpayer generally may file for the affected year one amended return, Form 1118 (Foreign Tax Credit—Corporations) or Form 1116 (Foreign Tax Credit), and one statement under § 1.905–4T(c) with respect to all of the redeterminations. Proposed § 1.905–4(b)(1)(iv) clarifies that, if more than one foreign tax redetermination requires a redetermination of U.S. tax liability for the same affected year and those redeterminations occur within the same taxable year or within two consecutive taxable years, the taxpayer may file for the affected year one amended return and one statement under proposed § 1.905–4(c) with respect to all of the redeterminations. Proposed § 1.905– PO 00000 Frm 00013 Fmt 4701 Sfmt 4702 4(b)(1)(iv) also provides that the due date of the amended return and statement varies depending on whether the net effect of the foreign tax redeterminations reduces or increases the U.S. tax liability in the affected taxable year. Section 1.905–4T(b)(1)(v) of the 2007 temporary regulations provides that, if a foreign tax redetermination requires a redetermination of U.S. tax liability that otherwise would result in an additional amount of U.S. tax due, but such amount is eliminated as a result of a carryback or carryover of an unused foreign tax under section 904(c), the taxpayer may, in lieu of applying the rules of §§ 1.905–4T(b)(1)(i) and (b)(1)(ii), notify the IRS of such redetermination by attaching a statement to the original return for the taxpayer’s taxable year in which the foreign tax redetermination occurs. Section 1.905–4T(b)(1)(v) of the 2007 temporary regulations does not apply if the foreign tax redetermination does not change the U.S. tax liability for the taxable year to which the tax relates for a reason other than the carryback or carryover of an unused foreign tax. Section 1.905–4T(b)(1)(v) of the 2007 temporary regulations also does not apply if more than one foreign tax redetermination occurring within the same taxable year or two consecutive taxable years requires a redetermination of U.S. tax liability for the same taxable year but, taking into account all such foreign tax redeterminations on a net basis, results in no additional amount of U.S. tax liability due for such taxable year. Proposed § 1.905–4(b)(1)(v) provides that, if a foreign tax redetermination (either alone or in combination with certain other foreign tax redeterminations as provided in proposed § 1.905–4(b)(1)(iv)) does not result in a change to the amount of U.S. tax due for a taxable year, for reasons including but not limited to a carryover or carryback of unused foreign taxes under section 904(c), no amended return is required for such year. Instead, appropriate adjustments are made to the amounts carried over from that year (for example, unused foreign taxes). If no amended return is required for any year, the taxpayer must attach a statement containing the information described in § 1.904–2(f) to the taxpayer’s timely filed (with extensions) original return for the taxpayer’s taxable year in which the foreign tax redetermination occurs. 2. Foreign Tax Redeterminations of Pass-Through Entities The 2007 temporary regulations did not specifically provide guidance for E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules pass-through entities that report creditable foreign taxes to their partners, shareholders, or beneficiaries and subsequently have a foreign tax redetermination with respect to such foreign taxes. The proposed regulations provide rules whereby these entities can satisfy their obligations under section 905(c). Proposed § 1.905–4(b)(2) generally provides that a pass-through entity that reports creditable foreign income tax to its partners, shareholders, or beneficiaries, is required to notify the IRS and its partners, shareholders, or beneficiaries if there is a foreign tax redetermination with respect to such foreign income tax. See proposed § 1.905–4(c) for the information required to be provided with the notification. Additionally, in 2015, Congress introduced the centralized audit partnership regime, which requires that certain adjustments be made at the level of the partnership, rather than by partners. See sections 6221 through 6241 (enacted in § 1101 of the Bipartisan Budget Act of 2015, Pub. L. 114–74 (‘‘BBA’’) and as amended by the Protecting Americans from Tax Hikes Act of 2015, Pub. L. 114–113, div Q, and by sections 201 through 207 of the Tax Technical Corrections Act of 2018, contained in Title II of Division U of the Consolidated Appropriations Act of 2018, Pub. L. 115–141). Under this regime, in order to make an adjustment to a partnership-related item (as defined in section 6241(2)), the partnership must file an administrative adjustment request (‘‘AAR’’). Sections 6227(d) and 6235(a) contemplate that these rules will be coordinated with the application of section 905(c). On June 14, 2017, the Treasury Department and the IRS published in the Federal Register (82 FR 27334) a notice of proposed rulemaking and on November 30, 2017, the Treasury Department and the IRS published in the Federal Register (82 FR 56765) another notice of proposed rulemaking. Each notice of proposed rulemaking requested comments on how a partnership subject to the centralized partnership audit regime should fulfill the requirements of section 905(c). One comment was received with respect to this issue and it recommended that partnerships satisfy their obligations under section 905(c) by filing an AAR under section 6227 and by following the procedures under that section to take necessary adjustments into account. Consistent with this request and with sections 6227(d) and 6235(a), proposed § 1.905–4(b)(2)(ii) provides that if a redetermination of U.S. tax liability would require a partnership adjustment as defined in § 301.6241–1(a)(6), the VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 partnership must file an AAR under section 6227 without regard to the time restrictions on filing an AAR in section 6227(c). See also § 1.6227–1(g). The use of the AAR process, even if the period under section 6227(c) is closed, is intended to further the purpose of sections 905(c), 6227(d), 6235(a), and 6241(11). An AAR is analogous to an amended return, which is required from other taxpayers who have a foreign tax redetermination, and provides an administrable process whereby a partnership, and its partners, can satisfy their obligations under section 905(c). The Treasury Department and the IRS request comments on any further coordination that may be required between sections 905(c) and 6227 in order to carry out the purposes of the foreign tax credit and the centralized partnership audit regime. 3. Alternative Notification Requirements Proposed § 1.905–4(b)(3) provides that an amended return and Form 1118 (Foreign Tax Credit—Corporations) or Form 1116 (Foreign Tax Credit), is not required to notify the IRS of a foreign tax redetermination and redetermination of U.S. tax liability if the taxpayer satisfies alternative notification requirements that may be prescribed by the IRS through forms, instructions, publications, or other guidance. For example, as provided in Notice 2016–10, 2016–1 I.R.B. 1, the Treasury Department and the IRS intend to issue regulations providing for alternative notification procedures in the case of tax refunds received by regulated investment companies making the election to pass through foreign tax credits under section 853. The Treasury Department and the IRS request comments on additional alternative approaches to complying with the notification requirements in section 905(c) that minimize burdens to both taxpayers and the IRS. 4. Foreign Tax Redeterminations of LB&I Taxpayers Section 1.905–4T(b)(3) of the 2007 temporary regulations provides a special rule for U.S. taxpayers under the jurisdiction of the Large and Mid-Size Business Division. The proposed regulations reflect the organization’s name change to Large Business and International Division (LB&I). Under the special rule for U.S. taxpayers under LB&I jurisdiction (‘‘LB&I rule’’), such taxpayers are required, in limited circumstances, to provide to their examiners notice of a foreign tax redetermination that requires a redetermination of U.S. tax, in lieu of PO 00000 Frm 00014 Fmt 4701 Sfmt 4702 69137 filing an amended return. One of the threshold requirements of § 1.905– 4T(b)(3) of the 2007 temporary regulations is that the taxpayer must provide the statement describing the foreign tax redetermination no later than 120 days after the latest of (1) the date the foreign tax redetermination occurs, (2) the opening conference of the examination for the affected taxable year, or (3) the hand-delivery or postmark date of the opening letter concerning the examination. In no case, however, can the alternative notification procedure apply if the 120-day period within which notification must be made would start after the due date of the return for the taxable year in which the foreign tax redetermination occurs. The LB&I rule contained in the proposed regulations is generally the same as the rule in the 2007 temporary regulations, and the Explanation of Provisions of the 2007 temporary regulations contains an explanation of the rules. However, one change has been made with respect to § 1.905–4T(b)(3) of the 2007 temporary regulations. Section 1.905–4T(b)(3) provides that, if that provision applies to permit notification during an audit, in lieu of filing an amended return a taxpayer must provide to the examiner the statement described in § 1.905–4T(c) of the 2007 temporary regulations, which contains information that enables the IRS to verify and compare the original computations with respect to a claimed foreign tax credit, the revised computations resulting from the foreign tax redetermination, and the net changes resulting therefrom. In order to satisfy the requirements of § 1.905– 4T(c), a taxpayer is required to recompute its U.S. tax liability during the course of an examination, rather than only at the conclusion of the audit. To minimize administrative burdens, the statement requirement at proposed § 1.905–4(b)(4)(iii) requires the taxpayer to provide to the examiner the original amount of foreign taxes paid or accrued in the year to which the foreign tax redetermination relates, the revised amount of foreign taxes paid or accrued, and documentation with respect to the revisions, including exchange rates and dates of accrual and/or payment. This information must be provided with a penalties-of-perjury declaration signed by a person authorized to sign the return of the taxpayer. In order to clarify when the special rules for LB&I taxpayers apply, the proposed regulations reorganize certain portions of the 2007 temporary regulations into a list of conditions, all of which must be met in order for § 1.905–4(b)(4) to apply. These E:\FR\FM\17DEP2.SGM 17DEP2 69138 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules jbell on DSKJLSW7X2PROD with PROPOSALS2 conditions are as follows: (1) A foreign tax redetermination occurs while the U.S. taxpayer is under the jurisdiction of LB&I (or a successor division); (2) the foreign tax redetermination results in a downward adjustment to the amount of foreign tax paid or accrued, or included in the computation of foreign taxes deemed paid; (3) the foreign tax redetermination requires a redetermination of U.S. tax liability and accordingly, but for § 1.905–4(b)(4), the taxpayer would be required to notify the IRS of such foreign tax redetermination under § 1.905–4(b)(1)(ii) by filing an amended return; (4) the return for the taxable year for which a redetermination of U.S. tax liability is required is under examination; and (5) the due date specified in § 1.905–4(b)(1)(ii) for providing notice of such foreign tax redetermination is not before the latest of the opening conference or the handdelivery or postmark date of the opening letter concerning the examination of the return for the taxable year for which a redetermination of U.S. tax liability is required by reason of such foreign tax redetermination. 5. Penalty Provisions Section 6689 provides that a taxpayer may be subject to a penalty if it fails to notify the IRS of a foreign tax redetermination on or before the date prescribed by regulations. Section 301.6689–1T(a) (issued in TD 8210 on June 22, 1988) states that the penalty may apply if a taxpayer fails to notify the IRS of a foreign tax redetermination ‘‘on or before the date prescribed in regulations.’’ However, the preamble of the 2007 temporary regulations, in describing section 6689, provides that, ‘‘Under section 6689, a taxpayer that fails to notify the IRS of a foreign tax redetermination in the time and manner prescribed by regulations for giving such notice is subject to a penalty.’’ (Emphasis added.) Because it is implicit in section 6689 that the required notification must comply with the requirements of section 905(c), the proposed regulations conform to the preamble description in the 2007 temporary regulations. Accordingly, proposed § 301.6689–1(a) provides that the penalty may apply if a taxpayer fails to notify the IRS of a foreign tax redetermination ‘‘on or before the date and in the manner prescribed in regulations.’’ The penalty under section 6689 is generally computed by reference to the amount of the deficiency resulting from a foreign tax redetermination. If a partnership fails to timely file an AAR as required under proposed § 1.905– 4(b)(2)(ii) such that the penalty under VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 section 6689 is applicable there is ambiguity regarding the correct base upon which the penalty is computed because partnerships do not generally have deficiencies in chapter 1 tax. Under the centralized partnership audit regime enacted by the BBA, if an adjustment is made to a partnershiprelated item of a partnership that is subject to the BBA (either by the IRS or by the partnership upon the filing of an AAR), the default rule is that the partnership is liable for an imputed underpayment calculated on the adjustments, which is an approximate substitute for the amount of chapter 1 tax that would have been owed by its partners. See sections 6221(a) and 6225. The fact that section 6689 is silent as to the proper base for calculating a section 6689 penalty for a partnership that is subject to BBA creates a special enforcement consideration and requires clarification. Therefore, consistent with the principles of section 6233(a)(3) (which treats the imputed underpayment as an understatement or underpayment for purposes of computing a penalty) and the requirement in section 6227(d) that regulations coordinate the application of sections 905(c) and 6227, proposed § 301.6689–1 provides that in computing the amount of the penalty imposed under section 6689, the penalty is calculated on a deficiency or by reference to the amount of the imputed underpayment that results from the foreign tax redetermination. Finally, because section 6662 may apply if a taxpayer’s U.S. tax liability is understated on an original return even if section 6689 applies to a failure to notify the IRS of a subsequent foreign tax redetermination, the proposed regulations eliminate the reference in § 301.6689–1(b) to section 6653(a) (the predecessor to section 6662). D. Transition Rule Relating to the TCJA The TCJA repealed the pooling rules of section 902 and related provisions of section 905(c) that mandated prospective pooling adjustments to account for redeterminations of foreign taxes paid by foreign corporations that were eligible to be deemed paid by domestic corporate shareholders of the foreign corporations. Proposed §§ 1.905–3(b)(2)(iv) and 1.905–5 provide a transition rule providing that post2017 redeterminations of pre-2018 foreign income taxes must be accounted for by adjusting the foreign corporation’s taxable income and earnings and profits, post-1986 undistributed earnings, and post-1986 foreign income taxes (or pre-1987 accumulated profits and pre-1987 PO 00000 Frm 00015 Fmt 4701 Sfmt 4702 foreign income taxes, as applicable) in the pre-2018 year to which the redetermined foreign taxes relate. A redetermination of U.S. tax liability is required to account for the effect of the foreign tax redetermination on foreign taxes deemed paid by domestic corporate shareholders of the foreign corporation in the relation-back year and any subsequent pre-2018 year in which the domestic corporate shareholder computed a deemed-paid credit under section 902 or 960 with respect to the foreign corporation, as well as any year to which unused foreign taxes from any such year were carried. The proposed regulations generally apply the currency translation rules applicable under prior law and the notification requirements of proposed § 1.904–4 to redeterminations of U.S. tax liability required by proposed § 1.905– 3(b)(2)(iv) in these circumstances. The Treasury Department and the IRS request comments on whether an alternative adjustment to account for post-2017 foreign tax redeterminations with respect to pre-2018 taxable years of foreign corporations, such as an adjustment to the foreign corporation’s taxable income and earnings and profits, post-1986 undistributed earnings, and post-1986 foreign income taxes as of the foreign corporation’s last taxable year beginning before January 1, 2018, may provide for a simplified and reasonably accurate alternative. IV. Foreign Income Taxes Taken Into Account Under Section 954(b)(4) As discussed in Part III.A of this Explanation of Provisions, proposed § 1.905–3(b)(2) provides that a U.S. tax redetermination is required when a foreign tax redetermination affects whether or not a taxpayer is eligible for the subpart F high-tax exception. Proposed § 1.954–1(d)(3)(iii) therefore provides that the subpart F high-tax exception is applied by taking into account the redetermined foreign tax in the adjusted year. The proposed regulations also include an additional clarification relating to schemes involving jurisdictions that do not impose corporate income tax on a CFC until its earnings are distributed. The Treasury Department and the IRS are aware that certain taxpayers claim that taxes are treated as paid or accrued for purposes of § 1.954–1(d)(3) even in the absence of any distribution triggering foreign tax. The IRS may challenge this position under existing law. Furthermore, the proposed regulations clarify that foreign income taxes that have not accrued because they are contingent on a future distribution are not taken into account for purposes E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules jbell on DSKJLSW7X2PROD with PROPOSALS2 of determining the amount of foreign income taxes paid or accrued with respect to an item of income. However, if a redetermination of U.S. tax liability is required under proposed §§ 1.905– 3(a) and 1.905–3(b)(2)(ii) when tax is imposed on the foreign corporation in connection with a distribution, the redetermined foreign tax is taken into account in applying § 1.954–1(d)(3) in the adjusted year. V. Disallowance of Foreign Tax Credits Under Section 965(g) The Treasury Department and the IRS are aware that certain taxpayers may have engaged in certain transactions that are intended to avoid the disallowance of foreign tax credits under section 965(g) with respect to distributions of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits. For example, certain U.S. shareholders of specified foreign corporations may incur foreign income taxes on distributions recognized for foreign tax purposes that are not recognized for U.S. tax purposes (for example, consent dividends). When the section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits are distributed for U.S. tax purposes, no foreign income tax is imposed by the foreign jurisdiction. The taxpayers may argue that the foreign income taxes on the foreign distributions are not associated with a distribution of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits for U.S. tax purposes, and, accordingly, the credit need not be reduced by the section 965(g) disallowance. Proposed § 1.965–5(b)(2) clarifies that the principles of § 1.904–6 apply in determining the extent to which foreign income taxes are attributable to distributions of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits for purposes of § 1.965– 5(b)(1). For example, under the principles of § 1.904–6, foreign withholding taxes imposed on an amount that is recognized as a dividend for foreign, but not Federal income, tax purposes are attributable to an item of income to which that amount would be assigned if recognized as a distribution for Federal income tax purposes. To the extent a distribution would be a distribution of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits if it were recognized for U.S. tax purposes, under proposed § 1.965– 5(b)(2) the tax would be associated with VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits and disallowed in part by reason of section 965(g). For foreign corporation taxable years beginning after December 31, 2019, § 1.861–20 applies in lieu of § 1.904–6. The IRS may challenge the credits claimed for foreign income taxes imposed on distributions recognized solely for foreign tax purposes in prior years to the extent that such foreign income taxes would be considered imposed on distributions of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits had such distributions been recognized for U.S. tax purposes. VI. Updates to Consolidated Foreign Tax Credit Rules Proposed § 1.1502–4 includes amendments to regulations under section 1502 relating to the computation of the consolidated foreign tax credit. The proposed amendments update the regulations to reflect changes in the law, such as by eliminating out-of-date references to the per-country limitation. For purposes of determining the foreign tax credit limitation, the proposed regulations also provide that the amount of foreign source income in each separate category, used as the numerator in the foreign tax credit limitation fraction, is determined by applying the rules of § 1.1502–11, as well as sections 904(f) and 904(g), on a group-wide basis, rather than applying those rules on a separate member basis and combining the results. The proposed regulations also add new rules for purposes of determining the source and separate category of a consolidated NOL, as well as the portion of a consolidated net operating loss (‘‘CNOL’’) that is apportioned to a separate return year of a member. The Treasury Department and the IRS have determined that, when characterizing a CNOL that is apportioned to a separate return year, it is generally appropriate to link the source and separate category of the CNOL with the member’s assets that are expected to produce income with that same source and separate category so as to minimize the creation of loss accounts under sections 904(f) and 904(g) in the year in which the CNOL is used. The proposed regulations achieve this result formulaically through a two-step process that generally determines a CNOL’s source and separate category by reference to the statutory and residual groupings described in § 1.861–8 for purposes of applying section 904 as the operative PO 00000 Frm 00016 Fmt 4701 Sfmt 4702 69139 section, which are foreign source income in each separate category, and the residual grouping, which is U.S. source income. First, the member determines a tentative apportionment, which is a proportionate share of the amount of the CNOL in each grouping based on a comparison of the value of the member’s assets in that grouping to the value of the group’s total assets in the grouping. Because the total of tentative apportionments of the CNOL does not necessarily equal the member’s total share of the CNOL, an adjustment is provided. If the total tentative apportionments exceed the CNOL attributable to the member, the tentative apportionment in each grouping is reduced by a pro rata share of the excess, in proportion to the amount of the tentative apportionment in that grouping over the total tentative apportionments. In contrast, if the total tentative apportionments are less than the CNOL attributable to the member, the tentative apportionment in each grouping is increased by a pro rata share of that deficiency, in proportion to the remaining CNOL in that grouping (after subtracting the tentative apportionment) over the total remaining CNOL in all groupings. VII. Applicability Dates The rules in proposed §§ 1.861–8, 1.861–9, 1.861–12, 1.861–14, 1.904– 4(c)(7) and (8), 1.904(b)–3, 1.954–1, and 1.954–2, generally apply to taxable years that end on or after December 16, 2019. The rules in proposed §§ 1.704– 1(b)(4)(viii)(d)(1), 1.861–17, 1.861–20, 1.904–6, and 1.960–1 apply to taxable years beginning after December 31, 2019. However, taxpayers that are on the sales method for taxable years beginning after December 31, 2017, and before January 1, 2020, may rely on proposed § 1.861–17 if they apply it consistently. Therefore, a taxpayer on the sales method for its taxable year beginning in 2018 may rely on proposed § 1.861–17 but must also apply the sales method (relying on proposed § 1.861– 17) for its taxable year beginning in 2019. Proposed §§ 1.904–4(e) and 1.904(g)– 3 apply to taxable years ending on or after the date the final regulations are filed with the Federal Register. In general, proposed §§ 1.905–3, 1.905–4, 1.905–5, and 301.6689–1 apply to foreign tax redeterminations (as defined in § 1.905–3(a)) occurring in taxable years ending on or after December 16, 2019, and to foreign tax redeterminations of foreign corporations occurring in taxable years that end with or within a taxable year of a U.S. E:\FR\FM\17DEP2.SGM 17DEP2 69140 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules A. Background and Need for the Proposed Regulations foreign jurisdiction and the United States taxed the same income, this framework could have resulted in double taxation. The U.S. foreign tax credit (FTC) regime alleviated potential double taxation by allowing a nonrefundable credit for foreign income taxes paid or accrued that could be applied to reduce the U.S. tax on foreign source income. Although TCJA eliminated the U.S. tax on some foreign source income, the United States continues to tax other foreign source income, and to provide foreign tax credits against this U.S. tax. The changes made by TCJA to international taxation necessitate certain changes in this FTC regime. The FTC calculation operates by defining different categories of foreign source income (a ‘‘separate category’’) based on the type of income.3 Foreign taxes paid or accrued as well as deductions for expenses borne by U.S. parents and domestic affiliates that support foreign operations are also allocated to the separate categories under similar principles. The taxpayer can then use foreign tax credits allocated to each category against the U.S. tax owed on income in that category. This approach means that taxpayers who pay foreign taxes on income in one category cannot claim a credit against U.S. taxes owed on income in a different category, an important feature of the FTC regime. For example, suppose a domestic corporate taxpayer has $100 of active foreign source income in the ‘‘general category’’ and $100 of passive foreign source income, such as interest income, in the ‘‘passive category.’’ It also has $50 of foreign taxes associated with the ‘‘general category’’ income and $0 of foreign taxes associated with the ‘‘passive category’’ income. The allowable FTC is determined separately for the two categories. Therefore, none of the $50 of ‘‘general category’’ FTCs can be used to offset U.S. tax on the ‘‘passive category’’ income. This taxpayer has a pre-FTC U.S. tax liability of $42 (21 percent of $200) but can claim a FTC for only $21 (21 percent of $100) of this liability, which is the U.S. tax owed with respect to active foreign source income in the general category. The $21 represents what is known as the taxpayer’s foreign tax credit limitation. The taxpayer may carry the remaining $29 of foreign taxes ($50 minus $21) back to the prior taxable Before the Tax Cuts and Jobs Act (TCJA), the United States taxed its citizens, residents, and domestic corporations on their worldwide income. However, to the extent that a 3 Prior to the TCJA, these categories were primarily the passive income and general income categories. The TCJA added new separate categories for global intangible low-taxed income (the section 951A category) and foreign branch income. shareholder ending on or after December 16, 2019. In the case of foreign tax redeterminations of foreign corporations, proposed § 1.905–3 is limited to foreign tax redeterminations that relate to taxable years of foreign corporations beginning after December 31, 2017, and proposed § 1.905–5 is limited to foreign tax redeterminations that relate to taxable years of foreign corporations beginning before January 1, 2018. Proposed § 1.965–5(b)(2) applies to taxable years of foreign corporations that end on or after December 16, 2019, and with respect to a United States person, to the taxable years in which or with which such taxable years of the foreign corporations end. Proposed § 1.1502–4 applies to taxable years for which the original consolidated Federal income tax return is due (without extensions) after December 17, 2019. Special Analyses I. Regulatory Planning and Review jbell on DSKJLSW7X2PROD with PROPOSALS2 Executive Orders 13563 and 12866 direct agencies to assess costs and benefits of available regulatory alternatives and, if regulation is necessary, to select regulatory approaches that maximize net benefits (including potential economic, environmental, public health and safety effects, distributive impacts, and equity). Executive Order 13563 emphasizes the importance of quantifying both costs and benefits, reducing costs, harmonizing rules, and promoting flexibility. The Executive Order 13771 designation for any final rule resulting from these proposed regulations will be informed by comments received. The proposed regulations have been designated by the Office of Information and Regulatory Affairs (OIRA) as subject to review under Executive Order 12866 pursuant to the Memorandum of Agreement (MOA, April 11, 2018) between the Treasury Department and the Office of Management and Budget regarding review of tax regulations. The Office of Information and Regulatory Affairs (OIRA) has designated these proposed regulations as significant under section 1(b) of the MOA. Accordingly, these proposed regulations have been reviewed by OIRA. VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 PO 00000 Frm 00017 Fmt 4701 Sfmt 4702 year and then forward for up to 10 years (until used), and is allowed a credit against U.S. tax on general category foreign source income in the carryover year, subject to certain restrictions. The proposed regulations are needed to address changes introduced by the TCJA and to respond to outstanding issues raised in comments to the 2018 FTC proposed regulations. In particular, the comments highlighted the following areas of concern: (a) Uncertainty concerning appropriate allocation of R&E expenditures across FTC categories, (b) the need to treat loans from partnerships to partners the same as loans from partners to partnerships with respect to aligning interest income to interest expense, and (c) uncertainty regarding the appropriate level of aggregation (affiliated group versus subgroup) at which expenses of insurance companies should be allocated to foreign source income. In addition, the proposed regulations are needed to expand the application of section 905(c) to cases where a foreign tax redetermination changes a taxpayer’s eligibility for the high-taxed exception under subpart F and GILTI. B. Overview of the Proposed Regulations These proposed regulations address the following issues: (1) The allocation and apportionment of deductions under sections 861 through 865, including new rules on the allocation and apportionment of research and experimentation (R&E) expenditures and certain deductions of life insurance companies; (2) the definition of financial services income under section 904(d)(2)(D); (3) the allocation of foreign income taxes to the foreign income to which such taxes relate; (4) the interaction of the branch loss and dual consolidated loss recapture rules with sections 904(f) and (g); (5) the effect of foreign tax redeterminations of foreign corporations on the application of the high-tax exception described in section 954(b)(4) (including for purposes of determining tested income under section 951A(c)(2)(A)(i)(III)), and required notifications under section 905(c) to the IRS of foreign tax redeterminations and related penalty provisions; (6) the definition of foreign personal holding company income under section 954; (7) the application of the foreign tax credit disallowance under section 965(g); and (8) the application of the foreign tax credit limitation to consolidated groups. E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules C. Economic Analysis jbell on DSKJLSW7X2PROD with PROPOSALS2 1. Baseline The Treasury Department and the IRS have assessed the benefits and costs of these proposed regulations relative to a no-action baseline reflecting anticipated Federal income tax-related behavior in the absence of these regulations. 2. Summary of Economic Effects The proposed regulations provide certainty and clarity to taxpayers regarding the allocation of income, expenses, and foreign income taxes to the separate categories. In the absence of the enhanced specificity provided by these regulations, similarly situated taxpayers might interpret the foreign tax credit provisions of the tax code differently, potentially resulting in inefficient patterns of economic activity. For example, in the absence of the proposed regulations, one taxpayer might have chosen not to undertake research (that is, incur R&E expenses) in a particular location, based on that taxpayer’s interpretation of the tax consequences of such expenditures, that another taxpayer, making a different interpretation of the tax treatment of R&E, might have chosen to pursue in that same location. If this difference in interpretations confers a competitive advantage on the less productive enterprise, U.S. economic performance may suffer. The guidance provided in these regulations helps to ensure that taxpayers face more uniform incentives when making economic decisions. In general, economic performance is enhanced when businesses face more uniform signals about tax treatment. Because the TCJA is new, the Treasury Department and the IRS do not know with reasonable precision the tax interpretations that taxpayers might make in the absence of this guidance. To the extent that taxpayers would generally have interpreted the foreign tax credit rules as being less favorable to the taxpayer than the proposed regulations provide, the proposed regulations may result in additional international activity by these taxpayers relative to the no-action baseline. This additional activity may include both activities that are beneficial to the U.S. economy (perhaps because they represent enhanced international opportunities for businesses with U.S. owners) and activities that are not beneficial (perhaps because they are accompanied by reduced activity in the United States). In essence, the Treasury Department and the IRS recognize that additional foreign economic activity by U.S. taxpayers may be a complement or substitute to activity within the United VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 States and that to the extent these regulations change this activity (relative to the no-action baseline or alternative regulatory approaches), a mix of results may occur. The Treasury Department and the IRS have not undertaken quantitative estimates of the economic effects of these regulations. The Treasury Department and the IRS do not have readily available data or models to estimate with reasonable precision (i) the tax stances that taxpayers would likely take in the absence of the proposed regulations or under alternative regulatory approaches; (ii) the difference in business decisions that taxpayers might make between the proposed regulations and the no-action baseline or alternative regulatory approaches; or (iii) how this difference in those business decisions will affect measures of U.S. economic performance. In the absence of such quantitative estimates, the Treasury Department and the IRS have undertaken a qualitative analysis of the economic effects of the proposed regulations relative to the noaction baseline and relative to alternative regulatory approaches. This analysis is presented in part I.C.3 of these Special Analyses. 3. Economic Effects of Specific Provisions i. Rules for Allocating R&E Expenditures Under the Sales Method a. Background Under long-standing foreign tax credit rules, taxpayers must allocate expenditures to income categories. In the case of research and experimentation (R&E) expenditures, taxpayers can elect between a ‘‘sales method’’ and a ‘‘gross income method’’ to allocate the R&E expenses.4 The TCJA created some uncertainty regarding the application of the sales method because of the introduction of the section 951A category. In particular, comments raised issues regarding whether any R&E expenditures should be allocated to the section 951A category. The fact that sales by CFCs generate tested income and tested income is generally assigned to the section 951A category might imply that R&E expenditures should be allocated to 4 If the taxpayer chooses the gross income method, 25 percent of the R&E expenditures are exclusively apportioned to the source where more than 50 percent of the taxpayer’s R&E activities occur (generally the United States), and the other 75 percent is apportioned ratably. If a taxpayer chooses the sales method then 50 percent of the R&E expenditures are exclusively apportioned on the same basis, and the other 50 percent is apportioned ratably. PO 00000 Frm 00018 Fmt 4701 Sfmt 4702 69141 the section 951A category. But the fact that royalty payments from the CFC to the U.S. taxpayer (e.g., in remuneration for IP held by the parent that is licensed to the CFC to create the products that are sold) are in the general category implies that R&E expenditures should be allocated to the general category. The gross income method is based on a different apportionment factor (gross income) as compared to the sales method (gross receipts). However, the gross income method is subject to certain conditions that require the result to be within a certain band around the result under the sales method, because historically the Treasury Department and the IRS have considered that the gross income method could lead to anomalous results and could be more easily manipulated than the sales method.5 The uncertainty with respect to R&E expense allocation under the sales method needed resolution, and because the gross income method is tied to the sales method, any changes to the sales method required consideration of the gross income method. b. Options Considered for the Proposed Regulations The Treasury Department and the IRS considered three options with respect to the allocation of R&E expenditures to the section 951A category for purposes of calculating the FTC limitation. The first option was to confirm that R&E expenditures are allocated to the section 951A category under the sales method and to otherwise leave their treatment under the gross income method unchanged. The second option was to revise the sales method to provide that R&E expenditures are only allocated to the income that represents the taxpayer’s return on intellectual property (thus, R&E expenditures could not be allocated to income from the taxpayer’s CFC sales) and otherwise leave their treatment under the gross income method unchanged. The third option was to revise the sales method as considered in the second option and eliminate the gross income method for purposes of allocating R&E expenditures. The proposed regulations adopt the last option. This option allows for the provision of an allocation and apportionment method for R&E 5 The gross income method is more susceptible to manipulation because taxpayers can manage the type and amount of their foreign gross income by, for example, not paying a dividend and because presuming a factual relationship between the R&E expenditure and the related class of income based on the relative amounts of a taxpayer’s gross income was more attenuated than a factual relationship based on sales. E:\FR\FM\17DEP2.SGM 17DEP2 69142 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules expenditures that generally matches the expense reasonably with the income it generates. The matching of income and expenses generally produces a more efficient tax system contingent on the overall Code. Additionally, because this option results in no R&E expense being allocated to section 951A category income, it does not incentivize taxpayers with excess credits in the section 951A category to perform R&E through foreign subsidiaries; instead, the chosen option generally incentivizes choosing the location of R&E based on economic considerations rather than tax-related reasons, contingent on the overall Code. Finally, because the proposed regulations adopt the principle of allocating and apportioning R&E expenditures to IP-related income of the U.S. taxpayer, the gross income method is no longer relevant, because it allocates and apportions R&E expenditures to the section 951A category, and section 951A category gross income is not IP income to the U.S. taxpayer. c. Number of Affected Taxpayers The Treasury Department and the IRS have determined that the population of affected taxpayers consists of any U.S. taxpayer with R&E expenditures and foreign operations. There are around 2,500 such taxpayers in currently available tax filings from taxable years 2015–2017. Based on Statistics of Income data for 2014, approximately $40 billion of R&E expenses of such taxpayers were allocated to foreign source income, out of a total of $190 billion in qualified research expenses reported by such taxpayers in that year.6 jbell on DSKJLSW7X2PROD with PROPOSALS2 ii. Application of Section 905(c) To Changes Affecting the High-Tax Exception a. Background Section 905(c) provides special rules for a foreign tax redetermination (FTR), which is when the amount of foreign tax paid in an earlier year (origin year) is changed in a later year (FTR year). This redetermination may be necessary, for example, because the taxpayer gets a refund or because a foreign audit determines that the taxpayer owes additional foreign tax. Since these additional taxes (or refunds) relate to the origin year, an FTR affects a taxpayer’s origin year tax position (as well as FTC carryovers from that year). Prior to TCJA, FTRs of foreign corporations generally resulted in 6 Note, however, that these taxpayers might have additional R&E expenses which are not qualified R&E expenses. The tax data do not separately identify such expenses. VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 prospective ‘‘pooling adjustments’’ to foreign tax credits. Under this approach, taxpayers simply added to or reduced the amount of foreign taxes in their foreign subsidiary’s FTC ‘‘pool’’ going forward rather than amend the deemed paid taxes claimed on their origin year return. TCJA eliminated the pooling mechanism for taxes (because the adoption of a participation exemption system along with the elimination of deferral made it unnecessary) and replaced it with a system where taxes are deemed paid each year with an inclusion or distribution of previously taxed earnings and profits (‘‘PTEP’’). The 2019 FTC final regulations make clear that an FTR of a United States taxpayer must always be accounted for in the origin year, and that the taxpayer must file an amended return reflecting any resulting change in the taxpayer’s U.S. tax liability. Section 905(c) provides tools to enforce this amended return requirement. It suspends the statute of limitations with respect to the assessment of any additional U.S. tax liability that results from an FTR, and imposes a civil penalty on taxpayers who fail to notify the IRS (through an amended return) of a FTR. To reflect the repeal of the pooling mechanism, the proposed regulations generally require taxpayers to account for FTRs of foreign subsidiaries on an amended return that reflects revised foreign taxes deemed paid under section 960 and any resulting change in the taxpayer’s U.S. tax liability. However, the 2019 FTC final regulations require U.S. tax redeterminations only by reason of FTRs that affect the amount of foreign tax credit taxpayers claimed in the origin year. The rules do not apply to other tax effects, such as when the FTR changes the amount of earnings and profits the taxpayer’s CFC had in the origin year, or affects whether or not the CFC’s income qualifies for the high-tax exception under GILTI or subpart F. The interaction of FTRs and the hightax exception under GILTI and subpart F increases the importance of filing an origin year amended return. In particular, FTRs can give rise to inaccurate origin year U.S. liability calculations in the absence of an amended return precisely because they can change taxpayers’ eligibility for the high-tax exception. Therefore, the proposed regulations provide that the section 905(c) rules cover situations in which the FTR affects not only the amount of FTCs taxpayers claimed in the origin year, but also whether or not their CFC’s income qualified for the high-tax exception. PO 00000 Frm 00019 Fmt 4701 Sfmt 4702 b. Options Considered for the Proposed Regulations The Treasury Department and the IRS considered two options for expanding section 905(c) to cover the high-tax exception. The first option was to limit section 905(c) to changes in the amount of FTCs. The second option was to provide that section 905(c) applies in connection with the high-tax exceptions under GILTI and subpart F. The proposed regulations adopt the second option. The first option would lead to frequent occurrences of inaccurate results with respect to the GILTI and subpart F high-tax exceptions because it is common for foreign audits to change the amount of tax paid in a prior year. Furthermore, taxpayers would have an incentive to overpay their CFC’s foreign tax in the origin year, claim the high-tax exception to avoid subpart F or GILTI inclusions, wait for the 3 year statute of limitations to pass, and then claim a foreign tax refund with the foreign authorities. Without section 905(c) applying, taxpayers would have no obligation or threat of penalty for not amending the origin year return. Although there are FTC regulations that deny a credit if taxpayers make a noncompulsory payment of tax (i.e., taxpayers paid more foreign tax than is necessary under foreign law), those rules are challenging to administer. While taxpayers have the burden to prove that they were legally required to pay the tax, the IRS may need to engage foreign tax law experts to establish that the taxpayer could have successfully fought paying it. The second option provides a more accurate tax calculation than the first option, and it is instrumental in avoiding abuse. The increased number of amended returns will increase compliance costs for taxpayers, but the Treasury Department and the IRS consider that, in light of the high-tax exception, accurate origin year tax liability calculations necessitate these increased costs; however, the Treasury Department and the IRS solicit comments on this issue. c. Number of Affected Taxpayers The Treasury Department and the IRS determined that the proposed regulations potentially affect those U.S. taxpayers that pay foreign taxes and have a redetermination of that tax. Although data reporting the number of taxpayers subject to an FTR in a given year do not exist, some taxpayers currently subject to FTRs will file amended returns. The Treasury Department and the IRS estimate that there are approximately 300 to 600 U.S. E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules companies with foreign affiliates that file amended returns per year. However, the expansion of the section 905(c) requirement to file an amended return to instances where a FTR changes eligibility for the high-tax exception under GILTI or subpart F has the potential to significantly increase the number of taxpayers filing amended returns. The Treasury Department and the IRS have determined that a high upper bound for the number of taxpayers subject to a FTR that will be required to file amended returns (i.e., taxpayers affected by this provision) can be derived by estimating the number of taxpayers with a potential GILTI or subpart F inclusion. Based on currently available tax filings for taxable years 2015 and 2016, there were about 15,000 C corporations with CFCs that filed at least one Form 5471 with their Form 1120 return. In addition, for the same period, there were about 30,000 individuals with CFCs that e-filed at least one Form 5471 with their Form 1040 return. In 2015 and 2016, there were about 3,000 S corporations with CFCs that filed at least one Form 5471 with their 1120S return. The identified S corporations had an estimated 150,000 shareholders, as an upper bound. Finally, the Treasury Department and the IRS estimate that there were approximately 7,000 U.S. partnerships with CFCs that e-filed at least one Form 5471 as Category 4 or 5 filers in 2015 and 2016. The identified partnerships had approximately 2 million partners, as indicated by the number of Schedules K–1 filed by the partnerships. This number includes both domestic and foreign partners, so it substantially overstates the number of partners that would actually be affected by the final regulations because it includes foreign partners. jbell on DSKJLSW7X2PROD with PROPOSALS2 iii. Extension of the Partnership Loan Rule to Loans From the Partner to the Partnership a. Background The 2019 FTC final regulations provide a rule that aligns interest income and expense when a U.S. partner makes a loan to the partnership. Under this matching rule, the partner’s gross interest income is apportioned between U.S. and foreign sources in each separate category based on the partner’s interest expense apportionment ratios. This rule minimizes the artificial increase in foreign source taxable income based solely on offsetting amounts of interest income and expense from a related party loan to a partnership. Comments in response to the 2018 FTC proposed VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 regulations requested an equivalent rule when the partnership makes a loan to a U.S. partner. b. Options Considered for the Proposed Regulations The Treasury Department and the IRS considered two options with respect to this rule. The first option was to not provide a rule, because the abuse the Treasury Department and the IRS were concerned about was not relevant with respect to loans from the partnership to the partner. In the absence of a matching rule, the U.S. partner’s U.S. source taxable income would be artificially increased but this income is not eligible to be sheltered by FTCs. The second option was to provide an identical rule for loans from the partnership to the partner as was provided in the 2019 FTC final regulations for loans from the partner to the partnership. The proposed regulations adopt the second option. This symmetry helps to ensure that similar economic transactions are treated similarly. c. Number of Affected Taxpayers The Treasury Department and the IRS consider the population of affected taxpayers to consist of any U.S. partner in a partnership which has a loan from the partnership to the partner or certain other parties related to the partner. The Treasury Department and the IRS estimate that there are approximately 450 partnerships and 5,000 partners that would be affected by this regulation. iv. Allocation and Apportionment of Expenses for Insurance Companies a. Background Section 818(f) provides that for purposes of applying the expense allocation rules to life insurance companies, the deduction for policyholder dividends, reserve adjustments, death benefits, and certain other amounts are treated as items that cannot be definitely allocated to an item or class of gross income. That means, in general, that the expenses are apportioned ratably across all gross income. Under the expense allocation rules, for most purposes, affiliated groups are treated as a single entity, although there are exceptions for certain expenses. The statute is unclear, however, about how affiliated groups are to be treated with respect to the allocation of certain expenses for insurance companies. Depending on the approach, the results could be different because the gross income categories across the affiliated group could be calculated in multiple ways. The Treasury Department and the IRS received comments and are aware PO 00000 Frm 00020 Fmt 4701 Sfmt 4702 69143 that in the absence of further guidance taxpayers are likely to take opposite positions on this treatment. Some taxpayers argue that the expenses described in section 818(f) are apportioned based on the gross income of the entire affiliated group, while others argue that expenses are apportioned on a separate company or subgroup basis taking into account only the gross income of life insurance companies. b. Options Considered for the Proposed Regulations The Treasury Department and the IRS are aware of at least five potential methods for allocating section 818(f) expenses in a life-nonlife consolidated group. First, the expenses might be allocated solely among items of the life insurance company that has the reserves (‘‘separate entity method’’). Second, to the extent the life insurance company has engaged in a reinsurance arrangement that constitutes an intercompany transaction (as defined in § 1.1502–13(b)(1)), the expenses might be allocated in a manner that achieves single entity treatment between the ceding member and the assuming member (‘‘limited single entity method’’). Third, the expenses might be allocated among items of all life insurance members (‘‘life subgroup method’’). Fourth, the expenses might be allocated among items of all members of the consolidated group (including both life and non-life members) (‘‘single entity method’’). Fifth, the expenses might be allocated based on a facts and circumstances analysis (‘‘facts and circumstances method’’). In response to the request for comments in the 2018 FTC proposed regulations, the Treasury Department and the IRS received comments advocating for certain of the aforementioned allocation methods. The proposed regulations adopt the separate entity method because it is consistent with section 818(f) and with the separate entity treatment of reserves under § 1.1502–13(e)(2). The Treasury Department and the IRS recognize, however, that this method may create opportunities for consolidated groups to use intercompany transactions to shift their section 818(f) expenses and achieve a more desirable foreign tax credit result. Accordingly, the Treasury Department and the IRS request comments on whether a life subgroup method more accurately reflects the relationship between section 818(f) expenses and the income producing activities of the life subgroup as a whole, and whether the life subgroup method is less susceptible to abuse E:\FR\FM\17DEP2.SGM 17DEP2 69144 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules because it might prevent a consolidated group from inflating its foreign tax credit limitation through intercompany transfers of assets, reinsurance transactions, or transfers of section 818(f) expenses. The Treasury Department and the IRS also request comments regarding the appropriate application of § 1.1502–13(c) to neutralize the ancillary effects of separate-entity computation of insurance reserves, such as the computation of limitations under section 904. c. Number of Affected Taxpayers The Treasury Department and the IRS have determined that the population of affected taxpayers consists of life insurance companies that are members of an affiliated group. The Treasury Department and the IRS have established that there are approximately 60 such taxpayers. II. Paperwork Reduction Act For purposes of the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) (‘‘PRA’’), there is a collection of information in proposed §§ 1.905–4 and 1.905–5(b). When a redetermination of U.S. tax liability is required by reason of a foreign tax redetermination (FTR), the proposed regulations generally require the taxpayer to notify the IRS of the FTR and provide certain information necessary to redetermine the U.S. tax due for the year or years affected by the FTR. If there is no change in the U.S. tax liability as a result of the FTR or if the FTR is caused by certain de minimis fluctuations in foreign currency rates, the taxpayer may simply attach the notification to their next filed tax return and make any appropriate adjustments in that year. However, taxpayers are generally required to file an amended return (or an administrative adjustment request in the case of certain partnerships) for the year or years affected by the FTR along with an updated Form 1116 Foreign Tax Credit (Individual, Estate, or Trust) (covered under OMB Control Number 1545–0074 individual, or 1545–0121 estate and trust) or Form 1118 Foreign Tax CreditCorporations (OMB Control Number 1545–0123), and a written statement providing specific information relating to the FTR. Since the burden for filing amended income tax returns and the Forms 1116 and 1118 are covered under the OMB Control Numbers listed in the prior sentence, the burden estimates for OMB Control Number 1545–1056 only cover the burden for the written statements. For purposes of the PRA, the reporting burden associated with proposed §§ 1.905–4 and 1.905–5(b) will be reflected in the PRA submission associated with OMB control number 1545–1056, which is set to expire on December 31, 2020. The number of respondents to this collection was estimated at 13,000 and the total estimated burden time was estimated to be 54,000 hours and total estimated monetized costs of $2,430,540 ($2016). For taxpayers who are required to file an amended return (along with related Form 1116 or Form 1118) in order to report an FTR, and for purposes of the PRA, the reporting burden for filing the amended return will be reflected in OMB control numbers 1545–0123 (relating to business filers, which represents a total estimated burden time, including all related forms and schedules, of 3.157 billion hours and total estimated monetized costs of $58.148 billion ($2017)), 1545–0074 (relating to individual filers, which represents a total estimated burden time, including all related forms and schedules, of 1.784 billion hours and total estimated monetized costs of $31.764 billion ($2017)), and 1545–0121 (relating to estate and trust filers, which represents a total estimated burden time, including all related forms and schedules, of 25,066,693 hours). These overall burden estimates for OMB control numbers 1545–0123, 1545–0074, and 1545–0121 include, but do not isolate, the estimated burden of the foreign tax credit-related forms as a result of the information collection in the proposed regulations. These numbers are therefore unrelated to the future calculations needed to assess the burden imposed by the proposed regulations. These burdens have also been reported for other regulations related to the taxation of cross-border income and the Treasury Department and the IRS urge readers to recognize that these numbers are duplicates and to guard against overcounting the burden that international tax provisions imposed prior to the TCJA. As a result of the changes made in the TCJA to the foreign tax credit rules generally, and to section 905(c) specifically, the Treasury Department and the IRS anticipate that the number of respondents may increase modestly among taxpayers who file Form 1120 series returns. The possible increase in the number of respondents is due to the elimination of adjustments to pools of post-1986 earnings and profits and post1986 foreign income taxes as an alternative to filing an amended return following the changes made in the TCJA. These changes to the burden estimate will be reflected in the PRA submission for the renewal of OMB control number 1545–1056 as well as in the OMB control numbers 1545–0074 (for individuals) and 1545–0123 (for business taxpayers). The estimates for the number of impacted filers with respect to the collections of information described in this Part II of the Special Analyses are based on filers of income tax returns that file a Form 1065, Form 1040, or Form 1120 series because only filers of these forms are generally subject to the collection of information requirement. The IRS estimates the number of impacted filers to be the following: TAX FORMS IMPACTED Number of respondents (estimated) Collection of information jbell on DSKJLSW7X2PROD with PROPOSALS2 § 1.905–4 .................................................. § 1.905–5(b) .............................................. 8,900–11,700 8,900–11,700 The Treasury Department and the IRS request comments on all aspects of information collection burdens related to these proposed regulations, including estimates for how much time it would take to comply with the paperwork VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 Forms to which the information may be attached Form 1065 series, Form 1040 series, and Form 1120 series. Form 1065 series, Form 1040 series, and Form 1120 series. burdens described in this Part II of the Special Analyses and ways for the IRS to minimize the paperwork burden. No burden estimates specific to the proposed regulations are currently available. The Treasury Department has PO 00000 Frm 00021 Fmt 4701 Sfmt 4702 not estimated the burden, including that of any new information collections, related to the requirements under the proposed regulations. Those estimates would capture both changes made by the TCJA and those that arise out of E:\FR\FM\17DEP2.SGM 17DEP2 69145 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules discretionary authority exercised in the proposed regulations. The Treasury Department and the IRS welcome comments on all aspects of information collection burdens related to the foreign tax credit. In addition, when available, drafts of IRS forms are posted for comment at https://apps.irs.gov/app/ picklist/list/draftTaxForms.htm. III. Regulatory Flexibility Act Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that the proposed regulations will not have a significant economic impact on a substantial number of small entities within the meaning of section 601(6) of the Regulatory Flexibility Act. The proposed regulations provide guidance needed to comply with statutory changes and affect individuals and corporations claiming foreign tax credits. The domestic small business entities that are subject to the foreign tax credit rules in the Code and in the proposed regulations are generally those domestic small business entities that are at least 10 percent corporate shareholders of foreign corporations, and so are eligible to claim dividends- received deductions or compute foreign taxes deemed paid under section 960 with respect to inclusions under subpart F and section 951A from CFCs. Other aspects of these proposed regulations also affect domestic small business entities that operate in foreign jurisdictions or that have income from sources outside of the United States. Based on 2017 Statistics of Income data, the Treasury Department and the IRS computed the fraction of taxpayers owning a CFC by gross receipts size class. The smaller size classes have a relatively small fraction of taxpayers that own CFCs, which suggests that many domestic small business entities would be unaffected by these regulations. Many of the important aspects of the proposed regulations, including all of the rules in proposed §§ 1.861– 8(d)(2)(ii)(B), 1.904–4(c)(7), 1.904–6(f), 1.905–3(b)(2), 1.905–5, 1.954–1, 1.954– 2, and 1.965–5(b)(2) apply only to U.S. persons that operate a foreign business in corporate form, and, in most cases, only if the foreign corporation is a CFC. Because it takes significant resources and investment for a business to operate outside of the United States in corporate form, and in particular to own a CFC, the owners of such businesses will infrequently be domestic small business entities, as indicated by the Table. Other provisions in the proposed regulations, including the rules in proposed §§ 1.861–8(d)(2)(v), 1.861–8(e)(16), 1.861–14, 1.904–4(e), 1.1502–4, and 1.1502–21, generally apply only to members of a consolidated group and insurance companies or other members of the financial services industry earning income from sources outside of the United States. It is infrequent for domestic small entities to operate as part of an affiliated group, to be taxed as an insurance company, or to constitute a financial services entity, and also earn income from sources outside of the United States. Consequently, the Treasury Department and the IRS project that the proposed regulations are unlikely to affect a substantial number of domestic small business entities, however adequate data are not available at this time to certify that a substantial number of small entities would be unaffected. FRACTION OF U.S. CORPORATE TAXPAYERS REPORTING CFC OWNERSHIP, BY GROSS RECEIPTS SIZE CLASS Percentage with a CFC Gross receipts size class <1 mil ................................................................................................................................................................................................... 1–5 mil ................................................................................................................................................................................................. 5–10 mil ............................................................................................................................................................................................... 10–20 mil ............................................................................................................................................................................................. 20–30 mil ............................................................................................................................................................................................. 30–50 mil ............................................................................................................................................................................................. 50–100 mil ........................................................................................................................................................................................... 100–150 mil ......................................................................................................................................................................................... 150–200 mil ......................................................................................................................................................................................... 200–250 mil ......................................................................................................................................................................................... 250–500 mil ......................................................................................................................................................................................... >=500 mil ............................................................................................................................................................................................. 0.40 0.80 2.70 4.50 9.30 12.00 19.70 26.80 32.50 37.40 43.70 63.50 * Data based on 2017 Statistics of Income sample for all 1120 returns except 1120–S and return type=2 (1120–L, 1120–RIC, 1120–F, 1120– REIT, 1120–PC,1120, 1120–L Consolidated 1504c return (controlling industries 524142 and 524143),1120–PC Consolidated 1504C return (controlling industries 524156, 524159), and 1120 Section 594/1504c consolidated return (controlling industries not 524142, 524143, 524156, 524159), 1120 Non-consolidated return). The Treasury Department and the IRS have determined that the proposed regulations will not have a significant economic impact on domestic small business entities. Based on published jbell on DSKJLSW7X2PROD with PROPOSALS2 Size (by business receipts) information from 2013, foreign tax credits as a percentage of three different tax-related measures of annual receipts (see Table for variables) by corporations are substantially less than the 3 to 5 percent threshold for significant economic impact. The amount of foreign tax credits in 2013 is an upper bound on the change in foreign tax credits resulting from the proposed regulations. Under $500,000 $500,000 under $1,000,000 $1,000,000 under $5,000,000 $5,000,000 under $10,000,000 $10,000,000 under $50,000,000 $50,000,000 under $100,000,000 $100,000,000 under $250,000,000 $250,000,000 or more (%) (%) (%) (%) (%) (%) (%) (%) FTC/Total Receipts ..................................... FTC/(Total Receipts-Total Deductions) ...... FTC/Business Receipts ............................... 0.03 0.48 0.05 0.00 0.03 0.00 0.00 0.04 0.00 0.01 0.26 0.01 0.01 0.22 0.01 0.03 0.51 0.04 Source: Statistics of Income (2013) Form 1120 available at https://www.irs.gov/statistics. VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 PO 00000 Frm 00022 Fmt 4701 Sfmt 4702 E:\FR\FM\17DEP2.SGM 17DEP2 0.09 1.20 0.10 0.56 9.00 0.64 69146 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules Although proposed § 1.905–4 contains a collection of information requirement, the small businesses that are subject to the requirements of proposed § 1.905–4 are domestic small entities with significant foreign operations. The data to assess precise counts of small entities affected by proposed § 1.905–4 are not readily available, but, as the data above suggest, a significant number of small entities are not likely to have significant foreign operations. Further, as demonstrated in the second table in this Part III, foreign tax credits do not have a significant economic impact for small business entities. Therefore, the Treasury Department and the IRS have determined that a substantial number of domestic small business entities will not be subject to proposed § 1.905–4. Moreover, as discussed in this Part III, the proposed regulations do not have a significant economic impact on small entities. Accordingly, it is hereby certified that the requirements of proposed § 1.905–4 will not have a significant economic impact on a substantial number of small entities. Pursuant to section 7805(f), these proposed regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses. The Treasury Department and the IRS also request comments from the public on the certifications in this Part III. jbell on DSKJLSW7X2PROD with PROPOSALS2 IV. Unfunded Mandates Reform Act Section 202 of the Unfunded Mandates Reform Act of 1995 (UMRA) requires that agencies assess anticipated costs and benefits and take certain other actions before issuing a final rule that includes any Federal mandate that may result in expenditures in any one year by a state, local, or tribal government, in the aggregate, or by the private sector, of $100 million in 1995 dollars, updated annually for inflation. In 2019, that threshold is approximately $154 million. This proposed rule does not include any Federal mandate that may result in expenditures by state, local, or tribal governments, or by the private sector in excess of that threshold. V. Executive Order 13132: Federalism Executive Order 13132 (entitled ‘‘Federalism’’) prohibits an agency from publishing any rule that has federalism implications if the rule either imposes substantial, direct compliance costs on state and local governments, and is not required by statute, or preempts state law, unless the agency meets the consultation and funding requirements of section 6 of the Executive Order. This proposed rule does not have federalism VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 implications and does not impose substantial direct compliance costs on state and local governments or preempt state law within the meaning of the Executive Order. Comments and Request for Public Hearing Before these proposed regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely to the IRS as prescribed in this preamble under the ADDRESSES heading. The Treasury Department and the IRS request comments on all aspects of the proposed rules. Additionally, the Treasury Department and the IRS have specifically requested comments in the following parts of the Explanation of Provisions: I.A.1 (various aspects of stewardship expense including definition and exceptions), I.A.5 (future implementation of section 864(f) and potential capitalization of certain expenses solely for purposes of § 1.861– 9), I.D (life subgroup method), I.E.1 (different classification methods for R&E expenditures), I.E.3 (contract research arrangements), II.A (additional guidance under sections 954(h) and 952(c)(1)(B)(vi) with respect to financial services entities), II.B (the treatment of foreign tax on base differences and on income that is recognized by a different person for U.S. tax purposes, the interaction of proposed § 1.904–6(f) with sections 245A(g) and 909, and the allocation and apportionment of certain state and foreign income taxes), III.B (foreign tax redeterminations and predecessor or successor entities), III.C.1 (alternative notification requirements under section 905(c)), III.C.2 (coordination between sections 905(c) and 6227), and III.D (alternative adjustments for post-2017 foreign tax redeterminations with respect to pre2018 taxable years of foreign corporations). All comments will be available at www.regulations.gov or upon request. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register. Drafting Information The principal authors of the proposed regulations are Karen J. Cate, Jeffrey P. Cowan, Jeffrey L. Parry, Larry R. Pounders, and Suzanne M. Walsh of the Office of Associate Chief Counsel (International). However, other personnel from the Treasury PO 00000 Frm 00023 Fmt 4701 Sfmt 4702 Department and the IRS participated in their development. List of Subjects 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 301 Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements. Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is proposed to be amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by revising the entries for § 1.861–14 and adding entries for §§ 1.905–4 and 1.905–4(b)(2)(ii) to read in part as follows: ■ Authority: 26 U.S.C. 7805. * * * * * Section 1.861–14 also issued under 26 U.S.C. 864(e)(7). * * * * * Section 1.905–4 also issued under 26 U.S.C. 989(c)(4) and 26 U.S.C. 6689(a). Section 1.905–4(b)(2)(ii) also issued under 26 U.S.C. 6227(d) and 26 U.S.C. 6241(11). * * * * * Par 2. Section 1.704–1 is amended by: 1. Revising the fourth sentence and adding a new fifth sentence in paragraph (b)(1)(ii)(b)(1). ■ 2. Revising paragraph (b)(4)(viii)(d)(1). The revisions read as follows: ■ ■ § 1.704–1 Partner’s distributive share. * * * * * (b) * * * (1) * * * (ii) * * * (b) * * * (1) * * * Except as provided in the next sentence, the provisions of paragraphs (b)(4)(viii)(a)(1), (b)(4)(viii)(c)(1), (b)(4)(viii)(c)(2)(ii) and (iii), (b)(4)(viii)(c)(3) and (4), (b)(4)(viii)(d)(1) (as in effect on July 24, 2019), and Examples 1, 2, and 3 in paragraphs (b)(6)(i), (ii), and (iii) of this section apply for partnership taxable years that both begin on or after January 1, 2016, and end after February 4, 2016. For partnership taxable years beginning after December 31, 2019, paragraph (b)(4)(viii)(d)(1) of this section applies. * * * * * * * * (4) * * * (viii) * * * (d) * * * 1 In general. CFTEs are allocated and apportioned to CFTE E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules categories in accordance with § 1.861– 20 by treating each CFTE category as a statutory grouping (with no residual grouping). See Examples 2 and 3 in paragraphs (b)(6)(ii) and (iii) of this section, which illustrate the application of this paragraph in the case of serial disregarded payments subject to withholding tax. In addition, if as described in § 1.861–20(e), foreign law does not provide for the direct allocation or apportionment of expenses, losses or other deductions allowed under foreign law to a CFTE category of income, then such expenses, losses or other deductions must be allocated and apportioned to gross income as determined under foreign law in a manner that is consistent with the allocation and apportionment of such items for purposes of determining the net income in the CFTE categories for Federal income tax purposes pursuant to paragraph (b)(4)(viii)c3 of this section. * * * * * ■ Par. 3. Section 1.861–8 is amended by: ■ 1. Adding a sentence to the end of paragraph (a)(1). ■ 2. Revising paragraph (d)(2)(ii)(B). ■ 3. Adding paragraph (d)(2)(v). ■ 4. Revising paragraph (e)(4)(ii). ■ 5. Revising the heading of paragraph (e)(5) and adding five sentences to the end of paragraph (e)(5). ■ 6. Revising the first sentence of paragraph (e)(6)(i). ■ 7. Revising paragraphs (e)(7) and (8). ■ 8. Adding paragraph (e)(16). ■ 9. Adding paragraphs (g)(15) through (18) and paragraph (g)(24); ■ 10. Revising paragraph (h). The additions and revisions read as follows: jbell on DSKJLSW7X2PROD with PROPOSALS2 § 1.861–8 Computation of taxable income from sources within the United States and from other sources and activities. (a) * * * (1) * * * The term ‘‘section 861 regulations’’ means this section, §§ 1.861–8T, 1.861–9, 1.861–9T, 1.861– 10, 1.861–10T, 1.861–11, 1.861–11T, 1.861–12, 1.861–12T, 1.861–13, 1.861– 14, 1.861–14T, 1.861–17, and § 1.861– 20. * * * * * (d) * * * (2) * * * (ii) * * * (B) Certain stock and dividends. The term ‘‘exempt income’’ includes the portion of the dividends that are deductible under section 243(a)(1) or (2) (relating to the dividends received deduction) or section 245(a) (relating to the dividends received deduction for dividends from certain foreign corporations). Thus, for purposes of VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 apportioning deductions using a gross income method, gross income does not include a dividend to the extent that it gives rise to a dividend received deduction under either section 243(a)(1), section 243(a)(2), or section 245(a). In addition, for purposes of apportioning deductions using an asset method, assets do not include that portion of the value of the stock (determined in accordance with § 1.861–9(g), and, as relevant, §§ 1.861– 12 and 1.861–13) equal to the portion of dividends paid thereon that would be deductible under either section 243(a)(1), section 243(a)(2), or section 245(a). For example, in the case of stock for which all dividends would be allowed a deduction of 50 percent under section 243(a)(1), 50 percent of the value of the stock is treated as an exempt asset. In the case of stock which generates, has generated, or can reasonably be expected to generate qualifying dividends deductible under section 243(a)(3), such stock does not constitute an exempt asset. However, such stock and the qualifying dividends thereon are eliminated from consideration in the apportionment of interest expense under the consolidation rule set forth in § 1.861– 11T(c), and in the apportionment of other expenses under the consolidation rules set forth in § 1.861–14T. * * * * * (v) Dividends received deduction and tax-exempt interest of insurance companies—(A) In general. For purposes of characterizing gross income or assets as exempt or not exempt under this section, the following rules apply on a company wide basis pursuant to the rules in paragraphs (d)(2)(v)(A)(1) and (2) of this section. (1) In the case of an insurance company taxable under section 801, the term ‘‘exempt income’’ includes the portion of dividends received that satisfy the requirements of deductibility under sections 243(a)(1) and (2) and 245(a) but without regard to any disallowance under section 805(a)(4)(A)(ii) of the policyholder’s share of the dividends or any similar disallowance under section 805(a)(4)(D), and also includes tax-exempt interest but without reduction for the policyholder’s share of tax-exempt interest that reduces the closing balance of items described in section 807(c), as provided under section 807(a)(2)(B) and 807(b)(1)(B). The term ‘‘exempt assets’’ includes the corresponding portion of assets that give rise to exempt income described in the preceding sentence. See § 1.861–8(e)(16) for a special rule concerning the allocation of reserve PO 00000 Frm 00024 Fmt 4701 Sfmt 4702 69147 expenses to dividends received by a life insurance company. (2) In the case of an insurance company taxable under section 831, the term ‘‘exempt income’’ includes the portion of interest and dividends deductible under sections 832(c)(7) and (12) or sections 834(c)(1) and (7). Exempt income also includes the amounts reducing the losses incurred under section 832(b)(5) to the extent such amounts are not already taken into account in the preceding sentence. The term ‘‘exempt assets’’ includes the corresponding portion of assets that give rise to exempt income described in the preceding two sentences. (B) Examples. The following examples illustrate the application of paragraph (d)(2)(v)(A) of this section. (1) Example 1—(i) Facts. U.S.C. is a domestic life insurance company that has $300x of gross income, consisting of $100x of foreign source general category income and $200x of U.S. source passive category interest income, $100x of which is tax-exempt interest income from municipal bonds under section 103. U.S.C.’s opening balance of its section 807(c) reserves is $50,000x and USP’s closing balance of its section 807(c) reserves is $50,130x. Under section 807(b)(1)(B), USP’s closing balance of its section 807(c) reserves, $50,130x, is reduced by the amount of the policyholder’s share of tax-exempt interest. The policyholder’s share of taxexempt interest under section 812(b) is equal to 30 percent of the $100x of tax-exempt interest ($30x). Therefore, under sections 803(a)(2) and 807(b), USP’s reserve deduction is $100x ($50,130x of reserve deduction minus $30x (30 percent of $100x of taxexempt interest), minus $50,000x). U.S.C. has no other income or deductions. (ii) Analysis—allocation. Under section 818(f)(1), U.S.C.’s reserve deduction is treated as an item that cannot be definitely allocated to an item or class of gross income. Accordingly, under paragraph (b)(5) of this section, U.S.C.’s reserve deduction is allocable to all of U.S.C.’s gross income as a class. (iii) Analysis—apportionment. Under paragraph (c)(3) of this section, the reserve deduction is ratably apportioned between the statutory grouping (foreign source general category income) and the residual grouping (U.S. source income) on the basis of the relative amounts of gross income in each grouping. For purposes of apportioning deductions under § 1.861–8T(d)(2)(i)(B), exempt income is not taken into account. Under paragraph (d)(2)(v)(A)(1) of this section, in the case of an insurance company taxable under section 801, exempt income includes tax-exempt interest without regard to any reduction for the policyholder’s share. U.S.C. has U.S. source income of $200x of which $100x is tax-exempt without regard to the reduction for the policyholder’s share of tax-exempt interest that reduces the closing balance of items described in section 807(c). Thus, the gross income taken into account in apportioning U.S.C.’s reserve deduction is $100x of foreign source general category E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69148 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules gross income and $100x of U.S. source gross income. Of U.S.C.’s $100x reserve deduction, $50x ($100x × $100x/$200x) is apportioned to foreign source general category gross income and $50x ($100x × $100x/$200x) is apportioned to U.S. source gross income. (2) Example 2—(i) Facts. U.S.C. is a domestic life insurance company that has $300x of gross income consisting of $100x of foreign source general category income and $200x of U.S. source general category dividend income eligible for the 50% dividends received deduction (DRD) under section 243(a)(1). Under section 805(a)(4)(A)(ii), U.S.C. is allowed a 50% DRD on the company’s share of the dividend received. Under section 812(a), the company’s share is equal to 70% of the dividend income eligible for the DRD under section 243(a)(1), which results in a DRD of $70x (70% × 50% × $200x), and under section 812(b), the policyholder’s share is equal to 30% of the dividend income eligible for the DRD under section 243(a)(1), or $30x. U.S.C. is entitled to a $130x deduction for an increase in its life insurance reserves under sections 803(a)(2) and 807(b). Unlike for taxexempt interest income, there is no adjustment under section 807(b)(1)(B) to the reserve deduction for the policyholder’s share of dividends eligible for the DRD under section 243(a)(1). U.S.C. has no other income or deductions. (ii) Analysis—allocation. Under section 818(f)(1), U.S.C.’s reserve is treated as an item that cannot be definitely allocated to an item or class of gross income except that, under § 1.861–8(e)(16), an amount of reserve expenses of a life insurance company equal to the DRD that is disallowed because it is attributable to the policyholder’s share of dividends is treated as definitely related to such dividends. Thus, U.S.C. has a life insurance reserve deduction of $130x, of which $30x (equal to the policyholder’s share of the DRD that would have been allowed under section 243(a)(1)) is directly allocated and apportioned to U.S. source dividend income. Under paragraph (b)(5) of this section, the remaining portion of U.S.C.’s reserve deduction ($100x) is allocable to all of U.S.C.’s gross income as a class. (iii) Analysis—apportionment. Under paragraph (c)(3) of this section, the deduction is ratably apportioned between the statutory grouping (foreign source general category income) and the residual grouping (U.S. source income) on the basis of the relative amounts of gross income in each grouping. For purposes of apportioning deductions under § 1.861–8T(d)(2)(i)(B), exempt income is not taken into account. Under paragraph (d)(2)(v)(A)(1) of this section, in the case of an insurance company taxable under section 801, exempt income includes dividends deductible under section 805(a)(4) without regard to any reduction to the DRD for the policyholder’s share in section 804(a)(4)(A)(ii). Thus, the gross income taken into account in apportioning $100x of U.S.C.’s remaining reserve deduction is $100x of foreign source general category gross income and $100x of U.S. source gross income. Of U.S.C.’s $100x remaining reserve deduction, $50x ($100x × $100x/$200x) is apportioned to foreign source general VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 category gross income and $50x ($100x × $100x/$200x) is apportioned to U.S. source gross income. * * * * * (e) * * * (4) * * * (ii) Stewardship expenses—(A) In general. Stewardship expenses result from ‘‘overseeing’’ functions undertaken for a corporation’s own benefit as an investor in a related corporation. For purposes of this section, stewardship expenses of a corporation are those expenses resulting from ‘‘duplicative activities’’ (as defined in § 1.482– 9(l)(3)(iii)) or ‘‘shareholder activities’’ (as defined in § 1.482–9(l)(3)(iv)) of the corporation with respect to the related corporation. Thus, for example, stewardship expenses include expenses of an activity the sole effect of which is either to protect the corporation’s capital investment in the related corporation or to facilitate compliance by the corporation with reporting, legal, or regulatory requirements applicable specifically to the corporation, or both. If a corporation has a foreign or international department which exercises overseeing functions with respect to related foreign corporations and, in addition, the department performs other functions that generate other foreign-source income (such as fees for services rendered outside of the United States for the benefit of foreign related corporations and foreign-source royalties), some part of the deductions with respect to that department are considered definitely related to the other foreign-source income. In some instances, the operations of a foreign or international department will also generate U.S. source income (such as fees for services performed in the United States). (B) Allocation. Stewardship expenses are considered definitely related and allocable to dividends and inclusions received or accrued, or to be received or accrued, under sections 78, 951 and 951A, as well as amounts included under sections 1291, 1293, and 1296, from the related corporation. (C) Apportionment. Stewardship expenses must be apportioned between the statutory grouping (or groupings) and residual grouping based on the relative values of the stock in each grouping held by a taxpayer, as determined and characterized under § 1.861–9T(g) (and, as relevant, §§ 1.861–12 and 1.861–13) for purposes of allocating and apportioning the taxpayer’s interest expense. (D) Partnerships. The principles of paragraph (e)(4)(ii)(A) of this section apply to determine if expenses incurred with respect to a partnership are PO 00000 Frm 00025 Fmt 4701 Sfmt 4702 stewardship expenses. Stewardship expenses incurred with respect to a partnership are considered definitely related and allocable to a partner’s distributive share of partnership income. The principles of paragraph (e)(4)(ii)(C) of this section apply to apportion expenses incurred with respect to a partnership. (5) Legal and accounting fees and expenses; damages awards, prejudgment interest, and settlement payments. * * * Awards for litigation or arbitral damages, prejudgment interest, and payments in settlement of or in anticipation of claims for damages, including punitive damages, arising from product liability and similar or related claims are definitely related and allocable to the class of gross income produced by the specific sales of the products or services that gave rise to the claims for damage or injury. If the claims arise from an event incident to the production of products or provision of services rather than from damage or injury caused by the product or service, the payments are definitely related and allocable to the class of gross income ordinarily produced by the assets used to produce the products or services that are involved in the event. If necessary, the deductions arising from the event are apportioned among the statutory and residual groupings on the basis of the relative values (as determined under § 1.861–9T(g) and, as relevant, §§ 1.861– 12 and 1.861–13, for purposes of allocating and apportioning the taxpayer’s interest expense) of the assets in each grouping. If the claims are made by investors in a corporation, arise from negligence, fraud, or other malfeasance of the corporation (or its representatives), and are not described in the preceding two sentences, then the damages, prejudgment interest, and settlement payments paid by the corporation are definitely related and allocable to all income of the corporation and are apportioned among the statutory and residual groupings based on the relative value of the corporation’s assets in each grouping (as determined under § 1.861–9T(g) and, as relevant, §§ 1.861–12 and 1.861–13, for purposes of allocating and apportioning the taxpayer’s interest expense). The grouping (or groupings) of income to which damages, prejudgment interest, and settlement payments is allocated and apportioned is determined based on the groupings to which the related income would be assigned if the income were recognized in the taxable year in which the deduction is allowed. (6) * * * (i) * * * The deduction for foreign income, war profits and excess profits taxes allowed by section 164 is E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules allocated and apportioned among the applicable statutory and residual groupings under § 1.861–20. * * * * * * * * (7) Losses on the sale, exchange, or other disposition of property. See §§ 1.865–1 and 1.865–2 for rules regarding the allocation of certain losses. (8) Net operating loss deduction—(i) Components of net operating loss. A net operating loss is assigned to statutory or residual grouping components by reference to the losses in each such statutory or residual grouping that are not allocated to reduce income in other groupings in the taxable year of the loss. For example, for purposes of section 904, the source and separate category components of a net operating loss are determined by reference to the amounts of separate limitation loss and U.S. source loss (determined without regard to adjustments required under section 904(b)) that are not allocated to reduce U.S. source income or income in other separate categories under the rules of sections 904(f) and 904(g) for the taxable year in which the net operating loss arose. See § 1.904(g)–3(d)(2). See § 1.1502–4 for rules applicable in computing the foreign tax credit limitation and determining the source and separate category of a net operating loss of a consolidated group. (ii) Components of section 172 deduction. A net operating loss deduction allowed under section 172 is allocated and apportioned to statutory and residual groupings by reference to the statutory and residual grouping components of the net operating loss that is deducted in the taxable year. Except as provided under the rules for an operative section, a partial net operating loss deduction is treated as ratably comprising the components of a net operating loss. See, for example, § 1.904(g)–3, which is an exception to the general rule described in the previous sentence and provides rules for determining the source and separate category of a partial net operating loss deduction for purposes of section 904 as the operative section. * * * * * (16) Special rule for the allocation of reserve expenses of a life insurance company. An amount of reserve expenses of a life insurance company equal to the dividends received deduction that is disallowed because it is attributable to the policyholders’ share of dividends received is treated as definitely related to such dividends. See paragraph (d)(2)(v)(B)(2) of this section (Example 2). * * * * * VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 (g) * * * (15) Example 15: Payment in settlement of claim for damages allocated to specific class of gross income—(i) Facts—USP, a domestic corporation, designs, manufactures, and sells Product A in the United States. USP also operates a foreign branch, within the meaning of § 1.904–4(f)(3)(vii), in Country X through FDE, a disregarded entity organized in Country X, which manufactures and sells Product A in Country X. USP earns $300x of U.S. source income from sales of Product A to customers in the United States. The sales of Product A to customers in Country X result in aggregate gross income of $100x, of which $80x is U.S. source income attributable to USP’s manufacturing activities and $20x is U.S. source income attributable to FDE’s distribution activities. The $100x of income from sales of Product A to customers in Country X constitutes foreign branch category income. FDE is sued under Country X law for damages after Product A harms a customer in Country X. FDE makes a deductible payment to the Country X customer in settlement of the legal claims for damages. (ii) Analysis. Because Product A caused the customer’s injury, the claim for damages arose from the specific sales of Product A to the customer in Country X. Claims that might arise from damages caused by Product A to customers in the United States are irrelevant in allocating the deduction for the settlement payments made to the customer in Country X. Therefore, FDE’s damages payment deduction is allocable to the class of gross income of sales of Product A in Country X. For purposes of section 904(d), because that class of gross income consists solely of U.S. source income, none of that income is included in the statutory grouping of foreign source foreign branch category income, and accordingly the damages payment deduction reduces USP’s residual grouping of U.S. source income. (16) Example 16: Legal damages payment arising from event prior to sale—(i) FactsThe facts are the same as in paragraph (g)(15) of this section (the facts in Example 15) except that there is a disaster at FDE’s warehouse in Country X arising from the negligence of an employee. The inventory of Product A in the warehouse is destroyed and FDE employees as well as residents in the vicinity of the warehouse are injured. USP’s reputation in the United States suffers such that USP expects to subsequently lose market share in the United States. FDE makes damages payments totaling $80x to both its injured employees and the nearby residents. (ii) Analysis. FDE’s warehouse in Country X is used in connection with sales of Product A to customers in Country X. Thus, the $80x damages payment is allocable to the class of gross income ordinarily produced by the assets used to produce Product A. No apportionment of the $80x is necessary for purposes of applying section 904(d) because the class of gross income to which the deduction is allocated consists solely of U.S. source income. (17) Example 17: Payment following a change in law—(i) Facts. The facts are the same as in paragraph (g)(15) (the facts in Example 15) except that FDE manufactures PO 00000 Frm 00026 Fmt 4701 Sfmt 4702 69149 and sells Product A in Country X in 2015 (before the enactment of the section 904(d)(1)(B) separate category for foreign branch income) and is sued in 2016 under Country X law for damages after Product A harms a customer in Country X. FDE makes a deductible damages payment to the Country X customer pursuant to a court judgment in 2019. (ii) Analysis. The specific sales of Product A in Country X in 2015 led to the customer’s injury in Country X. The payment in 2019 of the deductible damages payment is definitely related and allocable to the class of gross income consisting of Product A sales in Country X. Although the income earned from the Product A sales in Country X in 2015 was foreign source general category income, in 2019 the assets used to produce such income is U.S. source foreign branch category income. Accordingly, the deductible damages payment is allocated to foreign branch category income. No apportionment of the payment is necessary because the class of gross income to which the deduction is allocated consists solely of U.S. source income. (18) Example 18: Stewardship and supportive expenses—(i) Facts—(A) USP, a domestic corporation, manufactures and sells Product A in the United States. USP owns 100% of the stock of USSub, a domestic corporation, and CFC1, CFC2, and CFC3, which are all controlled foreign corporations. USP and USSub file separate returns for U.S. Federal income tax purposes but are members of the same affiliated group under section 243(b)(2). USSub, CFC1, CFC2, and CFC3 perform similar functions in the United States and in the foreign countries T, U, and V, respectively. The tax book value of USP’s stock in each of its four subsidiaries is $10,000x. (B) USP’s supervision department (the Department) incurs expenses of $1,500x. The Department is responsible for the supervision of its four subsidiaries and for rendering certain services to the subsidiaries, and the Department provides all the supportive functions necessary for USP’s foreign activities. The Department performs three principal types of activities. First, the Department performs services outside the United States for the direct benefit of CFC2 for which a fee is paid by CFC2 to USP. The cost to the Department of the services for CFC2 is $900x, which results in a total charge (after a $100x markup) to CFC2 of $1,000x, all of which is foreign source income to USP. Second, the Department provides services related to license agreements that USP maintains with subsidiaries CFC1 and CFC2 and which give rise to foreign source income to USP. The cost of the services is $60x. Third, it performs activities described in § 1.482–9(l)(3)(iii) that are in the nature of shareholder oversight, that duplicate functions performed by the subsidiaries’ own employees, and that do not provide an additional benefit to the subsidiaries. For example, a team of auditors from USP’s accounting department periodically audits the subsidiaries’ books and prepares internal reports for use by USP’s management. Similarly, USP’s treasurer periodically reviews for the board of directors of USP the E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69150 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules subsidiaries’ financial policies. These activities do not provide an additional benefit to the related corporations. The cost of the duplicative services and related supportive expenses is $540x. (C) USP also earns the following items of income. First, under section 951(a), USP includes $2,000x of subpart F income that is passive category income. Second, under section 951A and the section 951A regulations (as defined in § 1.951A–1(a)(1)), USP has a GILTI inclusion amount of $2,000x. USP’s deduction under section 250 is $1,000x (‘‘section 250 deduction’’), all of which is by reason of section 250(a)(1)(B)(i). No portion of USP’s section 250 deduction is reduced by reason of section 250(a)(2)(B). Finally, USP also earns $1,000x of fees from CFC2 and receives royalties of $1,000x from CFC1 and CFC2. (D) Under § 1.861–9T(g)(3), USSub owns assets that generate income described in the residual grouping of gross income from U.S. sources. USP uses the asset method described in § 1.861–12T(c)(3)(ii) to characterize the stock in its CFCs. After application of § 1.861–13(a), USP determines that $5,000x of the stock of each of the three CFCs is assigned to the section 951A category (‘‘section 951A category stock’’) in the nonsection 245A subgroup; $2,000x of the stock of each of the three CFCs is assigned to the general category in the section 245A subgroup; and $3,000x of the stock of each of the three CFCs is assigned to the passive category in the non-section 245A subgroup. Additionally, under § 1.861–8(d)(2)(ii)(C)(2), $2,500x of the stock of each of the three CFCs that is section 951A category stock is an exempt asset. Accordingly, with respect to the stock of its controlled foreign corporations in the aggregate, USP has $7,500x of section 951A category stock in a non-section 245A subgroup, $6,000x of general category stock in a section 245A subgroup, $9,000x of passive category stock in a non-section 245A subgroup, and $7,500x of stock that is an exempt asset. (ii) Analysis—(A) Character of USP Department services. The first and second activities (the services rendered for the benefit of CFC2, and the provision of services related to license agreements with CFC1 and CFC2) are not properly characterized as stewardship expenses because they are not incurred solely to protect the corporation’s capital investment in the related corporation or to facilitate compliance by the corporation with reporting, legal, or regulatory requirements applicable specifically to the corporation. The third activity described is in the nature of shareholder oversight and is characterized as stewardship as described in paragraph (e)(4)(ii)(A) of this section because the expense is related to duplicative activities. (B) Allocation. First, the deduction of $900x for expenses related to services rendered for the benefit of CFC2 is definitely related (and therefore allocable) to the $1,000x in fees for services that USP receives from CFC2. Second, the $60x of deductions attributable to USP’s license agreements with CFC1 and CFC2 are definitely related (and therefore allocable) solely to royalties received from CFC1 and CFC2. Third, the VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 stewardship deduction of $540x is definitely related (and therefore allocable) to dividends and inclusions received from all the subsidiaries. (C) Apportionment—(1) No apportionment of USP’s deduction of $900x for expenses related to the services is necessary because the class of gross income to which the deduction is allocated consists entirely of a single statutory grouping, foreign source general category income. (2) No apportionment of USP’s deduction of $60x attributable to the ancillary services is necessary because the class of gross income to which the deduction is allocated consists entirely of a single statutory grouping, foreign source general category income. (3) For purposes of apportioning USP’s $540x stewardship expenses in determining the foreign tax credit limitation, the statutory groupings are foreign source general category income, foreign source passive category income, and foreign source section 951A category income. The residual grouping is U.S. source income. (4) USP’s deduction of $540x for the Department’s stewardship expenses which are allocable to dividends and inclusions received from the subsidiaries are apportioned using the same value of USP’s stock in USSub, CFC1, CFC2, and CFC3 that is used for purposes of allocating and apportioning USP’s interest expense. However, the $10,000x value of USP’s stock of USSub is eliminated because USSub generates qualifying dividends deductible under section 243(a)(3). See § 1.861– 8(d)(2)(ii)(B). (5) Although USP may be allowed a section 245A deduction with respect to dividends from the CFCs, the value of the stock of the CFCs is not eliminated because the section 245A deduction does not create exempt income or result in the stock being treated as an exempt asset. See section 864(e)(3) and § 1.861–8T(d)(2)(iii)(C). Therefore, the only asset value upon which stewardship expenses are apportioned is the stock in USP’s CFCs. (6) Taking into account the characterization of USP’s stock in CFC1, CFC2, and CFC3, and excluding the exempt portion, the $540x of Department expenses is apportioned as follows: $180x ($540x × $7,500x/$22,500x) to section 951A category income, $144x ($540x × $6,000x/$22,500x) to general category income, and $216x ($540x × $9,000x/$22,500x) to passive category income. Section 904(b)(4)(B)(i) applies to $144x of the stewardship expense apportioned to the CFCs’ stock that is characterized as being in the section 245A subgroup in the general category. * * * * * (24) For guidance, see § 1.861–8T(g) Example 24. * * * * * (h) Applicability date—(1) Except as provided in paragraph (h)(2) of this section, this section applies to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018. PO 00000 Frm 00027 Fmt 4701 Sfmt 4702 (2) Paragraphs (d)(2)(ii)(B), (d)(2)(v), (e)(4), (e)(5), (e)(6)(i), (e)(8), (e)(16), and (g)(15) through (g)(18) of this section apply to taxable years that end on or after December 16, 2019. For taxable years that both begin after December 31, 2017, and end on or after December 4, 2018, and also end before December 16, 2019, see § 1.861–8(d)(2)(ii)(B), (e)(4), (e)(5), (e)(6)(i), and (e)(8) as in effect on December 17, 2019. ■ Par. 4. Section 1.861–8T is amended by revising paragraph (d)(2)(ii)(B) to read as follows: § 1.861–8T Computation of taxable income from sources within the United States and from other sources and activities (temporary). * * * * * (d) * * * (2)* * * (ii) * * * (B) For further guidance, see § 1.861– 8(d)(2)(ii)(B). * * * * * ■ Par. 5. Section 1.861–9 is amended by: ■ 1. Revising paragraphs (a) and (b). ■ 2. Revising paragraphs (c)(1) through (4). ■ 3. Adding paragraph (e)(9). ■ 4. Revising paragraph (k). The revisions and additions read as follows: § 1.861–9 Allocation and apportionment of interest expense and rules for asset-based apportionment. (a) For further guidance, see § 1.861– 9T(a). (b) Interest equivalent—(1) Certain expenses and losses—(i) General rule. Any expense or loss (to the extent deductible) incurred in a transaction or series of integrated or related transactions in which the taxpayer secures the use of funds for a period of time is subject to allocation and apportionment under the rules of this section and § 1.861–9T(b) if such expense or loss is substantially incurred in consideration of the time value of money. However, the allocation and apportionment of a loss under this paragraph (b) and § 1.861–9T(b) does not affect the characterization of such loss as capital or ordinary for any purpose other than for purposes of the section 861 regulations (as defined in § 1.861–8(a)(1)). (ii) Examples. For further guidance see § 1.861–9T(b)(1)(ii) (2) Certain foreign currency borrowings. For further guidance see § 1.861–9T(b)(2) through (7). (3) through (7) [Reserved] (8) Guaranteed payments. Any deductions for guaranteed payments for E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules the use of capital under section 707(c) are allocated and apportioned in the same manner as interest expense. (c)(1) Disallowed deductions. For further guidance, see § 1.861–9T(c)(1) through (4). (2) through (4) [Reserved] * * * * * (e) * * * (9) Special rule for upstream partnership loans—(i) In general. For purposes of apportioning interest expense that is not directly allocable under paragraph (e)(4) of this section or § 1.861–10T, an upstream partnership loan debtor’s (UPL debtor) pro rata share of the value of the upstream partnership loan (as determined under paragraph (h)(4)(i) of this section) is not considered an asset of the UPL debtor taken into account as described in paragraphs (e)(2) and (3) of this section. (ii) Treatment of interest expense and interest income attributable to an upstream partnership loan. If a UPL debtor (or any other person in the same affiliated group as the UPL debtor) takes into account a distributive share of upstream partnership loan interest income (UPL interest income), the UPL debtor assigns an amount of its distributive share of the UPL interest income equal to the matching expense amount for the taxable year that is attributable to the same loan to the same statutory and residual groupings using the same ratios as the statutory and residual groupings of gross income from which the upstream partnership loan interest expense (UPL interest expense) is deducted by the UPL debtor (or any other person in the same affiliated group as the UPL debtor). Therefore, the amount of the distributive share of UPL interest income that is assigned to each statutory and residual grouping is the amount that bears the same proportion to the matching expense amount as the UPL interest expense in that statutory or residual grouping bears to the total UPL interest expense of the UPL debtor (or any other person in the same affiliated group as the UPL debtor). (iii) Anti-avoidance rule for third party back-to-back loans. If, with a principal purpose of avoiding the rules in this paragraph (e)(9), a partnership makes a loan to a person that is not related (within the meaning of section 267(b) or 707) to the lender, the unrelated person makes a loan to a direct or indirect partner in the partnership (or any person in the same affiliated group as a direct or indirect partner), and the first loan would constitute an upstream partnership loan if made directly to the direct or indirect partner (or person in the same affiliated VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 group as a direct or indirect partner), then the rules of this paragraph (e)(9) apply as if the first loan was made directly by the partnership to the partner (or affiliate of the partner), and the interest expense paid by the partner is treated as made with respect to the first loan. Such a series of loans will be subject to this recharacterization rule without regard to whether there was a principal purpose of avoiding the rules in this paragraph (e)(9) if the loan to the unrelated person would not have been made or maintained on substantially the same terms but for the loan of funds by the unrelated person to the direct or indirect partner (or affiliate of the partner). The principles of this paragraph (e)(9)(iii) also apply to similar transactions that involve more than two loans and regardless of the order in which the loans are made. (iv) Interest equivalents. The principles of this paragraph (e)(9) apply in the case of a partner, or any person in the same affiliated group as the partner, that takes into account a distributive share of income and has a matching expense amount (treating any interest equivalent described in §§ 1.861–9(b) and 1.861–9T(b) as interest income or expense for purposes of paragraph (e)(9)(v)(B) of this section) that is allocated and apportioned in the same manner as interest expense under §§ 1.861–9(b) and 1.861–9T(b). (v) Definitions. For purposes of this paragraph (e)(9), the following definitions apply. (A) Affiliated group. The term affiliated group has the meaning provided in § 1.861–11(d)(1). (B) Matching expense amount. The term matching expense amount means the lesser of the total amount of the UPL interest expense taken into account directly or indirectly by the UPL debtor for the taxable year with respect to an upstream partnership loan or the total amount of the distributive shares of the UPL interest income of the UPL debtor (or any other person in the same affiliated group as the UPL debtor) with respect to the loan. (C) Upstream partnership loan debtor (UPL debtor). The term upstream partnership loan debtor, or UPL debtor, means the person that holds the payable with respect to an upstream partnership loan. If a partnership holds the payable, then any partner in the partnership (other than a partner described in paragraph (e)(4)(i) of this section) is also considered a UPL debtor. (D) Upstream partnership loan interest expense (UPL interest expense). The term upstream partnership loan interest expense, or UPL interest expense, means an item of interest PO 00000 Frm 00028 Fmt 4701 Sfmt 4702 69151 expense paid or accrued with respect to an upstream partnership loan, without regard to whether the expense was currently deductible (for example, by reason of section 163(j)). (E) Upstream partnership loan interest income (UPL interest income). The term upstream partnership loan interest income, or UPL interest income, means an item of gross interest income received or accrued with respect to an upstream partnership loan. (F) Upstream partnership loan. The term upstream partnership loan means a loan by a partnership to a person that owns an interest, directly or indirectly through one or more other partnerships or other pass-through entities, in the partnership, or to any person in the same affiliated group as that person. (vi) Examples. The following examples illustrate the application of this paragraph (e)(9). (A) Example 1—(1) Facts. US1, a domestic corporation, directly owns 60% of PRS, a foreign partnership that is not engaged in a U.S. trade or business. The remaining 40% of PRS is directly owned by US2, a domestic corporation that is unrelated to US1. US1, US2, and PRS all use the calendar year as their taxable year. In Year 1, PRS loans $1,000x to US1. For Year 1, US1 has $100x of interest expense with respect to the loan and PRS has $100x of interest income with respect to the loan. US1’s distributive share of the interest income is $60x. Under paragraph (e)(2) of this section, $75x of US1’s interest expense with respect to the loan is allocated to U.S. source income and $25x is allocated to foreign source foreign branch category income. Under paragraph (h)(4)(i) of this section, US1’s share of the total value of the loan between US1 and PRS is $600x. (2) Analysis. The loan by PRS to US1 is an upstream partnership loan and US1 is an UPL debtor. Under paragraph (e)(9)(iv)(B) of this section, the matching expense amount is $60x, the lesser of the UPL interest expense taken into account by US1 with respect to the loan for the taxable year ($100x) and US1’s distributive share of the UPL interest income ($60x). Under paragraph (e)(9)(ii) of this section, US1 assigns $45x of the UPL interest income to U.S. source income ($60x × $75x/ $100x) and $15x of the UPL interest income to foreign source foreign branch category income ($60x × $25x/$100x). Under paragraph (e)(9)(i) of this section, the disregarded portion of the upstream partnership loan is $600x. (B) Example 2—(1) Facts. The facts are the same as in paragraph (e)(9)(vi)(A)(1) of this section (the facts in Example 1), except that US1 and US2 are part of the same affiliated group, US2’s distributive share of the interest income is $40x, and under paragraph (h)(4)(i) of this section US2’s share of the total value of the loan between US1 and PRS is $400x. (2) Analysis. The loan by PRS to US1 is an upstream partnership loan and US1 is an UPL debtor. Under paragraph (e)(9)(iv)(B) of this section, the matching expense amount is $100x, the lesser of the UPL interest expense E:\FR\FM\17DEP2.SGM 17DEP2 69152 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules taken into account by US1 with respect to the loan for the taxable year ($100x) and the total amount of US1 and US2’s distributive shares of the UPL interest income ($100x). Under paragraph (e)(9)(ii) of this section, US1 assigns $75x of the UPL interest income to U.S. source income ($100x × $75x/$100x) and $25x of the UPL interest income to foreign source foreign branch category income ($100x × $25x/$100x). Under paragraph (e)(9)(i) of this section, the disregarded portion of the upstream partnership loan is $1,000x, the total amount of US1 and US2’s share of the loan between US1 and PRS. * * * * * (k) Applicability date—(1) Except as provided in paragraph (k)(2) of this section, this section applies to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018. (2) Paragraphs (b)(1)(i), (b)(8), and (e)(9) of this section apply to taxable years that end on or after December 16, 2019. For taxable years that both begin after December 31, 2017, and end on or after December 4, 2018, and also end before December 16, 2019, see § 1.861– 9T(b)(1)(i) as contained in 26 CFR part 1 revised as of April 1, 2019]. ■ Par. 6. Amend § 1.861–9T by revising paragraph (b)(1)(i) and adding paragraph (b)(8) to read as follows: § 1.861–9T Allocation and Apportionment of interest expense (temporary). * * * * * (b) * * * (1) * * * (i) General rule. For further guidance, see § 1.861–9(b)(1)(i). * * * * * (8) Guaranteed payments. For further guidance, see § 1.861–9(b)(8). * * * * * ■ Par. 7. Section 1.861–12 is amended by revising paragraphs (d) through (i) and adding paragraph (k) to read as follows: § 1.861–12 Characterization rules and adjustments for certain assets. jbell on DSKJLSW7X2PROD with PROPOSALS2 * * * * * (d) Treatment of notes. For further guidance, see § 1.861–12T(d) through (e). (e) [Reserved] (f) Assets connected with capitalized, deferred, or disallowed interest—(1) In general. In the case of any asset in connection with which interest expense accruing during a taxable year is capitalized, deferred, or disallowed under any provision of the Code, the value of the asset for allocation and apportionment purposes is reduced by the principal amount of indebtedness the interest on which is so capitalized, deferred, or disallowed. Assets are VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 connected with debt (the interest on which is capitalized, deferred, or disallowed) only if using the debt proceeds to acquire or produce the asset causes the interest to be capitalized, deferred, or disallowed. (2) Examples. The following examples illustrate the application of paragraph (f)(1) of this section. (i) Example 1: Capitalized interest under section 263A—(A) Facts. X is a domestic corporation that uses the tax book value method of apportionment. X has $1,000x of indebtedness and incurs $100x of interest expense. Using $800x of the $1,000x debt proceeds to produce tangible property, X capitalizes $80x of interest expense under the rules of section 263A. X deducts the remaining $20x of interest expense. (B) Analysis. Because interest on $800x of debt is capitalized under section 263A by reason of the use of debt proceeds to produce the tangible property, $800x of the principal amount of X’s debt is connected to the tangible property under paragraph (f)(1) of this section. Therefore, for purposes of apportioning the remaining $20x of X’s interest expense, the adjusted basis of the tangible property is reduced by $800x. (ii) Example 2: Disallowed interest under section 163(l)—(A) Facts. X, a domestic corporation, owns 100% of the stock of Y, a domestic corporation. X and Y file a consolidated return and use the tax book value method of apportionment. In Year 1, X makes a loan of $1,000x to Y (Loan A) and Y then uses the Loan A proceeds to acquire in a cash purchase all the stock of a foreign corporation, Z. Interest on Loan A is payable in U.S. dollars or, at the option of Y, in stock of Z. (B) Analysis. Under section 163(l), Loan A is a disqualified debt instrument because interest on Loan A is payable at the option of Y in stock of a related party to Y. Because Loan A is a disqualified debt instrument, section 163(l)(1) disallows Y’s interest deduction for interest payable on Loan A. In addition, the value of the Z stock is not reduced under paragraph (f)(1) of this section because the use of the Loan A proceeds to acquire the stock of Z is not the cause of Y’s interest deduction being disallowed. Rather, the Loan A terms allowing interest to be paid in stock of Z is the cause of Y’s interest deduction being disallowed under section 163(l). Therefore, no adjustment is made to Y’s adjusted basis in the stock of Z for purposes of allocating the interest expense of X and Y. (g) Special rules for FSCs. For further guidance, see § 1.861–12T(g) through (j). (h) [Reserved] (i) [Reserved] * * * * * (k) Applicability date—(1) Except as provided in paragraph (k)(2) of this section, this section applies to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018. (2) Paragraph (f) this section applies to taxable years that end on or after PO 00000 Frm 00029 Fmt 4701 Sfmt 4702 December 16, 2019. For taxable years that both begin after December 31, 2017, and end on or after December 4, 2018, and before December 16, 2019, see § 1.861–12T(f) as contained in 26 CFR part 1 revised as of April 1, 2019. ■ Par. 8. Section 1.861–12T is amended by revising paragraph (f) § 1.861–12T Characterization rules and adjustments or certain assets (Temporary regulations). * * * * * (f) Assets connected with capitalized, deferred, or disallowed interest. For further guidance, see § 1.861–12(f). * * * * * ■ Par. 9. Section 1.861–14 is amended by: ■ 1. Removing the last sentence in paragraph (d)(1). ■ 2. Revising paragraphs (d)(3) and (4). ■ 3. Revising paragraphs (e)(1) through (5). ■ 4. Redesignating paragraph (e)(6)(i) as paragraph (e)(6) and removing paragraph (e)(6)(ii). ■ 5. Revising paragraphs (f) through (k). The revisions read as follows: § 1.861–14 Special rules for allocating and apportioning certain expenses (other than interest expense) of an affiliated group of corporations. * * * * * (d) * * * (3) Inclusion of financial corporations. For further guidance, see § 1.861–14T(d)(3) through (d)(4). (4) [Reserved] (e) Expenses to be allocated and apportioned under this section—(1) Expenses not directly allocable to specific income producing activities or property—(i) The expenses that are required to be allocated and apportioned under the rules of this section are expenses that are not directly allocable to specific income producing activities or property solely of the member of the affiliated group that incurred the expense, including (but not limited to) certain expenses related to supportive functions, research and experimental expenses, stewardship expenses, legal and accounting expenses, and litigation damages awards, prejudgment interest, and settlement payments. Interest expense of members of an affiliated group of corporations is allocated and apportioned under § 1.861–11T and not under the rules of this section. Expenses that are included in inventory costs or that are capitalized are not subject to allocation and apportionment under the rules of this section. (ii) For further guidance, see § 1.861– 14T(e)(1)(ii). E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules (2) Research and experimental expenditures. R&E expenditures (as defined in § 1.861–17(a)) in the case of an affiliated group are allocated and apportioned under the rules of § 1.861– 17 as if all members of the affiliated group were a single taxpayer. Thus, R&E expenditures are allocated to all gross intangible income of all members of the affiliated group reasonably connected with the relevant broad SIC code category. If fewer than all members of the affiliated group derive gross intangible income reasonably connected with that relevant broad SIC code category, then such expenditures are apportioned under the rules of this paragraph (e)(2) only among those members, as if those members were a single taxpayer. (3) Expenses related to supportive functions. For further guidance, see § 1.861–14T(e)(3). (4) Stewardship expenses. Stewardship expenses are allocated and apportioned in accordance with the rules of § 1.861–8(e)(4). In general, stewardship expenses are considered definitely related and allocable to dividends and inclusions received or accrued, or to be received or accrued, from a related corporation. If members of the affiliated group, other than the member that incurred the stewardship expense, receive or may receive dividends or accrue or may accrue inclusions from the related corporation, such expense must be allocated and apportioned in accordance with the rules of paragraph (c) of this section as if all such members of the affiliated group that receive or may receive dividends were a single corporation. Such expenses must be apportioned between statutory and residual groupings of income within the appropriate class of gross income by reference to the apportionment factors contributed by the members of the affiliated group treated as a single corporation. (5) Legal and accounting fees and expenses; damages awards, prejudgment interest, and settlement payments. Legal and accounting fees and expenses, as well as litigation or arbitral damages awards, prejudgment interest, and settlement payments, are allocated and apportioned under the rules of § 1.861–8(e)(5). To the extent that under § 1.861–14T(c)(2) and (e)(1)(ii) of this section such expenses are not directly allocable to specific income-producing activities or property of one or more members of the affiliated group, such expenses must be allocated and apportioned as if all members of the affiliated group were a single corporation. Specifically, such expenses VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 must be allocated to a class of gross income that takes into account the gross income which is generated, has been generated, or is reasonably expected to be generated by the other members of the affiliated group. If the expenses relate to the gross income of fewer than all members of the affiliated group as determined under § 1.861–14T(c)(2), then those expenses must be apportioned under the rules of § 1.861– 14T(c)(2), as if those fewer members were a single corporation. Such expenses must be apportioned taking into account the apportionment factors contributed by the members of the group that are treated as a single corporation. * * * * * (f) Computation of FSC or DISC combined taxable income. For further guidance, see § 1.861–14T(f) through (g). (g) [Reserved] (h) Allocation of section 818(f) expenses. Life insurance company expenses specified in section 818(f)(1) are allocated and apportioned on a separate entity basis, including with regard to members of a consolidated group. Those expenses are not allocated and apportioned on a life-nonlife group or a life subgroup basis. See also § 1.861–8(e)(16) for rules on the allocation of reserve expenses with respect to dividends received by a life insurance company. (i) through (j) [Reserved] (k) Applicability date. This section applies to taxable years ending on or after December 16, 2019. ■ Par. 10. Section 1.861–14T is amended by revising paragraphs (e)(1)(i), (e)(2)(i) and (ii), (e)(4) and (5), and (h) to read as follows: § 1.861–14T Special rules for allocating and apportioning certain expenses (other than interest expense) of an affiliated group of corporations. (Temporary). * * * * * (e)(1)(i) For further guidance, see § 1.861–14(e)(1)(i). * * * * * (2)(i) For further guidance, see § 1.861–14(e)(2)(i) through § 1.861– 14(e)(2)(ii). (ii) [Reserved] * * * * * (4) Stewardship expenses. For further guidance, see § 1.861–14(e)(4) through § 1.861–14(e)(5). (5) [Reserved] * * * * * (h) Allocation of section 818(f) expenses. For further guidance, see § 1.861–14(h). * * * * * ■ Par. 11. Section 1.861–17 is revised to read as follows: PO 00000 Frm 00030 Fmt 4701 Sfmt 4702 69153 § 1.861–17 Allocation and apportionment of research and experimental expenditures. (a) Scope. This section provides rules for the allocation and apportionment of research and experimental expenditures that a taxpayer deducts, or amortizes and deducts, in a taxable year under section 174 or section 59(e) (applicable to expenditures that are allowable as a deduction under section 174(a)) (R&E expenditures). R&E expenditures do not include any expenditures that are not deductible by reason of the second sentence under § 1.482–7(j)(3)(i) (relating to CST Payments (as defined in § 1.482–7(b)(1)) owed to a controlled participant in a cost sharing arrangement), because nondeductible amounts are not allocated and apportioned under §§ 1.861–8 through 1.861–17. (b) Allocation—(1) In general. The method of allocation and apportionment of R&E expenditures set forth in this section recognizes that research and experimentation is an inherently speculative activity, that findings may contribute unexpected benefits, and that the gross income derived from successful research and experimentation must bear the cost of unsuccessful research and experimentation. In addition, the method set forth in this section recognizes that successful R&E expenditures ultimately result in the creation of intangible property that will be used to generate income. Therefore, R&E expenditures ordinarily are considered deductions that are definitely related to gross intangible income (as defined in paragraph (b)(2) of this section) reasonably connected with the relevant SIC code category (or categories) of the taxpayer and therefore allocable to gross intangible income as a class related to the SIC code category (or categories) and apportioned under the rules in this section. For purposes of this allocation, a taxpayer’s SIC code category (or categories) are determined in accordance with the provisions of paragraph (b)(3) of this section. For purposes of this section, the term intangible property means intangible property, as defined in section 367(d)(4), that is derived from R&E expenditures. (2) Definition of gross intangible income. The term gross intangible income means all gross income earned by a taxpayer that is attributable (in whole or in part) to intangible property and includes gross income from sales or leases of products or services derived (in whole or in part) from intangible property, income from sales of intangible property, income from platform contribution transactions described in § 1.482–7(b)(1)(ii), royalty E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69154 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules income from the licensing of intangible property, and amounts taken into account under section 367(d) by reason of a transfer of intangible property. Gross intangible income also includes a distributive share of any amounts described in the previous sentence, but does not include dividends or any amounts included in income under sections 951, 951A, or 1293. (3) SIC code categories—(i) Allocation based on SIC code categories. Ordinarily, a taxpayer’s R&E expenditures are incurred to produce gross intangible income that is reasonably connected with one or more relevant SIC code categories. Where research and experimentation is conducted with respect to more than one SIC code category, the taxpayer may aggregate the categories for purposes of allocation and apportionment. However, the taxpayer may not subdivide any categories. Where research and experimentation is not clearly related to any SIC code category (or categories), it will be considered conducted with respect to all of the taxpayer’s SIC code categories. (ii) Use of three digit standard industrial classification codes. A taxpayer determines the relevant SIC code categories by reference to the three digit classification of the Standard Industrial Classification Manual (SIC code). The SIC Manual is available at https://www.osha.gov/pls/imis/sic_ manual.html. (iii) Consistency. Once a taxpayer selects a SIC code category for the first taxable year for which this section applies to the taxpayer, it must continue to use that category in following years unless the taxpayer establishes to the satisfaction of the Commissioner that, due to changes in the relevant facts, a change in the category is appropriate. (iv) Wholesale trade and retail trade categories. A taxpayer must use a SIC code category within the divisions of ‘‘wholesale trade’’ or ‘‘retail trade’’ if it is engaged solely in sales-related activities with respect to a particular category of products. In the case of a taxpayer that conducts material nonsales-related activities with respect to a particular category of products, all R&E expenditures related to sales of the products must be allocated and apportioned as if the expenditures were reasonably connected to the most closely related three digit SIC code category other than those within the wholesale and retail trade divisions. For example, if a taxpayer engages in both the manufacturing and assembling of cars and trucks (SIC Code 371) and in a wholesaling activity related to motor vehicles and motor vehicle parts and VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 supplies (SIC Code 501), the taxpayer must allocate and apportion all R&E expenditures related to both activities as if they relate solely to the manufacturing SIC Code 371. By contrast, if the taxpayer engages only in the wholesaling activity related to motor vehicles and motor vehicle parts and supplies, the taxpayer must allocate and apportion all R&E expenditures to the wholesaling SIC Code 501. (c) Exclusive apportionment. Solely for purposes of applying this section to section 904 as the operative section, an amount equal to fifty percent of a taxpayer’s R&E expenditures in a SIC code category (or categories) is apportioned exclusively to the residual grouping of U.S. source gross intangible income if research and experimentation that accounts for at least fifty percent of such R&E expenditures was performed in the United States. Similarly, an amount equal to fifty percent of a taxpayer’s R&E expenditures in a SIC code category (or categories) is apportioned exclusively to the statutory grouping (or groupings) of foreign source gross intangible income in that SIC code category if research and experimentation that accounts for more than fifty percent of such R&E expenditures was performed outside the United States. If there are multiple separate categories with foreign source gross intangible income in the SIC code category, the fifty percent of R&E expenditures apportioned under the previous sentence is apportioned ratably to foreign source gross intangible income based on the relative amounts of gross receipts from gross intangible income in the SIC code category in each separate category, as determined under paragraph (d) of this section. (d) Apportionment based on gross receipts from sales of products or services—(1) In general. A taxpayer’s R&E expenditures not apportioned under paragraph (c) of this section are apportioned between the statutory grouping (or among the statutory groupings) within the class of gross intangible income and the residual grouping within such class according to the rules in paragraph (d)(1)(i) through (iv) of this section. See paragraph (b) of this section for defining the class of gross intangible income in relation to SIC code categories. (i) A taxpayer’s R&E expenditures not apportioned under paragraph (c) of this section are apportioned in the same proportions that: (A) The amounts of the taxpayer’s gross receipts from sales and leases of products (as measured by gross receipts without regard to cost of goods sold) or services that are related to gross PO 00000 Frm 00031 Fmt 4701 Sfmt 4702 intangible income within the statutory grouping (or statutory groupings) and in the residual grouping bear, respectively, to (B) The total amount of such gross receipts in the class. (ii) For purposes of this paragraph (d), the amount of the gross receipts used to apportion R&E expenditures also includes gross receipts from sales and leases of products or services of any controlled or uncontrolled party to the extent described in paragraph (d)(3) and (4) of this section. (iii) The statutory grouping (or groupings) or residual grouping to which the gross receipts are assigned is the grouping to which the gross intangible income related to the sale, lease, or service is assigned. In cases where the gross intangible income of the taxpayer is income not described in paragraph (d)(3) or (4) of this section, the grouping to which the taxpayer’s gross receipts and the gross intangible income are assigned is the same. In cases where the taxpayer’s gross intangible income is related to sales, leases, or services described in paragraphs (d)(3) or (4) of this section, the gross receipts that will be used for purposes of this paragraph (d) are the gross receipts of the controlled or uncontrolled parties that are exploiting the taxpayer’s intangible property. The grouping to which the controlled or uncontrolled parties’ gross receipts are assigned is determined based on the grouping of the taxpayer’s gross intangible income attributable to the license, sale, or other transfer of intangible property to such controlled or uncontrolled party as described in paragraph (d)(3)(i) or (d)(4)(i) of this section, and not the grouping to which the gross receipts would be assigned if the assignment were based on the income earned by the controlled or uncontrolled party. See paragraph (g)(1) of this section (Example 1). (iv) For purposes of applying this section to section 904 as the operative section, because a United States person’s gross intangible income cannot include income assigned to the section 951A category, no R&E expenditures of a United States person are apportioned to foreign source income in the section 951A category. (2) Apportionment in excess of gross income. Amounts apportioned under this section may exceed the amount of gross income related to the SIC code category within the statutory or residual grouping. In such case, the excess is applied against other gross income within the statutory or residual grouping. See § 1.861–8(d)(1) for applicable rules where the E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules apportionment results in an excess of deductions over gross income within the statutory or residual grouping. (3) Sales or services of uncontrolled parties—(i) In general. For purposes of the apportionment within a class under paragraph (d)(1) of this section, the gross receipts of each uncontrolled party from particular products or services incorporating intangible property that was licensed, sold, or transferred by the taxpayer to such uncontrolled party (directly or indirectly) are taken into account for determining the taxpayer’s apportionment if the taxpayer can reasonably be expected to license, sell, or transfer to that uncontrolled party, directly or indirectly, intangible property that would arise from the taxpayer’s current R&E expenditures. If the taxpayer has previously licensed, sold, or transferred intangible property related to a SIC code category to an uncontrolled party, the taxpayer is presumed to expect to license, sell, or transfer to that uncontrolled party all future intangible property related to the same SIC code category. (ii) Definition of uncontrolled party. For purposes of this paragraph (d)(3), the term uncontrolled party means a party that is not a person with a relationship to the taxpayer specified in section 267(b), or is not a member of a controlled group of corporations to which the taxpayer belongs (within the meaning of section 993(a)(3)). (iii) Sales of components. In the case of a sale or lease of a product by an uncontrolled party that is derived from the taxpayer’s intangible property but is incorporated as a component of a larger product (for example, where the product incorporating the intangible property is a component of a large machine), only the portion of the gross receipts from the larger product that are attributable to the component derived from the intangible property is included. For purposes of the preceding sentence, a reasonable estimate based on the principles of section 482 must be made. See paragraph (g)(4)(ii)(B)(3) of this section (Example 4). (iv) Reasonable estimates of gross receipts. If the amount of gross receipts of an uncontrolled party is unknown, a reasonable estimate of gross receipts must be made annually. Appropriate economic analyses, based on the principles of section 482, must be used to estimate gross receipts. See paragraph (g)(5)(B)(3)(ii) of this section (Example 5). (4) Sales or services of controlled corporations—(i) In general. For purposes of the apportionment within a class under paragraph (d)(1) of this section, the gross receipts from sales, VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 leases, or services of a controlled corporation are taken into account if the taxpayer can reasonably be expected to license, sell, or transfer to that controlled corporation, directly or indirectly, intangible property that would arise from the taxpayer’s current R&E expenditures. Except to the extent provided in paragraph (d)(4)(iv) of this section, if the taxpayer has previously licensed, sold, or transferred intangible property related to a SIC code category to a controlled corporation, the taxpayer is presumed to expect to license, sell, or transfer to that controlled corporation all future intangible property related to the same SIC code category. (ii) Definition of a corporation controlled by the taxpayer. For purposes of this paragraph (d)(4), the term controlled corporation means any corporation that has a relationship to the taxpayer specified in section 267(b) or is a member of a controlled group of corporations to which the taxpayer belongs (within the meaning of section 993(a)(3)). Because an affiliated group is treated as a single taxpayer, a member of an affiliated group is not a controlled corporation. See paragraph (e) of this section. (iii) Gross receipts not to be taken into account more than once. Sales, leases, or services between controlled corporations or between a controlled corporation and the taxpayer are not taken into account more than once; in such a situation, the amount of gross receipts of the selling corporation must be subtracted from the gross receipts of the buying corporation. (iv) Effect of cost sharing arrangements. If the controlled corporation has entered into a cost sharing arrangement, in accordance with the provisions of § 1.482–7, with the taxpayer for the purpose of developing intangible property, then the taxpayer is not reasonably expected to license, sell, or transfer to that controlled corporation, directly or indirectly, intangible property that would arise from the taxpayer’s share of the R&E expenditures with respect to the cost shared intangibles as defined in § 1.482–7(j)(1)(i). Therefore, solely for purposes of apportioning a taxpayer’s R&E expenditures (which does not include the amount of CST Payments received by the taxpayer; see paragraph (a) of this section) that are intangible development costs (as defined in § 1.482–7(d)) with respect to a cost sharing arrangement, the controlled corporation’s gross receipts are not taken into account for purposes of paragraphs (d)(1) and (d)(4)(i) of this section. PO 00000 Frm 00032 Fmt 4701 Sfmt 4702 69155 (5) Application of section 864(e)(3). Section 864(e)(3) and § 1.861–8(d)(2)(ii) do not apply for purposes of this section. (e) Affiliated groups. See § 1.861– 14(e)(2) for rules on allocating and apportioning R&E expenditures of an affiliated group (as defined in § 1.861– 14(d)). (f) Special rules for partnerships—(1) R&E expenditures. For purposes of applying this section, if R&E expenditures are incurred by a partnership in which the taxpayer is a partner, the taxpayer’s R&E expenditures include the taxpayer’s distributive share of the partnership’s R&E expenditures. (2) Purpose and location of expenditures. In applying exclusive apportionment under paragraph (c) of this section, a partner’s distributive share of R&E expenditures incurred by a partnership is treated as incurred by the partner for the same purpose and in the same location as incurred by the partnership. (3) Apportionment based on gross receipts. In applying the remaining apportionment under paragraph (d) of this section, a taxpayer’s gross receipts from a SIC code category include the full amount of any gross receipts from the SIC code category of any partnership not described in paragraph (d)(3)(ii) of this section in which the taxpayer is a direct or indirect partner if the gross receipts would have been included had the partnership been a corporation. (g) Examples. The following examples illustrate the application of the rules in this section. (1) Example 1—(i) Facts. X, a domestic corporation, is a manufacturer and distributor of small gasoline engines for lawnmowers. Gasoline engines are a product within the category, Engines and Turbines (SIC Industry Group 351). Y, a wholly owned foreign subsidiary of X, also manufactures and sells these engines abroad. X owns no other foreign subsidiaries. During Year 1, X incurred R&E expenditures of $60,000x, which it deducts under section 174 as a current expense, to invent and patent a new and improved gasoline engine. All of the research and experimentation was performed in the United States. Also in Year 1, the domestic gross receipts of X of gasoline engines total $500,000x and foreign gross receipts of Y total $300,000x. X provides technology for the manufacture of engines to Y through a license that requires the payment of an arm’s length royalty. In Year 1, X’s gross income is $200,000x, of which $140,000x is U.S. source income from domestic sales of gasoline engines, $40,000x is income included under section 951A all of which relates to Y’s foreign source income from sales of gasoline engines, $10,000x is foreign source royalties from Y, and $10,000x is U.S. source interest income. None of the E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69156 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules foreign source royalties are allocable to passive category income of Y, and therefore, under §§ 1.904–4(d) and 1.904–5(c)(3), the foreign source royalties are general category income to X. (ii) Analysis—(A) Allocation. The R&E expenditures were incurred in connection with developing intangible property related to small gasoline engines and they are definitely related to the items of gross intangible income related to the SIC code category 351, namely gross income from the sale of small gasoline engines in the United States and royalties received from subsidiary Y, a foreign manufacturer of gasoline engines. Accordingly, under paragraph (b) of this section, the R&E expenditures are allocable to the class of gross intangible income related to SIC code category 351, all of which is general category income of X. X’s U.S. source interest income and income included under section 951A are not within this class of gross intangible income and, therefore, no portion of the R&E expenditures are allocated to the U.S. source interest income or foreign source income in the section 951A category. (B) Apportionment—(1) In general. For purposes of applying this section to section 904 as the operative section, the statutory grouping of gross intangible income is foreign source general category income and the residual grouping of gross intangible income is U.S. source income. (2) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X’s research and experimental activity was performed in the United States, 50% of the R&E expenditures, or $30,000x ($60,000x × 50%), is apportioned exclusively to the residual grouping of U.S. source gross intangible income. The remaining 50% of the R&E expenditures is then apportioned between the statutory and residual groupings on the basis of the relative amounts of gross receipts from sales of small gasoline engines by X and Y that are related to the U.S. source sales income and foreign source royalty income, respectively. (3) Apportionment based on gross receipts. After taking into account exclusive apportionment, X has $30,000x ($60,000x ¥ $30,000x) of R&E expenditures that must be apportioned between the residual and statutory groupings. Because Y is a controlled corporation of X, its gross receipts within the SIC code are taken into account in apportioning X’s R&E expenditures if X is reasonably expected to license, sell, or transfer intangible property that would arise from the R&E expenditures that result in the $60,000x deduction. Because Y has licensed the intangible property developed by X related to the SIC code, it is presumed it is reasonably expected to license the intangible property that would be developed from the current research and experimentation. Therefore, under paragraphs (d)(1) and (5) of this section, $11,250x ($30,000x × $300,000x/ ($500,000x + $300,000x)) is apportioned to the statutory grouping of X’s gross intangible income attributable to its license of intangible property to Y, or foreign source general category income. No portion of the gross receipts by X or Y are disregarded under section 864(e)(3), regardless of whether the income related to those sales is eligible VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 for a deduction under section 250(a)(1)(A). The remaining $18,750x ($30,000x × $500,000x/($500,000x + $300,000x)) is apportioned to the residual grouping of gross intangible income, or U.S. source income. (4) Summary. Accordingly, for purposes of the foreign tax credit limitation, $11,250x of X’s R&E expenditures are apportioned to foreign source general category income, and $48,750x ($30,000x + $18,750x) of X’s R&E expenditures are apportioned to U.S. source income. (2) Example 2—(i) Facts. The facts are the same as in paragraph (g)(1)(i) of this section (the facts in Example 1) except that X also spends $30,000x in Year 1 for research on steam turbines, all of which is performed in the United States, and X has steam turbine gross receipts in the United States of $400,000x. X’s foreign subsidiary Y neither manufactures nor sells steam turbines. The steam turbine research is in addition to the $60,000x in R&E expenditures incurred by X on gasoline engines for lawnmowers. X thus has $90,000x of R&E expenditures. X’s gross income is $250,000x, of which $140,000x is U.S. source income from domestic sales of gasoline engines, $50,000x is U.S. source income from domestic sales of steam turbines, $40,000x is income included under section 951A all of which relates to foreign source income derived from Y’s sales of gasoline engines, $10,000x is foreign source royalties from Y, and $10,000x is U.S. source interest income. (ii) Analysis—(A) Allocation. X’s R&E expenditures generate gross intangible income from sales of small gasoline engines and steam turbines. Both of these products are in the same three digit SIC code category, Engines and Turbines (SIC Industry Group 351). Therefore, under paragraph (a) of this section, X’s R&E expenditures are definitely related to all items of gross intangible income attributable to SIC code category 351. These items of X’s gross intangible income are gross income from the sale of small gasoline engines and steam turbines in the United States and royalties from foreign subsidiary Y, a foreign manufacturer and seller of small gasoline engines. X’s U.S. source interest income and income included under section 951A is not within this class of gross intangible income and, therefore, no portion of X’s R&E expenditures are allocated to the U.S. source interest income or income in the section 951A category. (B) Apportionment—(1) In general. For purposes of applying this section to section 904 as the operative section, the statutory grouping of gross intangible income is foreign source general category income and the residual grouping of gross intangible income is U.S. source income. (2) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X’s research and experimental activity was performed in the United States, 50% of the R&E expenditures, or $45,000x ($90,000x × 50%), are apportioned exclusively to the residual grouping of U.S. source gross intangible income. The remaining 50% of the R&E expenditures is then apportioned between the residual and statutory groupings on the basis of the relative amounts of gross receipts of small PO 00000 Frm 00033 Fmt 4701 Sfmt 4702 gasoline engines and steam turbines by X and Y with respect to which gross intangible income is foreign source general category income and U.S. source income. (3) Apportionment based on gross receipts. After taking into account exclusive apportionment, X has $45,000x ($90,000x ¥ $45,000x) of R&E expenditures that must be apportioned between the residual and statutory groupings. Even though a portion of the R&E expenditures that must be apportioned are attributable to research performed with respect to steam turbines, and Y does not sell steam turbines, because Y previously licensed intangible property related to SIC code category 351, it is presumed that X expects to license all intangible property related to SIC code category 351, including intangible property related to steam turbines. Therefore, under paragraph (d)(1) of this section, $11,250x ($45,000x × $300,000x/($500,000x + $400,000x + $300,000x)) is apportioned to the statutory grouping of gross intangible income of the royalty income to which the gross receipts by Y were related, or foreign source general category income. The remaining $33,750x ($45,000x × ($500,000x + $400,000x)/($500,000x + $400,000x + $300,000x)) is apportioned to the residual grouping of gross intangible income, or U.S. source gross income. (4) Summary. Accordingly, for purposes of the foreign tax credit limitation, $11,250x of X’s R&E expenditures are apportioned to foreign source general category income and $78,750x ($45,000x + $33,750x) of X’s R&E expenditures are apportioned to U.S. source gross income. (3) Example 3—(i) Facts—(A) Acquisitions and transfers by X. The facts are the same as in paragraph (g)(1)(i) of this section (the facts in Example 1) except that, in Year 2, X and Y terminate the license for the manufacture of engines that was in place in Year 1 and enter into an arm’s length cost-sharing arrangement, in accordance with the provisions of § 1.482–7, to share the funding of all of X’s research activity. In Year 2, Y makes a PCT Payment (as defined in § 1.482– 7(b)(1)) of $50,000x that is sourced as a royalty and a CST Payment of $25,000x under the cost sharing arrangement. (B) Gross receipts and R&E expenditures. In Year 2, X and Y continue to sell gasoline engines, with gross receipts of $600,000x in the United States and $400,000x abroad by Y. X incurs research costs of $85,000x in Year 2 for research activities conducted in the United States, but cannot deduct $25,000x of that amount by reason of the second sentence under § 1.482–7(j)(3)(i) (relating to CST Payments). (C) Gross income of X. In Year 2, X’s gross income is $350,000x, of which $200,000x is U.S. source income from domestic sales of gasoline engines, $50,000x is foreign source income attributable to the PCT Payment, and $100,000x is income included under section 951A all of which relates to foreign source income derived from engine sales by Y. (ii) Analysis—(A) Allocation. The $60,000x of R&E expenditures were incurred in connection with small gasoline engines and they are definitely related to the items of gross intangible income related to the SIC E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules code category, namely gross income from the sale of small gasoline engines in the United States and PCT Payments from Y. Accordingly, under paragraph (a) of this section, the R&E expenditures are allocable to this class of gross intangible income. X’s income included under section 951A is not within this class of gross intangible income and, therefore, no portion of X’s R&E expenditures is allocated to X’s section 951A category income. (B) Apportionment—(1) In general. For purposes of applying this section to section 904 as the operative section, the statutory grouping of gross intangible income is foreign source general category income, and the residual grouping of gross intangible income is U.S. source income. (2) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X’s research and experimentation was performed in the United States, 50% of the R&E expenditures, or $30,000x ($60,000x × 50%), is apportioned exclusively to the residual grouping of gross intangible income, U.S. source gross income. (3) Apportionment based on gross receipts. Under paragraph (d)(5)(v) of this section, none of Y’s gross receipts are taken into account because they are attributable to the cost shared intangible under the valid cost sharing arrangement. Because all of the gross receipts from sales that are taken into account under paragraph (d)(1) of this section relate to gross intangible income that is included in the residual grouping, $30,000x is apportioned to the residual grouping of gross intangible income, or U.S. source gross income. (4) Summary. Accordingly, for purposes of the foreign tax credit limitation, $60,000x of X’s R&E expenditures are apportioned to U.S. source income. (4) Example 4—(i) Facts—(A) X’s R&E expenditures. X, a domestic corporation, is engaged in continuous research and experimentation to improve the quality of the products that it manufactures and sells, which are floodlights, flashlights, fuse boxes, and solderless connectors. X incurs $100,000x of R&E expenditures in Year 1 that was performed exclusively in the United States. As a result of this research activity, X acquires patents that it uses in its own manufacturing activity. (B) License to Y and Z. In Year 1, X licenses its floodlight patent to Y and Z, uncontrolled foreign corporations, for use in their own territories, Countries Y and Z, respectively. Corporation Y pays X a royalty of $3,000x plus $0.20x for each floodlight sold. Gross receipts from sales of floodlights by Y for the taxable year are $135,000x (at $4.50x per unit) or 30,000x units, and the royalty is $9,000x ($3,000x + $0.20x × 30,000x). Y has sales of other products of $500,000x. Z pays X a royalty of $3,000x plus $0.30x for each unit sold. Z manufactures 30,000x floodlights in the taxable year, and the royalty is $12,000x ($3,000x + $0.30x × 30,000x). The dollar value of Z’s gross receipts from floodlight sales is not known because, in this case, the floodlights are not sold separately by Z but are instead used as a component in Z’s manufacture of lighting equipment for theaters. However, a VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 reasonable estimate of Z’s gross receipts attributable to the floodlights, based on the principles of section 482, is $120,000x. The gross receipts from sales of all Z’s products, including the lighting equipment for theaters, are $1,000,000x. (C) X’s gross receipts and gross income. X’s gross receipts from sales of floodlights for the taxable year are $500,000x and its sales of its other products (flashlights, fuse boxes, and solderless connectors) are $400,000x. X has gross income of $500,000x, consisting of U.S. source gross income from domestic sales of floodlights, flashlights, fuse boxes, and solderless connectors of $479,000x, and foreign source royalty income of $9,000x and $12,000x from foreign corporations Y and Z respectively. The royalty income is general category income to X under section 904(d)(2)(A)(ii) and § 1.904–4(b)(2)(ii). (ii) Analysis—(A) Allocation. X’s R&E expenditures are definitely related to all of the gross intangible income from the products that it produces, which are floodlights, flashlights, fuse boxes, and solderless connectors. All of these products are in the same three digit SIC code category, Electric Lighting and Wiring Equipment (SIC Industry Group 364). Therefore, under paragraph (b) of this section, X’s R&E expenditures are definitely related to the class of gross intangible income related to SIC code category 354 and to all items of gross intangible income attributable to the class. These items of X’s gross intangible income are gross income from the sale of floodlights, flashlights, fuse boxes, and solderless connectors in the United States and royalties from Corporations Y and Z. (B) Apportionment—(1) In general. For purposes of applying this section to section 904 as the operative section, the statutory grouping of gross intangible income is foreign source general category income, and the residual grouping of gross intangible income is U.S. source income. (2) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X’s research and experimentation was performed in the United States, 50% of the R&E expenditures, or $50,000x ($100,000x × 50%), is apportioned exclusively to the residual grouping of U.S. source gross intangible income. (3) Apportionment based on gross receipts. After taking into account exclusive apportionment, X has $50,000x ($100,000x ¥ $50,000x) of R&E expenditures that must be apportioned between the residual and statutory groupings. Gross receipts from sales of Y and Z are taken into account in apportioning the R&E expenditures if X is reasonably expected to license, sell, or transfer the intangible property that would arise from the research and experimentation that results in the $100,000x deduction. Because X licensed intangible property related to the SIC code in Year 1, it is presumed that it would continue to license the intangible property that would be developed from the current research and experimentation. Under paragraph (d)(3)(i) of this section, because Y and Z are uncontrolled parties with respect to X, only gross receipts from their sales of the licensed product, floodlights, are included for PO 00000 Frm 00034 Fmt 4701 Sfmt 4702 69157 purposes of apportionment. In addition, under paragraph (d)(3)(iii) of this section, only the portion of Z’s gross receipts that are attributable to the floodlights that incorporate the intangible property licensed from X, rather than Z’s total gross receipts, are used for purposes of apportionment. All of X’s gross receipts from sales in the entire SIC code category are included for purposes of apportionment on the basis of gross intangible income attributable to those sales. Under paragraph (d)(1) of this section, $11,039x ($50,000x × ($135,000x + $120,000x)/($900,000x + $135,000x + $120,000x)) is apportioned to the statutory grouping of gross intangible income, or foreign source general category income. The remaining $38,961x ($50,000x × $900,000x/ ($900,000x + $135,000x + $120,000x)) is apportioned to the residual grouping of gross intangible income, or U.S. source gross income. (4) Summary. Accordingly, for purposes of the foreign tax credit limitation, $11,039x of X’s R&E expenditures are apportioned to foreign source general category income and $88,961x ($50,000x + $38.961x) of X’s R&E expenditures are apportioned to U.S. source gross income. (5) Example 5—(i) Facts. X, a domestic corporation, is a cloud storage service provider. Cloud storage services are a service within the category, Computer Programming, Data Processing, and other Computer Related Services (SIC Industry Group 737). During Year 1, X incurred R&E expenditures of $50,000x to invent and copyright new storage monitoring and management software. All of the research and experimentation was performed in the United States. X uses this software in its own business to provide services to customers. X also licenses a version of the software that can be used by other businesses that provide cloud storage services. X licenses the software to uncontrolled party U, which sub-licenses the software to other businesses that provide cloud storage services to customers. U does not use the software except to sublicense it. As a part of the licensing agreement with U, U and its sub-licensees are only permitted to use the software in certain countries outside of the United States. Under the contract with U, U pays X a royalty of 50% on the amount it receives from its sub-licensees that use the software to provide services to customers. In Year 1, X earns $300,000x of gross receipts from providing cloud storage services within the U.S. Further, in Year 1 U receives $10,000x of royalty income from its sublicensees and pays a royalty of $5,000x to X. Thus, X also earns $5,000x of foreign source royalty income from licensing its software to U for use outside of the United States. (ii) Analysis—(A) Allocation. The R&E expenditures were incurred in connection with the development of cloud computing software and they are definitely related to the items of gross intangible income related to the SIC Code category, namely gross income from the storage monitoring and management software in the United States and royalties received from U. Accordingly, under paragraph (b) of this section, the R&E expenditures are allocable to this class of gross intangible income, all of which is general category income of X. E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69158 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules (B) Apportionment—(1) In general. For purposes of applying this section to section 904 as the operative section, the statutory grouping of gross intangible income is foreign source general category income, and the residual grouping of gross intangible income is U.S. source income. (2) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X’s research and experimental activity was performed in the United States, 50% of the R&E expenditures, or $25,000x ($50,000x × 50%), is apportioned exclusively to the residual grouping of U.S. source gross intangible income. (3) Apportionment based on gross receipts—(i) In general. After taking into account exclusive apportionment, X has $25,000x ($50,000x ¥ $25,000x) of R&E expenditures that must be apportioned between the statutory and residual groupings. Because U’s sub-licensees’ gross receipts incorporate intangible property licensed by X, U’s sub-licensees’ gross receipts from services incorporating the licensed intangible property are taken into account in apportioning X’s R&E expenditures if X is reasonably expected to license, sell, or transfer intangible property that would arise from the R&E expenditures incurred in Year 1. Because U has licensed and the sublicensees have sublicensed the intangible property developed by X related to the SIC code, it is presumed that U would continue to license the intangible property that would be developed from the current research and experimentation. (ii) Determination of U’s sub-licensee’s gross receipts. Under paragraph (d)(3)(iv) of this section, X can make a reasonable estimate of the gross receipts of U’s sublicensees from services incorporating the intangible property licensed by X by estimating, after an appropriate economic analysis, that U would charge a 5% royalty on the sub-licensee’s sales. U received a royalty of $10,000x from the sub-licensees. X then determines U’s sub-licensees’ foreign sales by dividing the total royalty payments received by U by the royalty estimated rate ($10,000x/.05x = $200,000x). (iii) Results of apportionment based on gross receipts. Therefore, under paragraphs (d)(1) and (3) of this section, $10,000x ($25,000x × $200,000x/($300,000x + $200,000x)) is apportioned to the statutory grouping of gross intangible income, or foreign source general category income. The remaining $15,000x ($25,000x × $300,000x/ ($300,000x + $200,000x)) is apportioned to the residual grouping of gross intangible income, or U.S. source income. (4) Summary. Accordingly, for purposes of the foreign tax credit limitation, $10,000x of X’s R&E expenditures are apportioned to foreign source general category income and $40,000x ($25,000x + $15,000x) of X’s R&E expenditures are apportioned to U.S. source income. (h) Applicability date. This section applies to taxable years beginning after December 31, 2019. ■ Par 12. Section 1.861–20 is added to read as follows: VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 § 1.861–20 Allocation and apportionment of foreign income taxes. (a) Scope. This section provides rules for the allocation and apportionment of foreign income taxes, including allocating and apportioning foreign income taxes to separate categories for purposes of the foreign tax credit. The rules of this section apply except as modified under the rules for an operative section. See, for example, §§ 1.704–1(b)(4)(viii)(d)(1), 1.904–6, 1.960–1(d)(3)(ii), and 1.965–5(b)(2). Paragraph (b) of this section provides definitions for the purposes of this section. Paragraph (c) of this section provides the general rule for allocation and apportionment of foreign income taxes. Paragraph (d) of this section provides rules for assigning foreign gross income to statutory and residual groupings. Paragraph (e) of this section provides rules for allocating and apportioning foreign law deductions to foreign gross income in the statutory and residual groupings. Paragraph (f) of this section provides rules for apportioning foreign income taxes among statutory and residual groupings. Paragraph (g) of this section provides examples that illustrate the application of this section. Paragraph (h) of this section provides the applicability dates for this section. (b) Definitions. The following definitions apply for purposes of this section. (1) Corporation. The term corporation has the same meaning as set forth in § 301.7701–2(b), except that it does not include a reverse hybrid. (2) Corresponding U.S. item. The term corresponding U.S. item means the item of U.S. gross income or U.S. loss, if any, that arises from the same transaction or other realization event from which an item of foreign gross income also arises. An item of U.S. gross income or U.S. loss is a corresponding U.S. item even if the item of foreign gross income that arises from the same transaction or realization event differs in amount from the item of U.S. gross income or U.S. loss. A corresponding U.S. item does not include an item of gross income that is exempt, excluded or eliminated from U.S. gross income, nor does it include an item of U.S. gross income or U.S. loss that is not realized, recognized or taken into account by the taxpayer in the U.S. taxable year in which the taxpayer paid or accrued the foreign income tax. (3) Foreign capital gain amount. The term foreign capital gain amount means the portion of a distribution that under foreign law gives rise to gross income of a type described in section 301(c)(3)(A). (4) Foreign dividend amount. The term foreign dividend amount means PO 00000 Frm 00035 Fmt 4701 Sfmt 4702 the portion of a distribution that is taxable as a dividend under foreign law. (5) Foreign gross income. The term foreign gross income means the items of gross income included in the base upon which a foreign income tax is imposed. This includes all items of foreign gross income included in the foreign tax base, even if the foreign taxable year begins in the U.S. taxable year that precedes the U.S. taxable year in which the taxpayer pays or accrues the foreign income tax. (6) Foreign income tax. The term foreign income tax means an income, war profits, or excess profits tax within the meaning of § 1.901–2(a) that is a separate levy within the meaning of § 1.901–2(d). (7) Foreign law CFC. The term foreign law CFC means a foreign corporation certain of the earnings of which are taxable to its shareholder under a foreign law subpart F regime. (8) Foreign law distribution. The term foreign law distribution has the meaning provided in paragraph (d)(3)(i)(C) of this section. (9) Foreign law subpart F income. The term foreign law subpart F income means the items of a foreign law CFC, computed under foreign law, that give rise to an inclusion in a taxpayer’s foreign gross income by reason of a foreign law subpart F regime. (10) Foreign law subpart F regime. A foreign law subpart F regime is a foreign law tax regime similar to the subpart F regime described in sections 951 through 959 that imposes a tax on a shareholder of a corporation based on an inclusion in the shareholder’s taxable income of certain of the corporation’s current earnings that are of a type that is similar to subpart F income, whether or not the foreign law deems the corporation’s earnings to be distributed. (11) Foreign taxable income. The term foreign taxable income means foreign gross income reduced by the deductions that are allowed under foreign law. (12) Foreign taxable year. The term foreign taxable year has the meaning set forth in section 7701(a)(23), applied by substituting ‘‘under foreign law’’ for the phrase ‘‘under subtitle A.’’ (13) Reverse hybrid. The term reverse hybrid means an entity that is described in § 301.7701–2(b) and that is a fiscally transparent entity (under the principles of § 1.894–1(d)(3)) or a branch under the laws of a foreign country imposing tax on the income of the entity. (14) Taxpayer. The term taxpayer has the meaning described in § 1.901– 2(f)(1). (15) U.S. capital gain amount. The term U.S. capital gain amount means the portion of a distribution to which section 301(c)(3)(A) applies. E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules (16) U.S. dividend amount. The term U.S. dividend amount means the portion of a distribution that is made out of earnings and profits under Federal income tax law or out of previously taxed earnings and profits described in section 959(a) or (b). It also includes amounts included in gross income as a dividend by reason of section 1248 or section 964(e). (17) U.S. gross income. The term U.S. gross income means the items of gross income that a taxpayer recognizes and includes in taxable income under Federal income tax law for its U.S. taxable year. (18) U.S. loss. The term U.S. loss means the item of loss that a taxpayer recognizes and includes in taxable income under Federal income tax law for its U.S. taxable year. (19) U.S. return of capital amount. The term U.S. return of capital amount means the portion of a distribution to which section 301(c)(2) applies. (20) U.S. taxable year. The term U.S. taxable year has the same meaning as that of the term taxable year set forth in section 7701(a)(23). (c) General rule. A foreign income tax is allocated or apportioned to the statutory and residual groupings that include the items of foreign gross income included in the base on which the tax is imposed. Each foreign income tax (that is, each separate levy) is allocated and apportioned separately under the rules in this section. A foreign income tax is allocated and apportioned to or among the statutory and residual groupings under the following steps: (1) First, by assigning the items of foreign gross income to the groupings under the rules of paragraph (d) of this section; (2) Second, by allocating and apportioning the deductions that are allowed under foreign law to the foreign gross income in the groupings under the rules of paragraph (e) of this section; and (3) Third, by allocating and apportioning the foreign income tax by reference to the foreign taxable income in the groupings under the rules of paragraph (f) of this section. (d) Assigning items of foreign gross income to the statutory and residual groupings—(1) In general. Each item of foreign gross income is assigned to a statutory or residual grouping. The amount of the item is determined under foreign law. However, Federal income tax law applies to characterize the item and the transaction or other realization event from which the item arose, and to assign it to a grouping. Except as provided in paragraph (d)(3) of this section, if a taxpayer pays or accrues a VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 foreign income tax that is imposed on foreign taxable income that includes an item of foreign gross income in a U.S. taxable year in which the taxpayer also realizes, recognizes, or takes into account a corresponding U.S. item, then the item of foreign gross income is assigned to the grouping to which the corresponding U.S. item is assigned. If the corresponding U.S. item is a U.S. loss (or zero), the foreign gross income is assigned to the grouping to which a gain would be assigned had the transaction or other realization event given rise to a gain, rather than a U.S. loss (or zero), for Federal income tax purposes, and not (if different) to the grouping to which the U.S. loss is allocated and apportioned in computing U.S. taxable income. Paragraph (d)(3) of this section provides special rules regarding the assignment of the item of foreign gross income in particular circumstances. (2) Items of foreign gross income with no corresponding U.S. item. Except as provided in paragraph (d)(3) of this section, the rules in paragraphs (d)(2)(i) and (ii) of this section apply for purposes of characterizing an item of foreign gross income and assigning it to a grouping if the taxpayer does not realize, recognize, or take into account a corresponding U.S. item in the same U.S. taxable year in which the taxpayer pays or accrues foreign income tax that is imposed on foreign taxable income that includes the item of foreign gross income. (i) Foreign gross income from U.S. nonrecognition event, or U.S. recognition event that falls in a different U.S. taxable year. If a taxpayer recognizes an item of foreign gross income arising from a transaction or other foreign realization event that does not result in the recognition of gross income or loss under Federal income tax law in the same U.S. taxable year in which the foreign income tax is paid or accrued, then the item of foreign gross income is characterized and assigned to the grouping to which the corresponding U.S. item would be assigned if the event giving rise to the foreign gross income resulted in the recognition of gross income or loss under Federal income tax law in that U.S. taxable year. For example, if a foreign gross income item of gain arises from a distribution of property that is treated as a taxable disposition of the property under foreign law, and the realization event under foreign law does not cause the recognition of gain or loss under Federal income tax law, the foreign gross income item of gain is assigned to the grouping to which a corresponding U.S. item of gain or loss PO 00000 Frm 00036 Fmt 4701 Sfmt 4702 69159 on a taxable disposition of the property would be assigned. However, foreign gross income arising from the receipt of the distribution is assigned under the rules of paragraphs (d)(3)(i) and (ii) of this section. As another example, if a taxpayer pays or accrues a foreign income tax that is imposed on foreign taxable income that includes an item of foreign gross income by reason of a transaction or other realization event that also gave rise to an item of U.S. gross income or U.S. loss, but the U.S. and foreign taxable years end on different dates and the event occurred in the last U.S. taxable year that ends before the end of the foreign taxable year, then the item of foreign gross income is characterized and assigned to the grouping to which the corresponding U.S. item would be assigned if the item of U.S. gross income or U.S. loss were taken into account under Federal income tax law in the U.S. taxable year in which the foreign income tax is paid or accrued. (ii) Foreign gross income of a type that is recognized but excluded from U.S. gross income—(A) In general. If a taxpayer recognizes an item of foreign gross income that is a type of recognized gross income that Federal income tax law excludes from U.S. gross income, then the item of foreign gross income is assigned to the grouping to which the item of gross income would be assigned if it were included in U.S. gross income. Notwithstanding the previous sentence, foreign gross income that is attributable to a base difference is assigned under paragraph (d)(2)(ii)(B) of this section. (B) Base differences. If a taxpayer recognizes an item of foreign gross income that is attributable to a base difference, then the item of foreign gross income is assigned to the residual grouping. But see § 1.904–6(b)(1) (assigning foreign gross income attributable to a base difference to foreign source income in the separate category described in section 904(d)(2)(H)(i)) for purposes of applying section 904 as the operative section). An item of foreign gross income is attributable to a base difference under this paragraph (d)(2)(ii)(B) only if it is one of the following items: (1) Death benefits described in section 101; (2) Gifts and inheritances described in section 102; (3) Contributions to capital described in section 118; (4) The receipt of money or other property in exchange for stock described in section 1032 (including by reason of a transfer described in section 351(a)); E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69160 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules (5) The receipt of money or other property in exchange for a partnership interest described in section 721; (6) The portion of a distribution of property by a corporation to its shareholder with respect to its stock that is described in section 301(c)(2); and (7) A distribution to a partner described in section 733. (3) Special rules for assigning certain items of foreign gross income to a statutory or residual grouping—(i) Items of foreign gross income included by a taxpayer in its capacity as a shareholder—(A) Scope. The rules of this paragraph (d)(3)(i) apply to assign to a statutory or residual grouping an item of foreign gross income that a taxpayer includes in foreign taxable income in its capacity as a shareholder of a corporation as a result of a distribution, a foreign law distribution, an inclusion, or gain with respect to the stock of the corporation (as determined under foreign law). (B) Characterizing and assigning foreign gross income items that arise from a distribution—(1) In general. If there is a distribution by a corporation that is recognized for both foreign law and Federal income tax purposes, a taxpayer first applies the rules of paragraph (d)(3)(i)(B)(2) of this section, and then (if necessary) applies the rules of paragraph (d)(3)(i)(B)(3) of this section to determine the amount and the character of the items of foreign gross income that arise from the distribution. Foreign gross income arising from any portion of a distribution that is not recognized as a distribution for Federal income tax purposes is characterized under the rules for foreign law distributions in paragraph (d)(3)(i)(C) of this section. See § 1.960–1(d)(3)(ii) for rules for assigning foreign gross income arising from a distribution described in this paragraph to income groups or PTEP groups for purposes of section 960 as the operative section. (2) Characterizing and assigning the foreign dividend amount. The foreign dividend amount is, to the extent of the U.S. dividend amount, assigned to the same statutory and residual groupings from which a distribution of the U.S. dividend amount is made under Federal income tax law. If the foreign dividend amount exceeds the U.S. dividend amount, the excess foreign dividend amount is an item of foreign gross income that is, to the extent of the U.S. return of capital amount, treated as attributable to a base difference described in paragraph (d)(2)(ii)(B)(6) of this section. Any additional excess of the foreign dividend amount over the sum of the U.S. dividend amount and the U.S. return of capital amount is an VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 item of foreign gross income that is assigned to the statutory or residual grouping (or ratably to the groupings) to which the U.S. capital gain amount is assigned. (3) Characterizing and assigning the foreign capital gain amount. The foreign capital gain amount is, to the extent of the U.S. capital gain amount, assigned to the statutory and residual groupings to which the U.S. capital gain amount is assigned under Federal income tax law. If the foreign capital gain amount exceeds the U.S. capital gain amount, the excess is, to the extent of the U.S. return of capital amount, treated as attributable to a base difference described in paragraph (d)(2)(ii)(B)(6) of this section. Any additional excess of the foreign capital gain amount over the sum of the U.S. capital gain amount and the U.S. return of capital amount is assigned ratably to the statutory and residual groupings to which the U.S. dividend amount is assigned. (C) Foreign gross income items arising from a foreign law distribution. An item of foreign gross income that arises from an event that foreign law treats as a taxable distribution (other than by reason of a foreign law subpart F regime) but that Federal income tax law does not treat as a distribution of property (for example, a stock dividend described in section 305 or a foreign law consent dividend) (a foreign law distribution) is assigned under the rules of paragraph (d)(3)(i)(B) of this section to the same statutory or residual groupings to which the foreign gross income would be assigned if a distribution of property in the amount of the foreign law distribution were made for Federal income tax purposes in the U.S. taxable year in which the taxpayer paid or accrued the foreign income tax. (D) Foreign gross income from an inclusion under a foreign law subpart F regime. An item of foreign gross income that a taxpayer includes under foreign law in its capacity as a shareholder of a foreign law CFC under a foreign law subpart F regime is assigned to the same statutory and residual groupings as the item of foreign law subpart F income of the foreign law CFC that gives rise to the item of foreign gross income of the taxpayer. The assignment is made by treating the items of foreign gross income of the taxpayer attributable to the foreign law subpart F regime inclusion as the items of foreign gross income of the foreign law CFC and applying the rules in this paragraph (d) by treating the foreign law CFC as the taxpayer in its U.S. taxable year with or within which its foreign taxable year (under the law of the foreign PO 00000 Frm 00037 Fmt 4701 Sfmt 4702 jurisdiction imposing the shareholderlevel tax) ends. See § 1.904–6(f) for special rules with respect to items of foreign gross income relating to items of the foreign law CFC that give rise to inclusions under section 951A for purposes of applying section 904 as the operative section. (ii) Tax imposed on disregarded payments—(A) Disregarded payments made by a foreign branch. Except as provided in paragraph (d)(3)(ii)(C) of this section, an item of foreign gross income that a taxpayer includes by reason of the receipt of a disregarded payment made by a disregarded entity or other foreign branch is assigned to the statutory or residual grouping to which the income out of which the payment is made is assigned. For purposes of this paragraph (d)(3)(ii), a disregarded payment is considered to be made ratably out of all of the accumulated after-tax income of the foreign branch, as computed for Federal income tax purposes. The accumulated after-tax income of the foreign branch is deemed to have arisen in the statutory and residual groupings in the same ratio as the tax book value of the assets of the branch in the groupings, determined in accordance with § 1.987–6(b)(2), unless the payment was made with a principal purpose of avoiding the purposes of an operative section, or results in a material distortion in the association of foreign income tax with U.S. gross income in the same statutory or residual grouping as the foreign gross income from the payment. For purposes of applying § 1.987–6(b)(2) under this paragraph (d)(3)(ii), assets of the foreign branch include stock held by the foreign branch. But see § 1.904–6(b)(2)(i) (assigning certain items based on the separate category to which the U.S. gross income to which the disregarded payment is allocable is assigned under § 1.904–4(f)(2)(vi)(A) for purposes of applying section 904 as the operative section). (B) Disregarded payments made by an owner. Except as provided in paragraph (d)(3)(ii)(C) of this section, an item of foreign gross income that a taxpayer includes by reason of the receipt of a disregarded payment made to a foreign branch by a foreign branch owner is assigned to the residual grouping. But see § 1.904–6(b)(2)(ii) (assigning certain items to the foreign branch category for purposes of applying section 904 as the operative section). (C) Disregarded payments in connection with disregarded sales or exchanges of property. An item of foreign gross income attributable to gain recognized under foreign law by reason of a disregarded payment received in E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules exchange for property is characterized and assigned under the rules of paragraph (d)(2)(i) of this section. (D) Definitions. For purposes of this paragraph (d)(3)(ii) and paragraph (g) of this section, the terms disregarded entity, disregarded payment, foreign branch, and foreign branch owner have the same meaning given to those terms in § 1.904–4(f)(3). A foreign branch owner can include a foreign corporation. See § 1.904–4(f)(3)(viii). (iii) Reverse hybrids. An item of foreign gross income that a taxpayer includes in foreign taxable income in its capacity as the owner of a reverse hybrid is assigned to a statutory or residual grouping by treating the taxpayer’s items of foreign gross income included from the reverse hybrid as the foreign gross income of the reverse hybrid, and applying the rules in this paragraph (d) by treating the reverse hybrid as the taxpayer in the reverse hybrid’s U.S. taxable year with or within which its foreign taxable year (under the law of the foreign jurisdiction imposing the owner-level tax) ends. See § 1.904–6(f) for special rules that apply for purposes of section 904 with respect to items of foreign gross income that under this paragraph (d)(3)(iii) would be assigned to a separate category that includes income that gives rise to inclusions under section 951A. (iv) Gain on sale of disregarded entity. An item of foreign gross income arising from gain recognized on the disposition of a disregarded entity that is characterized as a disposition of assets for Federal income tax purposes is assigned to statutory and residual groupings in the same proportion as the gain that would be treated as foreign gross income in each grouping if the transaction were treated as a disposition of assets for foreign tax law purposes. (e) Allocating and apportioning deductions (allowed under foreign law) to foreign gross income in a grouping— (1) Application of foreign law expense allocation rules. In order to determine foreign taxable income in each statutory grouping, or the residual grouping, foreign gross income in each grouping is reduced by deducting any expenses, losses, or other amounts that are deductible under foreign law that are specifically allocable to the items of foreign gross income in the grouping under the laws of that foreign country. If expenses are not specifically allocated under foreign law, then the expenses are allocated and apportioned among the groupings under the principles of foreign law. Thus, for example, if foreign law provides that expenses will be apportioned on a gross income basis, VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 the foreign law deductions are apportioned on the basis of the relative amounts of foreign gross income assigned to each grouping. (2) Application of U.S. expense allocation rules in the absence of foreign law rules. If foreign law does not provide rules for the allocation or apportionment of expenses, losses or other deductions to particular items of foreign gross income, then the principles of the section 861 regulations (as defined in § 1.861–8(a)(1)) apply in allocating and apportioning such expenses, losses, or other deductions to foreign gross income. For example, in the absence of foreign law expense allocation rules, the principles of the section 861 regulations apply to allocate definitely related expenses to particular categories of foreign gross income and provide the methods for apportioning foreign law expenses that are definitely related to more than one statutory grouping or that are not definitely related to any statutory grouping. For this purpose, the apportionment of expenses required to be made under the principles of the section 861 regulations need not be made on other than a separate company basis. If the taxpayer applies the principles of the section 861 regulations for purposes of allocating foreign law deductions under this paragraph (e), the taxpayer must apply the principles in the same manner as the taxpayer applies such principles in determining the income or earnings and profits for Federal income tax purposes of the taxpayer (or of the foreign branch, controlled foreign corporation, or other entity that paid or accrued the foreign taxes, as the case may be). For example, a taxpayer must use the modified gross income method under § 1.861–9T when applying the principles of that section for purposes of this paragraph (e) to determine the amount of foreign taxable income in each grouping if the taxpayer applies the modified gross income method in determining the income and earnings and profits of a controlled foreign corporation for Federal income tax purposes. (f) Apportionment of foreign income tax among groupings. If foreign taxable income is assigned to more than one grouping, then the foreign income tax is apportioned among the statutory and residual groupings by multiplying the foreign income tax by a fraction, the numerator of which is the foreign taxable income in a grouping and the denominator of which is all foreign taxable income on which the foreign income tax is imposed. If foreign law, including by reason of an income tax convention, exempts certain types of income from tax, or if foreign taxable PO 00000 Frm 00038 Fmt 4701 Sfmt 4702 69161 income is reduced to or below zero by foreign law deductions, then no foreign income tax is allocated and apportioned to that income. A withholding tax (as defined in section 901(k)(1)(B)) is allocated and apportioned to the foreign gross income from which it is withheld. If foreign law, including by reason of an income tax convention, provides for a specific rate of tax with respect to certain types of income (for example, capital gains), or allows credits only against tax on particular items or types of income (for example, credit for foreign withholding taxes), then such provisions are taken into account in determining the amount of foreign tax imposed on such foreign taxable income. (g) Examples. The following examples illustrate the application of this section and § 1.904–6. (1) Presumed facts. Except as otherwise provided, the following facts are assumed for purposes of the examples: (i) USP and US2 are domestic corporations, which are unrelated; (ii) USP elects to claim a foreign tax credit under section 901; (iii) CFC, CFC1, and CFC2 are controlled foreign corporations organized in Country A, and are not reverse hybrids; (iv) All parties have a U.S. dollar functional currency and a U.S. taxable year and foreign taxable year that corresponds to the calendar year; (v) No party has expenses for Country A tax purposes or expenses for U.S. tax purposes (other than foreign income tax expense); and (vi) Section 904 is the operative section, and terms have the meaning provided in this section or §§ 1.904–4 and 1.904–5. (2) Example 1: Corresponding U.S. item— (i) Facts. USP conducts business in Country A that gives rise to a foreign branch. In Year 1, for Country A tax purposes, USP earns $600x of gross income from the sale of Asset X and incurs foreign income tax of $80x. Also in Year 1, for Federal income tax purposes, USP earns $800x of foreign branch category income from the sale of Asset X. (ii) Analysis. For purposes of allocating and apportioning the $80x of Country A foreign income tax, the $600x of Country A gross income from the sale of Asset X is first assigned to separate categories. The $800x of foreign branch category income from the sale of Asset X is the corresponding U.S. item to the Country A item of gross income. Under paragraph (d)(1) of this section, because USP recognizes a corresponding U.S. item with respect to the Country A item of gross income in the same U.S. taxable year, the $600x of Country A gross income is assigned to the same separate category as the corresponding U.S. item. This is the case even though the amount of gross income recognized for E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69162 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules Federal income tax purposes differs from the amount recognized for Country A tax purposes. Accordingly, the $600x of Country A gross income is assigned to the foreign branch category. Additionally, because all of the Country A taxable income is assigned to a single separate category, the $80x of Country A tax is also allocated to the foreign branch category. No apportionment of the $80x is necessary because the class of gross income to which the tax is allocated consists entirely of a single statutory grouping, foreign branch category income. (3) Example 2: Characterization of transactions—(i) Facts. USP owns all of the outstanding stock of CFC, which conducts business in Country A. In Year 1, USP sells all of the stock of CFC to US2. For Country A tax purposes, USP recognizes $800x of gain on which Country A imposes $80x of foreign income tax based on its rules for taxing capital gains of nonresidents. For Federal income tax purposes, USP recognizes $800x of gain on the sale of the stock of CFC, all of which is included in the gross income of USP as a dividend under section 1248(a). Under §§ 1.904–4(d) and 1.904–5(c)(4), the $800x is general category income to USP. (ii) Analysis. For purposes of allocating and apportioning the $80x of Country A foreign income tax, the $800x of Country A gross income from the sale of the stock of CFC is first assigned to separate categories. The $800x of general category income from the sale of the stock of CFC is the corresponding U.S. item to the Country A item of gross income. Under paragraph (d)(1) of this section, because USP recognizes a corresponding U.S. item with respect to the Country A gross income in the same U.S. taxable year, the $800x of Country A gross income is assigned to the same separate category as the corresponding U.S. item. Accordingly, the $800x of Country A gross income is assigned to the general category. This is the case even though for Country A tax purposes the $800x of Country A gross income is characterized as gain from the sale of stock, which would be passive category income under section 904(d)(2)(B)(i), because the income is assigned to a separate category based on the characterization of the gain as a dividend under Federal income tax law. Additionally, because all of the Country A taxable income is assigned to a single separate category, the $80x of Country A tax is also allocated to the general category. No apportionment of the $80x is necessary because the class of gross income to which the deduction is allocated consists entirely of a single statutory grouping, general category income. (4) Example 3: No corresponding U.S. item because of a timing difference—(i) Facts. USP owns all of the outstanding stock of CFC, which conducts business in Country A. CFC sells Asset X. For Country A tax purposes, the sale of Asset X occurs in Year 1, CFC recognizes $400x of foreign gross income and incurs $80x of foreign income tax. For Federal income tax purposes, the sale of Asset X occurs in Year 2 and CFC recognizes $500x of general category income. (ii) Analysis. For purposes of allocating and apportioning the $80x of Country A foreign income tax in Year 1, the $400x of VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 Country A gross income from the sale of Asset X is first assigned to separate categories. There is no corresponding U.S. item because the U.S. gross income related to the sale is recognized in a different U.S. taxable year than the item of foreign gross income. Under paragraph (d)(2)(i) of this section, because there would be a corresponding U.S. item if the realization event occurred in the same U.S. taxable year for U.S. and foreign tax purposes, the item of foreign gross income (the $400x from the sale of Asset X) is characterized and assigned to the groupings to which the corresponding U.S. item would be assigned if it were recognized for Federal income tax purposes in the same U.S. taxable year in which the item of foreign gross income is recognized. This is the case even though the amount of gross income recognized for Federal income tax purposes differs from the amount recognized for Country A tax purposes. Accordingly, the $400x of Country A gross income is assigned to the general category. Additionally, because all of the Country A taxable income is assigned to a single separate category, the $80x of Country A tax is also allocated to the general category. No apportionment of the $80x is necessary because the class of gross income to which the deduction is allocated consists entirely of a single statutory grouping, general category income. (5) Example 4: No corresponding U.S. item because excluded from gross income—(i) Facts. USP conducts business in Country A. In Year 1, USP earns $200x of interest income on a State or local bond. For Country A tax purposes, the $200x of income is included in gross income and incurs $10x of foreign income tax. For Federal income tax purposes, the $200x is excluded from gross income under section 103. (ii) Analysis. For purposes of allocating and apportioning the $10x of Country A foreign income tax, the $200x of Country A gross income is first assigned to separate categories. There is no corresponding U.S. item because the interest income is excluded from U.S. gross income. Thus, the rules of paragraph (d)(2) of this section apply to characterize and assign the foreign gross income to the groupings to which a corresponding U.S. item would be assigned if it were recognized under Federal income tax law in that U.S. taxable year. The interest income is excluded from U.S. gross income, but is otherwise described or identified by section 103. Accordingly, under paragraph (d)(2)(ii)(A) of this section, the $200x of Country A gross income is assigned to the separate category to which the interest income would be assigned under Federal income tax law if the income were included in gross income. Under section 904(d)(2)(B)(i), the interest income would be passive category income. Accordingly, the $200x of Country A gross income is assigned to the passive category. Additionally, because all of the Country A taxable income is assigned to a single separate category, the $10x of Country A tax is also allocated to the passive category (subject to the rules in § 1.904–4(c)). No apportionment of the $10x is necessary because the class of gross income to which the deduction is allocated PO 00000 Frm 00039 Fmt 4701 Sfmt 4702 consists entirely of a single statutory grouping, passive category income. (6) Example 5: Actual distribution—(1) Facts. USP owns all of the outstanding stock of CFC1, which in turn owns all of the outstanding stock of CFC2. CFC1 and CFC2 conduct business in Country A. In Year 1, CFC2 distributes $300x to CFC1. For Country A tax purposes, $100x of the distribution is the foreign dividend amount, $160x is treated as a nontaxable return of capital, and the remaining $40x is the foreign capital gain amount. CFC1 incurs $20x of foreign income tax with respect to the foreign dividend amount and $4x of foreign income tax with respect to the foreign capital gain amount. The $20x and $4x of foreign income tax are each a separate levy. For Federal income tax purposes, $150x of the distribution is the U.S. dividend amount, $100x is the U.S. return of capital amount, and the remaining $50x is the U.S. capital gain amount. Under section 904(d)(3)(D) and §§ 1.904–4(d) and 1.904–5(c)(4), the $150x of U.S. dividend amount consists solely of general category income in the hands of CFC1. Under section 904(d)(2)(B)(i) and § 1.904–4(b)(2)(i)(A), the $50x of U.S. capital gain amount is passive category income to CFC1. (ii) Analysis—(A) In general. Because the $20x of Country A foreign income tax and the $4x of Country A foreign income tax are separate levies, the taxes are allocated and apportioned separately. For purposes of allocating and apportioning each foreign income tax, the relevant item of Country A gross income (the foreign dividend amount or foreign capital gain amount) is first assigned to separate categories. The U.S. dividend amount and U.S. capital gain amount are corresponding U.S. items. However, paragraph (d)(3)(i)(B) of this section (and not paragraph (d)(1) of this section) applies to assign the items of foreign gross income arising from the distribution. (B) Foreign dividend amount. Under paragraph (d)(3)(i)(B)(2) of this section, the foreign dividend amount ($100x) is, to the extent of the U.S. dividend amount ($150x), assigned to the same separate category from which the distribution of the U.S. dividend amount is made under Federal income tax law. Thus, $100x of foreign gross income that is the foreign dividend amount is assigned to the general category. Additionally, because all of the Country A taxable income included in the base on which the $20x of foreign income tax is imposed is assigned to a single separate category, the $20x of Country A tax on the foreign dividend amount is also allocated to the general category. No apportionment of the $20x is necessary because the class of gross income to which the deduction is allocated consists entirely of a single statutory grouping, general category income. (C) Foreign capital gain amount. Under paragraph (d)(3)(i)(B)(3) of this section, the foreign capital gain amount ($40x) is, to the extent of the U.S. capital gain amount ($50x), assigned to the same separate category to which the U.S. capital gain is assigned under Federal income tax law. Thus, the $40x of foreign gross income that is the foreign capital gain amount is assigned to the passive category. Additionally, because all of the E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules Country A taxable income in the base on which the $4x of foreign income tax is imposed is assigned to a single separate category, the $4x of Country A tax on the foreign dividend amount is also allocated to the passive category. No apportionment of the $4x is necessary because the class of gross income to which the deduction is allocated consists entirely of a single statutory grouping, passive category income. (7) Example 6: Foreign law distribution— (i) Facts. USP owns all of the outstanding stock of CFC. In Year 1, for Country A tax purposes, CFC distributes $1,000x of its stock that is treated as a dividend to USP, and Country A imposes a withholding tax on USP of $150x with respect to the $1,000x of foreign gross income. For Federal income tax purposes, the distribution is treated as a stock dividend described in section 305(a) and USP recognizes no U.S. gross income. At the time of the distribution, CFC has $800x of section 965(a) PTEP (as defined in § 1.960– 3(c)(2)(vi)) in a single annual PTEP account (as defined in § 1.960–3(c)(1)), and $500x of earnings and profits described in section 959(c)(3). Section 965(g) is the operative section for purposes of applying this section. See § 1.965–5(b)(2). (ii) Analysis. For purposes of allocating and apportioning the $150x of Country A foreign income tax, the $1,000x of Country A gross income is first assigned to the relevant statutory and residual groupings for purposes of applying section 965(g) as the operative section. Under § 1.965–5(b)(2), the statutory grouping is the portion of the distribution that is attributable to section 965(a) previously taxed earnings and profits and the residual grouping is the portion of the distribution attributable to other earnings and profits. There is no corresponding U.S. item because under section 305 USP recognizes no U.S. gross income with respect to the distribution. Under paragraph (d)(3)(i)(C) of this section, the item of foreign gross income (the $1,000x distribution) is assigned under the rules of paragraph (d)(3)(i)(B) of this section to the same statutory or residual groupings to which the foreign gross income would be assigned if a distribution of the same amount were made for Federal income tax purposes in Year 1. Under paragraph (d)(3)(i)(B)(2) of this section, the foreign dividend amount ($1,000x) is, to the extent of the U.S. dividend amount ($1,000x), assigned to the same statutory or residual groupings from which a distribution of the U.S. dividend amount would be made under Federal income tax law. Thus, $800x of foreign gross income related to the foreign dividend amount is assigned to the statutory grouping for the portion of the distribution attributable to section 965(a) previously taxed earnings and profits and $200x of foreign gross income is assigned to the residual grouping. Under paragraph (f) of this section, $120x ($150x × $800x/$1,000x) of the Country A foreign income tax is apportioned to the statutory grouping and $30x ($150x × $200x/$1,000x) of the Country A foreign income tax is apportioned to the residual grouping. See section 965(g) and § 1.965–5(b) for application of the applicable percentage (as defined in § 1.965–5(d)) to the foreign income tax allocated and apportioned to the statutory grouping. VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 (8) Example 7: Foreign law subpart F regime, CFC shareholder—(i) Facts. USP owns all of the outstanding stock of CFC1, which in turn owns all of the outstanding stock of CFC2. CFC2 is organized and conducts business in Country B. Country A has a foreign law subpart F regime that imposes a tax on CFC1 for certain earnings of CFC2, a foreign law CFC. In Year 1, CFC2 earns $400x of interest income and $200x of royalty income. CFC2 incurs no foreign income tax. For Country A tax purposes, the $400x of interest income and $200x of royalty income are each an item of foreign law subpart F income of CFC2 that are included in the gross income of CFC1. CFC1 incurs $150x of Country A foreign income tax with respect to the foreign law subpart F income. For Federal income tax purposes, with respect to CFC2, the $400x of interest income is passive category income under section 904(d)(2)(B)(i) and the $200x of royalty income is general category income under § 1.904–4(b)(2)(iii). (ii) Analysis. For purposes of allocating and apportioning CFC1’s $150x of Country A foreign income tax, the $600x of Country A gross income is first assigned to separate categories. The $600x of foreign gross income is not included in the U.S. gross income of CFC1, and thus, there is no corresponding U.S. item. Under paragraph (d)(3)(i)(D) of this section, each item of foreign law subpart F income that is included in CFC1’s foreign gross income is assigned to the same separate category as the item of foreign law subpart F income of CFC2. With respect to CFC2, the $400x of interest income and the $200x of royalty income would be corresponding U.S. items if CFC2 were the taxpayer. Accordingly, $400x of CFC1’s foreign gross income is assigned to the passive category and $200x of CFC1’s foreign gross income is assigned to the general category. Under paragraph (f) of this section, $100x ($150x × $400x/$600x) of the Country A foreign income tax is apportioned to the passive category and $50x ($150x × $200x/$600x) of the Country A foreign income tax is apportioned to the general category. (9) Example 8: Foreign law subpart F regime, U.S. shareholder—(i) Facts. The facts are the same as in paragraph (g)(8)(i) of this section (the facts in Example 7), except that both CFC1 and CFC2 are organized and conduct business in Country B, all of the outstanding stock of CFC1 is owned by Individual X, a U.S. citizen resident in Country A, and Country A imposes tax of $150x on foreign gross income of $600x under its foreign law subpart F regime on Individual X, rather than on CFC1. For Federal income tax purposes, in the hands of CFC2, the $400x of interest income is passive category subpart F income and the $200x of royalty income is general category tested income (as defined in § 1.951A–2(b)(1)). CFC2’s $400x of interest income gives rise to a passive category subpart F inclusion under section 951(a)(1)(A), and its $200x of tested income gives rise to a GILTI inclusion amount (as defined in § 1.951A–1(c)(1)) of $200x, with respect to Individual X. (ii) Analysis. The analysis is the same as in paragraph (g)(8)(ii) of this section (the analysis in Example 7) except that under PO 00000 Frm 00040 Fmt 4701 Sfmt 4702 69163 § 1.904–6(f), because $50x of the Country A foreign income tax is allocated and apportioned under paragraph (d)(3)(i)(D) of this section to CFC2’s general category tested income group to which Individual X’s inclusion under section 951A is attributable, the $50x of Country A foreign income tax is allocated and apportioned in the hands of Individual X to the section 951A category. (10) Example 9: Disregarded payment—(i) Facts. USP owns all of the outstanding stock of CFC1. CFC1 owns all of the interests in FDE, a disregarded entity organized in Country A. FDE owns all of the outstanding stock of CFC2. In Year 1, FDE pays $400x of interest to CFC1. For Country A tax purposes, CFC1 includes the $400x of interest income in gross income and incurs foreign income tax of $80x. For Federal income tax purposes, the $400x payment is a disregarded payment and results in no income to CFC1. The tax book value of the assets of FDE, including the stock of CFC2, in each separate category (determined in accordance with § 1.987– 6(b)(2)) is as follows: $750x of general category assets and $250x of passive category assets. The payment of the $400x of interest is not made with the principal purpose of avoiding the purposes of section 904, and does not result in a material distortion of the association of foreign income tax with U.S. gross income in a separate category. (ii) Analysis. For purposes of allocating and apportioning CFC1’s $80x of foreign income tax, the $400x of Country A gross income is first assigned to separate categories. The $400x of foreign gross income is not included in the U.S. gross income of CFC1, and thus, there is no corresponding U.S. item. Under paragraph (d)(3)(ii)(A) of this section, the $400x payment is considered to be made ratably out of all of the accumulated after-tax income of FDE, which is deemed to have arisen in the separate categories in the same ratio of the tax book value of the assets in the separate categories (as determined under § 1.987–6(b)(2)). Accordingly, $300x ($400x × $750x/$1,000x) of the Country A gross income is assigned to the general category and $100x ($400x × $250x/$1,000x) of the Country A gross income is assigned to the passive category. Under paragraph (f) of this section, $60x ($80x × $300x/$400x) of the Country A foreign income tax is apportioned to the general category and $20x ($80x × $100x/ $400x) of the Country A foreign income tax is apportioned to the passive category. (11) Example 10: Disregarded transfer of built-in gain property—(i) Facts. USP owns FDE, a foreign branch operating in Country A. FDE transfers Asset F, equipment used in FDE’s trade or business in Country A, for no consideration to USP in a transaction that is disregarded for Federal income tax purposes but treated as a distribution of Asset F from a foreign corporation to its U.S. shareholder for Country A tax purposes. Asset F has a fair market value of $250x at the time of transfer and an adjusted basis of $100x for both Federal income tax and Country A tax purposes. Country A imposes $30x of tax on FDE with respect to the $150x of built-in gain on a deemed sale of Asset F, which is recognized for Country A tax purposes by reason of the transfer to USP. If FDE had sold E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69164 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules Asset F for $250x in a transaction that was regarded for Federal income tax purposes, FDE would also have recognized gain of $150x for Federal income tax purposes, and that gain would have been characterized as foreign branch category income as defined in § 1.904–4(f). Country A also imposes $25x of withholding tax on USP by reason of the distribution of Asset F, valued at $250x, to USP. (ii) Analysis—(A) Net basis tax on built-in gain. For purposes of allocating and apportioning the $30x of Country A foreign income tax imposed on FDE by reason of the deemed sale of Asset F, the $150x of Country A gross income from the deemed sale of Asset F is first assigned to a separate category. Because the transaction is disregarded for Federal income tax purposes, there is no corresponding U.S. item. However, FDE would have recognized gain of $150x, which would have been a corresponding U.S. item, if the deemed sale had been recognized for Federal income tax purposes. Therefore, under paragraph (d)(2)(i) of this section the item of foreign gross income is characterized and assigned to the grouping to which such corresponding U.S. item would have been assigned if the deemed sale were recognized under Federal income tax law. Because the sale of Asset F in a regarded transaction would have resulted in foreign branch category income, the foreign gross income is characterized as foreign branch category income. Because all of the Country A foreign taxable income is assigned to a single separate category, the $30x of Country A tax is also allocated to the foreign branch category. No apportionment of the $30x is necessary because the class of gross income to which the tax is allocated consists entirely of a single statutory grouping, foreign branch category income. (B) Withholding tax on distribution. For purposes of allocating and apportioning the $25x of Country A withholding tax imposed on USP by reason of the transfer of Asset F, the $250x of Country A gross income from the distribution of Asset F is first assigned to a separate category. The transfer is a remittance from FDE to USP that is disregarded for Federal income tax purposes (as described in § 1.904–4(f)(2)(vi)(C)(2) and § 1.904–4(f)(3)(ix)) and thus there is no corresponding U.S. item. Under paragraph (d)(3)(ii)(A) of this section the item of foreign gross income is assigned to the groupings to which the income out of which the payment is made is assigned, and the payment is considered to be made ratably out of all of the accumulated after-tax income of FDE, as computed for Federal income tax purposes. The accumulated after-tax income of FDE is deemed to have arisen in the statutory and residual groupings in the same ratio as the tax book value of the FDE’s assets in the groupings, determined in accordance with § 1.987–6(b)(2). Because all of FDE’s assets produce foreign branch category income, the foreign gross income is characterized as foreign branch category income. Because all of the Country A foreign taxable income from which the tax is withheld is assigned to a single separate category, under paragraph (f) of this section the $25x of Country A withholding tax is also allocated to the VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 foreign branch category. No apportionment of the $25x is necessary because the class of gross income to which the tax is allocated consists entirely of a single statutory grouping, foreign branch category income. (12) Example 11: Sale of disregarded entity—(i) Facts. USP sells FDE, a disregarded entity that is organized and operates in Country A, for $500x. FDE owns Asset X and Asset Y, each having a fair market value of $250x. For Country A tax purposes, FDE has a basis in Asset X of $100x and a basis in Asset Y of $200x; USP’s basis in FDE is $100x; and the sale is treated as a sale of stock. Country A imposes foreign income tax of $40x on USP on the Country A gross income of $400x resulting from the sale of FDE, based on its rules for taxing capital gains of nonresidents. For Federal income tax purposes, USP has a basis of $150x in Asset X, which produces passive category income, and a basis of $150x in Asset Y, which produces general category income that would not be foreign personal holding company income if earned by a CFC. For Federal income tax purposes USP recognizes $100x of passive category income and $100x of general category income from the sale of FDE. (ii) Analysis. For purposes of allocating and apportioning USP’s $40x of Country A foreign income tax, the $400x of Country A gross income resulting from the sale of FDE is first assigned to separate categories. Under paragraph (d)(3)(iv) of this section, USP’s $400x of Country A gross income is assigned among the statutory groupings in the same percentages as the foreign gross income in each category that would have resulted if the sale of FDE were treated as an asset sale for Country A tax purposes. Because for Country A tax purposes Asset X had a built-in gain of $150x and Asset Y had a built-in gain of $50x, $300x ($400x × $150x/$200x) of the Country A gross income is assigned to the passive category and $100x ($400x × $50x/ $200x) is assigned to the general category. Under paragraph (f) of this section, $30x ($40x × $300x/$400x) of the Country A foreign income tax is apportioned to the passive category, and $10x ($40x x $100x/ $400x) of the Country A foreign income tax is apportioned to the general category. (h) Applicability date. This section applies to taxable years beginning after December 31, 2019. ■ Par. 13. Section 1.904–4 is amended by: ■ 1. Revising paragraph (c)(7)(i). ■ 2. Revising the third and fourth sentences of paragraph (c)(7)(ii). ■ 3. Revising paragraph (c)(7)(iii). ■ 4. Adding paragraphs (c)(8)(v) through (viii). ■ 5. Revising paragraphs (e)(1)(ii) and (e)(2). ■ 6. Removing paragraphs (e)(3) and (4). ■ 7. Removing the language ‘‘§ 1.904– 6(b)’’ in paragraph (o) and adding the language ‘‘1.904–6(e)’’ in its place. ■ 8. Revising paragraph (q). The revisions and additions read as follows: PO 00000 Frm 00041 Fmt 4701 Sfmt 4702 § 1.904–4 Separate application of section 904 with respect to certain categories of income. * * * * * (c) * * * (7) * * * (i) In general. If the effective rate of tax imposed by a foreign country on income of a foreign corporation that is included in a taxpayer’s gross income is reduced under foreign law on distribution of such income, the rules of this paragraph (c) apply at the time that the income is included in the taxpayer’s gross income, without regard to the possibility of a subsequent reduction of foreign tax on the distribution. If the inclusion is considered to be high-taxed income, then the taxpayer must initially treat the inclusion as general category income, section 951A category income or income in a specified separate category as provided in paragraph (c)(1) of this section. When the foreign corporation distributes the earnings and profits to which the inclusion was attributable and the foreign tax on the inclusion is reduced, then if a redetermination of U.S. tax liability is required under § 1.905–3(b)(2), the taxpayer must redetermine whether the revised inclusion (if any) should be considered to be high-taxed income. See § 1.905–3(b)(2)(ii) (requiring a redetermination of the amount of the inclusion, the application of the hightax exception under section 954(b)(4), and the amount of foreign taxes deemed paid). If, taking into account the reduction in foreign tax, the inclusion would not have been considered hightaxed income, then the taxpayer, in redetermining its U.S. tax liability for the year or years affected, must treat the inclusion and the associated taxes (as reduced on the distribution) as passive category income and taxes. For this purpose, the foreign tax on an inclusion under section 951(a)(1) or 951A(a) is considered reduced on distribution of the earnings and profits associated with the inclusion if the total taxes paid and deemed paid on the inclusion and the distribution (taking into account any reductions in tax and any withholding taxes) is less than the total taxes deemed paid in the year of inclusion. Therefore, any foreign currency gain associated with the earnings and profits that are distributed with respect to the inclusion is not taken into account in determining whether there is a reduction of tax requiring a redetermination of whether the inclusion is high-taxed income. (ii) * * * 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 E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules 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 or tested income under section 954(b)(4) or section 951A(c)(2)(A)(i)(III), and finally on a LIFO basis to foreign taxes associated with other earnings and profits. Furthermore, in applying the ordering rules of section 959(c), distributions shall be considered made on a LIFO basis first out of earnings described in section 959(c)(1) and (2), then on a LIFO basis out of earnings and profits associated with income that remains passive income under paragraph (c)(7)(iii) of this section but that was excluded from subpart F income or tested income under section 954(b)(4) or section 951A(c)(2)(A)(i)(III), and finally on a LIFO basis out of other earnings and profits. * * * (iii) Treatment of income excluded under section 954(b)(4) or section 951A(c)(2)(A)(i)(III). If the effective rate of tax imposed by a foreign country on income of a foreign corporation is reduced under foreign law on distribution of that income, the rules of section 954(b)(4) (including for purposes of determining tested income under section 951A(c)(2)(A)(i)(III)) are applied in the year of inclusion without regard to the possibility of a subsequent reduction of foreign tax. See § 1.954– 1(d)(3)(iii) and § 1.951A–2(c)(6)(iv). If a taxpayer excludes passive income from a controlled foreign corporation’s foreign personal holding company income or tested income under section 954(b)(4) or section 951A(c)(2)(A)(i)(III), then, notwithstanding the general rule of § 1.904–5(d)(2), the income is considered to be passive category income until distribution of that income. At that time, if after the redetermination of U.S. tax liability required under § 1.905–3(b)(2) the taxpayer still elects to exclude the passive income under section 954(b)(4) or section 951A(c)(2)(A)(i)(III), the rules of this paragraph (c)(7)(iii) apply to determine whether the income is hightaxed income upon distribution and, therefore, income in another separate category. For purposes of determining whether a reduction in tax is attributable to taxes on income excluded under section 954(b)(4) or section 951A(c)(2)(A)(i)(III), the rules of paragraph (c)(7)(ii) of this section apply. The rules of paragraph (c)(7)(ii) of this section also apply for purposes of ordering distributions to determine whether such distributions are out of VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 earnings and profits associated with such excluded income. For an example illustrating the operation of this paragraph (c)(7)(iii), see paragraph (c)(8)(vi) of this section (Example 6). (8) * * * (v) Example 5—CFC, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. USP and CFC are calendar year taxpayers. In Year 1, CFC’s only earnings consist of $200x of pre-tax passive income that is foreign personal holding company income that is earned in foreign Country X. Under Country X’s tax system, the corporate tax on particular earnings is reduced on distribution of those earnings and no withholding tax is imposed. In Year 1, CFC pays $100x of foreign tax with respect to its passive income. USP does not elect to exclude this income from subpart F under section 954(b)(4) and includes $200x in gross income ($100x of net foreign personal holding company income and $100x of the amount under section 78 (the ‘‘section 78 dividend’’)). At the time of the inclusion, the income is considered to be high-taxed income under paragraphs (c)(1) and (c)(6)(i) of this section and is general category income to USP ($100x > $42x (21% × $200x)). CFC does not distribute any of its earnings in Year 1. In Year 2, CFC has no additional earnings. On December 31, Year 2, CFC distributes the $100x of earnings from Year 1. At that time, CFC receives a $60x refund from Country X attributable to the reduction of the Country X corporate tax imposed on the Year 1 earnings. The refund is a foreign tax redetermination under § 1.905–3(a) that under § 1.905–3(b)(2) and § 1.954–1(d)(3)(iii) requires a redetermination of CFC’s Year 1 subpart F income and the application of section 954(b)(4), as well as a redetermination of USP’s Year 1 inclusion under section 951(a)(1), its deemed paid taxes under section 960(a), and its Year 1 U.S. tax liability. As recomputed taking into account the $60x refund, CFC’s Year 1 passive category net foreign personal holding company income is increased by $60x to $160x, CFC’s foreign income taxes attributable to that income are reduced from $100x to $40x, and the income still qualifies to be excluded from CFC’s subpart F income under section 954(b)(4) ($40x > $37.80x (90% × 21% × $200x)). Assuming USP does not change its Year 1 election, USP’s Year 1 inclusion under section 951(a)(1) is increased by $60x to $160x, and the associated deemed paid tax and section 78 dividend are reduced by $60x to $40x. Under paragraph (c)(7)(i) of this section, in connection with the adjustments required under section 905(c), USP must redetermine whether the adjusted Year 1 inclusion is high-taxed income of USP. Taking into account the $60x refund, the inclusion is not considered high-taxed income of USP ($40x < $42x (21% × $200x)). Therefore, USP must treat the $200x of income ($160x inclusion plus $40x section 78 amount) and the $40x of taxes associated with the inclusion in Year 1 as passive category income and taxes. USP must also follow the appropriate procedures under § 1.905–4. (vi) Example 6. The facts are the same as in paragraph (c)(8)(v) of this section (the facts PO 00000 Frm 00042 Fmt 4701 Sfmt 4702 69165 in Example 5), except that in Year 1, USP elects to apply section 954(b)(4) to exclude CFC’s passive income from its subpart F income, both before and after the recomputation of CFC’s Year 1 subpart F income and USP’s Year 1 U.S. tax liability that is required by reason of the Year 2 $60x foreign tax redetermination. Although the income is not considered to be subpart F income, under paragraph (c)(7)(iii) of this section it remains passive category income until distribution. In Year 2, the $100x distribution is a dividend to USP, because CFC has $160x of accumulated earnings and profits described in section 959(c)(3) (the $100x of earnings in Year 1 increased by the $60x refund received in Year 2 that under § 1.905–3(b)(2) is taken into account in Year 1). Under paragraph (c)(7)(iii) of this section, USP must determine whether the dividend income is high-taxed income to USP in Year 2. The treatment of the dividend as passive category income may be relevant in determining deductions allocable or apportioned to such dividend income or related stock that are excluded in the computation of USP’s foreign tax credit limitation under section 904(a) in Year 2. See section 904(b)(4). Under paragraph (c)(1) of this section, the dividend income is passive category income to USP because the foreign taxes paid and deemed paid by USP ($0x) with respect to the dividend income do not exceed the highest U.S. tax rate on that income. (vii) Example 7. The facts are the same as in paragraph (c)(8)(v) of this section (the facts in Example 5), except that the distribution in Year 2 is subject to a withholding tax of $25x. Under paragraph (c)(7)(i) of this section, USP must redetermine whether its Year 1 inclusion should be considered high-taxed income of USP because there is a net $35x reduction ($60x refund of foreign corporate tax¥$25x withholding tax) of foreign tax. By taking into account both the reduction in foreign corporate tax and the additional withholding tax, the inclusion continues to be considered high-taxed income of USP in Year 1 ($65x > $42x (21% × $200). USP must follow the appropriate section 905(c) procedures. USP must redetermine its U.S. tax liability for Year 1, but the Year 1 inclusion and the $65x taxes ($40x of deemed paid tax in Year 1 and $25x withholding tax in Year 2) will continue to be treated as general category income and taxes. (viii) Example 8—(A) CFC, a controlled foreign corporation operating in Country G, is a wholly-owned subsidiary of USP, a domestic corporation. USP and CFC are calendar year taxpayers. Country G imposes a tax of 50% on CFC’s earnings. Under Country G’s system, the foreign corporate tax on particular earnings is reduced on distribution of those earnings to 30% and no withholding tax is imposed. Under Country G’s law, distributions are treated as made out of a pool of undistributed earnings subject to the 50% tax rate. For Year 1, CFC’s only earnings consist of passive income that is foreign personal holding company income that is earned in foreign Country G. CFC has taxable income of $110x for Federal income tax purposes and $100x for Country G E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69166 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules purposes. Country G, therefore, imposes a tax of $50x on the Year 1 earnings of CFC. USP does not elect to exclude this income from subpart F under section 954(b)(4) and includes $110x in gross income ($60x of net foreign personal holding company income under section 951(a) and $50x of the section 78 dividend). The highest rate of tax under section 11 in Year 1 is 34%. Therefore, at the time of the section 951(a) inclusion, the income is considered to be high-taxed income under paragraph (c) of this section and is general category income to USP. CFC does not distribute any of its earnings in Year 1. (B) In Year 2, CFC earns general category income that is not subpart F income or tested income. CFC again has $110x in taxable income for Federal income tax purposes and $100x in taxable income for Country G purposes, and CFC pays $50x of tax to foreign Country G. In Year 3, CFC has no taxable income or earnings. On December 31, Year 3, CFC distributes $60x of its total $120x of earnings and receives a refund of foreign tax of $24x. The $24x refund is a foreign tax redetermination under § 1.905– 3(a) that under § 1.905–3(b)(2) requires a redetermination of CFC’s Year 1 subpart F income and USP’s deemed paid taxes and Year 1 U.S. tax liability. Country G treats the distribution of earnings as out of the 50% tax rate pool of $200x of earnings accumulated in Year 1 and Year 2, as calculated for Country G tax purposes. However, under paragraph (c)(7)(ii) of this section, the distribution, and, therefore, the reduction of tax is treated as first attributable to the $60x of passive category earnings attributable to income previously taxed in Year 1, and none of the distribution is treated as made out of the $60x of earnings accumulated in Year 2 (which is not previously taxed). Because 40 percent (the reduction in tax rates from 50 percent to 30 percent is a 40 percent reduction in the tax) of the $50x of foreign taxes attributable to the $60x of Year 1 passive income as calculated for Federal income tax purposes is refunded, $20x of the $24x foreign tax refund reduces foreign taxes on CFC’s Year 1 passive income from $50x to $30x. The other $4x of the tax refund reduces the taxes imposed in Year 2 on CFC’s general category income from $50x to $46x. (C) Under paragraph (c)(7) of this section, in connection with the section 905(c) adjustment USP must redetermine whether its Year 1 subpart F inclusion should be considered high-taxed income. By taking into account the reduction in foreign tax, the inclusion is increased by $20x to $80x, the deemed paid taxes are reduced by $20x to $30x, and the inclusion is not considered high-taxed income ($30x < 34% × $110x). Therefore, USP must treat the revised section 951(a) inclusion and the taxes associated with the section 951(a) inclusion as passive category income and taxes in Year 1. USP must follow the appropriate procedures under § 1.905–4. * * * * * (e) * * * (1) * * * (ii) Definition of financial services income. The term financial services income means income derived by a VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 financial services entity, as defined in paragraph (e)(2) of this section, that is: (A) Income derived in the active conduct of a banking, financing, or similar business under section 954(h)(3)(A)(i); (B) Income that is of a kind that would be insurance income as defined in section 953(a)(1) (including related person insurance income as defined in section 953(c)(2) and without regard to the exception in section 953(a)(2) for income that is exempt insurance income under section 953(e)); (C) Income from the investment by an insurance company of its unearned premiums or reserves ordinary and necessary to the proper conduct of the insurance business; or (D) Passive income as defined in section 904(d)(2)(B) and paragraph (b) of this section as determined before the application of the exception for hightaxed income but after the application of the exception for export financing interest. * * * * * (2) Financial services entities—(i) Definition of financial services entity— (A) In general. The term financial services entity means an individual or corporation that is predominantly engaged in the active conduct of a banking, insurance, financing, or similar business (active financing business) within the meaning of paragraphs (e)(2)(i)(A)(1) through (4) of this section for any taxable year. Except as provided in paragraph (e)(2)(ii) of this section, a determination of whether an individual or corporation is a financial services entity is done on an individual or entity-by-entity basis. An individual or corporation is predominantly engaged in the active financing business for any year if for that year: (1) It is predominantly engaged in the active conduct of a banking, financing, or similar business under section 954(h)(2)(B) (substituting the reference to ‘‘controlled foreign corporation’’ with ‘‘individual or corporation’’); (2) It is an insurance company meeting the requirements of section 953(e)(3)(A) and (C) provided that the company’s foreign personal holding company income does not exceed the amount that would be treated as derived in the active conduct of an insurance business under section 954(i) if all of the insurance and annuity contracts issued or reinsured by the company had qualified as exempt contracts under section 953(e)(2); (3) It is a qualifying insurance corporation as defined in section 1297(f) that is engaged in the active conduct of an insurance business under section PO 00000 Frm 00043 Fmt 4701 Sfmt 4702 1297(b)(2)(B) (but without regard to whether the corporation is a foreign corporation); or (4) It is a domestic corporation, or a corporation that has elected to be treated as a domestic corporation under section 953(d), that is subject to Federal income tax under subchapter L on its net income and is subject to regulation as an insurance (or reinsurance) company in its jurisdiction of organization. (B) Certain gross income included and excluded. For purposes of applying the rules in paragraph (e)(2)(i)(A) of this section (including by reason of paragraph (e)(2)(ii) of this section), gross income includes interest on State and local bonds described in section 103(a), but does not include income from a distribution of previously taxed earnings and profits described in section 959(a) or (b). (C) Treatment of partnerships and other pass-through entities. For purposes of applying the rules in paragraph (e)(2)(i)(A) of this section (including by reason of paragraph (e)(2)(ii) of this section) with respect to an individual or corporation that is a direct or indirect partner in a partnership, the partner’s distributive share of partnership income is characterized as if each partnership item of gross income were realized directly by the partner. For example, in applying section 954(h)(2)(B) under paragraph (e)(2)(i)(A) of this section, a customer with respect to a partnership is treated as a related person with respect to an individual or corporation that is a partner in the partnership if the customer is related to the individual or corporation under section 954(d)(3). Similar principles apply for an individual or corporation’s share of income from any other pass-through entities. (ii) Financial services group. A corporation that is a member of a financial services group is deemed to be a financial services entity regardless of whether it is a financial services entity under paragraph (e)(2)(i) of this section. For purposes of this paragraph (e)(2)(ii), a financial services group means an affiliated group as defined in section 1504(a) (but determined without regard to paragraphs (2) or (3) of section 1504(b)) if the affiliated group as a whole meets the requirements of section 954(h)(2)(B)(i) (except that the reference to ‘‘controlled foreign corporation’’ is substituted with ‘‘affiliated group’’ in section 954(h)(2)(B)(i)). For purposes of determining whether an affiliated group is a financial services group under the previous sentence, only the income of group members that are domestic E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules jbell on DSKJLSW7X2PROD with PROPOSALS2 corporations or foreign corporations that are controlled foreign corporations in which U.S. members of the affiliated group own, directly or indirectly, at least 80 percent of the total voting power and value of the stock is included. In addition, indirect ownership is determined under section 318 and the regulations under that section, and the income of the group does not include any income from transactions with other members of the group. (iii) Examples. The following examples illustrate the application of paragraph (e)(2) of this section. (A) Example 1—(1) Facts. USP is a domestic corporation that is the parent of a consolidated group which includes B (a domestic corporation that is primarily engaged in a manufacturing business), C (a domestic corporation whose primary function is to manage the treasury operations of the consolidated group), and D (a domestic corporation that is engaged in the active and regular conduct of financing purchases by unrelated customers of B’s products). USP also owns a 20% partnership interest in PS, a domestic partnership that is engaged in the active and regular conduct of making loans to customers that are not related persons with respect to it or USP. The other 80% of PS is owned by USX, a domestic corporation unrelated to USP (or any other member of the USP consolidated group). B has gross income of $170x consisting of income from its manufacturing operations. C has gross income of $20x consisting of interest income from loans to B. D has gross income of $100x consisting of interest income from making loans to unrelated customers that purchase B’s products. PS has gross income of $50x consisting of interest on loans that it makes to customers in the ordinary course of its business, $10x of which is attributable to loans to C, $30x of which is attributable to loans to Z (a wholly owned subsidiary of USX), and $10 of which is attributable to loans to customers unrelated to either the USP or USX affiliated groups. USP, B, C, and D have no other items of gross income and no other intercompany transactions. (2) Analysis—(i) Entity test. Under paragraph (e)(2)(i)(A) of this section, B and C are not financial services entities because neither meets the requirements of being predominantly engaged in the active conduct of a banking, finance, insurance, or similar business. B does not meet the requirements because all of its income is derived from manufacturing. C does not meet the requirements because it lends solely to related persons. Under paragraph (e)(2)(i)(A)(1) of this section, D is a financial services entity because all of its gross income is derived from making loans to unrelated customers in the ordinary course of its lending business in a manner that meets the requirements of section 954(h)(2)(B)(i). Under paragraph (e)(2)(i)(C) of this section, USP’s distributive share of partnership income from PS is characterized as if each item of PS’s gross income were realized directly by USP. Thus, USP includes a $10x distributive share VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 of income from PS, $2x of which is from related party loans to C and $8x of which is from loans to persons that are not related persons with respect to USP. Under paragraph (e)(2)(i)(A)(1) of this section, USP is a financial services entity because more than 70% of its gross income is derived from making loans to unrelated customers in the ordinary course of a lending business ($8x/ $10x > 70% × $10x) and meets the requirements of section 954(h)(2)(B)(i). (ii) Affiliated group test. Under paragraph (e)(2)(ii) of this section, a corporation that is a member of a financial services group is deemed to be a financial services entity regardless of whether it is a financial services entity under paragraph (e)(2)(i) of this section. This would apply if the USP, B, C, and D affiliated group as a whole meets the requirements of section 954(h)(2)(B)(i). The USP affiliated group derives $108x ($100x by D and $8x by USP) from loans to unrelated customers and derives $278x of total gross income after making the adjustments provided in paragraph (e)(2)(ii) of this section ($300x total gross income minus $20x interest on intercompany loan from C to B and $2x interest on loan from PS to C). Because the gross income USP’s affiliated group derives directly from the active and regular conduct of a lending or finance business from transactions with customers which are not related persons is 39% ($108x divided by $278x), the USP affiliated group does not satisfy the more than 70% of gross income test of section 954(h)(2)(B)(i), and the USP affiliated group is not a financial services group. USP and D are financial services entities under paragraph (e)(2)(i)(A) of this section. B and C are not financial services entities under either of paragraphs (e)(2)(i) or (ii) of this section. (B) Example 2—(1) Facts. The facts are the same as in paragraph (e)(2)(iii)(A)(1) of this section (the facts in Example 1) except that USX is the parent of a consolidated group, which includes Y (a domestic corporation that is a U.S. licensed bank), and Z (a domestic corporation that is a non-bank lender that is engaged in the active and regular conduct of making loans to customers unrelated to USX or its affiliates). Y has gross income of $200x, consisting of $190x from making loans to unrelated customers in the ordinary course of its banking business and $10x of other income not described in section 954(h)(4). Z has gross income of $160x, consisting of interest income from making loans to unrelated customers. USX, Y, and Z have no other items of gross income and no other intercompany transactions. (2) Analysis—(i) Entity test. Under paragraph (e)(2)(i)(A) of this section, Y and Z are financial services entities. Y is a financial services entity because it satisfies the requirements of section 954(h)(2)(B)(ii). Z is a financial services entity because all of its gross income is derived from making loans to unrelated customers in the ordinary course of its lending business in a manner that meets the requirements of section 954(h)(2)(B)(i). Under paragraph (e)(2)(i)(C) of this section, USX’s distributive share of partnership income from PS is characterized as if each item of PS’s gross income were realized directly by USX. Thus, USX includes a $40x PO 00000 Frm 00044 Fmt 4701 Sfmt 4702 69167 distributive share of income from PS, $24x of which is from related party loans to Z and $16x of which is from loans to unrelated parties. Under paragraph (e)(2)(i)(A)(1) of this section, USX is not a financial services entity because only 60% ($24x divided by $40x) of its gross income is derived from making loans to unrelated customers in the ordinary course of a lending business and, therefore, USX does not meet the more than 70% of gross income test of section 954(h)(2)(B)(i). (ii) Affiliated group test. Under paragraph (e)(2)(ii) of this section, a corporation that is a member of a financial services group is deemed to be a financial services entity regardless of whether it is a financial services entity under paragraph (e)(2)(i) of this section. This would apply if the USX, Y, and Z affiliated group as a whole meets the requirements of section 954(h)(2)(B)(i). The USX affiliated group derives $366x ($190x by Y, $160x by Z, and $16x by USP) from loans to unrelated customers and derives $376x of total gross income after making the adjustments provided in paragraph (e)(2)(ii) of this section ($400x total gross income minus $24x interest on loans from PS to Z). Because the gross income USX’s affiliated group derives directly from the active and regular conduct of a lending or finance business from transactions with customers which are not related persons is 97% ($366x divided by $376x), the USX affiliated group satisfies the more than 70% of gross income test of section 954(h)(2)(B)(i), and the USX affiliated group is a financial services group. Y and Z are financial services entities under paragraph (e)(2)(i)(A). USX is a financial services entity under paragraph (e)(2)(ii) of this section. * * * * * (q) Applicability date—(1) Except as provided in paragraph (q)(2) and (3) of this section, this section applies for taxable years that both begin after December 31, 2017, and end on or after December 4, 2018. (2) Paragraphs (c)(7)(i), (c)(7)(iii), (c)(8)(v) through (viii) apply to taxable years ending on or after December 16, 2019. For taxable years that both begin after December 31, 2017, and end on or after December 4, 2018, and also end before December 16, 2019, see § 1.904– 4(c)(7)(i) and (c)(7)(iii) as in effect on December 17, 2019. (3) Paragraphs (e)(1)(ii) and (e)(2) of this section apply to taxable years ending on or after the date the final regulations are filed with the Federal Register. For taxable years that both begin after December 31, 2017, and end on or after December 4, 2018, and also end before the date the final regulations are filed with the Federal Register, see § 1.904–4(e)(1)(i) and (e)(2) as in effect on December 17, 2019. ■ Par. 14. § 1.904–6 is amended by: ■ 1. Revising the section heading. ■ 2. Revising paragraph (a). ■ 3. Redesignating paragraph (b) as paragraph (e) and adding a new paragraph (b). E:\FR\FM\17DEP2.SGM 17DEP2 69168 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules 4. Adding paragraph (c) and revising paragraph (d). ■ 5. Removing the language ‘‘paragraph (b)(4)(ii)’’ in newly-redesignated paragraph (e)(4)(i) and adding the language ‘‘paragraph (e)(4)(ii)’’ in its place. ■ 6. Removing the language ‘‘paragraph (b)(4)(ii)(B)’’ in newly-redesignated paragraph (e)(4)(ii)(C) and adding the language ‘‘paragraph (e)(4)(ii)(B)’’ in its place. ■ 7. Adding paragraphs (f) through (h). The revisions and additions read as follows: ■ jbell on DSKJLSW7X2PROD with PROPOSALS2 § 1.904–6 Allocation and apportionment of foreign income taxes. (a) In general. The amount of foreign income taxes paid or accrued with respect to a separate category (as defined in § 1.904–5(a)(4)(v)) of income (including U.S. source income assigned to the separate category) includes only those foreign income taxes that are allocated and apportioned to the separate category under the rules of § 1.861–20 (as modified by this section). In applying the foreign tax credit limitation under sections 904(a) and (d) to general category income described in section 904(d)(2)(A)(ii) and § 1.904–4(d), the general category is a statutory grouping. However, the general category income is the residual grouping of income for purposes of assigning foreign income taxes to separate categories. In addition, in determining the numerator of the foreign tax credit limitation under sections 904(a) and (d), where U.S. source income is the residual grouping, the amount of foreign income taxes paid or accrued for which a deduction is allowed, for example, under section 901(k)(7), with respect to foreign source income in a separate category includes only those foreign income taxes that are allocated and apportioned to foreign source income in the separate category under the rules of § 1.861–20 (as modified by this section). For purposes of this section, unless otherwise stated, terms have the same meaning as provided in § 1.861–20(b). (b) Assigning an item of foreign gross income to a separate category. For purposes of assigning an item of foreign gross income to a separate category or categories (or foreign source income in a separate category) under § 1.861–20, the rules of this paragraph (b) apply. (1) Base differences. Any item of foreign gross income that is attributable to a base difference described in § 1.861–20(d)(2)(ii)(B) is assigned to the separate category described in section 904(d)(2)(H)(i), and to foreign source income in that category. VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 (2) Certain disregarded payments—(i) Certain disregarded payments made by a foreign branch. Except in the case of disregarded payments in exchange for property described in § 1.861– 20(d)(3)(ii)(C), if in connection with a disregarded payment made by a foreign branch to another foreign branch or to a foreign branch owner that is described in § 1.861–20(d)(3)(ii)(A), U.S. gross income that would otherwise be attributable to a foreign branch is attributed to another foreign branch or to the foreign branch owner under § 1.904–4(f)(2)(vi)(A) (including by reason of § 1.904–4(f)(2)(vi)(D)), the item of foreign gross income that arises by reason of the disregarded payment is assigned to the same separate category as the reattributed U.S. gross income. (ii) Certain disregarded payments made by a foreign branch owner. Except in the case of disregarded payments in exchange for property described in § 1.861–20(d)(3)(ii)(C), an item that a United States person includes in foreign gross income solely by reason of the receipt of a disregarded payment that is described in § 1.861–20(d)(3)(ii)(B) (payment to a foreign branch by a foreign branch owner) is assigned to the foreign branch category (or a specified separate category associated with the foreign branch category), or, in the case of a foreign branch owner that is a partnership, to the partnership’s general category income that is attributable to the foreign branch. See § 1.960– 1(d)(3)(ii)(A) and (e) for rules providing that foreign income tax on a disregarded payment by a foreign branch owner that is a controlled foreign corporation is assigned to the residual grouping and cannot be deemed paid under section 960. (3) Disposition of property resulting in reattribution of U.S. gross income to or from a foreign branch. If a disposition of property results in the recognition of U.S. gross income that is reattributed under § 1.904–4(f)(2)(vi)(A) by reason of a disregarded payment described in § 1.904–4(f)(2)(vi)(B)(2) (or by reason of § 1.904–4(f)(2)(vi)(D)), any foreign gross income arising from that disposition of property under foreign law is assigned to a separate category under the rules in § 1.861–20(d)(1) applied without regard to the reattribution of U.S. gross income under § 1.904–4(f)(2)(vi)(A). (c) Allocating and apportioning deductions. For purposes of applying § 1.861–20(e) to allocate and apportion deductions allowed under foreign law to foreign gross income in the separate categories, before undertaking the steps outlined in § 1.861–20(e), foreign gross income in the passive category is first reduced by any related person interest PO 00000 Frm 00045 Fmt 4701 Sfmt 4702 expense that is allocated to the income under the principles of section 954(b)(5) and § 1.904–5(c)(2)(ii)(C). In allocating and apportioning expenses not specifically allocated under foreign law, the principles of foreign law are applied only after taking into account the reduction of passive income by the application of section 954(b)(5). In allocating and apportioning expenses when foreign law does not provide rules for the allocation or apportionment of expenses, losses or other deductions to particular items of foreign gross income, then the principles of section 954(b)(5), in addition to the principles of the section 861 regulations (as defined in § 1.861–8(a)(1)), apply to allocate and apportion expenses, losses or other foreign law deductions to foreign gross income after reduction of passive income by the amount of related person interest expense allocated to passive income under section 954(b)(5) and § 1.904–5(c)(2)(ii)(C). (d) Apportionment of taxes for purposes of applying the high-tax income tests. If taxes have been allocated and apportioned to passive income under the rules of paragraph (a) this section, the taxes must further be apportioned to the groups of income described in § 1.904–4(c)(3), (4) and (5) for purposes of determining if the group is high-taxed income that is recharacterized as income in another separate category under the rules of § 1.904–4(c). See also § 1.954– 1(c)(1)(iii)(B) (defining a single item of passive category foreign personal holding company income by reference to the grouping rules under § 1.904– 4(c)(3), (4) and (5)). Taxes are related to income in a particular group under the same rules as those in paragraph (a) of this section except that those rules are applied by apportioning foreign income taxes to the groups described in § 1.904– 4(c)(3), (4) and (5) instead of separate categories. * * * * * (f) Treatment of certain foreign income taxes paid or accrued by United States shareholders. Some or all of the foreign gross income of a United States shareholder of a controlled foreign corporation that is a foreign law CFC described in § 1.861–20(d)(3)(i)(D) or a reverse hybrid described in § 1.861– 20(d)(3)(iii) is assigned to the section 951A category if, were the controlled foreign corporation the taxpayer that recognizes the foreign gross income, the foreign gross income would be assigned to the controlled foreign corporation’s tested income group (as defined in § 1.960–1(b)(33)) within the general category to which an inclusion under E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules section 951A is attributable. The amount of the United States shareholder’s foreign gross income that is assigned to the section 951A category (or a specified separate category associated with the section 951A category) is based on the inclusion percentage (as defined in § 1.960– 2(c)(2)) of the United States shareholder. For example, if a United States shareholder has an inclusion percentage of 60 percent, then 60 percent of the foreign gross income of a United States shareholder that would be assigned (under § 1.861–20(d)(3)(iii)) to the tested income group within the general category income of a reverse hybrid that is a controlled foreign corporation to which an inclusion under section 951A is attributable is assigned to the section 951A category or the specified separate category for income resourced under a tax treaty, and not to the general category. (g) Examples. For examples illustrating the application of this section, see § 1.861–20(g). (h) Applicability date. This section applies to taxable years beginning after December 31, 2019. For taxable years that both begin after December 31, 2017, and end on or after December 4, 2018, and also begin before January 1, 2020, see § 1.904–6 as in effect on December 17, 2019. ■ Par. 15. Section 1.904(b)–3 is amended by adding paragraph (d)(2) and revising paragraph (f) to read as follows: § 1.904(b)–3 Disregard of certain dividends and deductions under section 904(b)(4). jbell on DSKJLSW7X2PROD with PROPOSALS2 * * * * * (d) * * * (2) Net operating losses. If the taxpayer has a net operating loss in the current taxable year, then solely for purposes of determining the source and separate category of the net operating loss, the overall foreign loss rules in section 904(f) and the overall domestic loss rules in section 904(g) are applied without taking into account the adjustments required under section 904(b) and this section. * * * * * (f) Applicability dates—(1) Except as provided in paragraph (f)(2) of this section, this section applies to taxable years beginning after December 31, 2017. (2) Paragraph (d)(2) of this section applies to taxable years ending on or after December 16, 2019. ■ Par. 16. Section 1.904(g)–3 is amended by: ■ 1. Adding a sentence at the end of paragraph (b)(1). VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 2. Adding paragraph (j) and revising paragraph (l). The addition and revisions read as follows: ■ § 1.904(g)–3 Ordering rules for the allocation of net operating losses, net capital losses, U.S. source losses, and separate limitation losses, and for the recapture of separate limitation losses, overall foreign losses, and overall domestic losses. * * * * * (b) * * * (1) * * * See §§ 1.861– 8(e)(8), 1.904(b)–3(d)(2), and 1.1502– 4(c)(1)(iii) for rules to determine the source and separate category components of a net operating loss. * * * * * (j) Step Nine: Dispositions that result in additional income recognition under the branch loss recapture and dual consolidated loss recapture rules—(1) In general. If, after any gain is required to be recognized under section 904(f)(3) on a transaction that is otherwise a nonrecognition transaction, an additional amount of income is recognized under section 91(d), section 367(a)(3)(C) (as applicable to losses incurred before January 1, 2018), or § 1.1503(d)–6, and that additional income amount is determined by taking into account an offset for the amount of gain recognized under section 904(f)(3) and so is not initially taken into account in applying paragraph (b) of this section, then paragraphs (b) through (h) of this section are applied to determine the allocation of any additional net operating loss deduction and other deductions or losses and the applicable increases in the taxpayer’s overall foreign loss, separate limitation loss, and overall domestic loss accounts, as well as any additional recapture and reduction of the taxpayer’s separate limitation loss, overall foreign loss, and overall domestic loss accounts. (2) Rules for additional recapture of loss accounts. For the purpose of recapturing and reducing loss accounts under paragraph (j)(1) of this section, the taxpayer also takes into account any creation of or addition to loss accounts that result from the application of paragraphs (b) through (i) of this section in the current tax year. If any of the additional income described in paragraph (j)(1) of this section is foreign source income in a separate category for which there is a remaining balance in an OFL account after applying paragraph (i) of this section, the section 904(f)(1) recapture amount under § 1.904(f)–2(c) for that additional income is determined by first computing a hypothetical recapture amount as it would have been determined prior to the application of PO 00000 Frm 00046 Fmt 4701 Sfmt 4702 69169 paragraph (i) of this section but taking into account the additional foreign source income described in this paragraph (j)(2) and then subtracting the actual OFL recapture determined prior to the application of paragraph (i) of this section (that did not take into account the additional foreign source income). The remainder is the OFL recapture amount with respect to the additional foreign source income described in this paragraph (j)(2). * * * * * (l) Applicability date. This section applies to taxable years ending on or after the date the final regulations are filed with the Federal Register. ■ Par. 17. Section 1.905–3 is amended by: ■ 1. Revising the section heading and the first sentence of paragraph (a). ■ 2. Adding paragraphs (b)(2) and (3). ■ 3. Revising paragraph (d). The revisions and additions read as follows: § 1.905–3 Adjustments to U.S. tax liability and to current earnings and profits as a result of a foreign tax redetermination. (a) * * * For purposes of this section and § 1.905–4, the term foreign tax redetermination means a change in the liability for foreign income taxes, as defined in § 1.960–1(b)(5), or certain other changes described in this paragraph (a) that may affect a taxpayer’s U.S. tax liability, including by reason of a change in the amount of its foreign tax credit, the amount of its distributions or inclusions under sections 951, 951A, or 1293, the application of the high-tax exception described in section 954(b)(4) (including for purposes of determining tested income under section 951A(c)(2)(A)(i)(III)), or the amount of tax determined under sections 1291(c)(2) and 1291(g)(1)(C)(ii). * * * (b) * * * (2) Foreign income taxes paid or accrued by foreign corporations—(i) In general. A redetermination of U.S. tax liability is required to account for the effect of a redetermination of foreign income taxes taken into account by a foreign corporation in the year accrued, or a refund of foreign income taxes taken into account by the foreign corporation in the year paid. (ii) Required adjustments. If a redetermination of U.S. tax liability is required for any taxable year under paragraph (b)(2)(i) of this section, the foreign corporation’s taxable income, earnings and profits, and current year taxes (as defined in § 1.960–1(b)(4)) must be adjusted in the year to which the redetermined tax relates (or, in the case of a foreign corporation that E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69170 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules receives a refund of foreign income tax and uses the cash basis of accounting, in the year the tax was paid). The redetermination of U.S. tax liability is made by treating the redetermined amount of foreign tax as the amount of tax paid or accrued by the foreign corporation in such year. For example, in the case of a refund of foreign income taxes taken into account in the year accrued, the foreign corporation’s subpart F income, tested income, and earnings and profits are increased, as appropriate, in the year to which the foreign tax relates to reflect the functional currency amount of the foreign income tax refund. The required redetermination of U.S. tax liability must account for the effect of the foreign tax redetermination on the characterization and amount of distributions or inclusions under sections 951, 951A, or 1293 taken into account by each of the foreign corporation’s United States shareholders, on the application of the high-tax exception described in section 954(b)(4) (including for purposes of determining tested income under section 951A(c)(2)(A)(i)(III)), and the amount of tax determined under sections 1291(c)(2) and 1291(g)(1)(C)(ii), as well as on the amount of foreign taxes deemed paid under section 960 in such year, regardless of whether any such shareholder chooses to deduct or credit its foreign income taxes in any taxable year. In addition, a redetermination of U.S. tax liability is required for any subsequent taxable year in which the characterization or amount of a United States shareholder’s distribution or inclusion from the foreign corporation is affected by the foreign tax redetermination, up to and including the taxable year in which the foreign tax redetermination occurs, as well as any year to which unused foreign taxes from such year were carried under section 904(c). (iii) Reduction of corporate level tax on distribution of earnings and profits. If a United States shareholder of a controlled foreign corporation receives a distribution out of previously taxed earnings and profits described in section 959(c)(1) and (2) and a foreign country has imposed tax on the income of the controlled foreign corporation, which tax is reduced on distribution of the earnings and profits of the corporation (resulting in a foreign tax redetermination), then the United States shareholder must redetermine its U.S. tax liability for the year or years affected. (iv) Foreign tax redeterminations relating to taxable years beginning before January 1, 2018. In the case of a VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 foreign tax redetermination of a foreign corporation that relates to a taxable year of the foreign corporation beginning before January 1, 2018, a redetermination of U.S. tax liability is required under the rules of § 1.905–5. (v) Examples. The following examples illustrate the application of this paragraph (b)(2). (A) Presumed Facts. Except as otherwise provided, the following facts are assumed for purposes of the examples: (1) All parties are accrual basis taxpayers that use the calendar year as their taxable year both for Federal income tax purposes and for foreign tax purposes and use the average exchange rate to translate accrued foreign income taxes; (2) CFC, CFC1, and CFC2 are controlled foreign corporations organized in Country X that use the ‘‘u’’ as their functional currency; (3) No income adjustment is required to reflect exchange gain or loss (within the meaning of § 1.988–1(e)) with respect to the disposition of nonfunctional currency attributable to a refund of foreign income taxes received by any CFC, because all foreign income taxes are denominated and paid in the CFC’s functional currency; (4) The highest rate of U.S. tax in section 11 and the rate applicable to USP in all years is 21 percent; and (5) USP’s foreign tax credit limitation under section 904(a) exceeds the amount of foreign income taxes it is deemed to pay. (B) Example 1: Refund of tested foreign income taxes—(1) Facts. CFC is a whollyowned subsidiary of USP, a domestic corporation. In Year 1, CFC earns 3,660u of general category gross tested income and accrues and pays 300u of foreign income taxes with respect to that income. CFC has no allowable deductions other than the foreign income tax expense. Accordingly, CFC has tested income of 3,360u in Year 1. CFC has no qualified business asset investment (within the meaning of section 951A(d) and § 1.951A–3(b)). In Year 1, no portion of USP’s deduction under section 250 (‘‘section 250 deduction’’) is reduced by reason of section 250(a)(2)(B)(ii). USP’s inclusion percentage (as defined in § 1.960– 2(c)(2)) is 100%. In Year 1, USP earns no other income and has no other expenses. The average exchange rate used to translate USP’s inclusion under section 951A and CFC’s foreign income taxes into dollars for Year 1 is $1x:1u. See section 989(b)(3) and §§ 1.951A–1(d)(1) and 1.986(a)–1(a)(1). Accordingly, for Year 1, USP’s tested foreign income taxes (as defined in § 1.960–2(c)(3)) with respect to CFC are $300x. In Year 3, CFC carries back a loss for foreign tax purposes and receives a refund of foreign tax of 100u that relates to Year 1. (2) Analysis—(i) Result in Year 1. In Year 1, CFC has tested income of 3,360u and PO 00000 Frm 00047 Fmt 4701 Sfmt 4702 tested foreign income taxes of $300x. Under section 951A(a) and § 1.951A–1(c)(1), USP has a GILTI inclusion amount of $3,360x (3,360u translated at $1x:1u). Under section 960(d) and § 1.960–2(c), USP is deemed to have paid $240x (80% × 100% × $300x) of foreign income taxes. Under section 78 and § 1.78–1(a), USP is treated as receiving a dividend of $300x (a ‘‘section 78 dividend’’). USP’s section 250 deduction is $1,830x (50% × ($3,360x + $300x)). Accordingly, for Year 1, USP has taxable income of $1,830x ($3,360x + $300x¥$1,830x) and pre-credit U.S. tax liability of $384.3x (21% × $1,830x). Accordingly, USP pays U.S. tax of $144.3x ($384.3x¥$240x). (ii) Result in Year 3. The refund of 100u to CFC in Year 3 is a foreign tax redetermination under paragraph (a) of this section. Under paragraph (b)(2)(ii) of this section, USP must account for the effect of the foreign tax redetermination on its GILTI inclusion amount and foreign taxes deemed paid in Year 1. In redetermining USP’s U.S. tax liability for Year 1, USP must increase CFC’s tested income and its earnings and profits in Year 1 by the refunded tax amount of 100u, must determine the effect of that increase on its GILTI inclusion amount, and must adjust the amount of foreign taxes deemed paid and the section 78 dividend to account for CFC’s refund of foreign tax. Under § 1.986(a)–1(c), the refund is translated into dollars at the exchange rate that was used to translate such amount when initially accrued. As a result of the foreign tax redetermination, for Year 1, CFC has tested income of 3,460u (3,360u + 100u) and tested foreign income taxes of $200x ($300x¥$100x). Under section 951A(a) and § 1.951A–1(c)(1), USP has a redetermined GILTI inclusion amount of $3,460x (3,460u translated at $1x:1u). Under section 960(d) and § 1.960–2(c), USP is deemed to have paid $160x (80% × 100% × $200x) of foreign income taxes. Under section 78 and § 1.78– 1(a), USP’s section 78 dividend is $200x. USP’s redetermined section 250 deduction is $1,830x (50% × ($3,460x + $200x)). Accordingly, USP’s redetermined taxable income is $1,830x ($3,460x + $200x¥$1,830x) and its pre-credit U.S. tax liability is $384.3x (21% × $1,830x). Therefore, USP’s redetermined U.S. tax liability is $224.3x ($384.3x¥$160x), an increase of $80x ($224.3x¥$144.3x). (C) Example 2: High tax exception election following a foreign tax redetermination—(1) Facts. CFC is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns 1,000u of general category gross foreign base company sales income and accrues and pays 100u of foreign income taxes with respect to that income. CFC has no allowable deductions other than the foreign income tax expense. The average exchange rate used to translate USP’s subpart F inclusion and CFC’s foreign income taxes into dollars for Year 1 is $1x:1u. See section 989(b)(3) and § 1.986(a)–1(a)(1). In Year 1, USP earns no other income and has no other expenses. In Year 5, pursuant to a Country X audit CFC accrues and pays additional foreign income tax of 80u with respect to its 1,000u of general category foreign base company sales income earned in Year 1. The spot rate (as E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules defined in § 1.988–1(d)) on the date of payment of the tax in Year 5 is $1x:0.8u. The foreign income taxes accrued and paid in Year 1 and Year 5 are properly attributable to CFC’s foreign base company sales income that is included in income by USP under section 951(a)(1)(A) (‘‘subpart F inclusion’’) in Year 1 with respect to CFC. (2) Analysis—(i) Result in Year 1. In Year 1, CFC has subpart F income of 900u (1,000u ¥ 100u). Accordingly, USP has a $900x (900u translated at $1x:1u) subpart F inclusion. Under section 960(a) and § 1.960– 2(b), USP is deemed to have paid $100x (100u translated at $1x:1u) of foreign income taxes. Under section 78 and § 1.78–1(a), USP’s section 78 dividend is $100x. Accordingly, for Year 1, USP has taxable income of $1,000x ($900x + $100x) and precredit U.S. tax liability of $210x (21% × $1,000x). Accordingly, USP’s U.S. tax liability is $110x ($210x ¥$100x). (ii) Result in Year 5. CFC’s payment of 80u of additional foreign income tax in Year 5 with respect to Year 1 is a foreign tax redetermination as defined in paragraph (a) of this section. Under paragraph (b)(2)(ii) of this section, USP must reduce CFC’s subpart F income and its earnings and profits in Year 1 by the additional tax amount of 80u. Further, USP must reduce its subpart F inclusion, adjust the amount of foreign taxes deemed paid, and adjust the amount of the section 78 dividend to account for CFC’s additional payment of foreign tax. Under section 986(a)(1)(B)(i) and § 1.986(a)– 1(a)(2)(i), because CFC’s payment of additional tax occurs more than 24 months after the close of the taxable year to which it relates, the additional tax is translated into dollars at the spot rate on the date of payment ($1x:0.8u). Therefore, CFC has foreign income taxes of $200x (100u translated at $1x:1u plus 80u translated at $1x:0.8u) that are properly attributable to CFC’s foreign base company sales income that gives rise to USP’s subpart F inclusion in Year 1. As a result of the foreign tax redetermination, for Year 1, USP has a subpart F inclusion of $820x (1,000u¥180u = 820u translated at $1x:1u). Under section 960(a) and § 1.960–2(b), USP is deemed to have paid $200x of foreign income taxes. Under section 78 and § 1.78–1(a), USP’s section 78 dividend is $200x. For purposes of section 954(b)(4), the effective tax rate on the general category foreign base company sales income is determined by dividing $200x, the U.S. dollar amount of the foreign taxes deemed paid, by the U.S. dollar amount of the net item of foreign base company sales income ($820x) plus the amount of the foreign income tax ($200x). Thus, the effective rate imposed on the general category foreign base company sales income in Year 1 is 19.6% ($200x/$1020x), which exceeds 18.9% (90% of 21%, the highest tax rate in section 11). Therefore, after the foreign tax redetermination, USP is eligible to elect to exclude the item of subpart F income under section 954(b)(4) and § 1.954–1(d). If USP makes the election under § 1.954–1(d), USP’s taxable income, pre-credit U.S. tax liability, and allowable foreign tax credit is zero, resulting in a decrease in USP’s U.S. tax liability of $110x. If USP does not make the VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 election under § 1.954–1(d), then USP’s redetermined U.S. taxable income is $1020x ($820x + $200x) and its pre-credit U.S. tax liability is $214.2x (21% × $1020x). Therefore, USP’s redetermined U.S. tax liability is $14.20x ($214.2x¥$200x), a decrease of $95.80x ($110x¥$14.20x). If USP makes a timely refund claim within the time period allowed by section 6511, USP will be entitled to a refund of any overpayment resulting from the redetermination of U.S. tax liability. (D) Example 3: Two-year rule—(1) Facts. CFC is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns 1,000u of general category gross foreign base company sales income and accrues 210u of foreign income taxes with respect to that income. In Year 1, USP earns no other income and has no other expenses. The average exchange rate used to translate USP’s subpart F inclusion and CFC’s foreign income taxes into dollars for Year 1 is $1x:1u. See sections 989(b)(3) and 986(a)(1)(A) and § 1.986(a)–1(a)(1). USP does not elect to treat CFC’s subpart F income as high taxed income under section 954(b)(4). CFC does not pay its foreign income taxes for Year 1 until September 1, Year 5, when the spot rate is $0.8x:1u. The foreign income taxes accrued and paid in Year 1 and Year 5, respectively, are properly attributable to CFC’s foreign base company sales income that gives rise to USP’s subpart F inclusion in Year 1 with respect to CFC. (2) Analysis—(i) Result in Year 1. In Year 1, CFC has subpart F income of 790u (1,000u ¥ 210u). Accordingly, USP has a $790x (790u translated at $1x:1u) subpart F inclusion. Under section 960(a) and § 1.960– 2(b), USP is deemed to have paid $210x (210u translated at $1x:1u) of foreign income taxes. Under section 78 and § 1.78–1(a), USP’s section 78 dividend is $210x. Accordingly, for Year 1, USP has taxable income of $1,000x ($790x + $210x) and precredit U.S. tax liability of $210x (21% × $1,000x). Accordingly, USP owes no U.S. tax ($210x ¥ $210x = 0). (ii) Result in Year 3. CFC’s failure to pay the tax by the end of Year 3 results in a foreign tax redetermination under paragraph (a) of this section. Because the taxes are not paid on or before the date 24 months after the close of the taxable year to which the tax relates, under paragraph (a) of this section CFC must account for the redetermination as if the unpaid 210u of taxes were refunded on the last day of Year 3. Under paragraph (b)(2)(ii) of this section, USP must increase CFC’s subpart F income and its earnings and profits in Year 1 by the unpaid tax amount of 210u. Further, USP must increase its subpart F inclusion, and decrease the amount of foreign taxes deemed paid and the amount of the section 78 dividend to account for the unpaid taxes. As a result of the foreign tax redetermination, for Year 1, USP has a subpart F inclusion of $1,000x (1,000u translated at $1x:1u). Under section 960(a) and § 1.960–2(b), USP is deemed to have paid no foreign income taxes. Under section 78 and § 1.78–1(a), USP has no section 78 dividend. Accordingly, USP’s redetermined taxable income is $1,000x and its pre-credit U.S. tax liability is unchanged at $210x (21% PO 00000 Frm 00048 Fmt 4701 Sfmt 4702 69171 × $1,000x). However, USP has no foreign tax credits. Therefore, USP’s redetermined U.S. tax liability for Year 1 is $210x, an increase of $210x. (iii) Result in Year 5. CFC’s payment of the Year 1 tax liability of 210u on September 1, Year 5, results in a second foreign tax redetermination under paragraph (a) of this section. Under paragraph (b)(2)(ii) of this section, USP must decrease CFC’s subpart F income and its earnings and profits in Year 1 by the tax paid amount of 210u. Further, USP must reduce its subpart F inclusion, and increase the amount of foreign taxes deemed paid and the amount of the section 78 dividend to account for CFC’s payment of foreign tax. Under section 986(a)(1)(B)(i) and § 1.986(a)–1(a)(2)(i), because the tax was paid more than 24 months after the close of the year to which the tax relates, CFC must translate the 210u of tax at the spot rate on the date of payment of the foreign taxes in Year 5. Therefore, CFC has foreign income taxes of $168x (210u translated at $0.8x:1u) that are properly attributable to CFC’s foreign base company sales income that gives rise to USP’s subpart F inclusion in Year 1. As a result of the foreign tax redetermination, for Year 1, USP has a subpart F inclusion of $790x (1,000u ¥ 210u = 790u translated at $1x:1u). Under section 960(a) and § 1.960– 2(b), USP is deemed to have paid $168x of foreign income taxes. Under section 78 and § 1.78–1(a), USP’s section 78 dividend is $168x. Accordingly, USP’s redetermined taxable income is $958x ($790x + $168x) and its pre-credit U.S. tax liability is $201.18x (21% × $958x). Under section 904(a), USP’s foreign tax credit limitation is $201.18x ($201.18x × $958x/$958x) and exceeds the $168x of foreign income tax that USP is deemed to have paid. Therefore USP’s redetermined U.S. tax liability is $33.18 ($201.18x ¥ $168x), a decrease of $176.82x ($210x ¥ $33.18x). (E) Example 4: Contested tax—(1) Facts. CFC is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns 360u of general category gross tested income and accrues and pays 160u of current year taxes with respect to that income. CFC has no allowable deductions other than the foreign income tax expense. Accordingly, CFC has tested income of 200u in year 1. CFC has no qualified business asset investment (within the meaning of section 951A(d) and § 1.951A–3(b)). In Year 1, no portion of USP’s section 250 deduction is reduced by reason of section 250(a)(2)(B)(ii). USP’s inclusion percentage (as defined in § 1.960–2(c)(2)) is 100%. In Year 1, USP earns no other income and has no other expenses. The average exchange rate used to translate USP’s section 951A inclusion and CFC’s foreign income taxes into dollars for Year 1 is $1x:1u. See section 989(b)(3) and §§ 1.951A–1(d)(1) and 1.986(a)–1(a)(1). Accordingly, for Year 1, USP’s tested foreign income taxes (as defined in § 1.960–2(c)(3)) with respect to CFC are $160x. In Year 3, Country X assessed an additional 30u of tax with respect to CFC’s Year 1 income. CFC did not pay the additional 30u of tax and contested the assessment. After exhausting all effective and practical remedies to reduce, over time, its liability for foreign tax, CFC settled the E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69172 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules contest with Country X in Year 4 for 20u, which CFC did not pay until January 15, Year 5, when the spot rate was $1.1x:1u. CFC did not earn any other income or accrue any other foreign income taxes in Years 2 through 6 and made no distributions to USP. The additional taxes paid in Year 5 are also tested foreign income taxes of USP with respect to CFC. (2) Analysis—(i) Result in Year 1. In Year 1, CFC has tested income of 200u and tested foreign income taxes of $160x. Under section 951A(a) and § 1.951A–1(c)(1), USP has a GILTI inclusion amount of $200x (200u translated at $1x:1u). Under section 960(d) and § 1.960–2(c), USP is deemed to have paid $128x (80% × 100% × $160x) of foreign income taxes. Under section 78 and § 1.78– 1(a), USP’s section 78 dividend is $160x. USP’s section 250 deduction is $180x (50% × ($200x + $160x)). Accordingly, for Year 1, USP has taxable income of $180x ($200x + $160x ¥ $180x) and a pre-credit U.S. tax liability of $37.8x (21% $180x). Under section 904(a), because all of USP’s income is section 951A category income (see § 1.904– 4(g)), USP’s foreign tax credit limitation is $37.8 ($37.8x × $180x/$180x), which is less than the $128x of foreign income tax that USP is deemed to have paid. Accordingly, USP owes no U.S. tax ($37.8x ¥ $37.8x = 0). (ii) Result in Year 5. CFC’s accrual and payment of the additional 20u of foreign income tax with respect to Year 1 is a foreign tax redetermination under paragraph (a) of this section. Under § 1.461–4(g)(6)(iii)(B), the additional taxes accrue when the tax contest is resolved, that is, in Year 4. However, because the taxes, which relate to Year 1, were not paid on or before the date 24 months after close of CFC’s taxable year to which the tax relates, that is, Year 1, under section 905(c)(2) and paragraph (a) of this section CFC cannot take these taxes into account when they accrue in Year 4. Instead, the taxes are taken into account when they are paid in Year 5. Under paragraph (b)(2)(ii) of this section, USP must decrease CFC’s tested income and its earnings and profits in Year 1 by the additional tax amount of 20u. Further, USP must adjust its GILTI inclusion amount, the amount of foreign taxes deemed paid, and the amount of the section 78 dividend to account for CFC’s additional payment of tax. Under section 986(a)(1)(B)(i) and § 1.986(a)–1(a)(2)(i), because CFC’s payment of additional tax occurs more than 24 months after the close of the taxable year to which it relates, the additional tax is translated into dollars at the spot rate on the date of payment ($1.1x:1u). Therefore, CFC has tested foreign income taxes of $182x (160u translated at $1x:1u plus 20u translated at $1.1x:1u). As a result of the foreign tax redetermination, for Year 1, CFC has tested income of 180u (200u¥20u). Under section 951A(a) and § 1.951A–1(c)(1), USP has a redetermined GILTI inclusion amount of $180x (180u, translated at $1x:1u). Under section 960(d) and § 1.960–2(c), USP is deemed to have paid $145.6x (80% × 100% × $182x) of foreign income taxes. Under section 78 and § 1.78–1(a), USP’s section 78 dividend is $182x. USP’s redetermined section 250 deduction is $181x (50% × ($180x + $182x)). Accordingly, USP’s VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 redetermined taxable income is $181x ($180x + $182x¥$181x) and its pre-credit U.S. tax liability is $38.01x (21% × $181x). Under section 904(a), USP’s foreign tax credit limitation is $38.01x ($38.01x × $181x/ $181x), which is less than the $145.6x of foreign tax credits that USP is deemed to have paid. Therefore, USP’s redetermined U.S. tax liability is zero ($38.01x¥$38.01x). (3) Foreign tax redeterminations of successors or transferees. If at the time of a foreign tax redetermination the person with legal liability for the tax (or in the case of a refund, the legal right to such refund) (the ‘‘successor’’) is a different person than the person that had legal liability for the tax in the year to which the redetermined tax relates (the ‘‘original taxpayer’’), the required redetermination of U.S. tax liability is made as if the foreign tax redetermination occurred in the hands of the original taxpayer. Federal income tax principles apply to determine the tax consequences if the successor remits (or receives a refund of) a tax that in the year to which the redetermined tax relates was the legal liability of, and thus under § 1.901–2(f) is considered paid by, the original taxpayer. * * * * * (d) Applicability dates. This section applies to foreign tax redeterminations occurring in taxable years ending on or after December 16, 2019, and to foreign tax redeterminations of foreign corporations occurring in taxable years that end with or within a taxable year of a United States shareholder ending on or after December 16, 2019 and that relate to taxable years of foreign corporations beginning after December 31, 2017. ■ Par. 18. Section 1.905–4, as proposed to be added at 72 FR 62805 (November 7, 2007), is further revised to read as follows: § 1.905–4 Notification of foreign tax redetermination. (a) Application of this section. The rules of this section apply if, as a result of a foreign tax redetermination (as defined in § 1.905–3(a)), a redetermination of U.S. tax liability is required under section 905(c) and § 1.905–3(b). (b) Time and manner of notification— (1) Redetermination of U.S. tax liability—(i) In general. Except as provided in paragraphs (b)(1)(v) and (b)(2) through (b)(4) of this section, any taxpayer for which a redetermination of U.S. tax liability is required must notify the Internal Revenue Service (IRS) of the foreign tax redetermination by filing an amended return, Form 1118 (Foreign Tax Credit—Corporations) or Form 1116 (Foreign Tax Credit), and the statement described in paragraph (c) of this PO 00000 Frm 00049 Fmt 4701 Sfmt 4702 section for the taxable year with respect to which a redetermination of U.S. tax liability is required. Such notification must be filed within the time prescribed by this paragraph (b) and contain the information described in paragraph (c) of this section. If a foreign tax redetermination requires an individual to redetermine the individual’s U.S. tax liability, and if, after taking into account such foreign tax redetermination, the amount of creditable foreign taxes (as defined in section 904(j)(3)(B)) that are paid or accrued by such individual during the taxable year does not exceed the applicable dollar limitation in section 904(j), the individual is not required to file Form 1116 with the amended return for such taxable year if the individual satisfies the requirements of section 904(j). (ii) Increase in amount of U.S. tax liability. Except as provided in paragraphs (b)(1)(iv) and (b)(2) through (b)(4) of this section, for each taxable year of the taxpayer with respect to which a redetermination of U.S. tax liability is required by reason of a foreign tax redetermination that increases the amount of U.S. tax liability, for example, by reason of a downward adjustment to the amount of foreign income taxes paid or accrued by the taxpayer or a foreign corporation with respect to which the taxpayer computes an amount of foreign taxes deemed paid, the taxpayer must file a separate notification by the due date (with extensions) of the original return for the taxpayer’s taxable year in which the foreign tax redetermination occurs. (iii) Decrease in amount of U.S. tax liability. Except as provided in paragraphs (b)(1)(iv) and (b)(2) through (b)(4) of this section, for each taxable year of the taxpayer with respect to which a redetermination of U.S. tax liability is required by reason of a foreign tax redetermination that decreases the amount of U.S. tax liability and results in an overpayment, for example, by reason of an increase in the amount of foreign income taxes paid or accrued by the taxpayer or a foreign corporation with respect to which the taxpayer computes an amount of foreign taxes deemed paid, the taxpayer must file a claim for refund with the IRS within the period provided in section 6511. See section 6511(d)(3)(A) for the special refund period for refunds attributable to an increase in foreign tax credits. (iv) Multiple redeterminations of U.S. tax liability for same taxable year. The rules of this paragraph (b)(1)(iv) apply except as provided in paragraphs (b)(1)(v), (b)(2) through (b)(4) of this section. If more than one foreign tax E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules redetermination requires a redetermination of U.S. tax liability for the same affected taxable year of the taxpayer and those foreign tax redeterminations occur within the same taxable year or within two consecutive taxable years of the taxpayer, the taxpayer may file for the affected taxable year one amended return, Form 1118 or Form 1116, and the statement described in paragraph (c) of this section that reflects all such foreign tax redeterminations. If the taxpayer chooses to file one notification for such redeterminations, one or more of such redeterminations would increase the U.S. tax liability, and the net effect of all such redeterminations is to increase the U.S. tax liability for the affected taxable year, the taxpayer must file such notification by the due date (with extensions) of the original return for the taxpayer’s taxable year in which the first foreign tax redetermination that would result in an increased U.S. tax liability occurred. If the taxpayer chooses to file one notification for such redeterminations, one or more of such redeterminations would decrease the U.S. tax liability, and the net effect of all such redeterminations is to decrease the total amount of U.S. tax liability for the affected taxable year, the taxpayer must file such notification as provided in paragraph (b)(1)(iii) of this section, within the period provided by section 6511. If a foreign tax redetermination with respect to the taxable year for which a redetermination of U.S. tax liability is required occurs after the date for providing such notification, more than one amended return may be required with respect to that taxable year. (v) Amended return required only if there is a change in amount of U.S. tax due. If a redetermination of U.S. tax liability is required by reason of a foreign tax redetermination, but does not change the amount of U.S. tax due for any taxable year, the taxpayer may, in lieu of applying the applicable rules of paragraphs (b)(1)(i) through (iv) of this section, notify the IRS of such redetermination by attaching a statement to the original return for the taxpayer’s taxable year in which the foreign tax redetermination occurs. Such statement must be filed by the due date (with extensions) of the original return for the taxpayer’s taxable year in which the foreign tax redetermination occurs and contain the information described in § 1.904–2(f). If a redetermination of U.S. tax liability is required by reason of a foreign tax redetermination (either alone, or if the taxpayer chooses to apply paragraph VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 (b)(1)(iv) of this section, in combination with other foreign tax redeterminations, as provided therein) and the redetermination of U.S. tax liability results in a change to the amount of U.S. tax due for a taxable year, but does not change the amount of U.S. tax due for other taxable years, for example, because of a carryback or carryover of an unused foreign tax under section 904(c), the notification requirements for such other taxable years are deemed to be satisfied if the taxpayer complies with the applicable rules of paragraphs (b)(1)(i) through (iv) of this section with respect to each taxable year for which the foreign tax redetermination changes the amount of U.S. tax due. (2) Notification with respect to a change in the amount of foreign tax reported to an owner by a pass-through entity—(i) In general. If a partnership, trust, or other pass-through entity that reports to its beneficial owners (or to any intermediary on behalf its beneficial owners), including partners, shareholders, beneficiaries, or similar persons, an amount of creditable foreign income taxes, such pass-through entity must notify both the IRS and its owners of any foreign tax redetermination described in § 1.905–3(a) with respect to the foreign tax so reported. For purposes of this paragraph (b)(2), whether or not a redetermination has occurred within the meaning of § 1.905–3(a) is determined as if the pass-through entity were a domestic corporation which had elected to and claimed foreign tax credits in the amount reported for the year to which such foreign taxes relate. The notification required under this paragraph (b)(2) must include the statement described in paragraph (c) of this section along with any information necessary for the owners to redetermine their U.S. tax liability. (ii) Partnerships subject to subchapter C of chapter 63. Except as provided in paragraph (b)(4) of this section, if a redetermination of U.S. tax liability that is required under § 1.905–3(b) by reason of a foreign tax redetermination described in § 1.905–3(a) would require a partnership adjustment as defined in § 301.6241–1(a)(6) of this chapter, the partnership must file an administrative adjustment request under section 6227 and make any adjustments required under section 6227. See § 301.6227–2 and § 301.6227–3 of this chapter for procedures for making adjustments with respect to an administrative adjustment request. An administrative adjustment request required under this paragraph (b)(2)(ii) must be filed by the due date (with extensions) of the original return for the partnership’s taxable year in which the foreign tax redetermination PO 00000 Frm 00050 Fmt 4701 Sfmt 4702 69173 occurs, and the restrictions in section 6227(c) do not apply to such filing. However, unless the administrative adjustment request may otherwise be filed after applying the limitations contained in section 6227(c), such a request is limited to adjustments that are required to be made under section 905(c). The requirements of paragraph (b)(2)(i) of this section are deemed to be satisfied with respect to any item taken into account in an administrative adjustment request filed under this paragraph (b)(2)(ii). (3) Alternative notification requirements. An amended return and Form 1118 (Foreign Tax Credit— Corporations) or Form 1116 (Foreign Tax Credit), is not required to notify the IRS of the foreign tax redetermination and redetermination of U.S. tax liability if the taxpayer satisfies alternative notification requirements that may be prescribed by the IRS through forms, instructions, publications, or other guidance. (4) Taxpayers under examination within the jurisdiction of the Large Business and International Division—(i) In general. The alternative notification requirements of this paragraph (b)(4) apply if all of the following conditions are satisfied: (A) A foreign tax redetermination occurs while the taxpayer is under examination within the jurisdiction of the Large Business and International Division (or a successor division); (B) The foreign tax redetermination results in a downward adjustment to the amount of foreign income taxes paid or accrued by the taxpayer or a foreign corporation with respect to which the taxpayer computes an amount of foreign income taxes deemed paid; (C) The foreign tax redetermination requires a redetermination of U.S. tax liability and accordingly, but for this paragraph (b)(4), the taxpayer would be required to notify the IRS of such foreign tax redetermination under paragraph (b)(1)(ii) of this section (determined without regard to paragraphs (b)(1)(iv) and (v) of this section) or (b)(2)(ii) of this section; (D) The return for the taxable year for which a redetermination of U.S. tax liability is required is under examination; and (E) The due date specified in paragraph (b)(1)(ii) or (b)(2) of this section for providing notice of such foreign tax redetermination is not before the later of the opening conference or the hand-delivery or postmark date of the opening letter concerning an examination of the return for the taxable year for which a redetermination of U.S. E:\FR\FM\17DEP2.SGM 17DEP2 jbell on DSKJLSW7X2PROD with PROPOSALS2 69174 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules tax liability is required by reason of such foreign tax redetermination. (ii) Notification requirements—(A) Foreign tax redetermination occurring before commencement of the examination. If a foreign tax redetermination described in paragraph (b)(4)(i)(B) and (C) of this section occurs before the later of the opening conference or the hand-delivery or postmark date of the opening letter and if the condition provided in paragraph (b)(4)(i)(E) of this section with respect to such foreign tax redetermination is met, the taxpayer, in lieu of applying the rules of paragraph (b)(1)(i) and (ii) of this section (requiring the filing of an amended return, Form 1118, and the statement described in paragraph (c) of this section) or (b)(2)(ii) of this section (requiring the filing of an administrative adjustment request), must notify the IRS of such redetermination by providing the statement described in paragraph (b)(4)(iii) of this section to the examiner no later than 120 days after the later of the date of the opening conference of the examination, or the hand-delivery or postmark date of the opening letter concerning the examination. (B) Foreign tax redetermination occurring within 180 days after commencement of the examination. If a foreign tax redetermination described in paragraph (b)(4)(i)(B) and (C) of this section occurs on or after the latest of the opening conference or the handdelivery or postmark date of the opening letter and on or before the date that is 180 days after the later of the opening conference or the hand-delivery or postmark date of the opening letter, the taxpayer, in lieu of applying the rules of paragraph (b)(1)(i) and (ii) of this section or (b)(2) of this section, must notify the IRS of such redetermination by providing the statement described in paragraph (b)(4)(iii) of this section to the examiner no later than 120 days after the date the foreign tax redetermination occurs. (C) Foreign tax redetermination occurring more than 180 days after commencement of the examination. If a foreign tax redetermination described in paragraphs (b)(4)(i)(B) and (C) of this section occurs after the date that is 180 days after the later of the opening conference or the hand-delivery or postmark date of the opening letter, the taxpayer must either apply the rules of paragraphs (b)(1)(i) and (ii) of this section or (b)(2) of this section, or, in lieu of applying paragraphs (b)(1)(i) and (ii) of this section or (b)(2) of this section, provide the statement described in paragraph (b)(4)(iii) of this section to the examiner within 120 days after the date the foreign tax redetermination VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 occurs. However, the IRS, in its discretion, may either accept such statement or require the taxpayer to comply with the rules of paragraphs (b)(1)(i) and (ii) of this section or (b)(2) of this section, as applicable. (iii) Statement. The statement required by paragraphs (b)(4)(ii)(A) and (B) of this section must provide the original amount of foreign income taxes paid or accrued, the revised amount of foreign income taxes paid or accrued, and documentation with respect to the revisions, including exchange rates and dates of accrual or payment, and, if applicable, the information described in paragraph (c)(8) of this section. The statement must include the following declaration signed by a person authorized to sign the return of the taxpayer: ‘‘Under penalties of perjury, I declare that I have examined this written statement, and to the best of my knowledge and belief, this written statement is true, correct, and complete.’’ (iv) Penalty for failure to file notice of a foreign tax redetermination. A taxpayer subject to the rules of this paragraph (b)(4) must satisfy the rules of paragraph (b)(4)(ii) of this section in order not to be subject to the penalty relating to the failure to file notice of a foreign tax redetermination under section 6689 and § 301.6689–1 of this chapter. (5) Examples. The following examples illustrate the application of paragraph (b) of this section. (i) Example 1—(A) X, a domestic corporation, is an accrual basis taxpayer and uses the calendar year as its U.S. taxable year. X conducts business through a branch in Country M, the currency of which is the m, and also conducts business through a branch in Country N, the currency of which is the n. X uses the average exchange rate to translate foreign income taxes. Assume that X is able to claim a credit under section 901 for all foreign income taxes paid or accrued. (B) In Year 1, X accrued and paid 100m of Country M income taxes with respect to 400m of foreign source foreign branch category income. The average exchange rate for Year 1 was $1:1m. Also in Year 1, X accrued and paid 50n of Country N income taxes with respect to 150n of foreign source foreign branch category income. The average exchange rate for Year 1 was $1:1n. On its Year 1 Federal income tax return, X claimed a foreign tax credit under section 901 of $150 ($100 (100m translated at $1:1m) + $50 (50n translated at $1:1n)) with respect to its foreign source foreign branch category income. See § 1.986(a)–1(a)(1). (C) In Year 2, X accrued and paid 100n of Country N income taxes with respect to 300n of foreign source foreign branch category income. The average exchange rate for Year 2 was $1.50:1n. On its Year 2 Federal income tax return X claimed a foreign tax credit PO 00000 Frm 00051 Fmt 4701 Sfmt 4702 under section 901 of $150 (100n translated at $1.5:1n). See § 1.986(a)–1(a)(1). (D) On June 15, Year 5, when the spot rate was $1.40:1n, X received a refund of 10n from Country N, and, on March 15, Year 6, when the spot rate was $1.20:1m, X was assessed by and paid Country M an additional 20m of tax. Both payments were with respect to X’s foreign source foreign branch category income in Year 1. On May 15, Year 6, when the spot rate was $1.45:1n, X received a refund of 5n from Country N with respect to its foreign source foreign branch category income in Year 2. (E) Both the refunds and the assessment are foreign tax redeterminations under § 1.905– 3(a). Under § 1.905–3(b)(1), X must redetermine its U.S. tax liability for both Year 1 and Year 2. With respect to Year 1, under paragraph (b)(1)(ii) of this section, X must notify the IRS of the June 15, Year 5, refund of 10n from Country N that increased X’s U.S. tax liability by filing an amended return, Form 1118, and the statement required in paragraph (c) of this section for Year 1 by the due date of the original return (with extensions) for Year 5. The amended return and Form 1118 reduces the amount of foreign income taxes claimed as a credit under section 901 and increases X’s U.S. tax liability by $10 (10n refund translated at the average exchange rate for Year 1, or $1:1n (see § 1.986(a)–1(c)). With respect to the March 15, Year 6, additional assessment of 20m by Country M, under paragraph (b)(1)(iii) of this section, X must notify the IRS within the time period provided by section 6511, increasing the foreign income taxes available as a credit and reducing X’s U.S. tax liability by $24 (20m translated at the spot rate on the date of payment, or $1.20:1m). See sections 986(a)(1)(B)(i) and 986(a)(2)(A) and § 1.986(a)–1(a)(2)(i). X may so notify the IRS by filing a second amended return, Form 1118, and the statement described in paragraph (c) of this section for Year 1, within the time period provided by section 6511. Alternatively, under paragraph (b)(1)(iv) of this section, when X redetermines its U.S. tax liability for Year 1 to take into account the 10n refund from Country N that occurred in Year 5, X may also take into account the 20m additional assessment by Country M that occurred on March 15, Year 6. If X reflects both foreign tax redeterminations on the same amended return, Form 1118, and in the statement described in paragraph (c) of this section for Year 1, the amount of X’s foreign income taxes available as a credit would be reduced by $10 (10n refund translated at $1:1n), and increased by $24 (20m additional assessment translated at the spot rate on the date of payment, March 15, Year 6, or $1.20:1m). The foreign income taxes available as a credit therefore would be increased by $14 ($24 (additional assessment)¥$10 (refund)). Because the net effect of the foreign tax redeterminations is to increase the amount of foreign taxes paid or accrued and decrease X’s U.S. tax liability, under paragraph (b)(1)(iv) of this section the Year 1 amended return, Form 1118, and the statement required in paragraph (c) of this section reflecting foreign tax redeterminations in both years must be filed within the time period provided by section 6511. E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules jbell on DSKJLSW7X2PROD with PROPOSALS2 (F) With respect to Year 2, under paragraph (b)(1)(ii) of this section, X must notify the IRS by filing an amended return, Form 1118, and the statement required in paragraph (c) of this section for Year 2 that is separate from that filed for Year 1. The amended return, Form 1118, and the statement required in paragraph (c) of this section for Year 2 must be filed by the due date (with extensions) of X’s original return for Year 6. The amended return and Form 1118 reduces the amount of foreign income taxes claimed as a credit under section 901 and increases X’s U.S. tax liability by $7.50 (5n refund translated at the average exchange rate for Year 2, or $1.50:1n). (ii) Example 2. X, a taxpayer within the jurisdiction of the Large Business and International Division, uses the calendar year as its U.S. taxable year. On November 15, Year 2, X receives a refund of foreign income taxes that constitutes a foreign tax redetermination and necessitates a redetermination of U.S. tax liability for X’s Year 1 taxable year. Under paragraph (b)(1)(ii) of this section, X is required to notify the IRS of the foreign tax redetermination that increased its U.S. tax liability by filing an amended return, Form 1118, and the statement described in paragraph (c) of this section for its Year 1 taxable year by October 15, Year 3 (the due date (with extensions) of the original return for X’s Year 2 taxable year). On December 15, Year 3, the IRS hand delivers an opening letter concerning the examination of the return for X’s Year 1 taxable year, and the opening conference for such examination is scheduled for January 15, Year 4. Because the date for notifying the IRS of the foreign tax redetermination under paragraph (b)(1)(ii) of this section (October 15, Year 3) is before the date of the opening conference concerning the examination of the return for X’s Year 1 taxable year (January 15, Year 4), the condition of paragraph (b)(4)(i)(E) of this section is not met, and so paragraph (b)(4)(i) of this section does not apply. Accordingly, X must notify the IRS of the foreign tax redetermination by filing an amended return, Form 1118, and the statement described in paragraph (c) of this section for the Year 1 taxable year by October 15, Year 3. (c) Notification contents. The statement required by paragraphs (b)(1)(i) through (iv) of this section and (b)(2) of this section must contain information sufficient for the IRS to redetermine U.S. tax liability if such a redetermination is required under section 905(c). The information must be in a form that enables the IRS to verify and compare the original computation of U.S. tax liability, the revised computation resulting from the foreign tax redetermination, and the net changes resulting therefrom. The statement must include the following: (1) The taxpayer’s name, address, identifying number, the taxable year or years of the taxpayer that are affected by the foreign tax redetermination, and, in the case of foreign taxes deemed paid, VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 the name and identifying number, if any, of the foreign corporation; (2) The date or dates the foreign income taxes were accrued, if applicable; the date or dates the foreign income taxes were paid; the amount of foreign income taxes paid or accrued on each date (in foreign currency) and the exchange rate used to translate each such amount, as provided in § 1.986(a)– 1(a) or (b); (3) Information sufficient to determine any change to the characterization of a distribution, the amount of any inclusion under section 951(a), 951A, or 1293, or the deferred tax amount under section 1291; (4) Information sufficient to determine any interest due from or owing to the taxpayer, including the amount of any interest paid by the foreign government to the taxpayer and the dates received; (5) In the case of any foreign income tax that is refunded in whole or in part, the taxpayer must provide the date of each such refund; the amount of such refund (in foreign currency); and the exchange rate that was used to translate such amount when originally claimed as a credit (as provided in § 1.986(a)–1(c)) and the spot rate (as defined in § 1.988– 1(d)) for the date the refund was received (for purposes of computing foreign currency gain or loss under section 988); (6) In the case of any foreign income taxes that are not paid on or before the date that is 24 months after the close of the taxable year to which such taxes relate, the amount of such taxes in foreign currency, and the exchange rate that was used to translate such amount when originally claimed as a credit or added to PTEP group taxes (as defined in § 1.960–3(d)(1)); (7) If a redetermination of U.S. tax liability results in an amount of additional tax due, and the carryback or carryover of an unused foreign income tax under section 904(c) only partially eliminates such amount, the information required in § 1.904–2(f); and (8) In the case of a pass-through entity, the name, address, and identifying number of each beneficial owner to which foreign taxes were reported for the taxable year or years to which the foreign tax redetermination relates, and the amount of foreign tax initially reported to each beneficial owner for each such year and the amount of foreign tax allocable to each beneficial owner for each such year after the foreign tax redetermination is taken into account. (d) Payment or refund of U.S. tax. The amount of tax, if any, due upon a redetermination of U.S. tax liability is PO 00000 Frm 00052 Fmt 4701 Sfmt 4702 69175 paid by the taxpayer after notice and demand has been made by the IRS. Subchapter B of chapter 63 of the Internal Revenue Code (relating to deficiency procedures) does not apply with respect to the assessment of the amount due upon such redetermination. In accordance with sections 905(c) and 6501(c)(5), the amount of additional tax due is assessed and collected without regard to the provisions of section 6501(a) (relating to limitations on assessment and collection). The amount of tax, if any, shown by a redetermination of U.S. tax liability to have been overpaid is credited or refunded to the taxpayer in accordance with subchapter B of chapter 66 (section 6511 et seq.). (e) Interest and penalties—(1) In general. If a redetermination of U.S. tax liability is required by reason of a foreign tax redetermination, interest is computed on the underpayment or overpayment in accordance with sections 6601 and 6611. No interest is assessed or collected on any underpayment resulting from a refund of foreign income taxes for any period before the receipt of the refund, except to the extent interest was paid by the foreign country or possession of the United States on the refund for the period before the receipt of the refund. See section 905(c)(5). In no case, however, will interest assessed and collected pursuant to the preceding sentence for any period before receipt of the refund exceed the amount that otherwise would have been assessed and collected under section 6601 for that period. Interest is assessed from the time the taxpayer (or the foreign corporation, partnership, trust, or other pass-through entity of which the taxpayer is a shareholder, partner, or beneficiary) receives a refund until the taxpayer pays the additional tax due the United States. (2) Imposition of penalty. Failure to comply with the provisions of this section subjects the taxpayer to the penalty provisions of section 6689 and § 301.6689–1 of this chapter. (f) Applicability date. This section applies to foreign tax redeterminations (as defined in § 1.905–3(a)) occurring in taxable years ending on or after December 16, 2019, and to foreign tax redeterminations of foreign corporations occurring in taxable years that end with or within a taxable year of a United States shareholder ending on or after December 16, 2019. ■ Par. 19. Section 1.905–5, as proposed to be added at 72 FR 62805 (November 7, 2007), is further revised to read as follows: E:\FR\FM\17DEP2.SGM 17DEP2 69176 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules jbell on DSKJLSW7X2PROD with PROPOSALS2 § 1.905–5 Foreign tax redeterminations of foreign corporations that relate to taxable years of the foreign corporation beginning before January 1, 2018. (a) In general—(1) Effect of foreign tax redetermination of a foreign corporation. A foreign tax redetermination (as defined in § 1.905– 3(a)) of a foreign corporation that relates to a taxable year of the foreign corporation beginning before January 1, 2018, and that may affect a taxpayer’s foreign tax credit in any taxable year, must be accounted for by adjusting the foreign corporation’s taxable income and earnings and profits, post-1986 undistributed earnings as defined in § 1.902–1(a)(9), and post-1986 foreign income taxes as defined in § 1.902– 1(a)(8) (or its pre-1987 accumulated profits as defined in § 1.902–1(a)(10)(i) and pre-1987 foreign income taxes as defined in § 1.902–1(a)(10)(iii), as applicable) in the taxable year of the foreign corporation to which the foreign taxes relate. (2) Requirement of U.S. tax redetermination. A redetermination of U.S. tax liability is required to account for the effect of the foreign tax redetermination on the earnings and profits and taxable income of the foreign corporation, the taxable income of a United States shareholder, and the amount of foreign taxes deemed paid by the United States shareholder under section 902 or 960 (as in effect before December 22, 2017), in the year to which the redetermined foreign taxes relate. For example, in the case of a refund of foreign income taxes, the subpart F income, earnings and profits, and post-1986 undistributed earnings (or pre-1987 accumulated profits, as applicable) of the foreign corporation are increased in the year to which the foreign tax relates to reflect the functional currency amount of the foreign income tax refund. The required redetermination of U.S. tax liability must account for the effect of the foreign tax redetermination on the characterization and amount of distributions or inclusions under sections 951 or 1293 taken into account by each of the foreign corporation’s United States shareholders and on the application of the high-tax exception described in section 954(b)(4), as well as on the amount of foreign income taxes deemed paid in such year. In addition, a redetermination of U.S. tax liability is required for any subsequent taxable year in which the United States shareholder received or accrued a distribution or inclusion from the foreign corporation, up to and including the taxable year in which the foreign tax redetermination occurs, as well as any year to which VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 unused foreign taxes from such year were carried under section 904(c). (b) Notification requirements—(1) In general. The notification requirements of § 1.905–4, as modified by paragraphs (b)(2) and (3) of this section, apply if a redetermination of U.S. tax liability is required under paragraph (a) of this section. (2) Notification relating to post-1986 undistributed earnings and post-1986 foreign income taxes. In the case of foreign tax redeterminations with respect to taxes included in post-1986 foreign income taxes, in addition to the information required by § 1.905–4(c), the taxpayer must provide the balances of the pools of post-1986 undistributed earnings and post-1986 foreign income taxes before and after adjusting the pools, the dates and amounts of any dividend distributions or other inclusions made out of earnings and profits for the affected year or years, and the amount of earnings and profits from which such dividends were paid or such inclusions were made for the affected year or years. (3) Notification relating to pre-1987 accumulated profits and pre-1987 foreign income taxes. In the case of foreign tax redeterminations with respect to pre-1987 accumulated profits, in addition to the information required by § 1.905–4(c), the taxpayer must provide the following: The dates and amounts of any dividend distributions made out of earnings and profits for the affected year or years; the rate of exchange on the date of any such distribution; and the amount of earnings and profits from which such dividends were paid for the affected year or years. (c) Currency translation rules for adjustments to pre-1987 foreign income taxes. Foreign income taxes paid with respect to pre-1987 accumulated profits that are deemed paid under section 960 (or under section 902 in the case of an amount treated as a dividend under section 1248) are translated into dollars at the spot rate for the date of the payment of the foreign income taxes, and refunds of such taxes are translated into dollars at the spot rate for the date of the refund. Foreign income taxes deemed paid by a taxpayer under section 902 with respect to an actual distribution of pre-1987 accumulated profits and refunds of such taxes are translated into dollars at the spot rate for the date of the distribution of the earnings to which the foreign income taxes relate. See section 902(c)(6) (as in effect before December 22, 2017) and § 1.902–1(a)(10)(iii). For purposes of this section, the term spot rate has the meaning provided in § 1.988–1(d). PO 00000 Frm 00053 Fmt 4701 Sfmt 4702 (d) Adjustments to pools of post-1986 foreign income taxes. The redetermination of U.S. tax liability required by paragraph (a) of this section is made in accordance with section 905(c) as in effect for those taxable years, without regard to rules that required prospective adjustments to a foreign corporation’s pools of post-1986 undistributed earnings and post-1986 foreign income taxes in the year of the foreign tax redetermination in lieu of redeterminations of U.S. tax liability. No underpayment or overpayment of U.S. tax liability results from a foreign tax redetermination unless the required adjustments change the U.S. tax liability. Consequently, no interest is paid by or to a taxpayer as a result of adjustments, required by reason of a foreign tax redetermination, to a foreign corporation’s pools of post-1986 undistributed earnings and post-1986 foreign income taxes in the year to which the redetermined foreign tax relates that did not result in a change to U.S. tax liability, for example, because no foreign taxes were deemed paid in that year. (e) Applicability date. This section applies to foreign tax redeterminations (as defined in § 1.905–3(a)) of foreign corporations occurring in taxable years that end with or within taxable years of a United States shareholder ending on or after December 16, 2019, and that relate to taxable years of foreign corporations beginning before January 1, 2018. ■ Par. 20. Section 1.954–1 is amended by: ■ 1. In paragraph (c)(1)(i)(C) removing the language ‘‘reduced by related person’’ and adding the language ‘‘reduced (but not below zero) by related person’’ in its place. ■ 2. Adding two sentences to the end of paragraph (d)(3)(iii). ■ 3. Revising paragraph (h)(1). The revisions and additions read as follows: § 1.954–1 Foreign base company income. * * * * * (d) * * * (3) * * * (iii) * * * In addition, foreign income taxes that have not been paid or accrued because they are contingent on a future distribution of earnings are not taken into account for purposes of this paragraph (d)(3). If, pursuant to section 905(c) and § 1.905–3(b)(2), a redetermination of U.S. tax liability is required to account for the effect of a foreign tax redetermination (as defined in § 1.905–3(a)), this paragraph (d) is applied in the adjusted year taking into E:\FR\FM\17DEP2.SGM 17DEP2 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules account the adjusted amount of the redetermined foreign tax. * * * * * (h) * * * (1) Paragraph (d)(3) of this section. Paragraph (d)(3) of this section applies to taxable years of a controlled foreign corporation ending on or after December 16, 2019. For taxable years of a controlled foreign corporation ending on or after December 4, 2018, but ending before December 16, 2019, see § 1.954– 1(d)(3) as contained in 26 CFR part 1 revised as of April 1, 2019. * * * * * ■ Par. 21. Section 1.954–2 is amended by: ■ 1. Removing the text ‘‘and’’ from paragraph (h)(2)(i)(H). ■ 2. Redesignating paragraph (h)(2)(i)(I) as paragraph (h)(2)(i)(J). ■ 3. Adding a new paragraph (h)(2)(i)(I). ■ 4. Adding a sentence to the end of paragraph (i)(2). The additions read as follows: § 1.954–2 Foreign personal holding company income. * * * * * (h) * * * (2) * * * (i) * * * (I) Any guaranteed payments for the use of capital under section 707(c); and * * * * * (i) * * * (2) * * * Paragraph (h)(2)(i)(I) of this section applies to taxable years of controlled foreign corporations ending on or after December 16, 2019, and to taxable years of United States shareholders in which or with which such taxable years end. ■ Par. 22. Section 1.960–1 is amended by: ■ 1. Adding a sentence at the end of paragraph (c)(2). ■ 2. Revising the first three sentences, and adding two new sentences after the third sentence, in paragraph (d)(3)(ii)(A). ■ 3. Removing and reserving paragraph (d)(3)(ii)(B). ■ 4. Revising the second, third, and seventh sentences of paragraph (d)(3)(ii)(C). The addition and revisions read as follows: § 1.960–1 Overview, definitions, and computational rules for determining foreign income taxes deemed paid under section 960(a), (b), and (d). jbell on DSKJLSW7X2PROD with PROPOSALS2 * * * * * (c) * * * (2) * * * An item of income with respect to a current taxable year does not include an amount included as subpart F income of a controlled foreign corporation by reason of the recharacterization of a recapture account established in a prior U.S. VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 taxable year (and the corresponding earnings and profits) of the controlled foreign corporation under section 952(c)(2) and § 1.952–1(f). * * * * * (d) * * * (3) * * * (ii) * * * (A) * * * A current year tax is allocated and apportioned among the section 904 categories under the rules of § 1.904–6. An amount of the current year tax that is allocated and apportioned to a section 904 category is then allocated and apportioned among the income groups within the section 904 category under § 1.861–20 (as modified by § 1.904–6(c)) by treating each income group as a statutory grouping and treating the residual income group as the residual grouping. Therefore, the portion of a current year tax that is attributable to foreign taxable income arising from a transaction that does not result in the recognition of gross income or loss for Federal income tax purposes in the current taxable year is assigned under § 1.861–20(d)(2)(i) to the section 904 category and income group within a section 904 category to which the corresponding U.S. item would be assigned if the event giving rise to the foreign taxable income resulted in the recognition of income or loss under Federal income tax law in that year. Foreign gross income arising from the receipt of a disregarded payment made by a disregarded entity or other foreign branch to its foreign branch owner that is a controlled foreign corporation is assigned to the income group or groups from which the payment is considered to be made under § 1.861–20(d)(3)(ii)(A). Foreign gross income attributable to a base difference, or resulting from the receipt of a disregarded payment made to a foreign branch, is assigned to the residual income grouping under §§ 1.861– 20(d)(2)(ii)(B) and 1.861–20(d)(3)(ii)(B). * * * * * * * * (C) * * * In such case, under § 1.861– 20, the portion of the foreign gross income (as defined in § 1.861–20(b)(5)) that is characterized under Federal income tax principles as a distribution of previously taxed earnings and profits that results in the increase in the PTEP group in the current taxable year is assigned to that PTEP group. If a PTEP group is not treated as an income group under the first sentence of this paragraph (d)(3)(ii)(C), and the rules of § 1.861–20 would otherwise apply to assign foreign gross income to a PTEP group, that foreign gross income is instead assigned to the subpart F PO 00000 Frm 00054 Fmt 4701 Sfmt 4702 69177 income group or tested income group to which the income that gave rise to the previously taxed earnings and profits would be assigned if the income were recognized by the recipient controlled foreign corporation under Federal income tax principles in the current taxable year. * * * That foreign gross income, however, may be assigned to a subpart F income group or tested income group. ■ Par. 23. Section 1.960–2 is amended by adding a sentence at the end of paragraph (b)(3)(iii) to read as follows: § 1.960–2 Foreign income taxes deemed paid under sections 960(a) and (d). * * * * * (b) * * * (3) * * * (iii) * * * See § 1.960–1(c)(2) for rule regarding the treatment of an increase in the subpart F income of a controlled foreign corporation by reason of the recharacterization of a recapture account and the corresponding accumulated earnings and profits under section 952(c) and § 1.952–1(f). ■ Par. 24. Section 1.960–7 is revised to read as follows: § 1.960–7 Applicability dates. (a) Except as provided in paragraph (b) of this section, §§ 1.960–1 through 1.960–6 apply to each taxable year of a foreign corporation ending on or after December 4, 2018, and to each taxable year of a domestic corporation that is a United States shareholder of the foreign corporation in which or with which such taxable year of such foreign corporation ends. (b) Section 1.960–1(d)(3)(ii) applies to taxable years of a foreign corporation beginning after December 31, 2019, and to each taxable year of a domestic corporation that is a United States shareholder of the foreign corporation in which or with which such taxable year of such foreign corporation ends. For taxable years of a foreign corporation that end on or after December 4, 2018, and also begin before January 1, 2020, see § 1.960–1(d)(3)(ii) as in effect on December 17, 2019. ■ Par. 25. Amend § 1.965–5 by: ■ 1. Redesignating paragraph (b) as paragraph (b)(1). ■ 2. Adding new introductory text for paragraph (b). ■ 3. Revising the heading of newly redesignated paragraph (b)(1). ■ 4. Adding paragraph (b)(2). The revision and additions read as follows: § 1.965–5 Allowance of a credit or deduction for foreign income taxes. * E:\FR\FM\17DEP2.SGM * * 17DEP2 * * 69178 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules (b) Rules for foreign income taxes paid or accrued—(1) In general. * * * (2) Attributing taxes to section 959(a) distributions of section 965 previously taxed earnings and profits. For purposes of paragraph (b)(1) of this section, foreign income taxes are attributable to a distribution of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits if such taxes would be allocated and apportioned to a distribution of such previously taxed earnings and profits under the principles of § 1.904–6(a)(1)(iv), regardless of whether an actual distribution is made or recognized for Federal income tax purposes. Therefore, for example, a credit or deduction for the applicable percentage of foreign income taxes imposed on a United States shareholder that pays foreign tax on a distribution that is not recognized for Federal income tax purposes (for example, in the case of a consent dividend or stock dividend upon which a withholding tax is imposed) is not allowed under paragraph (b)(1) of this section to the extent it is attributable to a distribution of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits under the principles of § 1.904–6(a)(1)(iv). For taxable years of foreign corporations beginning after December 31, 2019, in lieu of applying the principles of § 1.904–6 under this paragraph (b)(2), the rules in § 1.861–20 apply by treating the portion of a distribution attributable to section 965(a) previously taxed earnings and profits and the portion of a distribution attributable to section 965(b) previously taxed earnings and profits each as a statutory grouping, and the portion of the distribution that is attributable to other earnings and profits as the residual grouping. See § 1.861–20(g)(7) (Example 6). * * * * * ■ Par. 26. Section 1.965–9 is amended by adding a sentence to the end of paragraph (c) to read as follows: § 1.965–9 Applicability dates. jbell on DSKJLSW7X2PROD with PROPOSALS2 * * * * * (c) * * * Section 1.965–5(b)(2) applies to taxable years of foreign corporations that end on or after December 16, 2019, and with respect to a United States person, to the taxable years in which or with which such taxable years of the foreign corporations end. ■ Par. 27. Section 1.1502–4 is revised to read as follows: VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 § 1.1502–4 Consolidated foreign tax credit. (a) In general. The credit under section 901 for taxes paid or accrued to any foreign country or possession of the United States is allowed to the group only if the agent for the group (as defined in § 1.1502–77(a)) chooses to use the credit in the computation of the consolidated tax liability of the group for the consolidated return year. If that choice is made, section 275(a)(4) provides that no deduction against taxable income may be taken on the consolidated return for foreign taxes paid or accrued by any member. However, if section 275(a)(4) does not apply, a deduction against consolidated taxable income may be allowed for certain taxes for which a credit is not allowed, even though the choice is made to claim a credit for other taxes. See, for example, sections 901(j)(3), 901(k)(7), 901(l)(4), 901(m)(6), and 908(b). (b) Computation of foreign tax credit. The foreign tax credit for the consolidated return year is determined on a consolidated basis under the principles of sections 901 through 909 and 960. Taxes paid or accrued to all foreign countries and possessions by members of the group for the year (including those deemed paid under section 960 and paragraph (d) of this section) must be aggregated. (c) Computation of limitation on credit. For purposes of computing the group’s limiting fraction under section 904, the following rules apply: (1) Computation of taxable income from foreign sources—(i) Separate categories. The group must compute a separate foreign tax credit limitation for income in each separate category (as defined in § 1.904–5(a)(4)(v) for purposes of this section). The numerator of the limiting fraction in any separate category is the consolidated taxable income of the group determined in accordance with § 1.1502–11, taking into account adjustments required under section 904(b), if any, from sources without the United States in that category, determined in accordance with the rules of § 1.904–4, 1.904–5, and the section 861 regulations (as defined in § 1.861–8(a)(1)). (ii) Adjustments under sections 904(f) and (g). The rules for allocation and recapture of separate limitation losses and overall foreign losses under section 904(f) and § 1.1502–9 apply to determine the foreign source and U.S. source taxable income in each separate category of the consolidated group. Similarly, the rules for allocation and recapture of overall domestic losses under section 904(g) and § 1.1502–9 apply to determine the foreign source PO 00000 Frm 00055 Fmt 4701 Sfmt 4702 and U.S. source taxable income in each separate category of the consolidated group. See § 1.904(g)–3 for allocation rules under sections 904(f) and 904(g). The rules of sections 904(f) and 904(g) do not operate to recharacterize foreign income tax attributable to any separate category. (iii) Computation of consolidated net operating loss. The source and separate category of the group’s consolidated net operating loss (‘‘CNOL’’), as that term is defined in § 1.1502–21(e), for the taxable year, if any, is determined based on the amounts of any separate limitation losses and U.S. source loss that are not allocated to reduce U.S. source income or income in other separate categories under the rules of sections 904(f) and 904(g) in computing the group’s consolidated foreign tax credit limitations for the taxable year under paragraphs (c)(1)(i) and (ii) of this section. (iv) Characterization of CNOL carried to a separate return year—(A) In general. The total amount of CNOL attributable to a member that is carried to a separate return year is determined under the rules of § 1.1502–21(b)(2). The source and separate category of the portion of the CNOL that is attributable to a member is determined under this paragraph (c)(1)(iv). (B) Tentative apportionment. For the portion of the CNOL that is attributable to the member described in paragraph (c)(1)(iv) of this section, the consolidated group determines a tentative allocation and apportionment to each statutory and residual grouping (as described in § 1.861–8(a)(4) with respect to section 904 as the operative section) under the principles of § 1.1502–9(c)(2)(i), (ii), (iv) and (v) by treating the portion of the group’s CNOL in each statutory and residual grouping as if it were a CSLL account, as that term is described in § 1.1502–9(b)(4). This determination is made as of the end of the taxable year of the consolidated group in which the CNOL arose or, if earlier and applicable, when the member leaves the consolidated group. (C) Adjustments—(1) If the total tentative apportionment for all statutory and residual groupings exceeds the portion of the CNOL attributable to the member described in paragraph (c)(1)(iv)(A) of this section (the ‘‘excess amount’’), then the tentative apportionment in each grouping is reduced by an amount equal to the excess amount multiplied by a fraction, the numerator of which is the tentative apportionment in that grouping, and the denominator of which is the total tentative apportionments in all groupings. E:\FR\FM\17DEP2.SGM 17DEP2 69179 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules (2) If the total tentative apportionment for all statutory and residual groupings is less than the total CNOL attributable to the member described in paragraph (c)(1)(iv)(A) (the ‘‘deficiency’’), then the tentative apportionment in each grouping is increased by an amount equal to the deficiency multiplied by a fraction, the numerator of which is the CNOL in that grouping that was not tentatively apportioned, and the denominator of which is the total CNOL in all groupings that was not tentatively apportioned. (v) Consolidated net capital losses. The principles of the rules in paragraphs (c)(1)(i) through (iv) of this section apply for purposes of determining the source and separate category of consolidated net capital losses described in § 1.1502–22(e). (2) Computation of consolidated taxable income. The denominator of the limiting fraction in any separate category is the consolidated taxable income of the group determined in accordance with § 1.1502–11, taking into account adjustments required under section 904(b), if any. (3) Computation of tax against which credit is taken. The tax against which the limiting fraction under section 904(a) is applied will be the consolidated tax liability of the group determined under § 1.1502–2, but without regard to § 1.1502–2(a)(2), (3), (4), (8), and (9), and without regard to any credit against such liability. See sections 26(b) and 901(a). (d) Carryover and carryback of unused foreign tax—(1) Allowance of unused foreign tax as consolidated carryover or carryback. The consolidated group’s carryovers and carrybacks of unused foreign tax (as defined in § 1.904–2(c)(1)) to the taxable year is determined on a consolidated basis under the principles of section 904(c) and § 1.904–2 and is deemed to be paid or accrued to a foreign country or possession for that year. The consolidated group’s unused foreign tax carryovers and carrybacks to the taxable year consist of any unused foreign tax of the consolidated group, plus any unused foreign tax of members for separate return years, which may be carried over or back to the taxable year under the principles of section 904(c) and § 1.904–2. The consolidated group’s unused foreign tax carryovers and carrybacks do not include any unused foreign taxes apportioned to a corporation for a separate return year pursuant to § 1.1502–79(d). A consolidated group’s unused foreign tax in each separate category is the excess of the foreign taxes paid, accrued or deemed paid under section 960 by the consolidated group over the limitation in the applicable separate category for the consolidated return year. See paragraph (c) of this section. (2) Absorption rules. For purposes of determining the amount, if any, of an unused foreign tax which can be carried to a taxable year (whether a consolidated or separate return year), the amount of the unused foreign tax that is absorbed in a prior consolidated return year under section 904(c) shall be determined by— (i) Applying all unused foreign taxes which can be carried to a prior year in the order of the taxable years in which those unused foreign taxes arose, beginning with the taxable year that ends earliest, and (ii) All the unused foreign taxes which can be carried to such prior year from taxable years ending on the same date on a pro rata basis. (e) Example. The following example illustrates the application of this section: (1) Facts—(i) Domestic corporation P is incorporated on January 1, Year 1. On that same day, P incorporates domestic corporations S and T as wholly owned subsidiaries. P, S, and T file consolidated returns for Years 1 and 2 on the basis of a calendar year. T engages in business solely through a qualified business unit in Country A. S engages in business solely through qualified business units in countries A and B. P does business solely in the United States. During Year 1, T sold an item of inventory to P at a gain of $2,000. Under § 1.1502–13 the intercompany gain has not been taken into account as of the close of Year 1. The taxable income of each member for Year 1 from foreign and U.S. sources, and the foreign taxes paid on such foreign income, are as follows: jbell on DSKJLSW7X2PROD with PROPOSALS2 TABLE 1 TO PARAGRAPH (e)(1)(i) Corporation U.S. source taxable income Foreign branch category foreign source taxable income Foreign branch category foreign tax paid P ............................................................................................... T ............................................................................................... S ............................................................................................... $40,000 .............................. .............................. .............................. $20,000 20,000 .............................. $12,000 9,000 $40,000 20,000 20,000 Group ................................................................................ .............................. .............................. .............................. 80,000 (ii) The separate taxable income of each member was computed by taking into account the rules under § 1.1502–12. Accordingly, T’s intercompany gain of $2,000 is not included in T’s taxable income for Year 1. The group’s consolidated taxable income (computed in accordance with § 1.1502–11) is $80,000. The consolidated tax liability against which the credit may be taken (computed in accordance with paragraph (c)(3) of this section) is $16,800. (2) Analysis. The aggregate taxes paid to all foreign countries with respect to the foreign branch category income of $21,000 ($12,000 + $9,000) is limited to $8,400 ($16,800 × $40,000/$80,000). Assuming P, as the agent for the group, chooses to use the foreign taxes VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 paid as a credit, the group may claim a $8,400 foreign tax credit. (f) Applicability date. This section applies to taxable years for which the original consolidated Federal income tax return is due (without extensions) after December 17, 2019. ■ Par. 28. Section 1.1502–21 is amended by adding a sentence to the end of paragraph (b)(2)(iv)(B) to read as follows: § 1.1502–21. * * * (b) * * * (2) * * * PO 00000 Frm 00056 Net operating losses. * (iv) * * * (B) * * * The source and section 904(d) separate category of the CNOL attributable to a member is determined under § 1.1502–4(c)(1)(iii). * * * * * PART 301—PROCEDURE AND ADMINISTRATION Par. 29. The authority citation for part 301 is amended by adding an entry for § 301.6689–1, to read in part as follows: ■ * Authority: 26 U.S.C. 7805. * Fmt 4701 Sfmt 4702 Total taxable income E:\FR\FM\17DEP2.SGM * * 17DEP2 * * 69180 Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / Proposed Rules Section 301.6689–1 also issued under 26 U.S.C. 6689(a), 26 U.S.C. 6227(d), and 26 U.S.C. 6241(11). * * * * * Par. 30. Section 301.6227–1 is amended by adding paragraph (g) to read as follows: ■ § 301.6227–1 Administrative adjustment request by partnership. * * * * * (g) Notice requirement and partnership adjustments required as a result of a foreign tax redetermination. For special rules applicable when an adjustment to a partnership related item (as defined in section 6241(2)) is required as part of a redetermination of U.S. tax liability under section 905(c) and § 1.905–3(b) of this chapter as a result of a foreign tax redetermination (as defined in § 1.905–3(a) of this chapter), see § 1.905–4(b)(2)(ii) of this chapter. * * * * * ■ Par. 31. Section 301.6689–1, as proposed to be added at 72 FR 62807 (November 7, 2007), is further revised to read as follows: § 301.6689–1 Failure to file notice of redetermination of foreign income taxes. jbell on DSKJLSW7X2PROD with PROPOSALS2 (a) Application of civil penalty. If a foreign tax redetermination occurs, and the taxpayer failed to notify the Internal Revenue Service (IRS) on or before the date and in the manner prescribed in § 1.905–4 of this chapter, or as required under section 404A(g)(2), for giving VerDate Sep<11>2014 19:51 Dec 16, 2019 Jkt 250001 notice of a foreign tax redetermination, then, unless paragraph (d) of this section applies, there is added to the deficiency (or the imputed underpayment as determined under section 6225) attributable to such redetermination an amount determined under paragraph (b) of this section. Subchapter B of chapter 63 of the Internal Revenue Code (relating to deficiency proceedings) does not apply with respect to the assessment of the amount of the penalty. (b) Amount of the penalty. The amount of the penalty shall be equal to— (1) Five percent of the deficiency (or imputed underpayment) if the failure is for not more than one month, plus (2) An additional five percent of the deficiency (or imputed underpayment) for each month (or fraction thereof) during which the failure continues, but not to exceed in the aggregate twentyfive percent of the deficiency (or imputed underpayment). (c) Foreign tax redetermination defined. For purposes of this section, a foreign tax redetermination is any redetermination for which a notice is required under sections 905(c) or 404A(g)(2). See §§ 1.905–3 through 1.905–5 of this chapter for rules relating to the notice requirement under section 905(c). (d) Reasonable cause. The penalty set forth in this section shall not apply if it is established to the satisfaction of the IRS that the failure to file the PO 00000 Frm 00057 Fmt 4701 Sfmt 9990 notification within the prescribed time was due to reasonable cause and not due to willful neglect. An affirmative showing of reasonable cause must be made in the form of a written statement that sets forth all the facts alleged as reasonable cause for the failure to file the notification on time and that contains a declaration by the taxpayer that the statement is made under the penalties of perjury. This statement must be filed with the Internal Revenue Service Center in which the notification was required to be filed. The taxpayer must file this statement with the notice required under section 905(c) or section 404A(g)(2). If the taxpayer exercised ordinary business care and prudence and was nevertheless unable to file the notification within the prescribed time, then the delay will be considered to be due to reasonable cause and not willful neglect. (e) Applicability date. This section applies to foreign tax redeterminations occurring in taxable years ending on or after December 16, 2019, and to foreign tax redeterminations of foreign corporations occurring in taxable years that end with or within a taxable year of a United States shareholder ending on or December 16, 2019. Sunita Lough, Deputy Commissioner for Services and Enforcement. [FR Doc. 2019–24847 Filed 12–16–19; 8:45 am] BILLING CODE 4830–01–P E:\FR\FM\17DEP2.SGM 17DEP2

Agencies

[Federal Register Volume 84, Number 242 (Tuesday, December 17, 2019)]
[Proposed Rules]
[Pages 69124-69180]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-24847]



Federal Register / Vol. 84, No. 242 / Tuesday, December 17, 2019 / 
Proposed Rules

[[Page 69124]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 301

[REG-105495-19]
RIN 1545-BP21


Guidance Related to the Allocation and Apportionment of 
Deductions and Foreign Taxes, Financial Services Income, Foreign Tax 
Redeterminations, Foreign Tax Credit Disallowance Under Section 965(g), 
and Consolidated Groups

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations that provide 
guidance relating to the allocation and apportionment of deductions and 
creditable foreign taxes, the definition of financial services income, 
foreign tax redeterminations, availability of foreign tax credits under 
the transition tax, and the application of the foreign tax credit 
limitation to consolidated groups.

DATES: Written or electronic comments and requests for a public hearing 
must be received by February 18, 2020.

ADDRESSES: Send electronic submissions via the Federal eRulemaking 
Portal at www.regulations.gov (indicate IRS and REG-105495-19) by 
following the online instructions for submitting comments. Once 
submitted to the Federal eRulemaking Portal, comments cannot be edited 
or withdrawn. The Department of the Treasury (the ``Treasury 
Department'') and the IRS will publish for public availability any 
comment received to its public docket, whether submitted electronically 
or in hard copy. Send hard copy submissions to: CC:PA:LPD:PR (REG-
105495-19), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben 
Franklin Station, Washington, DC 20044. Submissions may be hand 
delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. 
to CC:PA:LPD:PR (REG-105495-19), Courier's Desk, Internal Revenue 
Service, 1111 Constitution Avenue NW, Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations 
under Sec. Sec.  1.861-8, 1.861-9(b), 1.861-12, 1.861-14, 1.861-17, and 
1.954-2(h), Jeffrey P. Cowan, (202) 317-4924; concerning Sec. Sec.  
1.704-1, 1.861-9(e), 1.904-4(e), 1.904(b)-3, 1.904(g)-3, 1.1502-4, and 
1.1502-21, Jeffrey L. Parry, (202) 317-4916; concerning Sec. Sec.  
1.861-20, 1.904-6, 1.960-1, and 1.960-7, Suzanne M. Walsh, (202) 317-
4908; concerning Sec. Sec.  1.904-4(c), 1.905-3, 1.905-4, 1.905-5, 
1.954-1, 301.6227-1, and 301.6689-1, Larry R. Pounders, (202) 317-5465; 
concerning Sec. Sec.  1.965-5 and 1.965-9, Karen J. Cate, (202) 317-
4667; concerning submissions of comments and requests for a public 
hearing, Regina Johnson, (202) 317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    On December 7, 2018, the Treasury Department and the IRS published 
proposed regulations (REG-105600-18) relating to foreign tax credits in 
the Federal Register (83 FR 63200) (the ``2018 FTC proposed 
regulations''). Those regulations addressed several significant changes 
that the Tax Cuts and Jobs Act (Pub. L. 115-97, 131 Stat. 2054, 2208 
(2017)) (the ``TCJA'') made with respect to the foreign tax credit 
rules and related rules for allocating and apportioning deductions in 
determining the foreign tax credit limitation. The preamble to those 
proposed regulations requested comments on how to modify the existing 
approaches for allocating and apportioning deductions, including in 
particular the rules under Sec.  1.861-17 for allocating and 
apportioning research and experimentation (``R&E'') expenditures. The 
2018 FTC proposed regulations are finalized in the Rules and 
Regulations section of this issue of the Federal Register (the ``2019 
FTC final regulations'').
    On June 25, 2012, the Federal Register published a notice of 
proposed rulemaking at 77 FR 37837 (the ``2012 OFL proposed 
regulations'') proposing rules for the coordination of the rules for 
determining high-taxed passive income with required adjustments to the 
foreign tax credit limitation in respect of capital gains and the 
allocation and recapture of overall foreign losses and overall domestic 
losses, as well as the coordination of the recapture of overall foreign 
losses on certain dispositions of property and other rules concerning 
overall foreign losses and overall domestic losses. The 2012 OFL 
proposed regulations are finalized in the 2019 FTC final regulations.
    On November 7, 2007, the Federal Register published temporary 
regulations (T.D. 9362) at 72 FR 62771 and a notice of proposed 
rulemaking by cross-reference to the temporary regulations at 72 FR 
62805 relating to sections 905(c), 986(a), and 6689. Portions of these 
temporary regulations are finalized in the 2019 FTC final regulations.
    This document contains proposed regulations (the ``proposed 
regulations'') addressing the following issues: (1) The allocation and 
apportionment of deductions under sections 861 through 865, including 
new rules on the allocation and apportionment of R&E expenditures and 
certain deductions of life insurance companies; (2) the definition of 
financial services income under section 904(d)(2)(D); (3) the 
allocation and apportionment of creditable foreign taxes; (4) the 
interaction of the branch loss and dual consolidated loss recapture 
rules with sections 904(f) and (g); (5) the effect of foreign tax 
redeterminations of foreign corporations on the application of the 
high-tax exception described in section 954(b)(4) (including for 
purposes of determining tested income under section 
951A(c)(2)(A)(i)(III)), and required notifications under section 905(c) 
to the IRS of foreign tax redeterminations and related penalty 
provisions; (6) the definition of foreign personal holding company 
income under section 954; (7) the application of the foreign tax credit 
disallowance under section 965(g); and (8) the application of the 
foreign tax credit limitation to consolidated groups.

Explanation of Provisions

I. Allocation and Apportionment of Deductions and the Calculation of 
Taxable Income for Purposes of Section 904(a)

A. Stewardship Expenses, Litigation Damages Awards and Settlement 
Payments, Net Operating Losses, and Interest Expense

1. Stewardship Expenses
    Under Sec.  1.861-8(e)(4)(i), stewardship expenses are definitely 
related and allocable to dividends received or to be received from 
related corporations. This reflects a determination that stewardship 
expenses are, at least in part, intended to protect the shareholder's 
capital investment and thus are factually related to the income that 
arises from the investment. Before the enactment of the TCJA, taxpayers 
with foreign subsidiaries often included in their income foreign source 
income only when that income was distributed to the taxpayer. However, 
as a result of the enactment of sections 951A and 245A, a significant 
portion of the foreign source income of foreign subsidiaries is 
included in income on a current basis or not at all. The Treasury 
Department and the IRS are aware that some taxpayers may be 
interpreting the ``dividends received, or to be received'' phrase in 
Sec.  1.861-8(e)(4)(ii) to exclude the gross up amount treated as a 
dividend under section 78 (the ``section

[[Page 69125]]

78 dividend''), as well as inclusions under section 951(a)(1), section 
951A, and similar provisions, even though the stewardship expenses may 
be factually related to such gross income.
    With respect to the allocation of stewardship expenses, income 
arising because of one's capital investment in a foreign corporation's 
stock ordinarily includes not only dividends, but also inclusions under 
sections 951 and 951A, as well as amounts included under sections 1291, 
1293, and 1296 (the ``passive foreign investment company provisions''). 
Therefore, the proposed regulations provide that stewardship expenses 
are allocated to dividends and inclusions received or accrued, or to be 
received or accrued, from related corporations.\1\ Thus, stewardship 
expenses are also allocated to inclusions under sections 951 and 951A, 
section 78 dividends, and all amounts included under the passive 
foreign investment company provisions.
---------------------------------------------------------------------------

    \1\ Duplicative activities or shareholder activities giving rise 
to stewardship expenses can only be performed with respect to 
members of a controlled group as described in Sec.  1.482-
9(l)(3)(iii)-(iv). Accordingly, relatedness in the context of 
stewardship expenses includes taxpayers that are members of the same 
controlled group as defined in Sec.  1.482-1(i)(6). A taxpayer could 
incur stewardship expenses with respect to a related foreign 
corporation that is a passive foreign investment company (in 
addition to a related foreign corporation that is a controlled 
foreign corporation).
---------------------------------------------------------------------------

    With respect to apportionment, the current regulations do not 
provide an explicit rule but instead provide examples of permissible 
methods. The Treasury Department and the IRS have determined that an 
explicit rule would provide certainty for taxpayers and the IRS on the 
appropriate methodology for apportioning stewardship expenses while 
ensuring that stewardship expenses are apportioned to gross income in a 
manner that reflects the purpose of the expenses to protect capital 
investments or to facilitate compliance with reporting, legal, or 
regulatory requirements. Therefore, the proposed regulations provide 
that stewardship expenses are apportioned based upon the relative 
values of a taxpayer's stock assets, as determined and characterized 
under Sec.  1.861-9T(g) (and, as relevant, Sec. Sec.  1.861-12 and 
1.861-13) for purposes of allocating and apportioning the taxpayer's 
interest expense. Therefore, a taxpayer will be required to use the 
same method to characterize and value its stock assets for purposes of 
allocating and apportioning its interest and stewardship expenses, and, 
in some cases as described in Part 1.A.2 of this Explanation of 
Provisions, certain damages payments. Accordingly, since the fair 
market value method may not be used for interest allocation and 
apportionment, it may also not be used for stewardship and certain 
damages payments. Conforming changes are also proposed with respect to 
Sec.  1.861-14T(e)(4), which provides rules for the treatment of 
stewardship expenses with respect to an affiliated group. See also 
Sec.  1.861-8(g)(18) (Example 18) for an example illustrating the 
application of the proposed rules for stewardship expenses.
    The Treasury Department and the IRS are aware that stewardship 
expenses that are incurred to facilitate compliance with reporting, 
legal, or regulatory requirements may be more appropriately treated as 
definitely related to the gross income produced by the particular 
asset, or assets, whose ownership required the stewardship expenditure. 
For example, the owner of an entity in a particular jurisdiction might 
have unique reporting requirements not triggered by the ownership of a 
similar entity in a different jurisdiction. The Treasury Department and 
the IRS request comments regarding exceptions to the general rule for 
the allocation and apportionment of stewardship expenses where it is 
more appropriate to treat stewardship expenses as definitely related to 
a more limited class of gross income. Comments are also requested on 
whether it is more appropriate in certain cases to allocate and 
apportion stewardship expenses on a separate entity, rather than an 
affiliated group, basis.
    The proposed regulations maintain the definition of stewardship 
expenses as a duplicative activity (as defined in Sec.  1.482-
9(l)(3)(iii)) or a shareholder activity (as defined in Sec.  1.482-
9(l)(3)(iv)). See proposed Sec.  1.861-8(e)(4)(ii)(A). In particular, 
shareholder activities are those that preserve the shareholder's 
capital investment or facilitate compliance with reporting, regulatory, 
or legal requirements. See Sec.  1.482-9(l)(3)(iv). However, the 
Treasury Department and the IRS are aware that it may be difficult for 
taxpayers to distinguish between stewardship expenses that result from 
oversight functions and expenses that are supportive in nature, as 
described in Sec.  1.861-8(b)(3), and are concerned that expenses may 
be misclassified as either stewardship or supportive expenses in 
certain cases. For example, day-to-day management activities do not 
give rise to stewardship expenses and are typically more supportive in 
nature. However, the distinction between day-to-day management and 
oversight may change over time as a taxpayer's investments change. 
Given these concerns, the Treasury Department and the IRS request 
comments regarding the definition of stewardship expenses and how to 
readily distinguish such expenses from supportive expenses that are 
allocated and apportioned under Sec.  1.861-8(b)(3).
    The proposed regulations extend the treatment of stewardship 
expenses to cover expenses incurred with respect to a partnership. See 
proposed Sec.  1.861-8(e)(4)(ii)(D). Rules similar to those with 
respect to corporations apply to allocate and apportion stewardship 
expenses incurred with respect to partnerships.
    Finally, the Treasury Department and the IRS are considering 
whether additional changes to the rules for allocating and apportioning 
stewardship and similar expenses are appropriate in light of the 
enactment of the TCJA, and in order to better reflect modern business 
practices that are increasingly global and mobile in nature. Comments 
are requested on this topic.
2. Litigation Damages Awards, Prejudgment Interest, and Settlement 
Payments
    The current rule for the allocation and apportionment of legal and 
accounting fees and expenses in Sec.  1.861-8(e)(5) does not 
specifically address damages awards, prejudgment interest, or 
settlement payments arising from product liability and similar claims. 
The Treasury Department and the IRS are aware that large, unplanned, 
and relatively rare expenses can have a significant effect on the 
calculation of a taxpayer's taxable income and foreign tax credit 
limitation, and, in the absence of clear rules, disputes have arisen 
regarding the proper treatment of such expenses. Proposed Sec.  1.861-
8(e)(5) provides that deductions for damages awards, prejudgment 
interest, and settlement payments arising from product liability and 
similar or related claims are allocated to the class or classes of 
gross income produced by the specific sales of products or services 
that gave rise to the claims for damage or injury. Damages, prejudgment 
interest, and settlement payments related to events incident to the 
production of goods or provision of services, such as damages for 
injuries caused by industrial accidents, are allocated to the class of 
gross income produced by the assets involved in the event and, if 
necessary, apportioned between groupings based on the relative value of 
the assets in such groupings. In the case of claims made by investors 
that arise from corporate negligence, fraud, or other malfeasance, the

[[Page 69126]]

proposed regulations provide that damages, prejudgment interest, and 
settlement payments paid by the corporation are allocated and 
apportioned based on the value of all the corporation's assets. In 
general, the deductions are allocated and apportioned to the statutory 
or residual groupings to which the related income would be assigned if 
recognized in the taxable year in which the deductions are allowed.
3. Net Operating Loss Deductions
    Under current rules, a net operating loss deduction is allocated 
and apportioned in the same manner as the deductions giving rise to the 
net operating loss deduction. However, the rule does not specify how 
the statutory and residual grouping components of a net operating loss 
are determined. See Sec.  1.861-8(e)(8). The proposed regulations 
provide that a net operating loss is assigned to the statutory and 
residual groupings by reference to the losses in each statutory or 
residual grouping (determined without regard to adjustments made under 
section 904(b)) that are not allocated to reduce income in a different 
grouping in the taxable year of the loss. See proposed Sec.  1.861-
8(e)(8)(i). Furthermore, the proposed regulations clarify that a net 
operating loss deduction for a taxable year is allocated and 
apportioned by reference to the statutory and residual grouping 
components of the net operating loss that is deducted in the taxable 
year. See proposed Sec.  1.861-8(e)(8)(ii). Finally, the proposed 
regulations provide that except as provided in regulations, for 
example, in Sec.  1.904(g)-3, a partial net operating loss deduction is 
treated as ratably comprising the components of the net operating 
loss.\2\ See id.
---------------------------------------------------------------------------

    \2\ A partial net operating loss deduction occurs when the full 
net operating loss is not deductible in the carryover year.
---------------------------------------------------------------------------

    In connection with the proposed regulations under section 250, 
comments requested clarification on the application of Sec.  1.861-
8(e)(8) with respect to net operating losses arising prior to the 
enactment of the TCJA when the net operating loss is deducted in a 
post-TCJA year for purposes of applying section 250 as the operative 
section. See 84 FR 8188 (March 6, 2019). These comments will be 
addressed as part of finalizing those proposed regulations.
4. Application of the Exempt Income/Asset Rule to Insurance Companies 
in Connection With Certain Dividends and Tax-Exempt Interest
    As explained in Part II.B.2 of the Summary of Comments and 
Explanation of Revisions to the 2019 FTC final regulations, one comment 
to the 2018 FTC proposed regulations suggested that insurance companies 
reduce exempt income and assets to reflect prorated amounts of 
dividends and tax exempt interest. See sections 805(a)(4), 807, 812, 
and 832(b)(5)(B). The 2019 FTC final regulations do not address this 
issue, and the proposed regulations do not adopt this comment.
    Under subchapter L, a nonlife insurance company includes in income 
its underwriting income, which consists of premiums earned on insurance 
contracts during the taxable year less losses incurred and expenses 
incurred. The proration rules reduce the company's losses incurred by 
the ``applicable percentage'' of tax exempt interest or deductible 
dividends received. See section 832(b)(5)(B). For a life insurance 
company, the proration rules apply in the case of tax exempt interest 
by reducing the closing balance of reserve items by the 
``policyholder's share'' (currently a fixed percentage, originally 
intended to be the portion of tax favored investment income used to 
fund the company's obligations to policyholders) of tax exempt 
interest. See sections 807(b)(1)(B) and 812. Similarly, a life 
insurance company is allowed a dividends received deduction (DRD) for 
intercorporate dividends from non-affiliates only in proportion to the 
``company's share'' of the dividends, but not for the policyholder's 
share. See section 805(a)(4)(A). Fully deductible dividends from 
affiliates are excluded from proration for life insurance companies if 
the dividends are not themselves distributions from tax exempt interest 
or from dividend income that would not be fully deductible if received 
directly by the taxpayer.
    While the mechanics of the proration rules differ depending on 
whether a company is a life or nonlife insurance company and whether 
the amount relates to dividends or tax exempt interest, the purpose of 
those provisions is the same. That is, the policyholder's share or 
applicable percentage of dividends and tax exempt interest should not 
create a double benefit by reason of a DRD or section 103 tax exemption 
for interest in the first instance and a reduction to income (via 
increases in unpaid losses and reserves during the taxable year) in the 
second. Regardless of the mechanics, however, the policyholder's share 
and applicable percentage adjustments do not change the fact that tax 
exempt interest and (for a nonlife insurance company) the applicable 
percentage of dividends eligible for DRDs remain exempt from U.S. tax. 
Including those exempt amounts and the corresponding exempt assets in 
the apportionment formula in allocating expenses under Sec.  1.861-
8T(d)(2)(i)(B), as the comment suggests, would effectively apportion 
reserve deductions (which already do not include the disallowed 
deductions deemed to be attributable to the exempt income, except in 
the case of the policyholder's share of life insurance DRDs) to exempt 
U.S. source income, with the result that those deductions would reduce 
unrelated U.S. source income, in contravention of the rule in Sec.  
1.861-8T(d)(2)(i)(B). See also Travelers Insurance Company v. United 
States, 303 F.3d 1373 (2002).
    The current regulations already provide the appropriate rules in 
this area. Section 1.861-8T(d)(2)(ii)(B) provides that the 
policyholder's share of dividends received by a life insurance company 
is treated as tax exempt income notwithstanding the partial 
disallowance of the DRD, and Sec.  1.861-14T(h) provides for the direct 
allocation to the dividends of an amount of reserve expenses equal to 
the disallowed portion of the DRDs. The current regulations do not 
provide a special rule for either tax exempt interest of a life 
insurance company or DRDs and tax exempt interest of a nonlife 
insurance company because, when a policyholder's share or applicable 
percentage is accounted for as either a reserve adjustment or a 
reduction to losses incurred, no further modification to the generally 
applicable rules is required to ensure that the appropriate amount of 
expenses are apportioned to U.S. source income.
    Nevertheless, in order to provide greater clarity, the proposed 
regulations provide in proposed Sec.  1.861-8(d)(2)(ii)(B), (d)(2)(v), 
and (e)(16) the effect of certain deduction limitations on the 
treatment of income and assets generating dividends received deductions 
and tax exempt interest held by insurance companies. More specifically, 
the proposed regulations provide that in the case of insurance 
companies, the term exempt income includes dividends for which a 
deduction is provided by sections 243(a)(1) and (2) and 245, without 
regard to the proration rules disallowing a portion of the deduction. 
Similarly, the term exempt income includes tax exempt interest without 
regard to the proration rules. These provisions apply on a company wide 
basis and therefore include each separate account of the company. Two 
examples are provided in proposed Sec.  1.861-8(d)(2)(v)(B) that 
illustrate the application of these rules.

[[Page 69127]]

5. Other Requests for Comments on Expense Allocation
    The Treasury Department and the IRS continue to study the rules for 
allocating and apportioning interest deductions. In addition, the 
Treasury Department and the IRS expect the implementation of section 
864(f) (which is effective for taxable years beginning after December 
31, 2020) will have a significant impact on the effect of interest 
expense apportionment and will necessitate a reexamination of the 
existing expense allocation rules. Therefore, the Treasury Department 
and the IRS are studying whether further guidance with respect to 
allocation and apportionment of interest expense, taking into account 
the changes made by the TCJA and the future implementation of section 
864(f), is required. Comments are requested on this topic.
    The Treasury Department and the IRS are also considering whether 
rules providing for the capitalization and amortization of certain 
expenses solely for purposes of Sec.  1.861-9 may better reflect asset 
values under the tax book value method. For example, solely for 
purposes of Sec.  1.861-9, research and experimental expenditures and 
advertising expenses could be treated as if they were capitalized and 
amortized. Comments are requested on this topic.
    As noted in Part III.B.4.iii of the Summary of Comments and 
Explanation of Revisions to the 2019 FTC final regulations, the 
Treasury Department and the IRS are studying whether additional rules 
for allocating and apportioning expenses to foreign branch category 
income or limiting the amount of the gross income reallocated as a 
result of certain disregarded payments are appropriate. Comments are 
requested on whether such special rules would more accurately reflect 
the business profits of a foreign branch, while maintaining 
administrability for taxpayers and the IRS.

B. Certain Loans Made by Partnerships to Partners

    The 2018 FTC proposed regulations included rules addressing the 
source and separate category of interest income and expense related to 
loans to a partnership by a U.S. person (or a member of its affiliated 
group) that owns an interest (directly or indirectly) in the 
partnership. These rules were finalized in the 2019 FTC final 
regulations. See Sec.  1.861.9(e)(8).
    As discussed in Part II.C.1 of the Summary of Comments and 
Explanation of Revisions of the 2019 FTC final regulations, several 
comments to the 2018 FTC proposed regulations requested that the rules 
under Sec.  1.861-9(e)(8) with respect to specified partnership loans 
be expanded to cover loans made by a partnership to a partner (an 
``upstream partnership loan''). The Treasury Department and the IRS 
agree with comments that rules addressing upstream partnership loans 
would reduce distortions that could otherwise affect the foreign tax 
credit limitation. Therefore, the comments are adopted in proposed 
Sec.  1.861-9(e)(9)(ii), which generally provides that, to the extent 
the borrower in an upstream partnership loan transaction takes into 
account both interest expense and interest income with respect to the 
same loan, the interest income is assigned to the same statutory and 
residual groupings as those groupings from which the matching amount of 
interest expense is deducted, as determined under the allocation and 
apportionment rules in Sec. Sec.  1.861-9 through 1.861-13. 
Additionally, proposed Sec.  1.861-9(e)(9)(i) provides that, for 
purposes of applying the allocation and apportionment rules, the 
borrower does not take into account as an asset its proportionate share 
of the loan, as otherwise provided under Sec.  1.861-9(e)(2) and (3). 
Proposed Sec.  1.861-9(e)(8)(iv) also applies the upstream partnership 
loan rules to transactions that are not loans but that give rise to 
deductions that are allocated and apportioned in the same manner as 
interest expense under Sec.  1.861-9T(b). An anti-avoidance rule 
similar to the rule in Sec.  1.861-9(e)(8)(iii) is included to cover 
back-to-back third-party loans that are intended to circumvent the 
purposes of the rules. See proposed Sec.  1.861-9(e)(8)(iii). These 
rules are being proposed in order to provide taxpayers an additional 
opportunity to comment on the rule.
    Additionally, the Treasury Department and the IRS are aware that 
some taxpayers may be converting existing partnership debt structures 
that were used to increase a taxpayer's foreign tax credit limitation 
before the issuance of Sec.  1.861-9(e)(8) from partnership debt into 
partnership equity that provides for guaranteed payments for the use of 
capital. The taxpayer then takes the position that the guaranteed 
payments are neither allocated and apportioned under the rules in Sec.  
1.861-9 nor included in subpart F income by reason of Sec.  1.954-2(h).
    Guaranteed payments for the use of capital are similar to a loan 
from the partner to the partnership because the payment is for the use 
of money and is generally deductible. See section 707(c). Because these 
arrangements raise the same policy concerns as ordinary debt 
instruments, the proposed regulations revise Sec.  1.861-9(b) and Sec.  
1.954-2(h)(2)(i) explicitly to provide that guaranteed payments for the 
use of capital described in section 707(c) are treated similarly to 
interest deductions for purposes of allocating and apportioning 
deductions under Sec. Sec.  1.861-8 through 1.861-14 and are treated as 
income equivalent to interest under section 954(c)(1)(E). No inference 
is intended as to whether or not Sec.  1.861-9T(b) or Sec.  1.954-
2(h)(2) include guaranteed payments for taxable years before the 
proposed regulations are applicable.

C. Treatment of Assets Connected With Capitalized, Deferred, or 
Disallowed Interest

    Section 1.861-12T(f)(1) provides that, in certain circumstances, 
where interest expense that is capitalized, deferred, or disallowed 
under a provision of the Code, the adjusted basis or fair market value 
of the asset to which the interest expense is connected is reduced by 
the principal amount of the interest that is capitalized, deferred, or 
disallowed. One comment with respect to the 2018 FTC proposed 
regulations recommended that the Treasury Department and the IRS 
consider narrowing the scope of the rule in Sec.  1.861-12T(f)(1) to 
prevent taxpayers from taking overly expansive views of the rule in 
order to minimize the value of controlled foreign corporation (``CFC'') 
stock that attracts interest expense to reduce the foreign tax credit 
limitation. In response to the comment, the proposed regulations 
clarify what it means for an asset to be connected with indebtedness, 
modify the existing example, and add a new example. See proposed Sec.  
1.861-12(f).

D. Treatment of Section 818(f) Reserve Expenses for Consolidated Groups

    Section 818(f)(1) provides that the deduction for life insurance 
reserves and certain other deductions (``section 818(f) expenses'') are 
treated as items which cannot definitely be allocated to an item or 
class of gross income. Therefore, when a life insurance company 
computes its foreign tax credit limitation, its section 818(f) expenses 
generally reduce its U.S. source income and foreign source income 
ratably. However, issues arise as to how to allocate and apportion 
section 818(f) expenses if the life insurance company is a member of an 
affiliated group of corporations (including both life and nonlife 
members) (the group, ``life-nonlife consolidated group'') that join in 
filing a consolidated return.
    The Treasury Department and the IRS are aware of at least five 
potential

[[Page 69128]]

methods for allocating section 818(f) expenses in a life-nonlife 
consolidated group. First, the expenses might be allocated solely among 
items of the life insurance company that has the reserves (``separate 
entity method''). Second, to the extent the life insurance company has 
engaged in a reinsurance arrangement that constitutes an intercompany 
transaction (as defined in Sec.  1.1502-13(b)(1)), the expenses might 
be allocated in a manner that achieves single entity treatment between 
the ceding member and the assuming member (``limited single entity 
method''). Third, the expenses might be allocated among items of all 
life insurance members (``life subgroup method''). Fourth, the expenses 
might be allocated among items of all members of the consolidated group 
(including both life and non-life members) (``single entity method''). 
Fifth, the expenses might be allocated based on a facts and 
circumstances analysis (``facts and circumstances method'').
    In response to the request for comments in the 2018 FTC proposed 
regulations, the Treasury Department and the IRS have received comments 
advocating for certain of the aforementioned allocation methods. One 
comment recommended an allocation method similar to the single entity 
method. The comment proposed that, if all members of a consolidated 
group were treated as a single corporation, and if that corporation 
would constitute a life insurance company, then section 818(f) expenses 
might be allocated and apportioned to all members of the consolidated 
group, including nonlife members of a life-nonlife consolidated group.
    Two other comments disagreed with the single entity method. These 
comments proposed that section 818(f) expenses generally be allocated 
on the separate entity method. However, if the facts and circumstances 
demonstrate a sufficient factual relationship between the expense and 
the income of more than one life insurance company, these comments 
proposed that such expenses might be allocated based on the facts and 
circumstances method. The comments did not provide examples of when 
facts and circumstances would demonstrate a sufficient relationship to 
qualify for this treatment.
    The Treasury Department and the IRS decline to adopt the single 
entity method in the proposed regulations. Section 818(f) only applies 
to a life insurance company; thus, section 818(f) expenses should not 
be allocated to nonlife members of a consolidated group. The Treasury 
Department and the IRS also decline to adopt the facts and 
circumstances method because a broad facts and circumstances approach 
would introduce substantial uncertainty into the tax system and would 
be difficult to administer.
    The Treasury Department and the IRS considered adopting the life 
subgroup method in the proposed regulations. This method would reflect 
a single entity approach for life insurance companies that operate 
businesses and manage assets and liabilities on a group basis. Under 
this paradigm, section 818(f) expenses would be treated as not 
definitely related to an item or class of gross income of the entire 
life subgroup for purposes of calculating the foreign tax credit 
limitation, and therefore generally ratably reduce U.S. source income 
and foreign source income of the life subgroup.
    The Treasury Department and the IRS also considered adopting the 
separate entity method. The separate entity method would allocate and 
apportion section 818(f) expenses on a separate company basis. This 
method is consistent with the Code because section 818(f) expenses 
generally are computed on a separate company basis and relate to the 
liabilities of a specific life insurance company. In addition, this 
method is consistent with the treatment of reserves when members of a 
consolidated group engage in an intercompany transaction. Under Sec.  
1.1502-13(e)(2)(ii)(A), direct insurance transactions between members 
of a consolidated group are accounted for by both members on a separate 
entity basis. For example, if one member provides life insurance 
coverage for another member with respect to its employees, the 
premiums, reserve increases and decreases, and death benefit payments 
are determined and taken into account by both members on a separate 
entity basis (rather than on a single entity basis under the general 
rules of Sec.  1.1502-13). See also Sec.  1.1502-13(e)(2)(ii)(B)(2) 
(providing that reserves resulting from intercompany reinsurance 
transactions are determined on a separate entity basis).
    After considering both methods, proposed Sec.  1.861-14(h)(1) 
adopts the separate entity method. As noted previously, this method 
generally is consistent with section 818(f) and with the separate 
entity treatment of reserves under Sec.  1.1502-13(e)(2). Nevertheless, 
the Treasury Department and the IRS are concerned that this method may 
create opportunities for consolidated groups to use intercompany 
transactions to shift their section 818(f) expenses and achieve a more 
desirable foreign tax credit result. Accordingly, the Treasury 
Department and the IRS request comments on whether a life subgroup 
method more accurately reflects the relationship between section 818(f) 
expenses and the income producing activities of the life subgroup as a 
whole, and whether the life subgroup method is less susceptible to 
abuse because it might prevent a consolidated group from inflating its 
foreign tax credit limitation through intercompany transfers of assets, 
reinsurance transactions, or transfers of section 818(f) expenses. The 
Treasury Department and the IRS also request comments on whether an 
anti-abuse rule may be appropriate to address concerns with the 
separate entity method, and regarding the appropriate application of 
Sec.  1.1502-13(c) to neutralize the ancillary effects of separate-
entity computation of insurance reserves, such as the computation of 
limitations under section 904.

E. Allocation and Apportionment of R&E Expenditures

    Part I.G of the Explanation of Provisions of the 2018 FTC proposed 
regulations discussed the interaction between the current rules for 
allocating and apportioning R&E expenditures and the changes made to 
section 904(d) by the TCJA, and requested comments on how the 
regulations should be revised to account for the new category in 
section 904(d)(1)(A) (the ``section 951A category''). The comments 
received are addressed in this Part I.E.
1. Relevant Class of Gross Income and Application of the Gross Income 
Method
    Several comments to the 2018 FTC proposed regulations recommended 
that the regulations for allocating and apportioning R&E expenditures 
under Sec.  1.861-17 be revised to preclude allocation and 
apportionment of R&E expenditures to the section 951A category. The 
comments stated that R&E expenditures are incurred by a U.S. taxpayer 
to develop intangible property that cannot generate income in the 
section 951A category, which is limited to inclusions under section 
951A (``GILTI inclusions'') and the related section 78 dividend in 
respect of deemed paid taxes. Further, to the extent a GILTI inclusion 
is attributable to a CFC's income derived from intangible property 
developed by the worldwide group, the comments stated that the 
intangible property must have either been developed by the CFC or a CFC 
affiliate (in which case the R&E expenditures were not borne by the 
U.S. taxpayer), or licensed or acquired by the CFC from a U.S. 
affiliate, which would

[[Page 69129]]

require that the U.S. affiliate take into account an arm's length 
royalty, gain on transfer, or a deemed income amount under section 
367(d) to which its R&E expenditures should be allocated.
    The Treasury Department and the IRS agree with the comments that 
the rules under Sec.  1.861-17 should be modified to reflect the fact 
that R&E expenditures that are deductible under section 174 generally 
give rise to intangible property, and that under the rules in sections 
367(d) and 482, the person incurring such R&E expenditures must be 
compensated properly when such intangible property gives rise to 
income. Therefore, proposed Sec.  1.861-17(b) provides that the rules 
in that section are premised on the fact that successful R&E 
expenditures ultimately result in the creation of intangible property 
(as defined in section 367(d)(4)) and, therefore, R&E expenditures 
ordinarily are considered deductions that are definitely related to all 
gross intangible income reasonably connected with the relevant Standard 
Industrial Classification Manual code (``SIC code'') category (or 
categories) of the taxpayer and so are allocable to all items of gross 
intangible income related to the SIC code category (or categories) as a 
class. Gross intangible income is defined as all gross income earned by 
a taxpayer that is attributable, in whole or in part, to intangible 
property derived from R&E expenditures and does not include dividends 
or any amounts included under section 951, 951A, or 1293. See proposed 
Sec.  1.861-17(b)(2). As a result, when applying Sec.  1.861-17 to 
section 904 as the operative section, because a U.S. taxpayer's gross 
intangible income, as defined in the proposed regulations, does not 
include income assigned to the section 951A category, none of its R&E 
expenditures are allocated or apportioned to the section 951A category.
    Under Sec.  1.861-17(c) and (d), a taxpayer may elect to apportion 
R&E expenditures, in excess of amounts exclusively apportioned to the 
place the R&E is performed under Sec.  1.861-17(b), on the basis of 
either sales or gross income. In contrast to the sales method, the 
gross income method of apportioning R&E expenditures (1) limits 
taxpayers to exclusively apportion only 25 percent of R&E expenditures 
based on the place of research activities (instead of 50 percent under 
the sales method), and (2) requires the apportionment to or among the 
statutory groupings to be at least half of what would have been 
apportioned under the sales method. These limits reflect concerns that 
the gross income method could produce inappropriate results in cases 
where the types of gross income recognized by the taxpayer in the 
statutory and residual groupings in a SIC code category are different. 
For example, if a taxpayer sells products incorporating its intangible 
property in the United States but earns royalties from licensing its 
intangible property used by others to make sales abroad, comparing the 
gross income from sales, which includes value attributable to other 
factors in addition to intangible property, to the gross royalty income 
will generally distort the extent to which the R&E expenditures produce 
U.S. and foreign source income from intangible property. In such cases, 
the gross income method is inconsistent with the general principle 
under Sec.  1.861-8T(c) that the method of apportionment ``reflect to a 
reasonably close extent the factual relationship between the deduction 
and the grouping of gross income.'' In comparison, the sales method 
requires that taxpayers use a single, consistent measure--gross 
receipts from sales and services--to attribute R&E expenditures to 
their various groupings and, therefore, more clearly reflects the 
anticipated income expected to be derived from successful R&E 
expenditures.
    Therefore, the proposed regulations eliminate the optional gross 
income method and require R&E expenditures in excess of the amount 
exclusively apportioned under Sec.  1.861-17(b) to be apportioned among 
the statutory and residual groupings within the class of gross 
intangible income on the basis of the relative amounts of gross 
receipts from sales and services in each grouping. See proposed Sec.  
1.861-17(d). For this purpose, gross receipts are assigned to the 
grouping to which the gross intangible income attributable to the sale 
or service is assigned. For example, where the taxpayer licenses 
intangible property to a CFC which, in turn, sells products or services 
incorporating the intangible property, the gross receipts of the CFC 
are assigned to a grouping based on the source and character of the 
related royalty included by the taxpayer. Proposed Sec.  1.861-
17(d)(1)(iii). This rule addresses concerns that the Treasury 
Department and the IRS have had since before the TCJA's enactment that 
taxpayers would assign the gross receipts from CFC sales to U.S. 
customers to the residual grouping for U.S. source income while arguing 
that the related royalty income earned by the U.S. company that owns 
the intangible property can be treated as foreign source income, with 
the mismatch resulting in an inflation of R&E expenditures apportioned 
to U.S. source income. The proposed regulations also clarify that the 
sales method applies to income from services.
    Under Sec.  1.861-17(a)(2)(ii), the relevant SIC code categories 
are determined by reference to the three digit classification of the 
SIC code. Proposed Sec.  1.861-17(b)(3)(iv) clarifies the rules 
relating to goods or property that are described in the SIC code 
category for ``wholesale trade'' or ``retail trade.'' The purpose of 
this rule is to match R&E expenditures with a taxpayer's core business 
and minimize the number of a taxpayer's SIC code categories. This rule 
provides that vertically integrated taxpayers that perform upstream 
activities (for example, extraction or manufacturing) before downstream 
wholesale and retail functions must aggregate their wholesale and 
retail R&E expenditures and sales with their R&E expenditures and sales 
in the most closely related three-digit SIC code category. A taxpayer 
cannot use a SIC code category within the wholesale or retail trade 
divisions unless its business is generally limited to sales-related 
activities. Taxpayers engaged in both wholesale and retail trade, but 
not related upstream activities, are not required to aggregate their 
wholesale and retail R&E expenditures and sales.
    Comments are requested on whether a different classification method 
that takes into account more recent changes in the economy and business 
practices should be used. For example, comments are requested on 
whether NAICS codes would be more appropriate.
    Comments to Sec.  1.861-17 were also received in connection with 
the proposed regulations under section 250. See 84 FR 8188 (March 6, 
2019). Further changes to the rules for allocating and apportioning R&E 
expenditures will be considered as part of addressing comments in 
finalizing those regulations.
2. Elimination of Legally Mandated R&E and Increased Exclusive 
Apportionment of R&E
    Under Sec.  1.861-17(a)(4), R&E expenditures that are undertaken 
solely to meet legal requirements (``legally mandated R&E'') imposed by 
a political entity and that cannot reasonably be expected to generate 
amounts of gross income (beyond de minimis amounts) outside a single 
geographic source are allocated directly to gross income within the 
geographic source imposing the requirement. A rule similar to the 
legally mandated R&E rule existed in regulations issued in 1977 that 
allocated

[[Page 69130]]

and apportioned R&E expenditures (``the 1977 regulations'').
    Since the adoption of the legally mandated R&E rule in the 1977 
regulations, the Treasury Department and the IRS have observed that 
taxpayers rarely rely on the legally mandated R&E rule. In particular, 
legal requirements for certain products may significantly overlap 
between multiple jurisdictions because those jurisdictions have similar 
legal requirements that relate to areas such as consumer safety, 
pollution, or pharmaceutical products. In addition, multiple 
jurisdictions may have similar legal requirements because of 
multilateral trade and investment agreements or because taxpayers 
choose to sell their products only in markets with similar 
requirements. See, for example, IRS Coordinated Issue Biotech and 
Pharmaceutical Industries Legally Mandated R&E Expense (June 18, 2003) 
(discussing the International Conference on Harmonization, subsequently 
the International Council for Harmonization, and its role in 
rationalizing and harmonizing pharmaceutical regulations in multiple 
jurisdictions). To reflect the changing international business 
environment and simplify the regulations with respect to R&E, the 
proposed regulations eliminate the legally mandated R&E rule.
    Under Sec.  1.861-17(b), an exclusive apportionment of R&E 
expenditures is made if activities representing more than 50 percent of 
the R&E expenditures were performed in a particular geographic 
location, such as the United States. Under Sec.  1.861-17(b)(1)(ii), 
for taxpayers electing the gross income method, 25 percent of R&E 
expenditures is exclusively apportioned to the geographic location 
where the R&E activities accounting for more than 50 percent of the 
deductible expenses were incurred. Under Sec.  1.861-17(b)(1)(i), for 
taxpayers electing the sales method, 50 percent of R&E expenditures are 
exclusively apportioned to the geographic location where the R&E 
activities accounting for more than 50 percent of the deductible 
expenses were incurred. After this initial exclusive apportionment, the 
remainder of the taxpayer's R&E expenditures are apportioned under 
either the sales or gross income methods.
    The 1977 regulations also included a rule similar to a rule in the 
current regulations at Sec.  1.861-17(b)(2). Under this rule, taxpayers 
may demonstrate to the satisfaction of the Commissioner that an even 
higher amount of R&E expenditures should be exclusively apportioned to 
a geographic location. According to the current regulations, the 
exclusive apportionment rules are based on the understanding that R&E 
may be more valuable where it is undertaken because R&E benefits 
products all of which may be sold in the nearest market but only some 
of which may be sold in foreign markets, and R&E is often used in the 
nearest market first before it is used in other markets. Therefore, 
under the increased exclusive apportionment rule, a taxpayer may 
establish to the satisfaction of the Commissioner that one or both of 
these conditions are satisfied--that is, its research is expected to 
have a particularly limited or long delayed application outside the 
geographic area where the research is performed, such that a greater 
amount of R&E expenditures should be initially exclusively apportioned.
    Similar to the legally mandated rule, the Treasury Department and 
the IRS have observed that taxpayers have rarely used the current 
increased exclusive apportionment rule since the issuance of the 1977 
regulations. Moreover, when it has been used, the facts and 
circumstances nature of the analysis has caused hard-to-resolve 
disagreements between the Commissioner and taxpayers. Changes in the 
international business environment have also contributed to the 
decreased utilization of this rule. Accordingly, the proposed 
regulations eliminate the increased exclusive apportionment rule.
    Finally, proposed Sec.  1.861-17(b) clarifies that the exclusive 
apportionment rule applies only to section 904 as the operative 
section. See also Part I.E.1 of this Explanation of Provisions (noting 
that comments were received in connection with proposed regulations 
under section 250 and that further changes will be considered as part 
of addressing comments in finalizing those regulations).
3. Sales Made by Other Entities
    The sales method for apportioning R&E expenditures provides that 
gross receipts from sales of products or provision of services within a 
relevant SIC code category by controlled parties of the taxpayer are 
taken into account in apportioning the taxpayer's R&E expenditures if 
the controlled party is reasonably expected to benefit from the 
taxpayer's research and experimentation. Under Sec.  1.861-
17(c)(3)(iv), the sales of controlled parties that enter a valid cost 
sharing arrangement (``CSA'') with a taxpayer are excluded from the 
apportionment formula because the controlled party is not expected to 
benefit from the taxpayer's remaining R&E expenditures.
    Proposed Sec.  1.861-17 clarifies the treatment of CSAs in two 
respects. First, consistent with Sec.  1.482-7, the taxpayer's R&E 
expenditures allocated and apportioned under Sec.  1.861-17 do not 
include any amounts that are not deductible by reason of the second 
sentence under Sec.  1.482-7(j)(3)(i) (relating to cost sharing 
transaction payments from a controlled party). Second, the proposed 
regulations clarify that the exclusion of the controlled party's gross 
receipts applies only for purposes of apportioning those R&E 
expenditures that are intangible development costs with respect to the 
CSA. If a taxpayer who enters a CSA also incurs R&E expenditures that 
are not intangible development costs with respect to the CSA, then 
those expenses would be apportioned under the generally applicable 
rules, including the rules concerning controlled party sales. See 
proposed Sec.  1.861-17(d)(4)(v).
    One comment suggested that Sec.  1.861-17 be modified to provide 
that a taxpayer's R&E expenditures that are funded by a foreign 
affiliate under a contract research arrangement should be directly 
allocated to the taxpayer's income from such arrangements. The terms of 
the contract research arrangement are not clear from the comment, and 
it is unclear whether the described expenditures that are reimbursed by 
a foreign affiliate are paid or incurred by the taxpayer to develop or 
improve a product in connection with the taxpayer's trade or business. 
See Sec. Sec.  1.174-1 and 1.174-2. If the expenditures are not paid or 
incurred by the taxpayer to develop or improve a product in connection 
with its trade or business, the taxpayer may not deduct them under 
section 174. As a result, Sec.  1.861-17 would not apply to these 
expenditures. The expenditures would instead be allocated and 
apportioned under the general rules in Sec.  1.861-8 on the basis of 
the factual relationship of deductions to gross income. See Sec.  
1.861-8(a)(2). The Treasury Department and the IRS request comments on 
whether contract research arrangements involving expenditures 
reimbursed by a foreign affiliate are generally paid or incurred by the 
taxpayer in connection with its trade or business such that a deduction 
under section 174 is allowable, and whether a special rule for such 
expenditures should be considered.
    Another comment suggested a special rule for ``licensor models'' 
whereby CFCs pay royalties to compensate for a taxpayer's R&E 
expenditures. The comment suggested that in order to avoid allocation 
and apportionment of R&E expenditures to the section 951A category, the 
activities of the licensee CFC should be excluded for purposes of 
apportioning the licensor's R&E

[[Page 69131]]

expenditures and should be treated similarly to cost sharing 
arrangements. The comment suggested in the alternative that if the CFC 
sales are not excluded entirely, that R&E expenditures should be netted 
against the royalty income to which the R&E expenditures are 
apportioned.
    The Treasury Department and the IRS agree that R&E expenditures 
should be allocated and apportioned solely with respect to the gross 
intangible income of the taxpayer rather than the net income of a 
licensee, and therefore not allocated and apportioned to the section 
951A category. See Part I.D.1 of this Explanation of Provisions. Unlike 
in the case of a CSA, however, a licensor earns royalties or other 
forms of gross intangible income from the use of its intangible 
property, and it would not be appropriate to exclude such royalties in 
allocating R&E expenditures of the licensor. The proposed regulations 
require the use of the sales method, which would effectively attribute 
R&E expenditures to the taxpayer's royalty income based on the 
proportion of the gross receipts of the licensees over the total gross 
receipts of the taxpayer and its licensees. This approach is preferable 
to the comment's alternative recommendation of netting R&E expenditures 
against the amount of royalties because taxpayers may earn different 
types of gross intangible income (for example, from sales of property 
as well as royalties) and comparing such amounts could lead to 
distortive results.
    Finally, under Sec.  1.861-17(c)(3)(ii) and (f)(3), sales made by 
controlled corporations and partnerships taken into account to 
apportion R&E expenditures are reduced to reflect the taxpayer's 
percentage ownership of such entities. This reduction is inappropriate 
because the taxpayer's gross intangible income is not dependent on its 
percentage ownership of the entity to which it transfers intangible 
property. The proposed regulations, therefore, eliminate the rule 
reducing sales of controlled corporations that are taken into account 
and include partnership sales to the same extent as those made by 
controlled corporations.

F. Application of Section 904(b) to Net Operating Losses

    The 2018 FTC proposed regulations included a rule in Sec.  
1.904(b)-3(d) coordinating the application of section 904(b)(4) with 
sections 904(f) and 904(g), which apply after section 904(b)(4). This 
rule is finalized substantially as proposed in the 2019 FTC final 
regulations. However, the 2018 FTC proposed regulations did not 
coordinate any of the adjustments required under section 904(b) with 
the net operating loss provisions. Therefore, the proposed regulations 
include a coordination rule. Under proposed Sec.  1.904(b)-3(d)(2), for 
purposes of determining the source and separate category of a net 
operating loss, the separate limitation loss and overall foreign loss 
rules of section 904(f) and the overall domestic loss rules of section 
904(g) are applied without taking into account the adjustments required 
under section 904(b). The Treasury Department and the IRS have 
determined this rule is appropriate because the amount of the net 
operating loss eligible to be carried to another year under section 172 
is not affected by the adjustments required by section 904(b).

II. Foreign Tax Credit Limitation Under Section 904

A. Definition of Financial Services Entity

    Section 904(d)(2)(D) provides that financial services income can 
only be received by a person ``predominantly engaged in the active 
conduct of a banking, insurance, financing, or similar business.'' 
Under current law, the principal significance of this provision is that 
under section 904(d)(2)(C), passive income of such a person is not 
assigned to the passive category. The preamble to the 2018 FTC proposed 
regulations noted that the Treasury Department and the IRS were 
considering modifications to the gross income-based test for 
determining financial services entity (``FSE'') status and requested 
comments in this regard. One comment was received requesting that any 
future modifications not affect the classification of income derived by 
a substantial (and genuinely active) financial services group. The 
Treasury Department and IRS agree that a substantial and genuinely 
active financial services group should be included in the definition of 
an FSE.
    However, numerous places in the Code use similar concepts and, at 
times, the same terms, but provide different definitions (even when 
largely overlapping in application). The Treasury Department and IRS 
have determined that interpretive guidance should be simplified and 
made consistent where possible and appropriate. For example, section 
954(h) in the subpart F rules defines ``predominantly engaged in the 
active conduct of a banking, financing, or similar business'' (which in 
the case of a lending or finance business, requires more than 70 
percent of the gross income be derived directly from transactions with 
unrelated customers); section 1297(b)(2)(B) in the passive foreign 
investment company (``PFIC'') rules defines ``active conduct of an 
insurance business by a qualifying insurance corporation''; and section 
953(e)(3) defines the term ``qualifying insurance company'' in order to 
determine the amount of passive income excluded from subpart F income 
as income derived in the active conduct of an insurance business under 
section 954(i).
    In order to promote simplification and greater consistency with 
other Code provisions that have complementary policy objectives, 
proposed Sec.  1.904-4(e)(2) modifies the definition of an FSE by 
adopting a definition of ``predominantly engaged in the active conduct 
of a banking, insurance, financing, or similar business'' and ``income 
derived in the active conduct of a banking, insurance, financing, or 
similar business'' that is generally consistent with sections 954(h), 
1297(b)(2)(B), and 953(e). Conforming changes are made to the rules for 
affiliated groups in proposed Sec.  1.904-4(e)(2)(ii) and partnerships 
in proposed Sec.  1.904-4(e)(2)(i)(C).
    Comments are requested on whether additional guidance is needed 
with respect to section 954(h) (including in particular section 
954(h)(2)(B)(ii), which authorizes the Treasury Department to issue 
regulations regarding corporations not licensed as a bank in the United 
States) and section 952(c)(1)(B)(vi) (defining a qualified financial 
institution for purposes of the qualified deficit rules).
    In addition, when the regulations defining an FSE were originally 
promulgated in 1988, section 904(d)(1)(C) assigned financial services 
income to its own separate category. This separate category was 
repealed in 2004, effective for taxable years beginning after 2006, but 
the rules in section 904(d)(2)(C) and (D) were retained. The proposed 
regulations make additional clarifying changes to reflect the repeal of 
the separate category for financial services income.
    Finally, in 2004, a definition of financial services group was 
added in section 904(d)(2)(C)(ii) which was based on the definition of 
an affiliated group under section 1504(a) but expanded to include 
insurance companies and foreign corporations. While the current 
regulations already include foreign corporations as part of an 
affiliated group, proposed Sec.  1.904-4(e)(2)(ii) conforms the 
definition of an affiliated group to also include insurance companies 
referenced in section 1504(b)(2).

[[Page 69132]]

B. Allocation and Apportionment of Foreign Income Taxes

    As explained in Part III.G of the Summary of Comments and 
Explanation of Revisions to the 2019 FTC final regulations, the 
Treasury Department and the IRS have determined that additional 
guidance regarding the allocation and apportionment to separate 
categories of creditable foreign income taxes in Sec.  1.904-6 is 
warranted. As a result of changes made by the TCJA, the accurate 
allocation and apportionment of foreign income taxes to the gross 
income to which they relate has taken on increased importance. See, for 
example, sections 245A(d), 960, 965(g), and Sec.  1.861-8(e)(6) 
(allocating the deduction for foreign income taxes, including at the 
level of a CFC, to statutory and residual groupings). Therefore, 
taxpayers will benefit from increased certainty on how to match foreign 
income taxes with income, particularly in the case of differences in 
how a U.S. taxable base and foreign taxable base are computed with 
respect to the same transaction. Furthermore, because these rules are 
relevant in numerous contexts outside of section 904, the general rules 
in Sec.  1.904-6 (which address allocating and apportioning taxes to 
separate categories) have been moved to new proposed Sec.  1.861-20 and 
generalized to apply for purposes of allocating and apportioning 
foreign income taxes to statutory and residual groupings. Rules 
specific to the allocation and apportionment of foreign income taxes to 
separate categories remain in proposed Sec.  1.904-6. Conforming 
changes are proposed to Sec. Sec.  1.704-1(b)(4)(viii)(d)(1) and 1.960-
1(d), which currently rely on the ``principles of'' Sec.  1.904-6, as 
well as Sec.  1.965-5(b)(2) (in the case of foreign corporation taxable 
years beginning after December 31, 2019).
    Current Sec.  1.904-6 provides that the allocation and 
apportionment of foreign tax expense to a section 904 separate category 
is made on the basis of the income as computed under foreign law on 
which the tax is imposed; foreign tax is allocated to the separate 
category to which the income included in the foreign tax base would be 
assigned under Federal income tax principles. See 1.904-6(a)(1). If the 
foreign tax base includes income in more than one separate category, 
the tax is apportioned among the separate categories on the basis of 
the relative amounts of foreign taxable income in each category. In 
making this determination, foreign law rules apply, with certain 
modifications, to determine the foreign law deductions that reduce the 
foreign law gross income to compute the foreign law amount of taxable 
income in each separate category. See Sec.  1.904-6(a)(1)(ii).
    Proposed Sec.  1.861-20 adopts the principles of Sec.  1.904-6 but 
provides more detailed guidance on how to apply those principles, which 
are illustrated by several examples. Proposed Sec.  1.861-20(c) 
provides that foreign tax expense is allocated and apportioned among 
the statutory and residual groupings by first assigning the items of 
gross income under foreign law (``foreign gross income'') on which a 
foreign tax is imposed to a grouping, then allocating and apportioning 
deductions under foreign law to that income, and finally allocating and 
apportioning the foreign tax among the groupings. See proposed Sec.  
1.861-20(c).
    Proposed Sec.  1.861-20(d)(1) provides a general rule for assigning 
foreign gross income to a statutory or residual grouping. Under this 
rule, a foreign gross income item is assigned to a grouping by 
characterizing the item under Federal income tax law. If an item of 
gross income or loss arises under Federal income tax law from the same 
transaction or realization event from which the foreign gross income 
item arose (a ``corresponding U.S. item''), the foreign gross income 
item is assigned to the same statutory or residual grouping as the 
corresponding U.S. item. In the case of a corresponding U.S. item that 
is an item of loss (or zero), the foreign gross income is assigned to 
the same grouping to which an item of gain would be assigned had the 
transaction or realization event given rise to an item of gain under 
Federal income tax law. See proposed Sec.  1.861-20(d)(1).
    Proposed Sec.  1.861-20(d)(2) sets forth rules for assigning a 
foreign gross income item to a grouping if there is no corresponding 
U.S. item in the U.S. taxable year in which the taxpayer paid or 
accrued the foreign income tax imposed on foreign taxable income that 
includes the foreign gross income item. Proposed Sec.  1.861-
20(d)(2)(i) generally addresses the circumstance in which there is no 
corresponding U.S. item either because the event giving rise to the 
foreign gross income is a nonrecognition event under Federal income tax 
law or because the recognition event giving rise to the foreign gross 
income occurred under Federal income tax law in a different U.S. 
taxable year. In both cases, proposed Sec.  1.861-20(d)(2)(i) assigns 
the foreign gross income to the grouping to which the corresponding 
U.S. item would be assigned if the event giving rise to the foreign 
gross income resulted in the recognition of gross income or loss under 
Federal income tax law in the same U.S. taxable year in which the 
foreign income tax is paid or accrued.
    Proposed Sec.  1.861-20(d)(2)(ii) provides guidance regarding the 
treatment of foreign gross income items that are either excluded from 
gross income under Federal income tax law or attributable to base 
differences. Under Sec.  1.861-20(d)(2)(ii)(A), with the exception of 
base difference items, foreign gross income that is a type of income 
expressly excluded from gross income under Federal income tax law is 
assigned to the grouping to which the gross income would be assigned if 
it were included in U.S. gross income. Proposed Sec.  1.861-
20(d)(2)(ii)(B) provides an exclusive list of items that are excluded 
from U.S. gross income and that, if taxable under foreign law, are 
treated as base differences. The items are death benefits described in 
section 101, gifts and inheritances described in section 102, 
contributions to capital described in section 118 and the receipt of 
property in exchange for stock described in section 1032, the receipt 
of property in exchange for a partnership interest described in section 
721, returns of capital described in section 301(c)(2), and 
distributions to partners described in section 733. The Treasury 
Department and the IRS have determined that foreign tax on these items, 
which are excluded from U.S. gross income, is particularly difficult to 
associate with a particular type of U.S. gross income. Accordingly, 
foreign tax on base difference items is assigned to the residual 
grouping, with the result that no credit is allowed if the tax is paid 
by a CFC, and the tax is assigned to the separate category described in 
section 904(d)(2)(H)(i) if paid (or treated as paid) by a taxpayer 
claiming a direct credit under section 901. Comments are requested on 
whether the list should be expanded to include other items that have no 
logical analogue to items included in U.S. gross income, or whether a 
different assignment of any of these types of foreign gross income 
would be more appropriate.
    Proposed Sec.  1.861-20(d)(3) sets forth special rules that apply 
for purposes of assigning certain items of foreign gross income to a 
grouping, including rules for distributions that both Federal income 
tax law and foreign law recognize, certain foreign law distributions 
such as consent dividends, inclusions under foreign law CFC regimes, 
disregarded payments, inclusions from reverse hybrids, and gain on the 
sale of a disregarded entity.
    In the case of a distribution from a non-hybrid corporation that is 
recognized for both Federal income tax

[[Page 69133]]

law and foreign tax law purposes, proposed Sec.  1.861-20(d)(3)(i)(B) 
treats foreign gross income arising from the distribution as a dividend 
and as capital gain to the extent of the portions of the distribution 
that are, under Federal income tax law, characterized as a dividend and 
capital gain, respectively. The foreign gross income is assigned to the 
same statutory and residual groupings as the corresponding amounts of 
dividend and capital gain as computed for U.S. tax purposes. Foreign 
gross income arising from the portion of the distribution that is a 
return of capital under Federal income tax law is treated as a base 
difference under proposed Sec.  1.861-20(d)(2)(ii)(B).
    If foreign law, but not Federal income tax law, recognizes a deemed 
distribution or consent dividend (a ``foreign law distribution''), 
proposed Sec.  1.861-20(d)(3)(i)(C) assigns the resulting foreign gross 
income to a statutory or residual grouping by applying proposed Sec.  
1.861-20(d)(3)(i)(B) as though Federal income tax law recognized the 
distribution in the U.S. taxable year in which the taxpayer paid or 
accrued tax with respect to the foreign law distribution. For example, 
if a taxpayer recognizes foreign gross income arising from a foreign 
law distribution, and proposed Sec.  1.861-20(d)(3)(i)(B) (as applied 
for purposes of section 904 as the operative section) would treat the 
distribution as made out of general category section 965(a) previously 
taxed earnings and profits if the distribution had also occurred under 
Federal income tax law, the foreign gross income is assigned to the 
general category.
    If a taxpayer (including an upper-tier CFC) includes an item of 
foreign gross income by reason of a foreign law regime similar to the 
subpart F provisions under sections 951 through 959 (a ``foreign law 
subpart F regime''), proposed Sec.  1.861-20(d)(3)(i)(D) assigns that 
item to the same statutory or residual grouping as the gross income 
(determined under the foreign law subpart F regime) of the foreign law 
CFC that gave rise to the foreign gross income of the taxpayer. The 
taxpayer's gross income included under the foreign law subpart F regime 
is, in other words, treated as the foreign gross income of the foreign 
law CFC, and the general rules of proposed Sec. Sec.  1.861-20(d)(1) 
and (2) apply to characterize that foreign gross income and assign it 
to the statutory and residual groupings. For example, in applying 
proposed Sec.  1.861-20(d)(3)(i)(D) in applying section 960 as the 
operative section where an upper-tier CFC is the taxpayer, the upper-
tier CFC's foreign law subpart F inclusion is treated as the foreign 
gross income of the foreign law CFC, which is treated as if it were the 
taxpayer. If the foreign law CFC has a corresponding U.S. item of 
subpart F income for which its United States shareholder elects to 
apply the high tax exception under section 954(b)(4), the foreign gross 
income and the associated foreign tax paid by the upper-tier CFC are 
assigned to a residual income group under Sec.  1.960-1(d). In 
addition, Sec.  1.904-6(f) includes a special rule assigning certain 
items of foreign gross income recognized by a United States shareholder 
of a CFC that is also a foreign law CFC to the section 951A category 
for purposes of applying section 904 as the operative section.
    Proposed Sec.  1.861-20(d)(3)(ii) addresses the assignment of 
foreign gross income arising from disregarded payments between a 
foreign branch (as defined in Sec.  1.904-4(f)(3)) and its owner. If 
the foreign gross income item arises from a payment made by a foreign 
branch to its owner, proposed Sec.  1.861-20(d)(3)(ii)(A) generally 
assigns the item to the statutory and residual groupings by deeming the 
payment to be made ratably out of the after-tax income, computed for 
Federal income tax purposes, of the foreign branch, and deeming the 
branch income to arise in the statutory and residual groupings in the 
same ratio as the tax book value of the assets, including stock, owned 
by the foreign branch. If the item of foreign gross income arises from 
a disregarded payment to a foreign branch from its owner, proposed 
Sec.  1.861-20(d)(3)(ii)(B) generally assigns the item to the residual 
grouping. However, proposed Sec.  1.861-20(d)(3)(ii)(C) assigns an item 
of foreign gross income attributable to gain recognized under foreign 
law with respect to the receipt of a disregarded payment in exchange 
for property under the rule in Sec.  1.861-20(d)(2)(i). In addition, 
proposed Sec.  1.904-6(b)(2) includes special rules assigning foreign 
gross income items arising from certain disregarded payments for 
purposes of applying section 904 as the operative section.
    Proposed Sec.  1.861-20(d)(3)(iii) addresses the assignment to a 
statutory or residual grouping of foreign gross income that a taxpayer 
includes by reason of its ownership of a reverse hybrid. Under this 
rule, the foreign gross income that a taxpayer recognizes from a 
reverse hybrid is assigned to the statutory and residual groupings by 
treating that foreign gross income as the income of the reverse hybrid 
and applying the general rules of proposed Sec.  1.861-20(d). However, 
Sec.  1.904-6(f) includes a special rule assigning certain items of 
foreign gross income recognized by a United States shareholder of a 
controlled foreign corporation that is a reverse hybrid to the section 
951A category for purposes of applying section 904 as the operative 
section. The Treasury Department and the IRS request comments on 
whether additional rules are needed to address other fact patterns in 
which the U.S. and a foreign country tax different persons on the same 
item of income, for example, in the case of a sale-repurchase 
agreement.
    Finally, under proposed Sec.  1.861-20(d)(3)(iv), if a taxpayer 
recognizes an item of foreign gross income that is gain from the sale 
of a disregarded entity, and Federal income tax law characterizes the 
transaction as a sale of the assets of the disregarded entity, the 
foreign gross income is assigned to the statutory and residual 
groupings in the same proportion as the gain that the taxpayer would 
have recognized if foreign law also treated the transaction as a sale 
of assets.
    Changes to Sec.  1.904-6 and Sec.  1.960-1 are proposed to clarify 
and, in certain cases, modify the application of proposed Sec.  1.861-
20 for purposes of computing the foreign tax credit limitation under 
section 904 and foreign income taxes deemed paid under section 960.
    Proposed Sec.  1.904-6(b)(1) assigns foreign gross income that is 
attributable to a base difference, and the associated tax, to the 
separate category described in section 904(d)(2)(H)(i). Proposed Sec.  
1.904-6(b)(2)(i) generally provides that if a foreign branch makes a 
disregarded payment to another foreign branch or to its owner that 
causes the taxpayer's gross income under Federal income tax law that is 
otherwise attributable to the foreign branch to be attributed to 
another foreign branch or to the foreign branch owner under Sec.  
1.904-4(f)(2)(vi)(A) or Sec.  1.904-4(f)(2)(vi)(D), the foreign gross 
income that arises by reason of the disregarded payment is assigned to 
the same category as the reattributed U.S. gross income. Under proposed 
Sec.  1.904-6(b)(2)(ii), items of foreign gross income that a taxpayer 
includes solely by reason of the receipt by a foreign branch of a 
disregarded payment from its foreign branch owner that is a United 
States person are generally assigned to the foreign branch category 
(or, in the case of a foreign branch owner that is a partnership, to 
the partnership's general category income that is attributable to the 
foreign branch). However, items of foreign gross income attributable to 
gain recognized under foreign law with respect to the receipt of a 
disregarded payment in exchange for property are characterized

[[Page 69134]]

and assigned under the rules of Sec.  1.861-20(d)(2)(i). Under proposed 
Sec.  1.904-6(b)(3), if a taxable disposition of property acquired in a 
disregarded sale results in the recognition of U.S. gross income that 
is reattributed to or from a foreign branch under Sec.  1.904-
4(f)(2)(vi)(A) or Sec.  1.904-4(f)(2)(vi)(D), any foreign gross income 
arising from that disposition of property under foreign law is assigned 
to the same separate category as the corresponding U.S. item of gain 
under Sec.  1.861-20(d)(1) without regard to the reattribution of U.S. 
gross income. This rule is intended to better match income and taxes in 
situations where the foreign country only taxes gain that arises during 
the period that follows the disregarded sale.
    Finally, Sec.  1.904-6(f) addresses the circumstance in which a 
United States shareholder pays or accrues foreign income tax with 
respect to foreign gross income that it recognizes because it owns a 
foreign law CFC or a reverse hybrid. The foreign income tax is 
allocated and apportioned to a category by treating the foreign gross 
income of the United States shareholder as the foreign gross income of 
the foreign law CFC or reverse hybrid under proposed Sec. Sec.  1.861-
20(d)(3)(i)(D) or 1.861-20(d)(3)(ii)(B). Proposed Sec.  1.904-6(f) 
reassigns to the section 951A category the foreign gross income that, 
if the foreign law CFC or reverse hybrid recognized the foreign gross 
income instead of the United States shareholder, would be assigned to 
the general category tested income group of the foreign law CFC or 
reverse hybrid to which an inclusion under section 951A is 
attributable. The amount of the foreign gross income that is reassigned 
is based upon the inclusion percentage, as defined in Sec.  1.960-
2(c)(2), of the United States shareholder.
    The Treasury Department and the IRS are continuing to study the 
allocation and apportionment of foreign income tax that is imposed on 
foreign gross income that is associated with the general category 
tested income group of a foreign law CFC or reverse hybrid under 
proposed Sec. Sec.  1.861-20(d)(3)(i)(D) and 1.861-20(d)(3)(ii)(B), 
respectively. Comments are requested on the proper treatment of such 
foreign income tax in the circumstance in which some or all of the tax 
is not assigned to the section 951A category under proposed Sec.  
1.904-6(f) because no inclusion is attributable to the tested income 
group, or the inclusion percentage of the United States shareholder is 
less than 100 percent. In particular, comments are requested on the 
interaction of proposed Sec.  1.904-6(f) with sections 245A(g) and 909.
    Proposed Sec.  1.960-1(d)(3)(ii) makes conforming changes and in 
addition clarifies that, if proposed Sec.  1.861-20 would otherwise 
apply to assign foreign gross income to a PTEP group that is not 
increased as a result of a distribution described in section 959(b), 
the foreign taxable income is assigned to the income group to which the 
income, computed under Federal income tax law, that gave rise to the 
PTEP would be assigned if recognized under Federal income tax law in 
the year in which tax was imposed.
    The Treasury Department and the IRS are also studying whether 
additional guidance should be provided on allocating and apportioning 
foreign taxes described in section 903 (tax in lieu of income tax), and 
foreign income taxes for which the foreign taxable base is computed 
formulaically with respect to a unitary business. The Treasury 
Department and the IRS are also studying whether the rules in Sec.  
1.861-8(e)(6) for allocating and apportioning state income taxes should 
be revised in light of changes made by the TCJA and changes to state 
rules for taxing foreign income. Comments are requested on these 
topics.

C. Overall Foreign Loss Recapture on Property Dispositions

    One comment was received with respect to the 2012 OFL proposed 
regulations, which recommended addressing dispositions that result in 
additional income recognition under branch loss recapture and dual 
consolidated loss recapture rules. The comment pointed out that these 
additional income recognition amounts are determined after first 
determining the additional recognition amount under section 904(f)(3) 
and therefore recommended adding the coordination of these rules as a 
new Step Nine in the ordering rules of Sec.  1.904(g)-3. The comment 
recommended that the additional income recognition amounts resulting 
from branch loss recapture and dual consolidated loss recapture should 
not be subject to the overall foreign loss (OFL) recapture rules.
    The branch loss recapture rules under section 367(a) referenced by 
the comment letter were repealed by the TCJA (subject to a special 
savings clause that applies with respect to losses incurred before 
January 1, 2018) and replaced with a new set of branch loss recapture 
rules in section 91. One of the principal differences between the two 
regimes is that previously the branch loss recapture amounts were 
treated as foreign source income, whereas under new section 91(d) they 
are treated as U.S. source income. Accordingly, although the branch 
loss recapture amounts for losses incurred after December 31, 2017, are 
no longer subject to the OFL recapture rules or separate limitation 
loss (SLL) recapture rules, they are now potentially subject to the 
overall domestic loss (ODL) recapture rules, and therefore ordering 
rules are still needed for the application of the branch loss recapture 
rules, including the rules for losses incurred before January 1, 2018, 
that are subject to the special savings clause.
    The Treasury Department and the IRS agree with the recommendation 
to add a new Step Nine to Sec.  1.904(g)-3 to clarify that additional 
income amounts recognized by reason of branch loss recapture and dual 
consolidated loss recapture are not taken into account for purposes of 
the ordering rules until after the section 904(f)(3) amounts are 
determined. However, the Treasury Department and the IRS do not agree 
that those additional income amounts should not be subject to the OFL 
or ODL recapture rules. The fact that a loss recapture rule may provide 
that the additional income amount is treated as U.S. source income does 
not mean it should be treated any differently than any other U.S. 
source income that is subject to the ODL recapture rules. The same 
reasoning applies to additional income amounts that are treated as 
foreign source income and therefore subject to the OFL recapture rules. 
Accordingly, Step Nine in proposed Sec.  1.904(g)-(3)(j) provides that 
like section 904(f)(3) recapture amounts addressed in Step Eight, the 
additional income recognized by reason of branch loss and dual 
consolidated loss recapture will be subject to the first seven steps of 
the ordering rules. However, Step Nine applies only to additional 
income amounts with respect to branch loss and dual consolidated loss 
recapture that are determined after taking into account an offset for a 
section 904(f)(3) recapture amount. For example, if a taxpayer has a 
dual consolidated loss recapture in a year in which there is no section 
904(f)(3) recapture, then there is only one application of Steps One 
through Seven, which takes into account the additional income, and 
Steps Eight and Nine will not apply.
    When Step Nine applies, the proposed regulations provide that for 
purposes of determining how much of the additional income with respect 
to branch loss and dual consolidated loss recapture will be subject to 
the ODL, OFL or SLL recapture rules, any increases to an ODL, OFL or 
SLL account balance in the current year due to the original application 
of Steps One

[[Page 69135]]

through Seven (prior to the application of Steps Eight or Nine) are 
taken into account.
    In addition, if any additional income with respect to a branch loss 
or dual consolidated loss recapture is foreign source income in a 
separate category for which there is a remaining OFL account balance 
after Steps One through Eight, a special rule applies for purposes of 
determining the OFL recapture amount under Sec.  1.904(f)-2(c) (the 
lesser of the maximum potential recapture or 50 percent of total 
foreign source income). The special rule provides that a taxpayer must 
first determine a hypothetical OFL recapture amount, which is the OFL 
recapture amount that would have been determined in the original 
application of Steps One through Seven (prior to the application of 
Steps Eight and Nine) if the additional income in Step Nine were also 
taken into account. From that hypothetical OFL recapture amount, the 
taxpayer subtracts the actual OFL recapture amount that was determined 
in the original application of Steps One through Seven (without taking 
into account the additional income in Step Nine). The remainder is then 
the OFL recapture amount with respect to the additional income in Step 
Nine. This special rule is necessary because a simple reapplication of 
the OFL recapture amount rules in Sec.  1.904(f)-2(c) to just the 
additional income in Step Nine could result in requiring an excessive 
amount of recapture, because the same amount of foreign source income 
in other separate categories may be used twice to increase the OFL 
recapture amount (once in the original calculation and again in the 
second calculation with respect to the additional income).

III. Foreign Tax Redeterminations Under Section 905(c)

    As discussed in Part III of the Background section of the 2019 FTC 
final regulations, portions of the temporary regulations relating to 
sections 905(c), 986(a), and 6689 (TD 9362) (the ``2007 temporary 
regulations'') are being reproposed in order to provide taxpayers an 
additional opportunity to comment on those rules in light of the 
changes made by the TCJA. References in this preamble to the 2007 
temporary regulations are understood to refer to the corresponding 
provisions of the accompanying proposed regulations, which were issued 
by cross-reference to the 2007 temporary regulations at 72 FR 62805.
    In particular, the rules being reproposed are: (1) Sec.  1.905-
3T(d)(2), which addresses foreign tax redeterminations that affect 
foreign taxes deemed paid under section 960, (2) Sec.  1.905-4T, which 
in general provides the procedural rules for how to notify the IRS of a 
foreign tax redetermination, and (3) Sec.  301.6689-1T, which provides 
rules for the penalty for failure to notify the IRS of a foreign tax 
redetermination. In addition, the proposed regulations contain a 
transition rule in proposed Sec. Sec.  1.905-3(b)(2)(iv) and 1.905-5 to 
address foreign tax redeterminations of foreign corporations that 
relate to taxable years before the amendments made by the TCJA. See 
Part III.D of this Explanation of Provisions.

A. Adjustments to Foreign Taxes Paid by Foreign Corporations

    Section 1.905-3T(d)(2) of the 2007 temporary regulations reflects 
the law in effect before the TCJA, which generally required foreign tax 
redeterminations of foreign corporations to be taken into account by 
prospectively adjusting the foreign corporations' pools of post-1986 
undistributed earnings and post-1986 foreign income taxes, rather than 
by adjusting the calculation of deemed-paid taxes and the United States 
shareholder's (``U.S. shareholder'') U.S. tax liability in the prior 
year or years in which the adjusted foreign tax was included in the 
calculation of foreign taxes deemed paid. Section 1.905-3T(d)(3) of the 
2007 temporary regulations provides exceptions to the pooling 
adjustment rules that required redeterminations of the U.S. 
shareholder's U.S. tax liability in situations where refunds or other 
downward adjustments to a foreign corporation's foreign tax liability 
would otherwise cause a substantial overstatement of deemed paid taxes. 
With the repeal of the pooling regime and related amendments to section 
905(c) in the TJCA, the statute now requires U.S. tax redeterminations 
to reflect all foreign tax redeterminations, including those that 
result in adjustments to foreign taxes deemed paid. Accordingly, 
proposed Sec.  1.905-3(b)(2)(i) provides that a U.S. tax 
redetermination is required in all cases to account for the effect of a 
foreign corporation's foreign tax redetermination.
    Section 1.905-3T(d)(3)(ii), illustrated by an example in Sec.  
1.905-3T(d)(3)(iii), provides that the required U.S. tax 
redetermination is made by taking the foreign tax redetermination into 
account in the prior year to which the redetermined foreign tax 
relates, and further provides that a U.S. tax redetermination is also 
required for any subsequent year in which the domestic corporate 
shareholder received or accrued a distribution or inclusion from the 
foreign corporation, which under pre-TCJA law would have resulted in 
foreign taxes deemed paid. Under these rules, the amount of the 
adjusted foreign tax was deemed to ``relate back'' and adjust the 
foreign corporation's earnings and profits, as well as its creditable 
foreign taxes, in the adjusted year.
    In any case where a U.S. tax redetermination and adjustment to 
deemed paid taxes is required, an adjustment to the foreign 
corporation's taxable income and earnings and profits in the functional 
currency amount of the adjusted foreign tax (whether upward to reflect 
a refund or downward to reflect an additional payment of foreign tax) 
in the relation-back year is necessary in order to coordinate the 
computation of the U.S. shareholder's inclusions with the amount of the 
section 78 dividend in the amount of the adjusted foreign taxes deemed 
paid. This is because under sections 954(b)(5) and 951A(c)(2)(ii), the 
creditable foreign tax reduces the foreign corporation's subpart F 
income, tested income, and earnings and profits, so that the amount 
included in the U.S. shareholder's income under sections 951 and 951A 
is an after-foreign-tax amount; the section 78 dividend prevents the 
effective allowance of both a deduction and a credit for an amount of 
foreign tax that both reduces the inclusion and is allowed as a deemed 
paid foreign tax credit. If the foreign corporation's deduction from 
income and earnings and profits in respect of foreign taxes were 
adjusted in a different year than the year in which its creditable 
foreign taxes were adjusted, the amount of foreign tax that reduces the 
U.S. shareholder's inclusion and the amount added to income under 
section 78 in respect of the deemed paid tax would not match, such that 
the U.S. shareholder's income would be understated or overstated by the 
amount of the foreign tax adjustment.
    Accordingly, proposed Sec.  1.905-3(b)(2)(ii) clarifies that the 
required adjustments by reason of a foreign tax redetermination of a 
foreign corporation include not only adjustments to the amount of 
foreign taxes deemed paid and related section 78 dividend, but also 
adjustments to the foreign corporation's income and earnings and 
profits and the amount of the U.S. shareholder's inclusions under 
sections 951 and 951A in the year to which the redetermined foreign tax 
relates. The TCJA amendments, by eliminating deemed paid taxes under 
section 902 with respect to dividends and basing deemed paid taxes 
under section 960

[[Page 69136]]

with respect to subpart F and GILTI inclusions on current year income 
and taxes rather than multi-year pools, will require more 
redeterminations of U.S. tax liability to adjust deemed paid credits 
under section 960, but fewer adjustments to intervening years, since a 
foreign tax adjustment to one year will generally no longer affect the 
calculation of deemed paid taxes with respect to inclusions in other 
years. New examples at proposed Sec.  1.905-3(b)(2)(v) illustrate these 
rules.
    Section 905(c)(1)(B) and (C) require a redetermination of U.S. tax 
if accrued taxes remain unpaid after two years, or if any tax paid is 
refunded in whole or in part. These provisions are not limited to cases 
in which the foreign tax redetermination reduces the amount of the 
foreign tax credit. Accordingly, proposed Sec. Sec.  1.905-3(a) and 
1.905-3(b)(2)(ii) also provide that the rules under section 905(c) 
apply in cases in which foreign tax redeterminations affect U.S. tax 
liability even though there may be no change to the amount of foreign 
tax credits originally claimed. For example, under the proposed 
regulations a redetermination of U.S. tax liability is required when a 
foreign tax redetermination affects whether or not a taxpayer is 
eligible for the high-tax exception under section 954(b)(4) (the 
``subpart F high-tax exception'') in the year to which the redetermined 
foreign tax relates. Similarly, a foreign tax redetermination could 
affect the subpart F income, tested income, and earnings and profits of 
a CFC in the year to which the tax relates, see proposed Sec.  1.905-
3(b)(2)(ii), and therefore affect the amount of a U.S. shareholder's 
inclusion under section 951 or section 951A with respect to the 
adjusted year. Corresponding amendments are proposed to the rules in 
Sec. Sec.  1.904-4(c)(7) and 1.954-1(d).

B. Foreign Tax Redeterminations of Successor Entities

    The proposed regulations at Sec.  1.905-3(b)(3) add a rule 
clarifying that if at the time of a foreign tax redetermination the 
person with legal liability for the tax (the ``successor'') is a 
different person than the person that had legal liability for the tax 
in the year to which the redetermined tax relates (the ``original 
taxpayer''), the required redetermination of U.S. tax liability is made 
as if the foreign tax redetermination occurred in the hands of the 
original taxpayer. This could occur, for example, if a disregarded 
entity is sold to a different taxpayer, or if a CFC liquidates into 
another CFC that has transferee liability for the liquidated CFC's 
foreign tax. The proposed regulations further provide that Federal 
income tax principles apply to determine the tax consequences if the 
successor remits, or receives a refund of, a tax that in the year to 
which the redetermined tax relates was the legal liability of, and thus 
considered paid by, the original taxpayer. Thus, for example, when the 
original taxpayer owns the successor which remits a tax that was the 
legal liability of, and considered paid by, the original taxpayer (for 
example, if a controlled foreign corporation that was formerly a 
disregarded entity pays additional tax after a foreign audit), then a 
distribution can result from the successor to the original taxpayer. 
See Herbert Enoch, 57 T.C. 781 (1972) (finding constructive dividend 
when a corporation discharged its shareholder's personal liability on 
debt). The Treasury Department and the IRS request comments on whether 
additional rules are required to address situations involving 
predecessors or successors.

C. Notification to the IRS of Foreign Tax Redeterminations and Related 
Penalty Provisions

    Proposed Sec.  1.905-4 contains rules for notifying the IRS of a 
foreign tax redetermination. Proposed Sec.  301.6689-1 contains rules 
regarding the penalty for failure to notify the IRS of a foreign tax 
redetermination. This Part III.C describes changes made to Sec. Sec.  
1.905-4 and 301.6689-1 relative to the rules that were contained in the 
2007 temporary regulations.
1. Notification Through Amended Returns
    Section 1.905-4T(b)(1)(iv) of the 2007 temporary regulations 
provides that, if more than one foreign tax redetermination requires a 
redetermination of U.S. tax liability for the same taxable year of the 
taxpayer (the affected year) and those redeterminations occur within 
two consecutive taxable years, the taxpayer generally may file for the 
affected year one amended return, Form 1118 (Foreign Tax Credit--
Corporations) or Form 1116 (Foreign Tax Credit), and one statement 
under Sec.  1.905-4T(c) with respect to all of the redeterminations. 
Proposed Sec.  1.905-4(b)(1)(iv) clarifies that, if more than one 
foreign tax redetermination requires a redetermination of U.S. tax 
liability for the same affected year and those redeterminations occur 
within the same taxable year or within two consecutive taxable years, 
the taxpayer may file for the affected year one amended return and one 
statement under proposed Sec.  1.905-4(c) with respect to all of the 
redeterminations. Proposed Sec.  1.905-4(b)(1)(iv) also provides that 
the due date of the amended return and statement varies depending on 
whether the net effect of the foreign tax redeterminations reduces or 
increases the U.S. tax liability in the affected taxable year.
    Section 1.905-4T(b)(1)(v) of the 2007 temporary regulations 
provides that, if a foreign tax redetermination requires a 
redetermination of U.S. tax liability that otherwise would result in an 
additional amount of U.S. tax due, but such amount is eliminated as a 
result of a carryback or carryover of an unused foreign tax under 
section 904(c), the taxpayer may, in lieu of applying the rules of 
Sec. Sec.  1.905-4T(b)(1)(i) and (b)(1)(ii), notify the IRS of such 
redetermination by attaching a statement to the original return for the 
taxpayer's taxable year in which the foreign tax redetermination 
occurs. Section 1.905-4T(b)(1)(v) of the 2007 temporary regulations 
does not apply if the foreign tax redetermination does not change the 
U.S. tax liability for the taxable year to which the tax relates for a 
reason other than the carryback or carryover of an unused foreign tax. 
Section 1.905-4T(b)(1)(v) of the 2007 temporary regulations also does 
not apply if more than one foreign tax redetermination occurring within 
the same taxable year or two consecutive taxable years requires a 
redetermination of U.S. tax liability for the same taxable year but, 
taking into account all such foreign tax redeterminations on a net 
basis, results in no additional amount of U.S. tax liability due for 
such taxable year.
    Proposed Sec.  1.905-4(b)(1)(v) provides that, if a foreign tax 
redetermination (either alone or in combination with certain other 
foreign tax redeterminations as provided in proposed Sec.  1.905-
4(b)(1)(iv)) does not result in a change to the amount of U.S. tax due 
for a taxable year, for reasons including but not limited to a 
carryover or carryback of unused foreign taxes under section 904(c), no 
amended return is required for such year. Instead, appropriate 
adjustments are made to the amounts carried over from that year (for 
example, unused foreign taxes). If no amended return is required for 
any year, the taxpayer must attach a statement containing the 
information described in Sec.  1.904-2(f) to the taxpayer's timely 
filed (with extensions) original return for the taxpayer's taxable year 
in which the foreign tax redetermination occurs.
2. Foreign Tax Redeterminations of Pass-Through Entities
    The 2007 temporary regulations did not specifically provide 
guidance for

[[Page 69137]]

pass-through entities that report creditable foreign taxes to their 
partners, shareholders, or beneficiaries and subsequently have a 
foreign tax redetermination with respect to such foreign taxes. The 
proposed regulations provide rules whereby these entities can satisfy 
their obligations under section 905(c). Proposed Sec.  1.905-4(b)(2) 
generally provides that a pass-through entity that reports creditable 
foreign income tax to its partners, shareholders, or beneficiaries, is 
required to notify the IRS and its partners, shareholders, or 
beneficiaries if there is a foreign tax redetermination with respect to 
such foreign income tax. See proposed Sec.  1.905-4(c) for the 
information required to be provided with the notification.
    Additionally, in 2015, Congress introduced the centralized audit 
partnership regime, which requires that certain adjustments be made at 
the level of the partnership, rather than by partners. See sections 
6221 through 6241 (enacted in Sec.  1101 of the Bipartisan Budget Act 
of 2015, Pub. L. 114-74 (``BBA'') and as amended by the Protecting 
Americans from Tax Hikes Act of 2015, Pub. L. 114-113, div Q, and by 
sections 201 through 207 of the Tax Technical Corrections Act of 2018, 
contained in Title II of Division U of the Consolidated Appropriations 
Act of 2018, Pub. L. 115-141). Under this regime, in order to make an 
adjustment to a partnership-related item (as defined in section 
6241(2)), the partnership must file an administrative adjustment 
request (``AAR''). Sections 6227(d) and 6235(a) contemplate that these 
rules will be coordinated with the application of section 905(c).
    On June 14, 2017, the Treasury Department and the IRS published in 
the Federal Register (82 FR 27334) a notice of proposed rulemaking and 
on November 30, 2017, the Treasury Department and the IRS published in 
the Federal Register (82 FR 56765) another notice of proposed 
rulemaking. Each notice of proposed rulemaking requested comments on 
how a partnership subject to the centralized partnership audit regime 
should fulfill the requirements of section 905(c). One comment was 
received with respect to this issue and it recommended that 
partnerships satisfy their obligations under section 905(c) by filing 
an AAR under section 6227 and by following the procedures under that 
section to take necessary adjustments into account. Consistent with 
this request and with sections 6227(d) and 6235(a), proposed Sec.  
1.905-4(b)(2)(ii) provides that if a redetermination of U.S. tax 
liability would require a partnership adjustment as defined in Sec.  
301.6241-1(a)(6), the partnership must file an AAR under section 6227 
without regard to the time restrictions on filing an AAR in section 
6227(c). See also Sec.  1.6227-1(g).
    The use of the AAR process, even if the period under section 
6227(c) is closed, is intended to further the purpose of sections 
905(c), 6227(d), 6235(a), and 6241(11). An AAR is analogous to an 
amended return, which is required from other taxpayers who have a 
foreign tax redetermination, and provides an administrable process 
whereby a partnership, and its partners, can satisfy their obligations 
under section 905(c). The Treasury Department and the IRS request 
comments on any further coordination that may be required between 
sections 905(c) and 6227 in order to carry out the purposes of the 
foreign tax credit and the centralized partnership audit regime.
3. Alternative Notification Requirements
    Proposed Sec.  1.905-4(b)(3) provides that an amended return and 
Form 1118 (Foreign Tax Credit--Corporations) or Form 1116 (Foreign Tax 
Credit), is not required to notify the IRS of a foreign tax 
redetermination and redetermination of U.S. tax liability if the 
taxpayer satisfies alternative notification requirements that may be 
prescribed by the IRS through forms, instructions, publications, or 
other guidance. For example, as provided in Notice 2016-10, 2016-1 
I.R.B. 1, the Treasury Department and the IRS intend to issue 
regulations providing for alternative notification procedures in the 
case of tax refunds received by regulated investment companies making 
the election to pass through foreign tax credits under section 853. The 
Treasury Department and the IRS request comments on additional 
alternative approaches to complying with the notification requirements 
in section 905(c) that minimize burdens to both taxpayers and the IRS.
4. Foreign Tax Redeterminations of LB&I Taxpayers
    Section 1.905-4T(b)(3) of the 2007 temporary regulations provides a 
special rule for U.S. taxpayers under the jurisdiction of the Large and 
Mid-Size Business Division. The proposed regulations reflect the 
organization's name change to Large Business and International Division 
(LB&I).
    Under the special rule for U.S. taxpayers under LB&I jurisdiction 
(``LB&I rule''), such taxpayers are required, in limited circumstances, 
to provide to their examiners notice of a foreign tax redetermination 
that requires a redetermination of U.S. tax, in lieu of filing an 
amended return. One of the threshold requirements of Sec.  1.905-
4T(b)(3) of the 2007 temporary regulations is that the taxpayer must 
provide the statement describing the foreign tax redetermination no 
later than 120 days after the latest of (1) the date the foreign tax 
redetermination occurs, (2) the opening conference of the examination 
for the affected taxable year, or (3) the hand-delivery or postmark 
date of the opening letter concerning the examination. In no case, 
however, can the alternative notification procedure apply if the 120-
day period within which notification must be made would start after the 
due date of the return for the taxable year in which the foreign tax 
redetermination occurs.
    The LB&I rule contained in the proposed regulations is generally 
the same as the rule in the 2007 temporary regulations, and the 
Explanation of Provisions of the 2007 temporary regulations contains an 
explanation of the rules. However, one change has been made with 
respect to Sec.  1.905-4T(b)(3) of the 2007 temporary regulations. 
Section 1.905-4T(b)(3) provides that, if that provision applies to 
permit notification during an audit, in lieu of filing an amended 
return a taxpayer must provide to the examiner the statement described 
in Sec.  1.905-4T(c) of the 2007 temporary regulations, which contains 
information that enables the IRS to verify and compare the original 
computations with respect to a claimed foreign tax credit, the revised 
computations resulting from the foreign tax redetermination, and the 
net changes resulting therefrom. In order to satisfy the requirements 
of Sec.  1.905-4T(c), a taxpayer is required to recompute its U.S. tax 
liability during the course of an examination, rather than only at the 
conclusion of the audit. To minimize administrative burdens, the 
statement requirement at proposed Sec.  1.905-4(b)(4)(iii) requires the 
taxpayer to provide to the examiner the original amount of foreign 
taxes paid or accrued in the year to which the foreign tax 
redetermination relates, the revised amount of foreign taxes paid or 
accrued, and documentation with respect to the revisions, including 
exchange rates and dates of accrual and/or payment. This information 
must be provided with a penalties-of-perjury declaration signed by a 
person authorized to sign the return of the taxpayer.
    In order to clarify when the special rules for LB&I taxpayers 
apply, the proposed regulations reorganize certain portions of the 2007 
temporary regulations into a list of conditions, all of which must be 
met in order for Sec.  1.905-4(b)(4) to apply. These

[[Page 69138]]

conditions are as follows: (1) A foreign tax redetermination occurs 
while the U.S. taxpayer is under the jurisdiction of LB&I (or a 
successor division); (2) the foreign tax redetermination results in a 
downward adjustment to the amount of foreign tax paid or accrued, or 
included in the computation of foreign taxes deemed paid; (3) the 
foreign tax redetermination requires a redetermination of U.S. tax 
liability and accordingly, but for Sec.  1.905-4(b)(4), the taxpayer 
would be required to notify the IRS of such foreign tax redetermination 
under Sec.  1.905-4(b)(1)(ii) by filing an amended return; (4) the 
return for the taxable year for which a redetermination of U.S. tax 
liability is required is under examination; and (5) the due date 
specified in Sec.  1.905-4(b)(1)(ii) for providing notice of such 
foreign tax redetermination is not before the latest of the opening 
conference or the hand-delivery or postmark date of the opening letter 
concerning the examination of the return for the taxable year for which 
a redetermination of U.S. tax liability is required by reason of such 
foreign tax redetermination.
5. Penalty Provisions
    Section 6689 provides that a taxpayer may be subject to a penalty 
if it fails to notify the IRS of a foreign tax redetermination on or 
before the date prescribed by regulations. Section 301.6689-1T(a) 
(issued in TD 8210 on June 22, 1988) states that the penalty may apply 
if a taxpayer fails to notify the IRS of a foreign tax redetermination 
``on or before the date prescribed in regulations.'' However, the 
preamble of the 2007 temporary regulations, in describing section 6689, 
provides that, ``Under section 6689, a taxpayer that fails to notify 
the IRS of a foreign tax redetermination in the time and manner 
prescribed by regulations for giving such notice is subject to a 
penalty.'' (Emphasis added.) Because it is implicit in section 6689 
that the required notification must comply with the requirements of 
section 905(c), the proposed regulations conform to the preamble 
description in the 2007 temporary regulations. Accordingly, proposed 
Sec.  301.6689-1(a) provides that the penalty may apply if a taxpayer 
fails to notify the IRS of a foreign tax redetermination ``on or before 
the date and in the manner prescribed in regulations.''
    The penalty under section 6689 is generally computed by reference 
to the amount of the deficiency resulting from a foreign tax 
redetermination. If a partnership fails to timely file an AAR as 
required under proposed Sec.  1.905-4(b)(2)(ii) such that the penalty 
under section 6689 is applicable there is ambiguity regarding the 
correct base upon which the penalty is computed because partnerships do 
not generally have deficiencies in chapter 1 tax. Under the centralized 
partnership audit regime enacted by the BBA, if an adjustment is made 
to a partnership-related item of a partnership that is subject to the 
BBA (either by the IRS or by the partnership upon the filing of an 
AAR), the default rule is that the partnership is liable for an imputed 
underpayment calculated on the adjustments, which is an approximate 
substitute for the amount of chapter 1 tax that would have been owed by 
its partners. See sections 6221(a) and 6225. The fact that section 6689 
is silent as to the proper base for calculating a section 6689 penalty 
for a partnership that is subject to BBA creates a special enforcement 
consideration and requires clarification. Therefore, consistent with 
the principles of section 6233(a)(3) (which treats the imputed 
underpayment as an understatement or underpayment for purposes of 
computing a penalty) and the requirement in section 6227(d) that 
regulations coordinate the application of sections 905(c) and 6227, 
proposed Sec.  301.6689-1 provides that in computing the amount of the 
penalty imposed under section 6689, the penalty is calculated on a 
deficiency or by reference to the amount of the imputed underpayment 
that results from the foreign tax redetermination.
    Finally, because section 6662 may apply if a taxpayer's U.S. tax 
liability is understated on an original return even if section 6689 
applies to a failure to notify the IRS of a subsequent foreign tax 
redetermination, the proposed regulations eliminate the reference in 
Sec.  301.6689-1(b) to section 6653(a) (the predecessor to section 
6662).

D. Transition Rule Relating to the TCJA

    The TCJA repealed the pooling rules of section 902 and related 
provisions of section 905(c) that mandated prospective pooling 
adjustments to account for redeterminations of foreign taxes paid by 
foreign corporations that were eligible to be deemed paid by domestic 
corporate shareholders of the foreign corporations. Proposed Sec. Sec.  
1.905-3(b)(2)(iv) and 1.905-5 provide a transition rule providing that 
post-2017 redeterminations of pre-2018 foreign income taxes must be 
accounted for by adjusting the foreign corporation's taxable income and 
earnings and profits, post-1986 undistributed earnings, and post-1986 
foreign income taxes (or pre-1987 accumulated profits and pre-1987 
foreign income taxes, as applicable) in the pre-2018 year to which the 
redetermined foreign taxes relate. A redetermination of U.S. tax 
liability is required to account for the effect of the foreign tax 
redetermination on foreign taxes deemed paid by domestic corporate 
shareholders of the foreign corporation in the relation-back year and 
any subsequent pre-2018 year in which the domestic corporate 
shareholder computed a deemed-paid credit under section 902 or 960 with 
respect to the foreign corporation, as well as any year to which unused 
foreign taxes from any such year were carried. The proposed regulations 
generally apply the currency translation rules applicable under prior 
law and the notification requirements of proposed Sec.  1.904-4 to 
redeterminations of U.S. tax liability required by proposed Sec.  
1.905-3(b)(2)(iv) in these circumstances.
    The Treasury Department and the IRS request comments on whether an 
alternative adjustment to account for post-2017 foreign tax 
redeterminations with respect to pre-2018 taxable years of foreign 
corporations, such as an adjustment to the foreign corporation's 
taxable income and earnings and profits, post-1986 undistributed 
earnings, and post-1986 foreign income taxes as of the foreign 
corporation's last taxable year beginning before January 1, 2018, may 
provide for a simplified and reasonably accurate alternative.

IV. Foreign Income Taxes Taken Into Account Under Section 954(b)(4)

    As discussed in Part III.A of this Explanation of Provisions, 
proposed Sec.  1.905-3(b)(2) provides that a U.S. tax redetermination 
is required when a foreign tax redetermination affects whether or not a 
taxpayer is eligible for the subpart F high-tax exception. Proposed 
Sec.  1.954-1(d)(3)(iii) therefore provides that the subpart F high-tax 
exception is applied by taking into account the redetermined foreign 
tax in the adjusted year.
    The proposed regulations also include an additional clarification 
relating to schemes involving jurisdictions that do not impose 
corporate income tax on a CFC until its earnings are distributed. The 
Treasury Department and the IRS are aware that certain taxpayers claim 
that taxes are treated as paid or accrued for purposes of Sec.  1.954-
1(d)(3) even in the absence of any distribution triggering foreign tax. 
The IRS may challenge this position under existing law. Furthermore, 
the proposed regulations clarify that foreign income taxes that have 
not accrued because they are contingent on a future distribution are 
not taken into account for purposes

[[Page 69139]]

of determining the amount of foreign income taxes paid or accrued with 
respect to an item of income. However, if a redetermination of U.S. tax 
liability is required under proposed Sec. Sec.  1.905-3(a) and 1.905-
3(b)(2)(ii) when tax is imposed on the foreign corporation in 
connection with a distribution, the redetermined foreign tax is taken 
into account in applying Sec.  1.954-1(d)(3) in the adjusted year.

V. Disallowance of Foreign Tax Credits Under Section 965(g)

    The Treasury Department and the IRS are aware that certain 
taxpayers may have engaged in certain transactions that are intended to 
avoid the disallowance of foreign tax credits under section 965(g) with 
respect to distributions of section 965(a) previously taxed earnings 
and profits or section 965(b) previously taxed earnings and profits. 
For example, certain U.S. shareholders of specified foreign 
corporations may incur foreign income taxes on distributions recognized 
for foreign tax purposes that are not recognized for U.S. tax purposes 
(for example, consent dividends). When the section 965(a) previously 
taxed earnings and profits or section 965(b) previously taxed earnings 
and profits are distributed for U.S. tax purposes, no foreign income 
tax is imposed by the foreign jurisdiction. The taxpayers may argue 
that the foreign income taxes on the foreign distributions are not 
associated with a distribution of section 965(a) previously taxed 
earnings and profits or section 965(b) previously taxed earnings and 
profits for U.S. tax purposes, and, accordingly, the credit need not be 
reduced by the section 965(g) disallowance.
    Proposed Sec.  1.965-5(b)(2) clarifies that the principles of Sec.  
1.904-6 apply in determining the extent to which foreign income taxes 
are attributable to distributions of section 965(a) previously taxed 
earnings and profits or section 965(b) previously taxed earnings and 
profits for purposes of Sec.  1.965-5(b)(1). For example, under the 
principles of Sec.  1.904-6, foreign withholding taxes imposed on an 
amount that is recognized as a dividend for foreign, but not Federal 
income, tax purposes are attributable to an item of income to which 
that amount would be assigned if recognized as a distribution for 
Federal income tax purposes. To the extent a distribution would be a 
distribution of section 965(a) previously taxed earnings and profits or 
section 965(b) previously taxed earnings and profits if it were 
recognized for U.S. tax purposes, under proposed Sec.  1.965-5(b)(2) 
the tax would be associated with section 965(a) previously taxed 
earnings and profits or section 965(b) previously taxed earnings and 
profits and disallowed in part by reason of section 965(g). For foreign 
corporation taxable years beginning after December 31, 2019, Sec.  
1.861-20 applies in lieu of Sec.  1.904-6.
    The IRS may challenge the credits claimed for foreign income taxes 
imposed on distributions recognized solely for foreign tax purposes in 
prior years to the extent that such foreign income taxes would be 
considered imposed on distributions of section 965(a) previously taxed 
earnings and profits or section 965(b) previously taxed earnings and 
profits had such distributions been recognized for U.S. tax purposes.

VI. Updates to Consolidated Foreign Tax Credit Rules

    Proposed Sec.  1.1502-4 includes amendments to regulations under 
section 1502 relating to the computation of the consolidated foreign 
tax credit. The proposed amendments update the regulations to reflect 
changes in the law, such as by eliminating out-of-date references to 
the per-country limitation. For purposes of determining the foreign tax 
credit limitation, the proposed regulations also provide that the 
amount of foreign source income in each separate category, used as the 
numerator in the foreign tax credit limitation fraction, is determined 
by applying the rules of Sec.  1.1502-11, as well as sections 904(f) 
and 904(g), on a group-wide basis, rather than applying those rules on 
a separate member basis and combining the results.
    The proposed regulations also add new rules for purposes of 
determining the source and separate category of a consolidated NOL, as 
well as the portion of a consolidated net operating loss (``CNOL'') 
that is apportioned to a separate return year of a member. The Treasury 
Department and the IRS have determined that, when characterizing a CNOL 
that is apportioned to a separate return year, it is generally 
appropriate to link the source and separate category of the CNOL with 
the member's assets that are expected to produce income with that same 
source and separate category so as to minimize the creation of loss 
accounts under sections 904(f) and 904(g) in the year in which the CNOL 
is used. The proposed regulations achieve this result formulaically 
through a two-step process that generally determines a CNOL's source 
and separate category by reference to the statutory and residual 
groupings described in Sec.  1.861-8 for purposes of applying section 
904 as the operative section, which are foreign source income in each 
separate category, and the residual grouping, which is U.S. source 
income.
    First, the member determines a tentative apportionment, which is a 
proportionate share of the amount of the CNOL in each grouping based on 
a comparison of the value of the member's assets in that grouping to 
the value of the group's total assets in the grouping. Because the 
total of tentative apportionments of the CNOL does not necessarily 
equal the member's total share of the CNOL, an adjustment is provided. 
If the total tentative apportionments exceed the CNOL attributable to 
the member, the tentative apportionment in each grouping is reduced by 
a pro rata share of the excess, in proportion to the amount of the 
tentative apportionment in that grouping over the total tentative 
apportionments. In contrast, if the total tentative apportionments are 
less than the CNOL attributable to the member, the tentative 
apportionment in each grouping is increased by a pro rata share of that 
deficiency, in proportion to the remaining CNOL in that grouping (after 
subtracting the tentative apportionment) over the total remaining CNOL 
in all groupings.

VII. Applicability Dates

    The rules in proposed Sec. Sec.  1.861-8, 1.861-9, 1.861-12, 1.861-
14, 1.904-4(c)(7) and (8), 1.904(b)-3, 1.954-1, and 1.954-2, generally 
apply to taxable years that end on or after December 16, 2019.
    The rules in proposed Sec. Sec.  1.704-1(b)(4)(viii)(d)(1), 1.861-
17, 1.861-20, 1.904-6, and 1.960-1 apply to taxable years beginning 
after December 31, 2019. However, taxpayers that are on the sales 
method for taxable years beginning after December 31, 2017, and before 
January 1, 2020, may rely on proposed Sec.  1.861-17 if they apply it 
consistently. Therefore, a taxpayer on the sales method for its taxable 
year beginning in 2018 may rely on proposed Sec.  1.861-17 but must 
also apply the sales method (relying on proposed Sec.  1.861-17) for 
its taxable year beginning in 2019.
    Proposed Sec. Sec.  1.904-4(e) and 1.904(g)-3 apply to taxable 
years ending on or after the date the final regulations are filed with 
the Federal Register.
    In general, proposed Sec. Sec.  1.905-3, 1.905-4, 1.905-5, and 
301.6689-1 apply to foreign tax redeterminations (as defined in Sec.  
1.905-3(a)) occurring in taxable years ending on or after December 16, 
2019, and to foreign tax redeterminations of foreign corporations 
occurring in taxable years that end with or within a taxable year of a 
U.S.

[[Page 69140]]

shareholder ending on or after December 16, 2019. In the case of 
foreign tax redeterminations of foreign corporations, proposed Sec.  
1.905-3 is limited to foreign tax redeterminations that relate to 
taxable years of foreign corporations beginning after December 31, 
2017, and proposed Sec.  1.905-5 is limited to foreign tax 
redeterminations that relate to taxable years of foreign corporations 
beginning before January 1, 2018.
    Proposed Sec.  1.965-5(b)(2) applies to taxable years of foreign 
corporations that end on or after December 16, 2019, and with respect 
to a United States person, to the taxable years in which or with which 
such taxable years of the foreign corporations end.
    Proposed Sec.  1.1502-4 applies to taxable years for which the 
original consolidated Federal income tax return is due (without 
extensions) after December 17, 2019.

Special Analyses

I. Regulatory Planning and Review

    Executive Orders 13563 and 12866 direct agencies to assess costs 
and benefits of available regulatory alternatives and, if regulation is 
necessary, to select regulatory approaches that maximize net benefits 
(including potential economic, environmental, public health and safety 
effects, distributive impacts, and equity). Executive Order 13563 
emphasizes the importance of quantifying both costs and benefits, 
reducing costs, harmonizing rules, and promoting flexibility. The 
Executive Order 13771 designation for any final rule resulting from 
these proposed regulations will be informed by comments received.
    The proposed regulations have been designated by the Office of 
Information and Regulatory Affairs (OIRA) as subject to review under 
Executive Order 12866 pursuant to the Memorandum of Agreement (MOA, 
April 11, 2018) between the Treasury Department and the Office of 
Management and Budget regarding review of tax regulations. The Office 
of Information and Regulatory Affairs (OIRA) has designated these 
proposed regulations as significant under section 1(b) of the MOA. 
Accordingly, these proposed regulations have been reviewed by OIRA.

A. Background and Need for the Proposed Regulations

    Before the Tax Cuts and Jobs Act (TCJA), the United States taxed 
its citizens, residents, and domestic corporations on their worldwide 
income. However, to the extent that a foreign jurisdiction and the 
United States taxed the same income, this framework could have resulted 
in double taxation. The U.S. foreign tax credit (FTC) regime alleviated 
potential double taxation by allowing a non-refundable credit for 
foreign income taxes paid or accrued that could be applied to reduce 
the U.S. tax on foreign source income. Although TCJA eliminated the 
U.S. tax on some foreign source income, the United States continues to 
tax other foreign source income, and to provide foreign tax credits 
against this U.S. tax. The changes made by TCJA to international 
taxation necessitate certain changes in this FTC regime.
    The FTC calculation operates by defining different categories of 
foreign source income (a ``separate category'') based on the type of 
income.\3\ Foreign taxes paid or accrued as well as deductions for 
expenses borne by U.S. parents and domestic affiliates that support 
foreign operations are also allocated to the separate categories under 
similar principles. The taxpayer can then use foreign tax credits 
allocated to each category against the U.S. tax owed on income in that 
category. This approach means that taxpayers who pay foreign taxes on 
income in one category cannot claim a credit against U.S. taxes owed on 
income in a different category, an important feature of the FTC regime. 
For example, suppose a domestic corporate taxpayer has $100 of active 
foreign source income in the ``general category'' and $100 of passive 
foreign source income, such as interest income, in the ``passive 
category.'' It also has $50 of foreign taxes associated with the 
``general category'' income and $0 of foreign taxes associated with the 
``passive category'' income. The allowable FTC is determined separately 
for the two categories. Therefore, none of the $50 of ``general 
category'' FTCs can be used to offset U.S. tax on the ``passive 
category'' income. This taxpayer has a pre-FTC U.S. tax liability of 
$42 (21 percent of $200) but can claim a FTC for only $21 (21 percent 
of $100) of this liability, which is the U.S. tax owed with respect to 
active foreign source income in the general category. The $21 
represents what is known as the taxpayer's foreign tax credit 
limitation. The taxpayer may carry the remaining $29 of foreign taxes 
($50 minus $21) back to the prior taxable year and then forward for up 
to 10 years (until used), and is allowed a credit against U.S. tax on 
general category foreign source income in the carryover year, subject 
to certain restrictions.
---------------------------------------------------------------------------

    \3\ Prior to the TCJA, these categories were primarily the 
passive income and general income categories. The TCJA added new 
separate categories for global intangible low-taxed income (the 
section 951A category) and foreign branch income.
---------------------------------------------------------------------------

    The proposed regulations are needed to address changes introduced 
by the TCJA and to respond to outstanding issues raised in comments to 
the 2018 FTC proposed regulations. In particular, the comments 
highlighted the following areas of concern: (a) Uncertainty concerning 
appropriate allocation of R&E expenditures across FTC categories, (b) 
the need to treat loans from partnerships to partners the same as loans 
from partners to partnerships with respect to aligning interest income 
to interest expense, and (c) uncertainty regarding the appropriate 
level of aggregation (affiliated group versus subgroup) at which 
expenses of insurance companies should be allocated to foreign source 
income. In addition, the proposed regulations are needed to expand the 
application of section 905(c) to cases where a foreign tax 
redetermination changes a taxpayer's eligibility for the high-taxed 
exception under subpart F and GILTI.

B. Overview of the Proposed Regulations

    These proposed regulations address the following issues: (1) The 
allocation and apportionment of deductions under sections 861 through 
865, including new rules on the allocation and apportionment of 
research and experimentation (R&E) expenditures and certain deductions 
of life insurance companies; (2) the definition of financial services 
income under section 904(d)(2)(D); (3) the allocation of foreign income 
taxes to the foreign income to which such taxes relate; (4) the 
interaction of the branch loss and dual consolidated loss recapture 
rules with sections 904(f) and (g); (5) the effect of foreign tax 
redeterminations of foreign corporations on the application of the 
high-tax exception described in section 954(b)(4) (including for 
purposes of determining tested income under section 
951A(c)(2)(A)(i)(III)), and required notifications under section 905(c) 
to the IRS of foreign tax redeterminations and related penalty 
provisions; (6) the definition of foreign personal holding company 
income under section 954; (7) the application of the foreign tax credit 
disallowance under section 965(g); and (8) the application of the 
foreign tax credit limitation to consolidated groups.

[[Page 69141]]

C. Economic Analysis

1. Baseline
    The Treasury Department and the IRS have assessed the benefits and 
costs of these proposed regulations relative to a no-action baseline 
reflecting anticipated Federal income tax-related behavior in the 
absence of these regulations.
2. Summary of Economic Effects
    The proposed regulations provide certainty and clarity to taxpayers 
regarding the allocation of income, expenses, and foreign income taxes 
to the separate categories. In the absence of the enhanced specificity 
provided by these regulations, similarly situated taxpayers might 
interpret the foreign tax credit provisions of the tax code 
differently, potentially resulting in inefficient patterns of economic 
activity. For example, in the absence of the proposed regulations, one 
taxpayer might have chosen not to undertake research (that is, incur 
R&E expenses) in a particular location, based on that taxpayer's 
interpretation of the tax consequences of such expenditures, that 
another taxpayer, making a different interpretation of the tax 
treatment of R&E, might have chosen to pursue in that same location. If 
this difference in interpretations confers a competitive advantage on 
the less productive enterprise, U.S. economic performance may suffer. 
The guidance provided in these regulations helps to ensure that 
taxpayers face more uniform incentives when making economic decisions. 
In general, economic performance is enhanced when businesses face more 
uniform signals about tax treatment.
    Because the TCJA is new, the Treasury Department and the IRS do not 
know with reasonable precision the tax interpretations that taxpayers 
might make in the absence of this guidance. To the extent that 
taxpayers would generally have interpreted the foreign tax credit rules 
as being less favorable to the taxpayer than the proposed regulations 
provide, the proposed regulations may result in additional 
international activity by these taxpayers relative to the no-action 
baseline. This additional activity may include both activities that are 
beneficial to the U.S. economy (perhaps because they represent enhanced 
international opportunities for businesses with U.S. owners) and 
activities that are not beneficial (perhaps because they are 
accompanied by reduced activity in the United States). In essence, the 
Treasury Department and the IRS recognize that additional foreign 
economic activity by U.S. taxpayers may be a complement or substitute 
to activity within the United States and that to the extent these 
regulations change this activity (relative to the no-action baseline or 
alternative regulatory approaches), a mix of results may occur.
    The Treasury Department and the IRS have not undertaken 
quantitative estimates of the economic effects of these regulations. 
The Treasury Department and the IRS do not have readily available data 
or models to estimate with reasonable precision (i) the tax stances 
that taxpayers would likely take in the absence of the proposed 
regulations or under alternative regulatory approaches; (ii) the 
difference in business decisions that taxpayers might make between the 
proposed regulations and the no-action baseline or alternative 
regulatory approaches; or (iii) how this difference in those business 
decisions will affect measures of U.S. economic performance.
    In the absence of such quantitative estimates, the Treasury 
Department and the IRS have undertaken a qualitative analysis of the 
economic effects of the proposed regulations relative to the no-action 
baseline and relative to alternative regulatory approaches. This 
analysis is presented in part I.C.3 of these Special Analyses.
3. Economic Effects of Specific Provisions
i. Rules for Allocating R&E Expenditures Under the Sales Method
a. Background
    Under long-standing foreign tax credit rules, taxpayers must 
allocate expenditures to income categories. In the case of research and 
experimentation (R&E) expenditures, taxpayers can elect between a 
``sales method'' and a ``gross income method'' to allocate the R&E 
expenses.\4\
---------------------------------------------------------------------------

    \4\ If the taxpayer chooses the gross income method, 25 percent 
of the R&E expenditures are exclusively apportioned to the source 
where more than 50 percent of the taxpayer's R&E activities occur 
(generally the United States), and the other 75 percent is 
apportioned ratably. If a taxpayer chooses the sales method then 50 
percent of the R&E expenditures are exclusively apportioned on the 
same basis, and the other 50 percent is apportioned ratably.
---------------------------------------------------------------------------

    The TCJA created some uncertainty regarding the application of the 
sales method because of the introduction of the section 951A category. 
In particular, comments raised issues regarding whether any R&E 
expenditures should be allocated to the section 951A category. The fact 
that sales by CFCs generate tested income and tested income is 
generally assigned to the section 951A category might imply that R&E 
expenditures should be allocated to the section 951A category. But the 
fact that royalty payments from the CFC to the U.S. taxpayer (e.g., in 
remuneration for IP held by the parent that is licensed to the CFC to 
create the products that are sold) are in the general category implies 
that R&E expenditures should be allocated to the general category.
    The gross income method is based on a different apportionment 
factor (gross income) as compared to the sales method (gross receipts). 
However, the gross income method is subject to certain conditions that 
require the result to be within a certain band around the result under 
the sales method, because historically the Treasury Department and the 
IRS have considered that the gross income method could lead to 
anomalous results and could be more easily manipulated than the sales 
method.\5\ The uncertainty with respect to R&E expense allocation under 
the sales method needed resolution, and because the gross income method 
is tied to the sales method, any changes to the sales method required 
consideration of the gross income method.
---------------------------------------------------------------------------

    \5\ The gross income method is more susceptible to manipulation 
because taxpayers can manage the type and amount of their foreign 
gross income by, for example, not paying a dividend and because 
presuming a factual relationship between the R&E expenditure and the 
related class of income based on the relative amounts of a 
taxpayer's gross income was more attenuated than a factual 
relationship based on sales.
---------------------------------------------------------------------------

b. Options Considered for the Proposed Regulations
    The Treasury Department and the IRS considered three options with 
respect to the allocation of R&E expenditures to the section 951A 
category for purposes of calculating the FTC limitation. The first 
option was to confirm that R&E expenditures are allocated to the 
section 951A category under the sales method and to otherwise leave 
their treatment under the gross income method unchanged. The second 
option was to revise the sales method to provide that R&E expenditures 
are only allocated to the income that represents the taxpayer's return 
on intellectual property (thus, R&E expenditures could not be allocated 
to income from the taxpayer's CFC sales) and otherwise leave their 
treatment under the gross income method unchanged. The third option was 
to revise the sales method as considered in the second option and 
eliminate the gross income method for purposes of allocating R&E 
expenditures.
    The proposed regulations adopt the last option. This option allows 
for the provision of an allocation and apportionment method for R&E

[[Page 69142]]

expenditures that generally matches the expense reasonably with the 
income it generates. The matching of income and expenses generally 
produces a more efficient tax system contingent on the overall Code. 
Additionally, because this option results in no R&E expense being 
allocated to section 951A category income, it does not incentivize 
taxpayers with excess credits in the section 951A category to perform 
R&E through foreign subsidiaries; instead, the chosen option generally 
incentivizes choosing the location of R&E based on economic 
considerations rather than tax-related reasons, contingent on the 
overall Code. Finally, because the proposed regulations adopt the 
principle of allocating and apportioning R&E expenditures to IP-related 
income of the U.S. taxpayer, the gross income method is no longer 
relevant, because it allocates and apportions R&E expenditures to the 
section 951A category, and section 951A category gross income is not IP 
income to the U.S. taxpayer.
c. Number of Affected Taxpayers
    The Treasury Department and the IRS have determined that the 
population of affected taxpayers consists of any U.S. taxpayer with R&E 
expenditures and foreign operations. There are around 2,500 such 
taxpayers in currently available tax filings from taxable years 2015-
2017. Based on Statistics of Income data for 2014, approximately $40 
billion of R&E expenses of such taxpayers were allocated to foreign 
source income, out of a total of $190 billion in qualified research 
expenses reported by such taxpayers in that year.\6\
---------------------------------------------------------------------------

    \6\ Note, however, that these taxpayers might have additional 
R&E expenses which are not qualified R&E expenses. The tax data do 
not separately identify such expenses.
---------------------------------------------------------------------------

ii. Application of Section 905(c) To Changes Affecting the High-Tax 
Exception
a. Background
    Section 905(c) provides special rules for a foreign tax 
redetermination (FTR), which is when the amount of foreign tax paid in 
an earlier year (origin year) is changed in a later year (FTR year). 
This redetermination may be necessary, for example, because the 
taxpayer gets a refund or because a foreign audit determines that the 
taxpayer owes additional foreign tax. Since these additional taxes (or 
refunds) relate to the origin year, an FTR affects a taxpayer's origin 
year tax position (as well as FTC carryovers from that year).
    Prior to TCJA, FTRs of foreign corporations generally resulted in 
prospective ``pooling adjustments'' to foreign tax credits. Under this 
approach, taxpayers simply added to or reduced the amount of foreign 
taxes in their foreign subsidiary's FTC ``pool'' going forward rather 
than amend the deemed paid taxes claimed on their origin year return. 
TCJA eliminated the pooling mechanism for taxes (because the adoption 
of a participation exemption system along with the elimination of 
deferral made it unnecessary) and replaced it with a system where taxes 
are deemed paid each year with an inclusion or distribution of 
previously taxed earnings and profits (``PTEP'').
    The 2019 FTC final regulations make clear that an FTR of a United 
States taxpayer must always be accounted for in the origin year, and 
that the taxpayer must file an amended return reflecting any resulting 
change in the taxpayer's U.S. tax liability. Section 905(c) provides 
tools to enforce this amended return requirement. It suspends the 
statute of limitations with respect to the assessment of any additional 
U.S. tax liability that results from an FTR, and imposes a civil 
penalty on taxpayers who fail to notify the IRS (through an amended 
return) of a FTR. To reflect the repeal of the pooling mechanism, the 
proposed regulations generally require taxpayers to account for FTRs of 
foreign subsidiaries on an amended return that reflects revised foreign 
taxes deemed paid under section 960 and any resulting change in the 
taxpayer's U.S. tax liability. However, the 2019 FTC final regulations 
require U.S. tax redeterminations only by reason of FTRs that affect 
the amount of foreign tax credit taxpayers claimed in the origin year. 
The rules do not apply to other tax effects, such as when the FTR 
changes the amount of earnings and profits the taxpayer's CFC had in 
the origin year, or affects whether or not the CFC's income qualifies 
for the high-tax exception under GILTI or subpart F.
    The interaction of FTRs and the high-tax exception under GILTI and 
subpart F increases the importance of filing an origin year amended 
return. In particular, FTRs can give rise to inaccurate origin year 
U.S. liability calculations in the absence of an amended return 
precisely because they can change taxpayers' eligibility for the high-
tax exception. Therefore, the proposed regulations provide that the 
section 905(c) rules cover situations in which the FTR affects not only 
the amount of FTCs taxpayers claimed in the origin year, but also 
whether or not their CFC's income qualified for the high-tax exception.
b. Options Considered for the Proposed Regulations
    The Treasury Department and the IRS considered two options for 
expanding section 905(c) to cover the high-tax exception. The first 
option was to limit section 905(c) to changes in the amount of FTCs. 
The second option was to provide that section 905(c) applies in 
connection with the high-tax exceptions under GILTI and subpart F.
    The proposed regulations adopt the second option. The first option 
would lead to frequent occurrences of inaccurate results with respect 
to the GILTI and subpart F high-tax exceptions because it is common for 
foreign audits to change the amount of tax paid in a prior year. 
Furthermore, taxpayers would have an incentive to overpay their CFC's 
foreign tax in the origin year, claim the high-tax exception to avoid 
subpart F or GILTI inclusions, wait for the 3 year statute of 
limitations to pass, and then claim a foreign tax refund with the 
foreign authorities. Without section 905(c) applying, taxpayers would 
have no obligation or threat of penalty for not amending the origin 
year return. Although there are FTC regulations that deny a credit if 
taxpayers make a noncompulsory payment of tax (i.e., taxpayers paid 
more foreign tax than is necessary under foreign law), those rules are 
challenging to administer. While taxpayers have the burden to prove 
that they were legally required to pay the tax, the IRS may need to 
engage foreign tax law experts to establish that the taxpayer could 
have successfully fought paying it.
    The second option provides a more accurate tax calculation than the 
first option, and it is instrumental in avoiding abuse. The increased 
number of amended returns will increase compliance costs for taxpayers, 
but the Treasury Department and the IRS consider that, in light of the 
high-tax exception, accurate origin year tax liability calculations 
necessitate these increased costs; however, the Treasury Department and 
the IRS solicit comments on this issue.
c. Number of Affected Taxpayers
    The Treasury Department and the IRS determined that the proposed 
regulations potentially affect those U.S. taxpayers that pay foreign 
taxes and have a redetermination of that tax. Although data reporting 
the number of taxpayers subject to an FTR in a given year do not exist, 
some taxpayers currently subject to FTRs will file amended returns. The 
Treasury Department and the IRS estimate that there are approximately 
300 to 600 U.S.

[[Page 69143]]

companies with foreign affiliates that file amended returns per year. 
However, the expansion of the section 905(c) requirement to file an 
amended return to instances where a FTR changes eligibility for the 
high-tax exception under GILTI or subpart F has the potential to 
significantly increase the number of taxpayers filing amended returns. 
The Treasury Department and the IRS have determined that a high upper 
bound for the number of taxpayers subject to a FTR that will be 
required to file amended returns (i.e., taxpayers affected by this 
provision) can be derived by estimating the number of taxpayers with a 
potential GILTI or subpart F inclusion. Based on currently available 
tax filings for taxable years 2015 and 2016, there were about 15,000 C 
corporations with CFCs that filed at least one Form 5471 with their 
Form 1120 return. In addition, for the same period, there were about 
30,000 individuals with CFCs that e-filed at least one Form 5471 with 
their Form 1040 return. In 2015 and 2016, there were about 3,000 S 
corporations with CFCs that filed at least one Form 5471 with their 
1120S return. The identified S corporations had an estimated 150,000 
shareholders, as an upper bound. Finally, the Treasury Department and 
the IRS estimate that there were approximately 7,000 U.S. partnerships 
with CFCs that e-filed at least one Form 5471 as Category 4 or 5 filers 
in 2015 and 2016. The identified partnerships had approximately 2 
million partners, as indicated by the number of Schedules K-1 filed by 
the partnerships. This number includes both domestic and foreign 
partners, so it substantially overstates the number of partners that 
would actually be affected by the final regulations because it includes 
foreign partners.
iii. Extension of the Partnership Loan Rule to Loans From the Partner 
to the Partnership
a. Background
    The 2019 FTC final regulations provide a rule that aligns interest 
income and expense when a U.S. partner makes a loan to the partnership. 
Under this matching rule, the partner's gross interest income is 
apportioned between U.S. and foreign sources in each separate category 
based on the partner's interest expense apportionment ratios. This rule 
minimizes the artificial increase in foreign source taxable income 
based solely on offsetting amounts of interest income and expense from 
a related party loan to a partnership. Comments in response to the 2018 
FTC proposed regulations requested an equivalent rule when the 
partnership makes a loan to a U.S. partner.
b. Options Considered for the Proposed Regulations
    The Treasury Department and the IRS considered two options with 
respect to this rule. The first option was to not provide a rule, 
because the abuse the Treasury Department and the IRS were concerned 
about was not relevant with respect to loans from the partnership to 
the partner. In the absence of a matching rule, the U.S. partner's U.S. 
source taxable income would be artificially increased but this income 
is not eligible to be sheltered by FTCs. The second option was to 
provide an identical rule for loans from the partnership to the partner 
as was provided in the 2019 FTC final regulations for loans from the 
partner to the partnership. The proposed regulations adopt the second 
option. This symmetry helps to ensure that similar economic 
transactions are treated similarly.
c. Number of Affected Taxpayers
    The Treasury Department and the IRS consider the population of 
affected taxpayers to consist of any U.S. partner in a partnership 
which has a loan from the partnership to the partner or certain other 
parties related to the partner. The Treasury Department and the IRS 
estimate that there are approximately 450 partnerships and 5,000 
partners that would be affected by this regulation.
iv. Allocation and Apportionment of Expenses for Insurance Companies
a. Background
    Section 818(f) provides that for purposes of applying the expense 
allocation rules to life insurance companies, the deduction for 
policyholder dividends, reserve adjustments, death benefits, and 
certain other amounts are treated as items that cannot be definitely 
allocated to an item or class of gross income. That means, in general, 
that the expenses are apportioned ratably across all gross income.
    Under the expense allocation rules, for most purposes, affiliated 
groups are treated as a single entity, although there are exceptions 
for certain expenses. The statute is unclear, however, about how 
affiliated groups are to be treated with respect to the allocation of 
certain expenses for insurance companies. Depending on the approach, 
the results could be different because the gross income categories 
across the affiliated group could be calculated in multiple ways. The 
Treasury Department and the IRS received comments and are aware that in 
the absence of further guidance taxpayers are likely to take opposite 
positions on this treatment. Some taxpayers argue that the expenses 
described in section 818(f) are apportioned based on the gross income 
of the entire affiliated group, while others argue that expenses are 
apportioned on a separate company or subgroup basis taking into account 
only the gross income of life insurance companies.
b. Options Considered for the Proposed Regulations
    The Treasury Department and the IRS are aware of at least five 
potential methods for allocating section 818(f) expenses in a life-
nonlife consolidated group. First, the expenses might be allocated 
solely among items of the life insurance company that has the reserves 
(``separate entity method''). Second, to the extent the life insurance 
company has engaged in a reinsurance arrangement that constitutes an 
intercompany transaction (as defined in Sec.  1.1502-13(b)(1)), the 
expenses might be allocated in a manner that achieves single entity 
treatment between the ceding member and the assuming member (``limited 
single entity method''). Third, the expenses might be allocated among 
items of all life insurance members (``life subgroup method''). Fourth, 
the expenses might be allocated among items of all members of the 
consolidated group (including both life and non-life members) (``single 
entity method''). Fifth, the expenses might be allocated based on a 
facts and circumstances analysis (``facts and circumstances method'').
    In response to the request for comments in the 2018 FTC proposed 
regulations, the Treasury Department and the IRS received comments 
advocating for certain of the aforementioned allocation methods. The 
proposed regulations adopt the separate entity method because it is 
consistent with section 818(f) and with the separate entity treatment 
of reserves under Sec.  1.1502-13(e)(2). The Treasury Department and 
the IRS recognize, however, that this method may create opportunities 
for consolidated groups to use intercompany transactions to shift their 
section 818(f) expenses and achieve a more desirable foreign tax credit 
result. Accordingly, the Treasury Department and the IRS request 
comments on whether a life subgroup method more accurately reflects the 
relationship between section 818(f) expenses and the income producing 
activities of the life subgroup as a whole, and whether the life 
subgroup method is less susceptible to abuse

[[Page 69144]]

because it might prevent a consolidated group from inflating its 
foreign tax credit limitation through intercompany transfers of assets, 
reinsurance transactions, or transfers of section 818(f) expenses. The 
Treasury Department and the IRS also request comments regarding the 
appropriate application of Sec.  1.1502-13(c) to neutralize the 
ancillary effects of separate-entity computation of insurance reserves, 
such as the computation of limitations under section 904.
c. Number of Affected Taxpayers
    The Treasury Department and the IRS have determined that the 
population of affected taxpayers consists of life insurance companies 
that are members of an affiliated group. The Treasury Department and 
the IRS have established that there are approximately 60 such 
taxpayers.

II. Paperwork Reduction Act

    For purposes of the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) (``PRA''), there is a collection of information in proposed 
Sec. Sec.  1.905-4 and 1.905-5(b).
    When a redetermination of U.S. tax liability is required by reason 
of a foreign tax redetermination (FTR), the proposed regulations 
generally require the taxpayer to notify the IRS of the FTR and provide 
certain information necessary to redetermine the U.S. tax due for the 
year or years affected by the FTR. If there is no change in the U.S. 
tax liability as a result of the FTR or if the FTR is caused by certain 
de minimis fluctuations in foreign currency rates, the taxpayer may 
simply attach the notification to their next filed tax return and make 
any appropriate adjustments in that year. However, taxpayers are 
generally required to file an amended return (or an administrative 
adjustment request in the case of certain partnerships) for the year or 
years affected by the FTR along with an updated Form 1116 Foreign Tax 
Credit (Individual, Estate, or Trust) (covered under OMB Control Number 
1545-0074 individual, or 1545-0121 estate and trust) or Form 1118 
Foreign Tax Credit-Corporations (OMB Control Number 1545-0123), and a 
written statement providing specific information relating to the FTR. 
Since the burden for filing amended income tax returns and the Forms 
1116 and 1118 are covered under the OMB Control Numbers listed in the 
prior sentence, the burden estimates for OMB Control Number 1545-1056 
only cover the burden for the written statements.
    For purposes of the PRA, the reporting burden associated with 
proposed Sec. Sec.  1.905-4 and 1.905-5(b) will be reflected in the PRA 
submission associated with OMB control number 1545-1056, which is set 
to expire on December 31, 2020. The number of respondents to this 
collection was estimated at 13,000 and the total estimated burden time 
was estimated to be 54,000 hours and total estimated monetized costs of 
$2,430,540 ($2016).
    For taxpayers who are required to file an amended return (along 
with related Form 1116 or Form 1118) in order to report an FTR, and for 
purposes of the PRA, the reporting burden for filing the amended return 
will be reflected in OMB control numbers 1545-0123 (relating to 
business filers, which represents a total estimated burden time, 
including all related forms and schedules, of 3.157 billion hours and 
total estimated monetized costs of $58.148 billion ($2017)), 1545-0074 
(relating to individual filers, which represents a total estimated 
burden time, including all related forms and schedules, of 1.784 
billion hours and total estimated monetized costs of $31.764 billion 
($2017)), and 1545-0121 (relating to estate and trust filers, which 
represents a total estimated burden time, including all related forms 
and schedules, of 25,066,693 hours). These overall burden estimates for 
OMB control numbers 1545-0123, 1545-0074, and 1545-0121 include, but do 
not isolate, the estimated burden of the foreign tax credit-related 
forms as a result of the information collection in the proposed 
regulations. These numbers are therefore unrelated to the future 
calculations needed to assess the burden imposed by the proposed 
regulations. These burdens have also been reported for other 
regulations related to the taxation of cross-border income and the 
Treasury Department and the IRS urge readers to recognize that these 
numbers are duplicates and to guard against overcounting the burden 
that international tax provisions imposed prior to the TCJA.
    As a result of the changes made in the TCJA to the foreign tax 
credit rules generally, and to section 905(c) specifically, the 
Treasury Department and the IRS anticipate that the number of 
respondents may increase modestly among taxpayers who file Form 1120 
series returns. The possible increase in the number of respondents is 
due to the elimination of adjustments to pools of post-1986 earnings 
and profits and post-1986 foreign income taxes as an alternative to 
filing an amended return following the changes made in the TCJA. These 
changes to the burden estimate will be reflected in the PRA submission 
for the renewal of OMB control number 1545-1056 as well as in the OMB 
control numbers 1545-0074 (for individuals) and 1545-0123 (for business 
taxpayers).
    The estimates for the number of impacted filers with respect to the 
collections of information described in this Part II of the Special 
Analyses are based on filers of income tax returns that file a Form 
1065, Form 1040, or Form 1120 series because only filers of these forms 
are generally subject to the collection of information requirement. The 
IRS estimates the number of impacted filers to be the following:

                           Tax Forms Impacted
------------------------------------------------------------------------
                                    Number of       Forms to which the
   Collection of information       respondents      information may be
                                   (estimated)           attached
------------------------------------------------------------------------
Sec.   1.905-4.................    8,900-11,700  Form 1065 series, Form
                                                  1040 series, and Form
                                                  1120 series.
Sec.   1.905-5(b)..............    8,900-11,700  Form 1065 series, Form
                                                  1040 series, and Form
                                                  1120 series.
------------------------------------------------------------------------

    The Treasury Department and the IRS request comments on all aspects 
of information collection burdens related to these proposed 
regulations, including estimates for how much time it would take to 
comply with the paperwork burdens described in this Part II of the 
Special Analyses and ways for the IRS to minimize the paperwork burden. 
No burden estimates specific to the proposed regulations are currently 
available. The Treasury Department has not estimated the burden, 
including that of any new information collections, related to the 
requirements under the proposed regulations. Those estimates would 
capture both changes made by the TCJA and those that arise out of

[[Page 69145]]

discretionary authority exercised in the proposed regulations. The 
Treasury Department and the IRS welcome comments on all aspects of 
information collection burdens related to the foreign tax credit. In 
addition, when available, drafts of IRS forms are posted for comment at 
https://apps.irs.gov/app/picklist/list/draftTaxForms.htm.

III. Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it 
is hereby certified that the proposed regulations will not have a 
significant economic impact on a substantial number of small entities 
within the meaning of section 601(6) of the Regulatory Flexibility Act.
    The proposed regulations provide guidance needed to comply with 
statutory changes and affect individuals and corporations claiming 
foreign tax credits. The domestic small business entities that are 
subject to the foreign tax credit rules in the Code and in the proposed 
regulations are generally those domestic small business entities that 
are at least 10 percent corporate shareholders of foreign corporations, 
and so are eligible to claim dividends-received deductions or compute 
foreign taxes deemed paid under section 960 with respect to inclusions 
under subpart F and section 951A from CFCs. Other aspects of these 
proposed regulations also affect domestic small business entities that 
operate in foreign jurisdictions or that have income from sources 
outside of the United States. Based on 2017 Statistics of Income data, 
the Treasury Department and the IRS computed the fraction of taxpayers 
owning a CFC by gross receipts size class. The smaller size classes 
have a relatively small fraction of taxpayers that own CFCs, which 
suggests that many domestic small business entities would be unaffected 
by these regulations.
    Many of the important aspects of the proposed regulations, 
including all of the rules in proposed Sec. Sec.  1.861-8(d)(2)(ii)(B), 
1.904-4(c)(7), 1.904-6(f), 1.905-3(b)(2), 1.905-5, 1.954-1, 1.954-2, 
and 1.965-5(b)(2) apply only to U.S. persons that operate a foreign 
business in corporate form, and, in most cases, only if the foreign 
corporation is a CFC. Because it takes significant resources and 
investment for a business to operate outside of the United States in 
corporate form, and in particular to own a CFC, the owners of such 
businesses will infrequently be domestic small business entities, as 
indicated by the Table. Other provisions in the proposed regulations, 
including the rules in proposed Sec. Sec.  1.861-8(d)(2)(v), 1.861-
8(e)(16), 1.861-14, 1.904-4(e), 1.1502-4, and 1.1502-21, generally 
apply only to members of a consolidated group and insurance companies 
or other members of the financial services industry earning income from 
sources outside of the United States. It is infrequent for domestic 
small entities to operate as part of an affiliated group, to be taxed 
as an insurance company, or to constitute a financial services entity, 
and also earn income from sources outside of the United States. 
Consequently, the Treasury Department and the IRS project that the 
proposed regulations are unlikely to affect a substantial number of 
domestic small business entities, however adequate data are not 
available at this time to certify that a substantial number of small 
entities would be unaffected.

 Fraction of U.S. Corporate Taxpayers Reporting CFC Ownership, by Gross
                           Receipts Size Class
------------------------------------------------------------------------
                                                            Percentage
                Gross receipts size class                   with a CFC
------------------------------------------------------------------------
<1 mil..................................................            0.40
1-5 mil.................................................            0.80
5-10 mil................................................            2.70
10-20 mil...............................................            4.50
20-30 mil...............................................            9.30
30-50 mil...............................................           12.00
50-100 mil..............................................           19.70
100-150 mil.............................................           26.80
150-200 mil.............................................           32.50
200-250 mil.............................................           37.40
250-500 mil.............................................           43.70
>=500 mil...............................................           63.50
------------------------------------------------------------------------
* Data based on 2017 Statistics of Income sample for all 1120 returns
  except 1120-S and return type=2 (1120-L, 1120-RIC, 1120-F, 1120-REIT,
  1120-PC,1120, 1120-L Consolidated 1504c return (controlling industries
  524142 and 524143),1120-PC Consolidated 1504C return (controlling
  industries 524156, 524159), and 1120 Section 594/1504c consolidated
  return (controlling industries not 524142, 524143, 524156, 524159),
  1120 Non-consolidated return).

    The Treasury Department and the IRS have determined that the 
proposed regulations will not have a significant economic impact on 
domestic small business entities. Based on published information from 
2013, foreign tax credits as a percentage of three different tax-
related measures of annual receipts (see Table for variables) by 
corporations are substantially less than the 3 to 5 percent threshold 
for significant economic impact. The amount of foreign tax credits in 
2013 is an upper bound on the change in foreign tax credits resulting 
from the proposed regulations.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                              $500,000    $1,000,000   $5,000,000  $10,000,000   $50,000,000  $100,000,000
         Size (by business receipts)              Under        under        under        under        under         under         under     $250,000,000
                                                 $500,000    $1,000,000   $5,000,000  $10,000,000  $50,000,000  $100,000,000  $250,000,000     or more
                                                       (%)          (%)          (%)          (%)          (%)           (%)           (%)           (%)
--------------------------------------------------------------------------------------------------------------------------------------------------------
FTC/Total Receipts...........................         0.03         0.00         0.00         0.01         0.01          0.03          0.09          0.56
FTC/(Total Receipts-Total Deductions)........         0.48         0.03         0.04         0.26         0.22          0.51          1.20          9.00
FTC/Business Receipts........................         0.05         0.00         0.00         0.01         0.01          0.04          0.10          0.64
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: Statistics of Income (2013) Form 1120 available at https://www.irs.gov/statistics.


[[Page 69146]]

    Although proposed Sec.  1.905-4 contains a collection of 
information requirement, the small businesses that are subject to the 
requirements of proposed Sec.  1.905-4 are domestic small entities with 
significant foreign operations. The data to assess precise counts of 
small entities affected by proposed Sec.  1.905-4 are not readily 
available, but, as the data above suggest, a significant number of 
small entities are not likely to have significant foreign operations. 
Further, as demonstrated in the second table in this Part III, foreign 
tax credits do not have a significant economic impact for small 
business entities. Therefore, the Treasury Department and the IRS have 
determined that a substantial number of domestic small business 
entities will not be subject to proposed Sec.  1.905-4. Moreover, as 
discussed in this Part III, the proposed regulations do not have a 
significant economic impact on small entities. Accordingly, it is 
hereby certified that the requirements of proposed Sec.  1.905-4 will 
not have a significant economic impact on a substantial number of small 
entities.
    Pursuant to section 7805(f), these proposed regulations will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small businesses. The 
Treasury Department and the IRS also request comments from the public 
on the certifications in this Part III.

IV. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 (UMRA) 
requires that agencies assess anticipated costs and benefits and take 
certain other actions before issuing a final rule that includes any 
Federal mandate that may result in expenditures in any one year by a 
state, local, or tribal government, in the aggregate, or by the private 
sector, of $100 million in 1995 dollars, updated annually for 
inflation. In 2019, that threshold is approximately $154 million. This 
proposed rule does not include any Federal mandate that may result in 
expenditures by state, local, or tribal governments, or by the private 
sector in excess of that threshold.

V. Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on state and local 
governments, and is not required by statute, or preempts state law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive Order. This proposed rule does not have 
federalism implications and does not impose substantial direct 
compliance costs on state and local governments or preempt state law 
within the meaning of the Executive Order.

Comments and Request for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the Addresses heading. 
The Treasury Department and the IRS request comments on all aspects of 
the proposed rules. Additionally, the Treasury Department and the IRS 
have specifically requested comments in the following parts of the 
Explanation of Provisions: I.A.1 (various aspects of stewardship 
expense including definition and exceptions), I.A.5 (future 
implementation of section 864(f) and potential capitalization of 
certain expenses solely for purposes of Sec.  1.861-9), I.D (life 
subgroup method), I.E.1 (different classification methods for R&E 
expenditures), I.E.3 (contract research arrangements), II.A (additional 
guidance under sections 954(h) and 952(c)(1)(B)(vi) with respect to 
financial services entities), II.B (the treatment of foreign tax on 
base differences and on income that is recognized by a different person 
for U.S. tax purposes, the interaction of proposed Sec.  1.904-6(f) 
with sections 245A(g) and 909, and the allocation and apportionment of 
certain state and foreign income taxes), III.B (foreign tax 
redeterminations and predecessor or successor entities), III.C.1 
(alternative notification requirements under section 905(c)), III.C.2 
(coordination between sections 905(c) and 6227), and III.D (alternative 
adjustments for post-2017 foreign tax redeterminations with respect to 
pre-2018 taxable years of foreign corporations).
    All comments will be available at www.regulations.gov or upon 
request. A public hearing will be scheduled if requested in writing by 
any person that timely submits written comments. If a public hearing is 
scheduled, notice of the date, time, and place for the public hearing 
will be published in the Federal Register.

Drafting Information

    The principal authors of the proposed regulations are Karen J. 
Cate, Jeffrey P. Cowan, Jeffrey L. Parry, Larry R. Pounders, and 
Suzanne M. Walsh of the Office of Associate Chief Counsel 
(International). However, other personnel from the Treasury Department 
and the IRS participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 301

    Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income 
taxes, Penalties, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by revising 
the entries for Sec.  1.861-14 and adding entries for Sec. Sec.  1.905-
4 and 1.905-4(b)(2)(ii) to read in part as follows:

    Authority: 26 U.S.C. 7805.
* * * * *
    Section 1.861-14 also issued under 26 U.S.C. 864(e)(7).
* * * * *
    Section 1.905-4 also issued under 26 U.S.C. 989(c)(4) and 26 
U.S.C. 6689(a).
    Section 1.905-4(b)(2)(ii) also issued under 26 U.S.C. 6227(d) 
and 26 U.S.C. 6241(11).
* * * * *

0
Par 2. Section 1.704-1 is amended by:
0
1. Revising the fourth sentence and adding a new fifth sentence in 
paragraph (b)(1)(ii)(b)(1).
0
2. Revising paragraph (b)(4)(viii)(d)(1).
    The revisions read as follows:


Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) * * *
    (1) * * *
    (ii) * * *
    (b) * * *
    (1) * * * Except as provided in the next sentence, the provisions 
of paragraphs (b)(4)(viii)(a)(1), (b)(4)(viii)(c)(1), 
(b)(4)(viii)(c)(2)(ii) and (iii), (b)(4)(viii)(c)(3) and (4), 
(b)(4)(viii)(d)(1) (as in effect on July 24, 2019), and Examples 1, 2, 
and 3 in paragraphs (b)(6)(i), (ii), and (iii) of this section apply 
for partnership taxable years that both begin on or after January 1, 
2016, and end after February 4, 2016. For partnership taxable years 
beginning after December 31, 2019, paragraph (b)(4)(viii)(d)(1) of this 
section applies. * * *
* * * * *
    (4) * * *
    (viii) * * *
    (d) * * * 1 In general. CFTEs are allocated and apportioned to CFTE

[[Page 69147]]

categories in accordance with Sec.  1.861-20 by treating each CFTE 
category as a statutory grouping (with no residual grouping). See 
Examples 2 and 3 in paragraphs (b)(6)(ii) and (iii) of this section, 
which illustrate the application of this paragraph in the case of 
serial disregarded payments subject to withholding tax. In addition, if 
as described in Sec.  1.861-20(e), foreign law does not provide for the 
direct allocation or apportionment of expenses, losses or other 
deductions allowed under foreign law to a CFTE category of income, then 
such expenses, losses or other deductions must be allocated and 
apportioned to gross income as determined under foreign law in a manner 
that is consistent with the allocation and apportionment of such items 
for purposes of determining the net income in the CFTE categories for 
Federal income tax purposes pursuant to paragraph (b)(4)(viii)c3 of 
this section.
* * * * *
0
Par. 3. Section 1.861-8 is amended by:
0
1. Adding a sentence to the end of paragraph (a)(1).
0
2. Revising paragraph (d)(2)(ii)(B).
0
3. Adding paragraph (d)(2)(v).
0
4. Revising paragraph (e)(4)(ii).
0
5. Revising the heading of paragraph (e)(5) and adding five sentences 
to the end of paragraph (e)(5).
0
6. Revising the first sentence of paragraph (e)(6)(i).
0
7. Revising paragraphs (e)(7) and (8).
0
8. Adding paragraph (e)(16).
0
9. Adding paragraphs (g)(15) through (18) and paragraph (g)(24);
0
10. Revising paragraph (h).
    The additions and revisions read as follows:


Sec.  1.861-8  Computation of taxable income from sources within the 
United States and from other sources and activities.

    (a) * * * (1) * * * The term ``section 861 regulations'' means this 
section, Sec. Sec.  1.861-8T, 1.861-9, 1.861-9T, 1.861-10, 1.861-10T, 
1.861-11, 1.861-11T, 1.861-12, 1.861-12T, 1.861-13, 1.861-14, 1.861-
14T, 1.861-17, and Sec.  1.861-20.
* * * * *
    (d) * * *
    (2) * * *
    (ii) * * *
    (B) Certain stock and dividends. The term ``exempt income'' 
includes the portion of the dividends that are deductible under section 
243(a)(1) or (2) (relating to the dividends received deduction) or 
section 245(a) (relating to the dividends received deduction for 
dividends from certain foreign corporations). Thus, for purposes of 
apportioning deductions using a gross income method, gross income does 
not include a dividend to the extent that it gives rise to a dividend 
received deduction under either section 243(a)(1), section 243(a)(2), 
or section 245(a). In addition, for purposes of apportioning deductions 
using an asset method, assets do not include that portion of the value 
of the stock (determined in accordance with Sec.  1.861-9(g), and, as 
relevant, Sec. Sec.  1.861-12 and 1.861-13) equal to the portion of 
dividends paid thereon that would be deductible under either section 
243(a)(1), section 243(a)(2), or section 245(a). For example, in the 
case of stock for which all dividends would be allowed a deduction of 
50 percent under section 243(a)(1), 50 percent of the value of the 
stock is treated as an exempt asset. In the case of stock which 
generates, has generated, or can reasonably be expected to generate 
qualifying dividends deductible under section 243(a)(3), such stock 
does not constitute an exempt asset. However, such stock and the 
qualifying dividends thereon are eliminated from consideration in the 
apportionment of interest expense under the consolidation rule set 
forth in Sec.  1.861-11T(c), and in the apportionment of other expenses 
under the consolidation rules set forth in Sec.  1.861-14T.
* * * * *
    (v) Dividends received deduction and tax-exempt interest of 
insurance companies--(A) In general. For purposes of characterizing 
gross income or assets as exempt or not exempt under this section, the 
following rules apply on a company wide basis pursuant to the rules in 
paragraphs (d)(2)(v)(A)(1) and (2) of this section.
    (1) In the case of an insurance company taxable under section 801, 
the term ``exempt income'' includes the portion of dividends received 
that satisfy the requirements of deductibility under sections 243(a)(1) 
and (2) and 245(a) but without regard to any disallowance under section 
805(a)(4)(A)(ii) of the policyholder's share of the dividends or any 
similar disallowance under section 805(a)(4)(D), and also includes tax-
exempt interest but without reduction for the policyholder's share of 
tax-exempt interest that reduces the closing balance of items described 
in section 807(c), as provided under section 807(a)(2)(B) and 
807(b)(1)(B). The term ``exempt assets'' includes the corresponding 
portion of assets that give rise to exempt income described in the 
preceding sentence. See Sec.  1.861-8(e)(16) for a special rule 
concerning the allocation of reserve expenses to dividends received by 
a life insurance company.
    (2) In the case of an insurance company taxable under section 831, 
the term ``exempt income'' includes the portion of interest and 
dividends deductible under sections 832(c)(7) and (12) or sections 
834(c)(1) and (7). Exempt income also includes the amounts reducing the 
losses incurred under section 832(b)(5) to the extent such amounts are 
not already taken into account in the preceding sentence. The term 
``exempt assets'' includes the corresponding portion of assets that 
give rise to exempt income described in the preceding two sentences.
    (B) Examples. The following examples illustrate the application of 
paragraph (d)(2)(v)(A) of this section.

    (1) Example 1--(i) Facts. U.S.C. is a domestic life insurance 
company that has $300x of gross income, consisting of $100x of 
foreign source general category income and $200x of U.S. source 
passive category interest income, $100x of which is tax-exempt 
interest income from municipal bonds under section 103. U.S.C.'s 
opening balance of its section 807(c) reserves is $50,000x and USP's 
closing balance of its section 807(c) reserves is $50,130x. Under 
section 807(b)(1)(B), USP's closing balance of its section 807(c) 
reserves, $50,130x, is reduced by the amount of the policyholder's 
share of tax-exempt interest. The policyholder's share of tax-exempt 
interest under section 812(b) is equal to 30 percent of the $100x of 
tax-exempt interest ($30x). Therefore, under sections 803(a)(2) and 
807(b), USP's reserve deduction is $100x ($50,130x of reserve 
deduction minus $30x (30 percent of $100x of tax-exempt interest), 
minus $50,000x). U.S.C. has no other income or deductions.
    (ii) Analysis--allocation. Under section 818(f)(1), U.S.C.'s 
reserve deduction is treated as an item that cannot be definitely 
allocated to an item or class of gross income. Accordingly, under 
paragraph (b)(5) of this section, U.S.C.'s reserve deduction is 
allocable to all of U.S.C.'s gross income as a class.
    (iii) Analysis--apportionment. Under paragraph (c)(3) of this 
section, the reserve deduction is ratably apportioned between the 
statutory grouping (foreign source general category income) and the 
residual grouping (U.S. source income) on the basis of the relative 
amounts of gross income in each grouping. For purposes of 
apportioning deductions under Sec.  1.861-8T(d)(2)(i)(B), exempt 
income is not taken into account. Under paragraph (d)(2)(v)(A)(1) of 
this section, in the case of an insurance company taxable under 
section 801, exempt income includes tax-exempt interest without 
regard to any reduction for the policyholder's share. U.S.C. has 
U.S. source income of $200x of which $100x is tax-exempt without 
regard to the reduction for the policyholder's share of tax-exempt 
interest that reduces the closing balance of items described in 
section 807(c). Thus, the gross income taken into account in 
apportioning U.S.C.'s reserve deduction is $100x of foreign source 
general category

[[Page 69148]]

gross income and $100x of U.S. source gross income. Of U.S.C.'s 
$100x reserve deduction, $50x ($100x x $100x/$200x) is apportioned 
to foreign source general category gross income and $50x ($100x x 
$100x/$200x) is apportioned to U.S. source gross income.
    (2) Example 2--(i) Facts. U.S.C. is a domestic life insurance 
company that has $300x of gross income consisting of $100x of 
foreign source general category income and $200x of U.S. source 
general category dividend income eligible for the 50% dividends 
received deduction (DRD) under section 243(a)(1). Under section 
805(a)(4)(A)(ii), U.S.C. is allowed a 50% DRD on the company's share 
of the dividend received. Under section 812(a), the company's share 
is equal to 70% of the dividend income eligible for the DRD under 
section 243(a)(1), which results in a DRD of $70x (70% x 50% x 
$200x), and under section 812(b), the policyholder's share is equal 
to 30% of the dividend income eligible for the DRD under section 
243(a)(1), or $30x. U.S.C. is entitled to a $130x deduction for an 
increase in its life insurance reserves under sections 803(a)(2) and 
807(b). Unlike for tax-exempt interest income, there is no 
adjustment under section 807(b)(1)(B) to the reserve deduction for 
the policyholder's share of dividends eligible for the DRD under 
section 243(a)(1). U.S.C. has no other income or deductions.
    (ii) Analysis--allocation. Under section 818(f)(1), U.S.C.'s 
reserve is treated as an item that cannot be definitely allocated to 
an item or class of gross income except that, under Sec.  1.861-
8(e)(16), an amount of reserve expenses of a life insurance company 
equal to the DRD that is disallowed because it is attributable to 
the policyholder's share of dividends is treated as definitely 
related to such dividends. Thus, U.S.C. has a life insurance reserve 
deduction of $130x, of which $30x (equal to the policyholder's share 
of the DRD that would have been allowed under section 243(a)(1)) is 
directly allocated and apportioned to U.S. source dividend income. 
Under paragraph (b)(5) of this section, the remaining portion of 
U.S.C.'s reserve deduction ($100x) is allocable to all of U.S.C.'s 
gross income as a class.
    (iii) Analysis--apportionment. Under paragraph (c)(3) of this 
section, the deduction is ratably apportioned between the statutory 
grouping (foreign source general category income) and the residual 
grouping (U.S. source income) on the basis of the relative amounts 
of gross income in each grouping. For purposes of apportioning 
deductions under Sec.  1.861-8T(d)(2)(i)(B), exempt income is not 
taken into account. Under paragraph (d)(2)(v)(A)(1) of this section, 
in the case of an insurance company taxable under section 801, 
exempt income includes dividends deductible under section 805(a)(4) 
without regard to any reduction to the DRD for the policyholder's 
share in section 804(a)(4)(A)(ii). Thus, the gross income taken into 
account in apportioning $100x of U.S.C.'s remaining reserve 
deduction is $100x of foreign source general category gross income 
and $100x of U.S. source gross income. Of U.S.C.'s $100x remaining 
reserve deduction, $50x ($100x x $100x/$200x) is apportioned to 
foreign source general category gross income and $50x ($100x x 
$100x/$200x) is apportioned to U.S. source gross income.
* * * * *
    (e) * * *
    (4) * * *
    (ii) Stewardship expenses--(A) In general. Stewardship expenses 
result from ``overseeing'' functions undertaken for a corporation's own 
benefit as an investor in a related corporation. For purposes of this 
section, stewardship expenses of a corporation are those expenses 
resulting from ``duplicative activities'' (as defined in Sec.  1.482-
9(l)(3)(iii)) or ``shareholder activities'' (as defined in Sec.  1.482-
9(l)(3)(iv)) of the corporation with respect to the related 
corporation. Thus, for example, stewardship expenses include expenses 
of an activity the sole effect of which is either to protect the 
corporation's capital investment in the related corporation or to 
facilitate compliance by the corporation with reporting, legal, or 
regulatory requirements applicable specifically to the corporation, or 
both. If a corporation has a foreign or international department which 
exercises overseeing functions with respect to related foreign 
corporations and, in addition, the department performs other functions 
that generate other foreign-source income (such as fees for services 
rendered outside of the United States for the benefit of foreign 
related corporations and foreign-source royalties), some part of the 
deductions with respect to that department are considered definitely 
related to the other foreign-source income. In some instances, the 
operations of a foreign or international department will also generate 
U.S. source income (such as fees for services performed in the United 
States).
    (B) Allocation. Stewardship expenses are considered definitely 
related and allocable to dividends and inclusions received or accrued, 
or to be received or accrued, under sections 78, 951 and 951A, as well 
as amounts included under sections 1291, 1293, and 1296, from the 
related corporation.
    (C) Apportionment. Stewardship expenses must be apportioned between 
the statutory grouping (or groupings) and residual grouping based on 
the relative values of the stock in each grouping held by a taxpayer, 
as determined and characterized under Sec.  1.861-9T(g) (and, as 
relevant, Sec. Sec.  1.861-12 and 1.861-13) for purposes of allocating 
and apportioning the taxpayer's interest expense.
    (D) Partnerships. The principles of paragraph (e)(4)(ii)(A) of this 
section apply to determine if expenses incurred with respect to a 
partnership are stewardship expenses. Stewardship expenses incurred 
with respect to a partnership are considered definitely related and 
allocable to a partner's distributive share of partnership income. The 
principles of paragraph (e)(4)(ii)(C) of this section apply to 
apportion expenses incurred with respect to a partnership.
    (5) Legal and accounting fees and expenses; damages awards, 
prejudgment interest, and settlement payments. * * * Awards for 
litigation or arbitral damages, prejudgment interest, and payments in 
settlement of or in anticipation of claims for damages, including 
punitive damages, arising from product liability and similar or related 
claims are definitely related and allocable to the class of gross 
income produced by the specific sales of the products or services that 
gave rise to the claims for damage or injury. If the claims arise from 
an event incident to the production of products or provision of 
services rather than from damage or injury caused by the product or 
service, the payments are definitely related and allocable to the class 
of gross income ordinarily produced by the assets used to produce the 
products or services that are involved in the event. If necessary, the 
deductions arising from the event are apportioned among the statutory 
and residual groupings on the basis of the relative values (as 
determined under Sec.  1.861-9T(g) and, as relevant, Sec. Sec.  1.861-
12 and 1.861-13, for purposes of allocating and apportioning the 
taxpayer's interest expense) of the assets in each grouping. If the 
claims are made by investors in a corporation, arise from negligence, 
fraud, or other malfeasance of the corporation (or its 
representatives), and are not described in the preceding two sentences, 
then the damages, prejudgment interest, and settlement payments paid by 
the corporation are definitely related and allocable to all income of 
the corporation and are apportioned among the statutory and residual 
groupings based on the relative value of the corporation's assets in 
each grouping (as determined under Sec.  1.861-9T(g) and, as relevant, 
Sec. Sec.  1.861-12 and 1.861-13, for purposes of allocating and 
apportioning the taxpayer's interest expense). The grouping (or 
groupings) of income to which damages, prejudgment interest, and 
settlement payments is allocated and apportioned is determined based on 
the groupings to which the related income would be assigned if the 
income were recognized in the taxable year in which the deduction is 
allowed.
    (6) * * * (i) * * * The deduction for foreign income, war profits 
and excess profits taxes allowed by section 164 is

[[Page 69149]]

allocated and apportioned among the applicable statutory and residual 
groupings under Sec.  1.861-20. * * *
* * * * *
    (7) Losses on the sale, exchange, or other disposition of property. 
See Sec. Sec.  1.865-1 and 1.865-2 for rules regarding the allocation 
of certain losses.
    (8) Net operating loss deduction--(i) Components of net operating 
loss. A net operating loss is assigned to statutory or residual 
grouping components by reference to the losses in each such statutory 
or residual grouping that are not allocated to reduce income in other 
groupings in the taxable year of the loss. For example, for purposes of 
section 904, the source and separate category components of a net 
operating loss are determined by reference to the amounts of separate 
limitation loss and U.S. source loss (determined without regard to 
adjustments required under section 904(b)) that are not allocated to 
reduce U.S. source income or income in other separate categories under 
the rules of sections 904(f) and 904(g) for the taxable year in which 
the net operating loss arose. See Sec.  1.904(g)-3(d)(2). See Sec.  
1.1502-4 for rules applicable in computing the foreign tax credit 
limitation and determining the source and separate category of a net 
operating loss of a consolidated group.
    (ii) Components of section 172 deduction. A net operating loss 
deduction allowed under section 172 is allocated and apportioned to 
statutory and residual groupings by reference to the statutory and 
residual grouping components of the net operating loss that is deducted 
in the taxable year. Except as provided under the rules for an 
operative section, a partial net operating loss deduction is treated as 
ratably comprising the components of a net operating loss. See, for 
example, Sec.  1.904(g)-3, which is an exception to the general rule 
described in the previous sentence and provides rules for determining 
the source and separate category of a partial net operating loss 
deduction for purposes of section 904 as the operative section.
* * * * *
    (16) Special rule for the allocation of reserve expenses of a life 
insurance company. An amount of reserve expenses of a life insurance 
company equal to the dividends received deduction that is disallowed 
because it is attributable to the policyholders' share of dividends 
received is treated as definitely related to such dividends. See 
paragraph (d)(2)(v)(B)(2) of this section (Example 2).
* * * * *
    (g) * * *

    (15) Example 15: Payment in settlement of claim for damages 
allocated to specific class of gross income--(i) Facts--USP, a 
domestic corporation, designs, manufactures, and sells Product A in 
the United States. USP also operates a foreign branch, within the 
meaning of Sec.  1.904-4(f)(3)(vii), in Country X through FDE, a 
disregarded entity organized in Country X, which manufactures and 
sells Product A in Country X. USP earns $300x of U.S. source income 
from sales of Product A to customers in the United States. The sales 
of Product A to customers in Country X result in aggregate gross 
income of $100x, of which $80x is U.S. source income attributable to 
USP's manufacturing activities and $20x is U.S. source income 
attributable to FDE's distribution activities. The $100x of income 
from sales of Product A to customers in Country X constitutes 
foreign branch category income. FDE is sued under Country X law for 
damages after Product A harms a customer in Country X. FDE makes a 
deductible payment to the Country X customer in settlement of the 
legal claims for damages.
    (ii) Analysis. Because Product A caused the customer's injury, 
the claim for damages arose from the specific sales of Product A to 
the customer in Country X. Claims that might arise from damages 
caused by Product A to customers in the United States are irrelevant 
in allocating the deduction for the settlement payments made to the 
customer in Country X. Therefore, FDE's damages payment deduction is 
allocable to the class of gross income of sales of Product A in 
Country X. For purposes of section 904(d), because that class of 
gross income consists solely of U.S. source income, none of that 
income is included in the statutory grouping of foreign source 
foreign branch category income, and accordingly the damages payment 
deduction reduces USP's residual grouping of U.S. source income.
    (16) Example 16: Legal damages payment arising from event prior 
to sale--(i) Facts- The facts are the same as in paragraph (g)(15) 
of this section (the facts in Example 15) except that there is a 
disaster at FDE's warehouse in Country X arising from the negligence 
of an employee. The inventory of Product A in the warehouse is 
destroyed and FDE employees as well as residents in the vicinity of 
the warehouse are injured. USP's reputation in the United States 
suffers such that USP expects to subsequently lose market share in 
the United States. FDE makes damages payments totaling $80x to both 
its injured employees and the nearby residents.
    (ii) Analysis. FDE's warehouse in Country X is used in 
connection with sales of Product A to customers in Country X. Thus, 
the $80x damages payment is allocable to the class of gross income 
ordinarily produced by the assets used to produce Product A. No 
apportionment of the $80x is necessary for purposes of applying 
section 904(d) because the class of gross income to which the 
deduction is allocated consists solely of U.S. source income.
    (17) Example 17: Payment following a change in law--(i) Facts. 
The facts are the same as in paragraph (g)(15) (the facts in Example 
15) except that FDE manufactures and sells Product A in Country X in 
2015 (before the enactment of the section 904(d)(1)(B) separate 
category for foreign branch income) and is sued in 2016 under 
Country X law for damages after Product A harms a customer in 
Country X. FDE makes a deductible damages payment to the Country X 
customer pursuant to a court judgment in 2019.
    (ii) Analysis. The specific sales of Product A in Country X in 
2015 led to the customer's injury in Country X. The payment in 2019 
of the deductible damages payment is definitely related and 
allocable to the class of gross income consisting of Product A sales 
in Country X. Although the income earned from the Product A sales in 
Country X in 2015 was foreign source general category income, in 
2019 the assets used to produce such income is U.S. source foreign 
branch category income. Accordingly, the deductible damages payment 
is allocated to foreign branch category income. No apportionment of 
the payment is necessary because the class of gross income to which 
the deduction is allocated consists solely of U.S. source income.
    (18) Example 18: Stewardship and supportive expenses--(i) 
Facts--(A) USP, a domestic corporation, manufactures and sells 
Product A in the United States. USP owns 100% of the stock of USSub, 
a domestic corporation, and CFC1, CFC2, and CFC3, which are all 
controlled foreign corporations. USP and USSub file separate returns 
for U.S. Federal income tax purposes but are members of the same 
affiliated group under section 243(b)(2). USSub, CFC1, CFC2, and 
CFC3 perform similar functions in the United States and in the 
foreign countries T, U, and V, respectively. The tax book value of 
USP's stock in each of its four subsidiaries is $10,000x.
    (B) USP's supervision department (the Department) incurs 
expenses of $1,500x. The Department is responsible for the 
supervision of its four subsidiaries and for rendering certain 
services to the subsidiaries, and the Department provides all the 
supportive functions necessary for USP's foreign activities. The 
Department performs three principal types of activities. First, the 
Department performs services outside the United States for the 
direct benefit of CFC2 for which a fee is paid by CFC2 to USP. The 
cost to the Department of the services for CFC2 is $900x, which 
results in a total charge (after a $100x markup) to CFC2 of $1,000x, 
all of which is foreign source income to USP. Second, the Department 
provides services related to license agreements that USP maintains 
with subsidiaries CFC1 and CFC2 and which give rise to foreign 
source income to USP. The cost of the services is $60x. Third, it 
performs activities described in Sec.  1.482-9(l)(3)(iii) that are 
in the nature of shareholder oversight, that duplicate functions 
performed by the subsidiaries' own employees, and that do not 
provide an additional benefit to the subsidiaries. For example, a 
team of auditors from USP's accounting department periodically 
audits the subsidiaries' books and prepares internal reports for use 
by USP's management. Similarly, USP's treasurer periodically reviews 
for the board of directors of USP the

[[Page 69150]]

subsidiaries' financial policies. These activities do not provide an 
additional benefit to the related corporations. The cost of the 
duplicative services and related supportive expenses is $540x.
    (C) USP also earns the following items of income. First, under 
section 951(a), USP includes $2,000x of subpart F income that is 
passive category income. Second, under section 951A and the section 
951A regulations (as defined in Sec.  1.951A-1(a)(1)), USP has a 
GILTI inclusion amount of $2,000x. USP's deduction under section 250 
is $1,000x (``section 250 deduction''), all of which is by reason of 
section 250(a)(1)(B)(i). No portion of USP's section 250 deduction 
is reduced by reason of section 250(a)(2)(B). Finally, USP also 
earns $1,000x of fees from CFC2 and receives royalties of $1,000x 
from CFC1 and CFC2.
    (D) Under Sec.  1.861-9T(g)(3), USSub owns assets that generate 
income described in the residual grouping of gross income from U.S. 
sources. USP uses the asset method described in Sec.  1.861-
12T(c)(3)(ii) to characterize the stock in its CFCs. After 
application of Sec.  1.861-13(a), USP determines that $5,000x of the 
stock of each of the three CFCs is assigned to the section 951A 
category (``section 951A category stock'') in the non-section 245A 
subgroup; $2,000x of the stock of each of the three CFCs is assigned 
to the general category in the section 245A subgroup; and $3,000x of 
the stock of each of the three CFCs is assigned to the passive 
category in the non-section 245A subgroup. Additionally, under Sec.  
1.861-8(d)(2)(ii)(C)(2), $2,500x of the stock of each of the three 
CFCs that is section 951A category stock is an exempt asset. 
Accordingly, with respect to the stock of its controlled foreign 
corporations in the aggregate, USP has $7,500x of section 951A 
category stock in a non-section 245A subgroup, $6,000x of general 
category stock in a section 245A subgroup, $9,000x of passive 
category stock in a non-section 245A subgroup, and $7,500x of stock 
that is an exempt asset.
    (ii) Analysis--(A) Character of USP Department services. The 
first and second activities (the services rendered for the benefit 
of CFC2, and the provision of services related to license agreements 
with CFC1 and CFC2) are not properly characterized as stewardship 
expenses because they are not incurred solely to protect the 
corporation's capital investment in the related corporation or to 
facilitate compliance by the corporation with reporting, legal, or 
regulatory requirements applicable specifically to the corporation. 
The third activity described is in the nature of shareholder 
oversight and is characterized as stewardship as described in 
paragraph (e)(4)(ii)(A) of this section because the expense is 
related to duplicative activities.
    (B) Allocation. First, the deduction of $900x for expenses 
related to services rendered for the benefit of CFC2 is definitely 
related (and therefore allocable) to the $1,000x in fees for 
services that USP receives from CFC2. Second, the $60x of deductions 
attributable to USP's license agreements with CFC1 and CFC2 are 
definitely related (and therefore allocable) solely to royalties 
received from CFC1 and CFC2. Third, the stewardship deduction of 
$540x is definitely related (and therefore allocable) to dividends 
and inclusions received from all the subsidiaries.
    (C) Apportionment--(1) No apportionment of USP's deduction of 
$900x for expenses related to the services is necessary because the 
class of gross income to which the deduction is allocated consists 
entirely of a single statutory grouping, foreign source general 
category income.
    (2) No apportionment of USP's deduction of $60x attributable to 
the ancillary services is necessary because the class of gross 
income to which the deduction is allocated consists entirely of a 
single statutory grouping, foreign source general category income.
    (3) For purposes of apportioning USP's $540x stewardship 
expenses in determining the foreign tax credit limitation, the 
statutory groupings are foreign source general category income, 
foreign source passive category income, and foreign source section 
951A category income. The residual grouping is U.S. source income.
    (4) USP's deduction of $540x for the Department's stewardship 
expenses which are allocable to dividends and inclusions received 
from the subsidiaries are apportioned using the same value of USP's 
stock in USSub, CFC1, CFC2, and CFC3 that is used for purposes of 
allocating and apportioning USP's interest expense. However, the 
$10,000x value of USP's stock of USSub is eliminated because USSub 
generates qualifying dividends deductible under section 243(a)(3). 
See Sec.  1.861-8(d)(2)(ii)(B).
    (5) Although USP may be allowed a section 245A deduction with 
respect to dividends from the CFCs, the value of the stock of the 
CFCs is not eliminated because the section 245A deduction does not 
create exempt income or result in the stock being treated as an 
exempt asset. See section 864(e)(3) and Sec.  1.861-
8T(d)(2)(iii)(C). Therefore, the only asset value upon which 
stewardship expenses are apportioned is the stock in USP's CFCs.
    (6) Taking into account the characterization of USP's stock in 
CFC1, CFC2, and CFC3, and excluding the exempt portion, the $540x of 
Department expenses is apportioned as follows: $180x ($540x x 
$7,500x/$22,500x) to section 951A category income, $144x ($540x x 
$6,000x/$22,500x) to general category income, and $216x ($540x x 
$9,000x/$22,500x) to passive category income. Section 
904(b)(4)(B)(i) applies to $144x of the stewardship expense 
apportioned to the CFCs' stock that is characterized as being in the 
section 245A subgroup in the general category.
* * * * *

    (24) For guidance, see Sec.  1.861-8T(g) Example 24.
* * * * *
    (h) Applicability date--(1) Except as provided in paragraph (h)(2) 
of this section, this section applies to taxable years that both begin 
after December 31, 2017, and end on or after December 4, 2018.
    (2) Paragraphs (d)(2)(ii)(B), (d)(2)(v), (e)(4), (e)(5), (e)(6)(i), 
(e)(8), (e)(16), and (g)(15) through (g)(18) of this section apply to 
taxable years that end on or after December 16, 2019. For taxable years 
that both begin after December 31, 2017, and end on or after December 
4, 2018, and also end before December 16, 2019, see Sec.  1.861-
8(d)(2)(ii)(B), (e)(4), (e)(5), (e)(6)(i), and (e)(8) as in effect on 
December 17, 2019.
0
Par. 4. Section 1.861-8T is amended by revising paragraph (d)(2)(ii)(B) 
to read as follows:


Sec.  1.861-8T  Computation of taxable income from sources within the 
United States and from other sources and activities (temporary).

* * * * *
    (d) * * *
    (2)* * *
    (ii) * * *
    (B) For further guidance, see Sec.  1.861-8(d)(2)(ii)(B).
* * * * *
0
Par. 5. Section 1.861-9 is amended by:
0
1. Revising paragraphs (a) and (b).
0
2. Revising paragraphs (c)(1) through (4).
0
3. Adding paragraph (e)(9).
0
4. Revising paragraph (k).
    The revisions and additions read as follows:


Sec.  1.861-9  Allocation and apportionment of interest expense and 
rules for asset-based apportionment.

    (a) For further guidance, see Sec.  1.861-9T(a).
    (b) Interest equivalent--(1) Certain expenses and losses--(i) 
General rule. Any expense or loss (to the extent deductible) incurred 
in a transaction or series of integrated or related transactions in 
which the taxpayer secures the use of funds for a period of time is 
subject to allocation and apportionment under the rules of this section 
and Sec.  1.861-9T(b) if such expense or loss is substantially incurred 
in consideration of the time value of money. However, the allocation 
and apportionment of a loss under this paragraph (b) and Sec.  1.861-
9T(b) does not affect the characterization of such loss as capital or 
ordinary for any purpose other than for purposes of the section 861 
regulations (as defined in Sec.  1.861-8(a)(1)).
    (ii) Examples. For further guidance see Sec.  1.861-9T(b)(1)(ii)
    (2) Certain foreign currency borrowings. For further guidance see 
Sec.  1.861-9T(b)(2) through (7).
    (3) through (7) [Reserved]
    (8) Guaranteed payments. Any deductions for guaranteed payments for

[[Page 69151]]

the use of capital under section 707(c) are allocated and apportioned 
in the same manner as interest expense.
    (c)(1) Disallowed deductions. For further guidance, see Sec.  
1.861-9T(c)(1) through (4).
    (2) through (4) [Reserved]
* * * * *
    (e) * * *
    (9) Special rule for upstream partnership loans--(i) In general. 
For purposes of apportioning interest expense that is not directly 
allocable under paragraph (e)(4) of this section or Sec.  1.861-10T, an 
upstream partnership loan debtor's (UPL debtor) pro rata share of the 
value of the upstream partnership loan (as determined under paragraph 
(h)(4)(i) of this section) is not considered an asset of the UPL debtor 
taken into account as described in paragraphs (e)(2) and (3) of this 
section.
    (ii) Treatment of interest expense and interest income attributable 
to an upstream partnership loan. If a UPL debtor (or any other person 
in the same affiliated group as the UPL debtor) takes into account a 
distributive share of upstream partnership loan interest income (UPL 
interest income), the UPL debtor assigns an amount of its distributive 
share of the UPL interest income equal to the matching expense amount 
for the taxable year that is attributable to the same loan to the same 
statutory and residual groupings using the same ratios as the statutory 
and residual groupings of gross income from which the upstream 
partnership loan interest expense (UPL interest expense) is deducted by 
the UPL debtor (or any other person in the same affiliated group as the 
UPL debtor). Therefore, the amount of the distributive share of UPL 
interest income that is assigned to each statutory and residual 
grouping is the amount that bears the same proportion to the matching 
expense amount as the UPL interest expense in that statutory or 
residual grouping bears to the total UPL interest expense of the UPL 
debtor (or any other person in the same affiliated group as the UPL 
debtor).
    (iii) Anti-avoidance rule for third party back-to-back loans. If, 
with a principal purpose of avoiding the rules in this paragraph 
(e)(9), a partnership makes a loan to a person that is not related 
(within the meaning of section 267(b) or 707) to the lender, the 
unrelated person makes a loan to a direct or indirect partner in the 
partnership (or any person in the same affiliated group as a direct or 
indirect partner), and the first loan would constitute an upstream 
partnership loan if made directly to the direct or indirect partner (or 
person in the same affiliated group as a direct or indirect partner), 
then the rules of this paragraph (e)(9) apply as if the first loan was 
made directly by the partnership to the partner (or affiliate of the 
partner), and the interest expense paid by the partner is treated as 
made with respect to the first loan. Such a series of loans will be 
subject to this recharacterization rule without regard to whether there 
was a principal purpose of avoiding the rules in this paragraph (e)(9) 
if the loan to the unrelated person would not have been made or 
maintained on substantially the same terms but for the loan of funds by 
the unrelated person to the direct or indirect partner (or affiliate of 
the partner). The principles of this paragraph (e)(9)(iii) also apply 
to similar transactions that involve more than two loans and regardless 
of the order in which the loans are made.
    (iv) Interest equivalents. The principles of this paragraph (e)(9) 
apply in the case of a partner, or any person in the same affiliated 
group as the partner, that takes into account a distributive share of 
income and has a matching expense amount (treating any interest 
equivalent described in Sec. Sec.  1.861-9(b) and 1.861-9T(b) as 
interest income or expense for purposes of paragraph (e)(9)(v)(B) of 
this section) that is allocated and apportioned in the same manner as 
interest expense under Sec. Sec.  1.861-9(b) and 1.861-9T(b).
    (v) Definitions. For purposes of this paragraph (e)(9), the 
following definitions apply.
    (A) Affiliated group. The term affiliated group has the meaning 
provided in Sec.  1.861-11(d)(1).
    (B) Matching expense amount. The term matching expense amount means 
the lesser of the total amount of the UPL interest expense taken into 
account directly or indirectly by the UPL debtor for the taxable year 
with respect to an upstream partnership loan or the total amount of the 
distributive shares of the UPL interest income of the UPL debtor (or 
any other person in the same affiliated group as the UPL debtor) with 
respect to the loan.
    (C) Upstream partnership loan debtor (UPL debtor). The term 
upstream partnership loan debtor, or UPL debtor, means the person that 
holds the payable with respect to an upstream partnership loan. If a 
partnership holds the payable, then any partner in the partnership 
(other than a partner described in paragraph (e)(4)(i) of this section) 
is also considered a UPL debtor.
    (D) Upstream partnership loan interest expense (UPL interest 
expense). The term upstream partnership loan interest expense, or UPL 
interest expense, means an item of interest expense paid or accrued 
with respect to an upstream partnership loan, without regard to whether 
the expense was currently deductible (for example, by reason of section 
163(j)).
    (E) Upstream partnership loan interest income (UPL interest 
income). The term upstream partnership loan interest income, or UPL 
interest income, means an item of gross interest income received or 
accrued with respect to an upstream partnership loan.
    (F) Upstream partnership loan. The term upstream partnership loan 
means a loan by a partnership to a person that owns an interest, 
directly or indirectly through one or more other partnerships or other 
pass-through entities, in the partnership, or to any person in the same 
affiliated group as that person.
    (vi) Examples. The following examples illustrate the application of 
this paragraph (e)(9).

    (A) Example 1--(1) Facts. US1, a domestic corporation, directly 
owns 60% of PRS, a foreign partnership that is not engaged in a U.S. 
trade or business. The remaining 40% of PRS is directly owned by 
US2, a domestic corporation that is unrelated to US1. US1, US2, and 
PRS all use the calendar year as their taxable year. In Year 1, PRS 
loans $1,000x to US1. For Year 1, US1 has $100x of interest expense 
with respect to the loan and PRS has $100x of interest income with 
respect to the loan. US1's distributive share of the interest income 
is $60x. Under paragraph (e)(2) of this section, $75x of US1's 
interest expense with respect to the loan is allocated to U.S. 
source income and $25x is allocated to foreign source foreign branch 
category income. Under paragraph (h)(4)(i) of this section, US1's 
share of the total value of the loan between US1 and PRS is $600x.
    (2) Analysis. The loan by PRS to US1 is an upstream partnership 
loan and US1 is an UPL debtor. Under paragraph (e)(9)(iv)(B) of this 
section, the matching expense amount is $60x, the lesser of the UPL 
interest expense taken into account by US1 with respect to the loan 
for the taxable year ($100x) and US1's distributive share of the UPL 
interest income ($60x). Under paragraph (e)(9)(ii) of this section, 
US1 assigns $45x of the UPL interest income to U.S. source income 
($60x x $75x/$100x) and $15x of the UPL interest income to foreign 
source foreign branch category income ($60x x $25x/$100x). Under 
paragraph (e)(9)(i) of this section, the disregarded portion of the 
upstream partnership loan is $600x.
    (B) Example 2--(1) Facts. The facts are the same as in paragraph 
(e)(9)(vi)(A)(1) of this section (the facts in Example 1), except 
that US1 and US2 are part of the same affiliated group, US2's 
distributive share of the interest income is $40x, and under 
paragraph (h)(4)(i) of this section US2's share of the total value 
of the loan between US1 and PRS is $400x.
    (2) Analysis. The loan by PRS to US1 is an upstream partnership 
loan and US1 is an UPL debtor. Under paragraph (e)(9)(iv)(B) of this 
section, the matching expense amount is $100x, the lesser of the UPL 
interest expense

[[Page 69152]]

taken into account by US1 with respect to the loan for the taxable 
year ($100x) and the total amount of US1 and US2's distributive 
shares of the UPL interest income ($100x). Under paragraph 
(e)(9)(ii) of this section, US1 assigns $75x of the UPL interest 
income to U.S. source income ($100x x $75x/$100x) and $25x of the 
UPL interest income to foreign source foreign branch category income 
($100x x $25x/$100x). Under paragraph (e)(9)(i) of this section, the 
disregarded portion of the upstream partnership loan is $1,000x, the 
total amount of US1 and US2's share of the loan between US1 and PRS.

* * * * *
    (k) Applicability date--(1) Except as provided in paragraph (k)(2) 
of this section, this section applies to taxable years that both begin 
after December 31, 2017, and end on or after December 4, 2018.
    (2) Paragraphs (b)(1)(i), (b)(8), and (e)(9) of this section apply 
to taxable years that end on or after December 16, 2019. For taxable 
years that both begin after December 31, 2017, and end on or after 
December 4, 2018, and also end before December 16, 2019, see Sec.  
1.861-9T(b)(1)(i) as contained in 26 CFR part 1 revised as of April 1, 
2019].
0
Par. 6. Amend Sec.  1.861-9T by revising paragraph (b)(1)(i) and adding 
paragraph (b)(8) to read as follows:


Sec.  1.861-9T  Allocation and Apportionment of interest expense 
(temporary).

* * * * *
    (b) * * *
    (1) * * *
    (i) General rule. For further guidance, see Sec.  1.861-9(b)(1)(i).
* * * * *
    (8) Guaranteed payments. For further guidance, see Sec.  1.861-
9(b)(8).
* * * * *
0
Par. 7. Section 1.861-12 is amended by revising paragraphs (d) through 
(i) and adding paragraph (k) to read as follows:


Sec.  1.861-12  Characterization rules and adjustments for certain 
assets.

* * * * *
    (d) Treatment of notes. For further guidance, see Sec.  1.861-
12T(d) through (e).
    (e) [Reserved]
    (f) Assets connected with capitalized, deferred, or disallowed 
interest--(1) In general. In the case of any asset in connection with 
which interest expense accruing during a taxable year is capitalized, 
deferred, or disallowed under any provision of the Code, the value of 
the asset for allocation and apportionment purposes is reduced by the 
principal amount of indebtedness the interest on which is so 
capitalized, deferred, or disallowed. Assets are connected with debt 
(the interest on which is capitalized, deferred, or disallowed) only if 
using the debt proceeds to acquire or produce the asset causes the 
interest to be capitalized, deferred, or disallowed.
    (2) Examples. The following examples illustrate the application of 
paragraph (f)(1) of this section.

    (i) Example 1: Capitalized interest under section 263A--(A) 
Facts. X is a domestic corporation that uses the tax book value 
method of apportionment. X has $1,000x of indebtedness and incurs 
$100x of interest expense. Using $800x of the $1,000x debt proceeds 
to produce tangible property, X capitalizes $80x of interest expense 
under the rules of section 263A. X deducts the remaining $20x of 
interest expense.
    (B) Analysis. Because interest on $800x of debt is capitalized 
under section 263A by reason of the use of debt proceeds to produce 
the tangible property, $800x of the principal amount of X's debt is 
connected to the tangible property under paragraph (f)(1) of this 
section. Therefore, for purposes of apportioning the remaining $20x 
of X's interest expense, the adjusted basis of the tangible property 
is reduced by $800x.
    (ii) Example 2: Disallowed interest under section 163(l)--(A) 
Facts. X, a domestic corporation, owns 100% of the stock of Y, a 
domestic corporation. X and Y file a consolidated return and use the 
tax book value method of apportionment. In Year 1, X makes a loan of 
$1,000x to Y (Loan A) and Y then uses the Loan A proceeds to acquire 
in a cash purchase all the stock of a foreign corporation, Z. 
Interest on Loan A is payable in U.S. dollars or, at the option of 
Y, in stock of Z.
    (B) Analysis. Under section 163(l), Loan A is a disqualified 
debt instrument because interest on Loan A is payable at the option 
of Y in stock of a related party to Y. Because Loan A is a 
disqualified debt instrument, section 163(l)(1) disallows Y's 
interest deduction for interest payable on Loan A. In addition, the 
value of the Z stock is not reduced under paragraph (f)(1) of this 
section because the use of the Loan A proceeds to acquire the stock 
of Z is not the cause of Y's interest deduction being disallowed. 
Rather, the Loan A terms allowing interest to be paid in stock of Z 
is the cause of Y's interest deduction being disallowed under 
section 163(l). Therefore, no adjustment is made to Y's adjusted 
basis in the stock of Z for purposes of allocating the interest 
expense of X and Y.

    (g) Special rules for FSCs. For further guidance, see Sec.  1.861-
12T(g) through (j).
    (h) [Reserved]
    (i) [Reserved]
* * * * *
    (k) Applicability date--(1) Except as provided in paragraph (k)(2) 
of this section, this section applies to taxable years that both begin 
after December 31, 2017, and end on or after December 4, 2018.
    (2) Paragraph (f) this section applies to taxable years that end on 
or after December 16, 2019. For taxable years that both begin after 
December 31, 2017, and end on or after December 4, 2018, and before 
December 16, 2019, see Sec.  1.861-12T(f) as contained in 26 CFR part 1 
revised as of April 1, 2019.
0
Par. 8. Section 1.861-12T is amended by revising paragraph (f)


Sec.  1.861-12T  Characterization rules and adjustments or certain 
assets (Temporary regulations).

* * * * *
    (f) Assets connected with capitalized, deferred, or disallowed 
interest. For further guidance, see Sec.  1.861-12(f).
* * * * *
0
Par. 9. Section 1.861-14 is amended by:
0
1. Removing the last sentence in paragraph (d)(1).
0
2. Revising paragraphs (d)(3) and (4).
0
3. Revising paragraphs (e)(1) through (5).
0
4. Redesignating paragraph (e)(6)(i) as paragraph (e)(6) and removing 
paragraph (e)(6)(ii).
0
5. Revising paragraphs (f) through (k).
    The revisions read as follows:


Sec.  1.861-14  Special rules for allocating and apportioning certain 
expenses (other than interest expense) of an affiliated group of 
corporations.

* * * * *
    (d) * * *
    (3) Inclusion of financial corporations. For further guidance, see 
Sec.  1.861-14T(d)(3) through (d)(4).
    (4) [Reserved]
    (e) Expenses to be allocated and apportioned under this section--
(1) Expenses not directly allocable to specific income producing 
activities or property--(i) The expenses that are required to be 
allocated and apportioned under the rules of this section are expenses 
that are not directly allocable to specific income producing activities 
or property solely of the member of the affiliated group that incurred 
the expense, including (but not limited to) certain expenses related to 
supportive functions, research and experimental expenses, stewardship 
expenses, legal and accounting expenses, and litigation damages awards, 
prejudgment interest, and settlement payments. Interest expense of 
members of an affiliated group of corporations is allocated and 
apportioned under Sec.  1.861-11T and not under the rules of this 
section. Expenses that are included in inventory costs or that are 
capitalized are not subject to allocation and apportionment under the 
rules of this section.
    (ii) For further guidance, see Sec.  1.861-14T(e)(1)(ii).

[[Page 69153]]

    (2) Research and experimental expenditures. R&E expenditures (as 
defined in Sec.  1.861-17(a)) in the case of an affiliated group are 
allocated and apportioned under the rules of Sec.  1.861-17 as if all 
members of the affiliated group were a single taxpayer. Thus, R&E 
expenditures are allocated to all gross intangible income of all 
members of the affiliated group reasonably connected with the relevant 
broad SIC code category. If fewer than all members of the affiliated 
group derive gross intangible income reasonably connected with that 
relevant broad SIC code category, then such expenditures are 
apportioned under the rules of this paragraph (e)(2) only among those 
members, as if those members were a single taxpayer.
    (3) Expenses related to supportive functions. For further guidance, 
see Sec.  1.861-14T(e)(3).
    (4) Stewardship expenses. Stewardship expenses are allocated and 
apportioned in accordance with the rules of Sec.  1.861-8(e)(4). In 
general, stewardship expenses are considered definitely related and 
allocable to dividends and inclusions received or accrued, or to be 
received or accrued, from a related corporation. If members of the 
affiliated group, other than the member that incurred the stewardship 
expense, receive or may receive dividends or accrue or may accrue 
inclusions from the related corporation, such expense must be allocated 
and apportioned in accordance with the rules of paragraph (c) of this 
section as if all such members of the affiliated group that receive or 
may receive dividends were a single corporation. Such expenses must be 
apportioned between statutory and residual groupings of income within 
the appropriate class of gross income by reference to the apportionment 
factors contributed by the members of the affiliated group treated as a 
single corporation.
    (5) Legal and accounting fees and expenses; damages awards, 
prejudgment interest, and settlement payments. Legal and accounting 
fees and expenses, as well as litigation or arbitral damages awards, 
prejudgment interest, and settlement payments, are allocated and 
apportioned under the rules of Sec.  1.861-8(e)(5). To the extent that 
under Sec.  1.861-14T(c)(2) and (e)(1)(ii) of this section such 
expenses are not directly allocable to specific income-producing 
activities or property of one or more members of the affiliated group, 
such expenses must be allocated and apportioned as if all members of 
the affiliated group were a single corporation. Specifically, such 
expenses must be allocated to a class of gross income that takes into 
account the gross income which is generated, has been generated, or is 
reasonably expected to be generated by the other members of the 
affiliated group. If the expenses relate to the gross income of fewer 
than all members of the affiliated group as determined under Sec.  
1.861-14T(c)(2), then those expenses must be apportioned under the 
rules of Sec.  1.861-14T(c)(2), as if those fewer members were a single 
corporation. Such expenses must be apportioned taking into account the 
apportionment factors contributed by the members of the group that are 
treated as a single corporation.
* * * * *
    (f) Computation of FSC or DISC combined taxable income. For further 
guidance, see Sec.  1.861-14T(f) through (g).
    (g) [Reserved]
    (h) Allocation of section 818(f) expenses. Life insurance company 
expenses specified in section 818(f)(1) are allocated and apportioned 
on a separate entity basis, including with regard to members of a 
consolidated group. Those expenses are not allocated and apportioned on 
a life-nonlife group or a life subgroup basis. See also Sec.  1.861-
8(e)(16) for rules on the allocation of reserve expenses with respect 
to dividends received by a life insurance company.
    (i) through (j) [Reserved]
    (k) Applicability date. This section applies to taxable years 
ending on or after December 16, 2019.
0
Par. 10. Section 1.861-14T is amended by revising paragraphs (e)(1)(i), 
(e)(2)(i) and (ii), (e)(4) and (5), and (h) to read as follows:


Sec.  1.861-14T  Special rules for allocating and apportioning certain 
expenses (other than interest expense) of an affiliated group of 
corporations. (Temporary).

* * * * *
    (e)(1)(i) For further guidance, see Sec.  1.861-14(e)(1)(i).
* * * * *
    (2)(i) For further guidance, see Sec.  1.861-14(e)(2)(i) through 
Sec.  1.861-14(e)(2)(ii).
    (ii) [Reserved]
* * * * *
    (4) Stewardship expenses. For further guidance, see Sec.  1.861-
14(e)(4) through Sec.  1.861-14(e)(5).
    (5) [Reserved]
* * * * *
    (h) Allocation of section 818(f) expenses. For further guidance, 
see Sec.  1.861-14(h).
* * * * *
0
Par. 11. Section 1.861-17 is revised to read as follows:


Sec.  1.861-17  Allocation and apportionment of research and 
experimental expenditures.

    (a) Scope. This section provides rules for the allocation and 
apportionment of research and experimental expenditures that a taxpayer 
deducts, or amortizes and deducts, in a taxable year under section 174 
or section 59(e) (applicable to expenditures that are allowable as a 
deduction under section 174(a)) (R&E expenditures). R&E expenditures do 
not include any expenditures that are not deductible by reason of the 
second sentence under Sec.  1.482-7(j)(3)(i) (relating to CST Payments 
(as defined in Sec.  1.482-7(b)(1)) owed to a controlled participant in 
a cost sharing arrangement), because nondeductible amounts are not 
allocated and apportioned under Sec. Sec.  1.861-8 through 1.861-17.
    (b) Allocation--(1) In general. The method of allocation and 
apportionment of R&E expenditures set forth in this section recognizes 
that research and experimentation is an inherently speculative 
activity, that findings may contribute unexpected benefits, and that 
the gross income derived from successful research and experimentation 
must bear the cost of unsuccessful research and experimentation. In 
addition, the method set forth in this section recognizes that 
successful R&E expenditures ultimately result in the creation of 
intangible property that will be used to generate income. Therefore, 
R&E expenditures ordinarily are considered deductions that are 
definitely related to gross intangible income (as defined in paragraph 
(b)(2) of this section) reasonably connected with the relevant SIC code 
category (or categories) of the taxpayer and therefore allocable to 
gross intangible income as a class related to the SIC code category (or 
categories) and apportioned under the rules in this section. For 
purposes of this allocation, a taxpayer's SIC code category (or 
categories) are determined in accordance with the provisions of 
paragraph (b)(3) of this section. For purposes of this section, the 
term intangible property means intangible property, as defined in 
section 367(d)(4), that is derived from R&E expenditures.
    (2) Definition of gross intangible income. The term gross 
intangible income means all gross income earned by a taxpayer that is 
attributable (in whole or in part) to intangible property and includes 
gross income from sales or leases of products or services derived (in 
whole or in part) from intangible property, income from sales of 
intangible property, income from platform contribution transactions 
described in Sec.  1.482-7(b)(1)(ii), royalty

[[Page 69154]]

income from the licensing of intangible property, and amounts taken 
into account under section 367(d) by reason of a transfer of intangible 
property. Gross intangible income also includes a distributive share of 
any amounts described in the previous sentence, but does not include 
dividends or any amounts included in income under sections 951, 951A, 
or 1293.
    (3) SIC code categories--(i) Allocation based on SIC code 
categories. Ordinarily, a taxpayer's R&E expenditures are incurred to 
produce gross intangible income that is reasonably connected with one 
or more relevant SIC code categories. Where research and 
experimentation is conducted with respect to more than one SIC code 
category, the taxpayer may aggregate the categories for purposes of 
allocation and apportionment. However, the taxpayer may not subdivide 
any categories. Where research and experimentation is not clearly 
related to any SIC code category (or categories), it will be considered 
conducted with respect to all of the taxpayer's SIC code categories.
    (ii) Use of three digit standard industrial classification codes. A 
taxpayer determines the relevant SIC code categories by reference to 
the three digit classification of the Standard Industrial 
Classification Manual (SIC code). The SIC Manual is available at 
https://www.osha.gov/pls/imis/sic_manual.html.
    (iii) Consistency. Once a taxpayer selects a SIC code category for 
the first taxable year for which this section applies to the taxpayer, 
it must continue to use that category in following years unless the 
taxpayer establishes to the satisfaction of the Commissioner that, due 
to changes in the relevant facts, a change in the category is 
appropriate.
    (iv) Wholesale trade and retail trade categories. A taxpayer must 
use a SIC code category within the divisions of ``wholesale trade'' or 
``retail trade'' if it is engaged solely in sales-related activities 
with respect to a particular category of products. In the case of a 
taxpayer that conducts material non-sales-related activities with 
respect to a particular category of products, all R&E expenditures 
related to sales of the products must be allocated and apportioned as 
if the expenditures were reasonably connected to the most closely 
related three digit SIC code category other than those within the 
wholesale and retail trade divisions. For example, if a taxpayer 
engages in both the manufacturing and assembling of cars and trucks 
(SIC Code 371) and in a wholesaling activity related to motor vehicles 
and motor vehicle parts and supplies (SIC Code 501), the taxpayer must 
allocate and apportion all R&E expenditures related to both activities 
as if they relate solely to the manufacturing SIC Code 371. By 
contrast, if the taxpayer engages only in the wholesaling activity 
related to motor vehicles and motor vehicle parts and supplies, the 
taxpayer must allocate and apportion all R&E expenditures to the 
wholesaling SIC Code 501.
    (c) Exclusive apportionment. Solely for purposes of applying this 
section to section 904 as the operative section, an amount equal to 
fifty percent of a taxpayer's R&E expenditures in a SIC code category 
(or categories) is apportioned exclusively to the residual grouping of 
U.S. source gross intangible income if research and experimentation 
that accounts for at least fifty percent of such R&E expenditures was 
performed in the United States. Similarly, an amount equal to fifty 
percent of a taxpayer's R&E expenditures in a SIC code category (or 
categories) is apportioned exclusively to the statutory grouping (or 
groupings) of foreign source gross intangible income in that SIC code 
category if research and experimentation that accounts for more than 
fifty percent of such R&E expenditures was performed outside the United 
States. If there are multiple separate categories with foreign source 
gross intangible income in the SIC code category, the fifty percent of 
R&E expenditures apportioned under the previous sentence is apportioned 
ratably to foreign source gross intangible income based on the relative 
amounts of gross receipts from gross intangible income in the SIC code 
category in each separate category, as determined under paragraph (d) 
of this section.
    (d) Apportionment based on gross receipts from sales of products or 
services--(1) In general. A taxpayer's R&E expenditures not apportioned 
under paragraph (c) of this section are apportioned between the 
statutory grouping (or among the statutory groupings) within the class 
of gross intangible income and the residual grouping within such class 
according to the rules in paragraph (d)(1)(i) through (iv) of this 
section. See paragraph (b) of this section for defining the class of 
gross intangible income in relation to SIC code categories.
    (i) A taxpayer's R&E expenditures not apportioned under paragraph 
(c) of this section are apportioned in the same proportions that:
    (A) The amounts of the taxpayer's gross receipts from sales and 
leases of products (as measured by gross receipts without regard to 
cost of goods sold) or services that are related to gross intangible 
income within the statutory grouping (or statutory groupings) and in 
the residual grouping bear, respectively, to
    (B) The total amount of such gross receipts in the class.
    (ii) For purposes of this paragraph (d), the amount of the gross 
receipts used to apportion R&E expenditures also includes gross 
receipts from sales and leases of products or services of any 
controlled or uncontrolled party to the extent described in paragraph 
(d)(3) and (4) of this section.
    (iii) The statutory grouping (or groupings) or residual grouping to 
which the gross receipts are assigned is the grouping to which the 
gross intangible income related to the sale, lease, or service is 
assigned. In cases where the gross intangible income of the taxpayer is 
income not described in paragraph (d)(3) or (4) of this section, the 
grouping to which the taxpayer's gross receipts and the gross 
intangible income are assigned is the same. In cases where the 
taxpayer's gross intangible income is related to sales, leases, or 
services described in paragraphs (d)(3) or (4) of this section, the 
gross receipts that will be used for purposes of this paragraph (d) are 
the gross receipts of the controlled or uncontrolled parties that are 
exploiting the taxpayer's intangible property. The grouping to which 
the controlled or uncontrolled parties' gross receipts are assigned is 
determined based on the grouping of the taxpayer's gross intangible 
income attributable to the license, sale, or other transfer of 
intangible property to such controlled or uncontrolled party as 
described in paragraph (d)(3)(i) or (d)(4)(i) of this section, and not 
the grouping to which the gross receipts would be assigned if the 
assignment were based on the income earned by the controlled or 
uncontrolled party. See paragraph (g)(1) of this section (Example 1).
    (iv) For purposes of applying this section to section 904 as the 
operative section, because a United States person's gross intangible 
income cannot include income assigned to the section 951A category, no 
R&E expenditures of a United States person are apportioned to foreign 
source income in the section 951A category.
    (2) Apportionment in excess of gross income. Amounts apportioned 
under this section may exceed the amount of gross income related to the 
SIC code category within the statutory or residual grouping. In such 
case, the excess is applied against other gross income within the 
statutory or residual grouping. See Sec.  1.861-8(d)(1) for applicable 
rules where the

[[Page 69155]]

apportionment results in an excess of deductions over gross income 
within the statutory or residual grouping.
    (3) Sales or services of uncontrolled parties--(i) In general. For 
purposes of the apportionment within a class under paragraph (d)(1) of 
this section, the gross receipts of each uncontrolled party from 
particular products or services incorporating intangible property that 
was licensed, sold, or transferred by the taxpayer to such uncontrolled 
party (directly or indirectly) are taken into account for determining 
the taxpayer's apportionment if the taxpayer can reasonably be expected 
to license, sell, or transfer to that uncontrolled party, directly or 
indirectly, intangible property that would arise from the taxpayer's 
current R&E expenditures. If the taxpayer has previously licensed, 
sold, or transferred intangible property related to a SIC code category 
to an uncontrolled party, the taxpayer is presumed to expect to 
license, sell, or transfer to that uncontrolled party all future 
intangible property related to the same SIC code category.
    (ii) Definition of uncontrolled party. For purposes of this 
paragraph (d)(3), the term uncontrolled party means a party that is not 
a person with a relationship to the taxpayer specified in section 
267(b), or is not a member of a controlled group of corporations to 
which the taxpayer belongs (within the meaning of section 993(a)(3)).
    (iii) Sales of components. In the case of a sale or lease of a 
product by an uncontrolled party that is derived from the taxpayer's 
intangible property but is incorporated as a component of a larger 
product (for example, where the product incorporating the intangible 
property is a component of a large machine), only the portion of the 
gross receipts from the larger product that are attributable to the 
component derived from the intangible property is included. For 
purposes of the preceding sentence, a reasonable estimate based on the 
principles of section 482 must be made. See paragraph (g)(4)(ii)(B)(3) 
of this section (Example 4).
    (iv) Reasonable estimates of gross receipts. If the amount of gross 
receipts of an uncontrolled party is unknown, a reasonable estimate of 
gross receipts must be made annually. Appropriate economic analyses, 
based on the principles of section 482, must be used to estimate gross 
receipts. See paragraph (g)(5)(B)(3)(ii) of this section (Example 5).
    (4) Sales or services of controlled corporations--(i) In general. 
For purposes of the apportionment within a class under paragraph (d)(1) 
of this section, the gross receipts from sales, leases, or services of 
a controlled corporation are taken into account if the taxpayer can 
reasonably be expected to license, sell, or transfer to that controlled 
corporation, directly or indirectly, intangible property that would 
arise from the taxpayer's current R&E expenditures. Except to the 
extent provided in paragraph (d)(4)(iv) of this section, if the 
taxpayer has previously licensed, sold, or transferred intangible 
property related to a SIC code category to a controlled corporation, 
the taxpayer is presumed to expect to license, sell, or transfer to 
that controlled corporation all future intangible property related to 
the same SIC code category.
    (ii) Definition of a corporation controlled by the taxpayer. For 
purposes of this paragraph (d)(4), the term controlled corporation 
means any corporation that has a relationship to the taxpayer specified 
in section 267(b) or is a member of a controlled group of corporations 
to which the taxpayer belongs (within the meaning of section 
993(a)(3)). Because an affiliated group is treated as a single 
taxpayer, a member of an affiliated group is not a controlled 
corporation. See paragraph (e) of this section.
    (iii) Gross receipts not to be taken into account more than once. 
Sales, leases, or services between controlled corporations or between a 
controlled corporation and the taxpayer are not taken into account more 
than once; in such a situation, the amount of gross receipts of the 
selling corporation must be subtracted from the gross receipts of the 
buying corporation.
    (iv) Effect of cost sharing arrangements. If the controlled 
corporation has entered into a cost sharing arrangement, in accordance 
with the provisions of Sec.  1.482-7, with the taxpayer for the purpose 
of developing intangible property, then the taxpayer is not reasonably 
expected to license, sell, or transfer to that controlled corporation, 
directly or indirectly, intangible property that would arise from the 
taxpayer's share of the R&E expenditures with respect to the cost 
shared intangibles as defined in Sec.  1.482-7(j)(1)(i). Therefore, 
solely for purposes of apportioning a taxpayer's R&E expenditures 
(which does not include the amount of CST Payments received by the 
taxpayer; see paragraph (a) of this section) that are intangible 
development costs (as defined in Sec.  1.482-7(d)) with respect to a 
cost sharing arrangement, the controlled corporation's gross receipts 
are not taken into account for purposes of paragraphs (d)(1) and 
(d)(4)(i) of this section.
    (5) Application of section 864(e)(3). Section 864(e)(3) and Sec.  
1.861-8(d)(2)(ii) do not apply for purposes of this section.
    (e) Affiliated groups. See Sec.  1.861-14(e)(2) for rules on 
allocating and apportioning R&E expenditures of an affiliated group (as 
defined in Sec.  1.861-14(d)).
    (f) Special rules for partnerships--(1) R&E expenditures. For 
purposes of applying this section, if R&E expenditures are incurred by 
a partnership in which the taxpayer is a partner, the taxpayer's R&E 
expenditures include the taxpayer's distributive share of the 
partnership's R&E expenditures.
    (2) Purpose and location of expenditures. In applying exclusive 
apportionment under paragraph (c) of this section, a partner's 
distributive share of R&E expenditures incurred by a partnership is 
treated as incurred by the partner for the same purpose and in the same 
location as incurred by the partnership.
    (3) Apportionment based on gross receipts. In applying the 
remaining apportionment under paragraph (d) of this section, a 
taxpayer's gross receipts from a SIC code category include the full 
amount of any gross receipts from the SIC code category of any 
partnership not described in paragraph (d)(3)(ii) of this section in 
which the taxpayer is a direct or indirect partner if the gross 
receipts would have been included had the partnership been a 
corporation.
    (g) Examples. The following examples illustrate the application of 
the rules in this section.

    (1) Example 1--(i) Facts. X, a domestic corporation, is a 
manufacturer and distributor of small gasoline engines for 
lawnmowers. Gasoline engines are a product within the category, 
Engines and Turbines (SIC Industry Group 351). Y, a wholly owned 
foreign subsidiary of X, also manufactures and sells these engines 
abroad. X owns no other foreign subsidiaries. During Year 1, X 
incurred R&E expenditures of $60,000x, which it deducts under 
section 174 as a current expense, to invent and patent a new and 
improved gasoline engine. All of the research and experimentation 
was performed in the United States. Also in Year 1, the domestic 
gross receipts of X of gasoline engines total $500,000x and foreign 
gross receipts of Y total $300,000x. X provides technology for the 
manufacture of engines to Y through a license that requires the 
payment of an arm's length royalty. In Year 1, X's gross income is 
$200,000x, of which $140,000x is U.S. source income from domestic 
sales of gasoline engines, $40,000x is income included under section 
951A all of which relates to Y's foreign source income from sales of 
gasoline engines, $10,000x is foreign source royalties from Y, and 
$10,000x is U.S. source interest income. None of the

[[Page 69156]]

foreign source royalties are allocable to passive category income of 
Y, and therefore, under Sec. Sec.  1.904-4(d) and 1.904-5(c)(3), the 
foreign source royalties are general category income to X.
    (ii) Analysis--(A) Allocation. The R&E expenditures were 
incurred in connection with developing intangible property related 
to small gasoline engines and they are definitely related to the 
items of gross intangible income related to the SIC code category 
351, namely gross income from the sale of small gasoline engines in 
the United States and royalties received from subsidiary Y, a 
foreign manufacturer of gasoline engines. Accordingly, under 
paragraph (b) of this section, the R&E expenditures are allocable to 
the class of gross intangible income related to SIC code category 
351, all of which is general category income of X. X's U.S. source 
interest income and income included under section 951A are not 
within this class of gross intangible income and, therefore, no 
portion of the R&E expenditures are allocated to the U.S. source 
interest income or foreign source income in the section 951A 
category.
    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory 
grouping of gross intangible income is foreign source general 
category income and the residual grouping of gross intangible income 
is U.S. source income.
    (2) Exclusive apportionment. Under paragraph (c) of this 
section, because at least 50% of X's research and experimental 
activity was performed in the United States, 50% of the R&E 
expenditures, or $30,000x ($60,000x x 50%), is apportioned 
exclusively to the residual grouping of U.S. source gross intangible 
income. The remaining 50% of the R&E expenditures is then 
apportioned between the statutory and residual groupings on the 
basis of the relative amounts of gross receipts from sales of small 
gasoline engines by X and Y that are related to the U.S. source 
sales income and foreign source royalty income, respectively.
    (3) Apportionment based on gross receipts. After taking into 
account exclusive apportionment, X has $30,000x ($60,000x - 
$30,000x) of R&E expenditures that must be apportioned between the 
residual and statutory groupings. Because Y is a controlled 
corporation of X, its gross receipts within the SIC code are taken 
into account in apportioning X's R&E expenditures if X is reasonably 
expected to license, sell, or transfer intangible property that 
would arise from the R&E expenditures that result in the $60,000x 
deduction. Because Y has licensed the intangible property developed 
by X related to the SIC code, it is presumed it is reasonably 
expected to license the intangible property that would be developed 
from the current research and experimentation. Therefore, under 
paragraphs (d)(1) and (5) of this section, $11,250x ($30,000x x 
$300,000x/($500,000x + $300,000x)) is apportioned to the statutory 
grouping of X's gross intangible income attributable to its license 
of intangible property to Y, or foreign source general category 
income. No portion of the gross receipts by X or Y are disregarded 
under section 864(e)(3), regardless of whether the income related to 
those sales is eligible for a deduction under section 250(a)(1)(A). 
The remaining $18,750x ($30,000x x $500,000x/($500,000x + 
$300,000x)) is apportioned to the residual grouping of gross 
intangible income, or U.S. source income.
    (4) Summary. Accordingly, for purposes of the foreign tax credit 
limitation, $11,250x of X's R&E expenditures are apportioned to 
foreign source general category income, and $48,750x ($30,000x + 
$18,750x) of X's R&E expenditures are apportioned to U.S. source 
income.
    (2) Example 2--(i) Facts. The facts are the same as in paragraph 
(g)(1)(i) of this section (the facts in Example 1) except that X 
also spends $30,000x in Year 1 for research on steam turbines, all 
of which is performed in the United States, and X has steam turbine 
gross receipts in the United States of $400,000x. X's foreign 
subsidiary Y neither manufactures nor sells steam turbines. The 
steam turbine research is in addition to the $60,000x in R&E 
expenditures incurred by X on gasoline engines for lawnmowers. X 
thus has $90,000x of R&E expenditures. X's gross income is 
$250,000x, of which $140,000x is U.S. source income from domestic 
sales of gasoline engines, $50,000x is U.S. source income from 
domestic sales of steam turbines, $40,000x is income included under 
section 951A all of which relates to foreign source income derived 
from Y's sales of gasoline engines, $10,000x is foreign source 
royalties from Y, and $10,000x is U.S. source interest income.
    (ii) Analysis--(A) Allocation. X's R&E expenditures generate 
gross intangible income from sales of small gasoline engines and 
steam turbines. Both of these products are in the same three digit 
SIC code category, Engines and Turbines (SIC Industry Group 351). 
Therefore, under paragraph (a) of this section, X's R&E expenditures 
are definitely related to all items of gross intangible income 
attributable to SIC code category 351. These items of X's gross 
intangible income are gross income from the sale of small gasoline 
engines and steam turbines in the United States and royalties from 
foreign subsidiary Y, a foreign manufacturer and seller of small 
gasoline engines. X's U.S. source interest income and income 
included under section 951A is not within this class of gross 
intangible income and, therefore, no portion of X's R&E expenditures 
are allocated to the U.S. source interest income or income in the 
section 951A category.
    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory 
grouping of gross intangible income is foreign source general 
category income and the residual grouping of gross intangible income 
is U.S. source income.
    (2) Exclusive apportionment. Under paragraph (c) of this 
section, because at least 50% of X's research and experimental 
activity was performed in the United States, 50% of the R&E 
expenditures, or $45,000x ($90,000x x 50%), are apportioned 
exclusively to the residual grouping of U.S. source gross intangible 
income. The remaining 50% of the R&E expenditures is then 
apportioned between the residual and statutory groupings on the 
basis of the relative amounts of gross receipts of small gasoline 
engines and steam turbines by X and Y with respect to which gross 
intangible income is foreign source general category income and U.S. 
source income.
    (3) Apportionment based on gross receipts. After taking into 
account exclusive apportionment, X has $45,000x ($90,000x - 
$45,000x) of R&E expenditures that must be apportioned between the 
residual and statutory groupings. Even though a portion of the R&E 
expenditures that must be apportioned are attributable to research 
performed with respect to steam turbines, and Y does not sell steam 
turbines, because Y previously licensed intangible property related 
to SIC code category 351, it is presumed that X expects to license 
all intangible property related to SIC code category 351, including 
intangible property related to steam turbines. Therefore, under 
paragraph (d)(1) of this section, $11,250x ($45,000x x $300,000x/
($500,000x + $400,000x + $300,000x)) is apportioned to the statutory 
grouping of gross intangible income of the royalty income to which 
the gross receipts by Y were related, or foreign source general 
category income. The remaining $33,750x ($45,000x x ($500,000x + 
$400,000x)/($500,000x + $400,000x + $300,000x)) is apportioned to 
the residual grouping of gross intangible income, or U.S. source 
gross income.
    (4) Summary. Accordingly, for purposes of the foreign tax credit 
limitation, $11,250x of X's R&E expenditures are apportioned to 
foreign source general category income and $78,750x ($45,000x + 
$33,750x) of X's R&E expenditures are apportioned to U.S. source 
gross income.
    (3) Example 3--(i) Facts--(A) Acquisitions and transfers by X. 
The facts are the same as in paragraph (g)(1)(i) of this section 
(the facts in Example 1) except that, in Year 2, X and Y terminate 
the license for the manufacture of engines that was in place in Year 
1 and enter into an arm's length cost-sharing arrangement, in 
accordance with the provisions of Sec.  1.482-7, to share the 
funding of all of X's research activity. In Year 2, Y makes a PCT 
Payment (as defined in Sec.  1.482-7(b)(1)) of $50,000x that is 
sourced as a royalty and a CST Payment of $25,000x under the cost 
sharing arrangement.
    (B) Gross receipts and R&E expenditures. In Year 2, X and Y 
continue to sell gasoline engines, with gross receipts of $600,000x 
in the United States and $400,000x abroad by Y. X incurs research 
costs of $85,000x in Year 2 for research activities conducted in the 
United States, but cannot deduct $25,000x of that amount by reason 
of the second sentence under Sec.  1.482-7(j)(3)(i) (relating to CST 
Payments).
    (C) Gross income of X. In Year 2, X's gross income is $350,000x, 
of which $200,000x is U.S. source income from domestic sales of 
gasoline engines, $50,000x is foreign source income attributable to 
the PCT Payment, and $100,000x is income included under section 951A 
all of which relates to foreign source income derived from engine 
sales by Y.
    (ii) Analysis--(A) Allocation. The $60,000x of R&E expenditures 
were incurred in connection with small gasoline engines and they are 
definitely related to the items of gross intangible income related 
to the SIC

[[Page 69157]]

code category, namely gross income from the sale of small gasoline 
engines in the United States and PCT Payments from Y. Accordingly, 
under paragraph (a) of this section, the R&E expenditures are 
allocable to this class of gross intangible income. X's income 
included under section 951A is not within this class of gross 
intangible income and, therefore, no portion of X's R&E expenditures 
is allocated to X's section 951A category income.
    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory 
grouping of gross intangible income is foreign source general 
category income, and the residual grouping of gross intangible 
income is U.S. source income.
    (2) Exclusive apportionment. Under paragraph (c) of this 
section, because at least 50% of X's research and experimentation 
was performed in the United States, 50% of the R&E expenditures, or 
$30,000x ($60,000x x 50%), is apportioned exclusively to the 
residual grouping of gross intangible income, U.S. source gross 
income.
    (3) Apportionment based on gross receipts. Under paragraph 
(d)(5)(v) of this section, none of Y's gross receipts are taken into 
account because they are attributable to the cost shared intangible 
under the valid cost sharing arrangement. Because all of the gross 
receipts from sales that are taken into account under paragraph 
(d)(1) of this section relate to gross intangible income that is 
included in the residual grouping, $30,000x is apportioned to the 
residual grouping of gross intangible income, or U.S. source gross 
income.
    (4) Summary. Accordingly, for purposes of the foreign tax credit 
limitation, $60,000x of X's R&E expenditures are apportioned to U.S. 
source income.
    (4) Example 4--(i) Facts--(A) X's R&E expenditures. X, a 
domestic corporation, is engaged in continuous research and 
experimentation to improve the quality of the products that it 
manufactures and sells, which are floodlights, flashlights, fuse 
boxes, and solderless connectors. X incurs $100,000x of R&E 
expenditures in Year 1 that was performed exclusively in the United 
States. As a result of this research activity, X acquires patents 
that it uses in its own manufacturing activity.
    (B) License to Y and Z. In Year 1, X licenses its floodlight 
patent to Y and Z, uncontrolled foreign corporations, for use in 
their own territories, Countries Y and Z, respectively. Corporation 
Y pays X a royalty of $3,000x plus $0.20x for each floodlight sold. 
Gross receipts from sales of floodlights by Y for the taxable year 
are $135,000x (at $4.50x per unit) or 30,000x units, and the royalty 
is $9,000x ($3,000x + $0.20x x 30,000x). Y has sales of other 
products of $500,000x. Z pays X a royalty of $3,000x plus $0.30x for 
each unit sold. Z manufactures 30,000x floodlights in the taxable 
year, and the royalty is $12,000x ($3,000x + $0.30x x 30,000x). The 
dollar value of Z's gross receipts from floodlight sales is not 
known because, in this case, the floodlights are not sold separately 
by Z but are instead used as a component in Z's manufacture of 
lighting equipment for theaters. However, a reasonable estimate of 
Z's gross receipts attributable to the floodlights, based on the 
principles of section 482, is $120,000x. The gross receipts from 
sales of all Z's products, including the lighting equipment for 
theaters, are $1,000,000x.
    (C) X's gross receipts and gross income. X's gross receipts from 
sales of floodlights for the taxable year are $500,000x and its 
sales of its other products (flashlights, fuse boxes, and solderless 
connectors) are $400,000x. X has gross income of $500,000x, 
consisting of U.S. source gross income from domestic sales of 
floodlights, flashlights, fuse boxes, and solderless connectors of 
$479,000x, and foreign source royalty income of $9,000x and $12,000x 
from foreign corporations Y and Z respectively. The royalty income 
is general category income to X under section 904(d)(2)(A)(ii) and 
Sec.  1.904-4(b)(2)(ii).
    (ii) Analysis--(A) Allocation. X's R&E expenditures are 
definitely related to all of the gross intangible income from the 
products that it produces, which are floodlights, flashlights, fuse 
boxes, and solderless connectors. All of these products are in the 
same three digit SIC code category, Electric Lighting and Wiring 
Equipment (SIC Industry Group 364). Therefore, under paragraph (b) 
of this section, X's R&E expenditures are definitely related to the 
class of gross intangible income related to SIC code category 354 
and to all items of gross intangible income attributable to the 
class. These items of X's gross intangible income are gross income 
from the sale of floodlights, flashlights, fuse boxes, and 
solderless connectors in the United States and royalties from 
Corporations Y and Z.
    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory 
grouping of gross intangible income is foreign source general 
category income, and the residual grouping of gross intangible 
income is U.S. source income.
    (2) Exclusive apportionment. Under paragraph (c) of this 
section, because at least 50% of X's research and experimentation 
was performed in the United States, 50% of the R&E expenditures, or 
$50,000x ($100,000x x 50%), is apportioned exclusively to the 
residual grouping of U.S. source gross intangible income.
    (3) Apportionment based on gross receipts. After taking into 
account exclusive apportionment, X has $50,000x ($100,000x - 
$50,000x) of R&E expenditures that must be apportioned between the 
residual and statutory groupings. Gross receipts from sales of Y and 
Z are taken into account in apportioning the R&E expenditures if X 
is reasonably expected to license, sell, or transfer the intangible 
property that would arise from the research and experimentation that 
results in the $100,000x deduction. Because X licensed intangible 
property related to the SIC code in Year 1, it is presumed that it 
would continue to license the intangible property that would be 
developed from the current research and experimentation. Under 
paragraph (d)(3)(i) of this section, because Y and Z are 
uncontrolled parties with respect to X, only gross receipts from 
their sales of the licensed product, floodlights, are included for 
purposes of apportionment. In addition, under paragraph (d)(3)(iii) 
of this section, only the portion of Z's gross receipts that are 
attributable to the floodlights that incorporate the intangible 
property licensed from X, rather than Z's total gross receipts, are 
used for purposes of apportionment. All of X's gross receipts from 
sales in the entire SIC code category are included for purposes of 
apportionment on the basis of gross intangible income attributable 
to those sales. Under paragraph (d)(1) of this section, $11,039x 
($50,000x x ($135,000x + $120,000x)/($900,000x + $135,000x + 
$120,000x)) is apportioned to the statutory grouping of gross 
intangible income, or foreign source general category income. The 
remaining $38,961x ($50,000x x $900,000x/($900,000x + $135,000x + 
$120,000x)) is apportioned to the residual grouping of gross 
intangible income, or U.S. source gross income.
    (4) Summary. Accordingly, for purposes of the foreign tax credit 
limitation, $11,039x of X's R&E expenditures are apportioned to 
foreign source general category income and $88,961x ($50,000x + 
$38.961x) of X's R&E expenditures are apportioned to U.S. source 
gross income.
    (5) Example 5--(i) Facts. X, a domestic corporation, is a cloud 
storage service provider. Cloud storage services are a service 
within the category, Computer Programming, Data Processing, and 
other Computer Related Services (SIC Industry Group 737). During 
Year 1, X incurred R&E expenditures of $50,000x to invent and 
copyright new storage monitoring and management software. All of the 
research and experimentation was performed in the United States. X 
uses this software in its own business to provide services to 
customers. X also licenses a version of the software that can be 
used by other businesses that provide cloud storage services. X 
licenses the software to uncontrolled party U, which sub-licenses 
the software to other businesses that provide cloud storage services 
to customers. U does not use the software except to sublicense it. 
As a part of the licensing agreement with U, U and its sub-licensees 
are only permitted to use the software in certain countries outside 
of the United States. Under the contract with U, U pays X a royalty 
of 50% on the amount it receives from its sub-licensees that use the 
software to provide services to customers. In Year 1, X earns 
$300,000x of gross receipts from providing cloud storage services 
within the U.S. Further, in Year 1 U receives $10,000x of royalty 
income from its sub-licensees and pays a royalty of $5,000x to X. 
Thus, X also earns $5,000x of foreign source royalty income from 
licensing its software to U for use outside of the United States.
    (ii) Analysis--(A) Allocation. The R&E expenditures were 
incurred in connection with the development of cloud computing 
software and they are definitely related to the items of gross 
intangible income related to the SIC Code category, namely gross 
income from the storage monitoring and management software in the 
United States and royalties received from U. Accordingly, under 
paragraph (b) of this section, the R&E expenditures are allocable to 
this class of gross intangible income, all of which is general 
category income of X.

[[Page 69158]]

    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory 
grouping of gross intangible income is foreign source general 
category income, and the residual grouping of gross intangible 
income is U.S. source income.
    (2) Exclusive apportionment. Under paragraph (c) of this 
section, because at least 50% of X's research and experimental 
activity was performed in the United States, 50% of the R&E 
expenditures, or $25,000x ($50,000x x 50%), is apportioned 
exclusively to the residual grouping of U.S. source gross intangible 
income.
    (3) Apportionment based on gross receipts--(i) In general. After 
taking into account exclusive apportionment, X has $25,000x 
($50,000x - $25,000x) of R&E expenditures that must be apportioned 
between the statutory and residual groupings. Because U's sub-
licensees' gross receipts incorporate intangible property licensed 
by X, U's sub-licensees' gross receipts from services incorporating 
the licensed intangible property are taken into account in 
apportioning X's R&E expenditures if X is reasonably expected to 
license, sell, or transfer intangible property that would arise from 
the R&E expenditures incurred in Year 1. Because U has licensed and 
the sub-licensees have sublicensed the intangible property developed 
by X related to the SIC code, it is presumed that U would continue 
to license the intangible property that would be developed from the 
current research and experimentation.
    (ii) Determination of U's sub-licensee's gross receipts. Under 
paragraph (d)(3)(iv) of this section, X can make a reasonable 
estimate of the gross receipts of U's sub-licensees from services 
incorporating the intangible property licensed by X by estimating, 
after an appropriate economic analysis, that U would charge a 5% 
royalty on the sub-licensee's sales. U received a royalty of 
$10,000x from the sub-licensees. X then determines U's sub-
licensees' foreign sales by dividing the total royalty payments 
received by U by the royalty estimated rate ($10,000x/.05x = 
$200,000x).
    (iii) Results of apportionment based on gross receipts. 
Therefore, under paragraphs (d)(1) and (3) of this section, $10,000x 
($25,000x x $200,000x/($300,000x + $200,000x)) is apportioned to the 
statutory grouping of gross intangible income, or foreign source 
general category income. The remaining $15,000x ($25,000x x 
$300,000x/($300,000x + $200,000x)) is apportioned to the residual 
grouping of gross intangible income, or U.S. source income.
    (4) Summary. Accordingly, for purposes of the foreign tax credit 
limitation, $10,000x of X's R&E expenditures are apportioned to 
foreign source general category income and $40,000x ($25,000x + 
$15,000x) of X's R&E expenditures are apportioned to U.S. source 
income.

    (h) Applicability date. This section applies to taxable years 
beginning after December 31, 2019.
0
Par 12. Section 1.861-20 is added to read as follows:


Sec.  1.861-20  Allocation and apportionment of foreign income taxes.

    (a) Scope. This section provides rules for the allocation and 
apportionment of foreign income taxes, including allocating and 
apportioning foreign income taxes to separate categories for purposes 
of the foreign tax credit. The rules of this section apply except as 
modified under the rules for an operative section. See, for example, 
Sec. Sec.  1.704-1(b)(4)(viii)(d)(1), 1.904-6, 1.960-1(d)(3)(ii), and 
1.965-5(b)(2). Paragraph (b) of this section provides definitions for 
the purposes of this section. Paragraph (c) of this section provides 
the general rule for allocation and apportionment of foreign income 
taxes. Paragraph (d) of this section provides rules for assigning 
foreign gross income to statutory and residual groupings. Paragraph (e) 
of this section provides rules for allocating and apportioning foreign 
law deductions to foreign gross income in the statutory and residual 
groupings. Paragraph (f) of this section provides rules for 
apportioning foreign income taxes among statutory and residual 
groupings. Paragraph (g) of this section provides examples that 
illustrate the application of this section. Paragraph (h) of this 
section provides the applicability dates for this section.
    (b) Definitions. The following definitions apply for purposes of 
this section.
    (1) Corporation. The term corporation has the same meaning as set 
forth in Sec.  301.7701-2(b), except that it does not include a reverse 
hybrid.
    (2) Corresponding U.S. item. The term corresponding U.S. item means 
the item of U.S. gross income or U.S. loss, if any, that arises from 
the same transaction or other realization event from which an item of 
foreign gross income also arises. An item of U.S. gross income or U.S. 
loss is a corresponding U.S. item even if the item of foreign gross 
income that arises from the same transaction or realization event 
differs in amount from the item of U.S. gross income or U.S. loss. A 
corresponding U.S. item does not include an item of gross income that 
is exempt, excluded or eliminated from U.S. gross income, nor does it 
include an item of U.S. gross income or U.S. loss that is not realized, 
recognized or taken into account by the taxpayer in the U.S. taxable 
year in which the taxpayer paid or accrued the foreign income tax.
    (3) Foreign capital gain amount. The term foreign capital gain 
amount means the portion of a distribution that under foreign law gives 
rise to gross income of a type described in section 301(c)(3)(A).
    (4) Foreign dividend amount. The term foreign dividend amount means 
the portion of a distribution that is taxable as a dividend under 
foreign law.
    (5) Foreign gross income. The term foreign gross income means the 
items of gross income included in the base upon which a foreign income 
tax is imposed. This includes all items of foreign gross income 
included in the foreign tax base, even if the foreign taxable year 
begins in the U.S. taxable year that precedes the U.S. taxable year in 
which the taxpayer pays or accrues the foreign income tax.
    (6) Foreign income tax. The term foreign income tax means an 
income, war profits, or excess profits tax within the meaning of Sec.  
1.901-2(a) that is a separate levy within the meaning of Sec.  1.901-
2(d).
    (7) Foreign law CFC. The term foreign law CFC means a foreign 
corporation certain of the earnings of which are taxable to its 
shareholder under a foreign law subpart F regime.
    (8) Foreign law distribution. The term foreign law distribution has 
the meaning provided in paragraph (d)(3)(i)(C) of this section.
    (9) Foreign law subpart F income. The term foreign law subpart F 
income means the items of a foreign law CFC, computed under foreign 
law, that give rise to an inclusion in a taxpayer's foreign gross 
income by reason of a foreign law subpart F regime.
    (10) Foreign law subpart F regime. A foreign law subpart F regime 
is a foreign law tax regime similar to the subpart F regime described 
in sections 951 through 959 that imposes a tax on a shareholder of a 
corporation based on an inclusion in the shareholder's taxable income 
of certain of the corporation's current earnings that are of a type 
that is similar to subpart F income, whether or not the foreign law 
deems the corporation's earnings to be distributed.
    (11) Foreign taxable income. The term foreign taxable income means 
foreign gross income reduced by the deductions that are allowed under 
foreign law.
    (12) Foreign taxable year. The term foreign taxable year has the 
meaning set forth in section 7701(a)(23), applied by substituting 
``under foreign law'' for the phrase ``under subtitle A.''
    (13) Reverse hybrid. The term reverse hybrid means an entity that 
is described in Sec.  301.7701-2(b) and that is a fiscally transparent 
entity (under the principles of Sec.  1.894-1(d)(3)) or a branch under 
the laws of a foreign country imposing tax on the income of the entity.
    (14) Taxpayer. The term taxpayer has the meaning described in Sec.  
1.901-2(f)(1).
    (15) U.S. capital gain amount. The term U.S. capital gain amount 
means the portion of a distribution to which section 301(c)(3)(A) 
applies.

[[Page 69159]]

    (16) U.S. dividend amount. The term U.S. dividend amount means the 
portion of a distribution that is made out of earnings and profits 
under Federal income tax law or out of previously taxed earnings and 
profits described in section 959(a) or (b). It also includes amounts 
included in gross income as a dividend by reason of section 1248 or 
section 964(e).
    (17) U.S. gross income. The term U.S. gross income means the items 
of gross income that a taxpayer recognizes and includes in taxable 
income under Federal income tax law for its U.S. taxable year.
    (18) U.S. loss. The term U.S. loss means the item of loss that a 
taxpayer recognizes and includes in taxable income under Federal income 
tax law for its U.S. taxable year.
    (19) U.S. return of capital amount. The term U.S. return of capital 
amount means the portion of a distribution to which section 301(c)(2) 
applies.
    (20) U.S. taxable year. The term U.S. taxable year has the same 
meaning as that of the term taxable year set forth in section 
7701(a)(23).
    (c) General rule. A foreign income tax is allocated or apportioned 
to the statutory and residual groupings that include the items of 
foreign gross income included in the base on which the tax is imposed. 
Each foreign income tax (that is, each separate levy) is allocated and 
apportioned separately under the rules in this section. A foreign 
income tax is allocated and apportioned to or among the statutory and 
residual groupings under the following steps:
    (1) First, by assigning the items of foreign gross income to the 
groupings under the rules of paragraph (d) of this section;
    (2) Second, by allocating and apportioning the deductions that are 
allowed under foreign law to the foreign gross income in the groupings 
under the rules of paragraph (e) of this section; and
    (3) Third, by allocating and apportioning the foreign income tax by 
reference to the foreign taxable income in the groupings under the 
rules of paragraph (f) of this section.
    (d) Assigning items of foreign gross income to the statutory and 
residual groupings--(1) In general. Each item of foreign gross income 
is assigned to a statutory or residual grouping. The amount of the item 
is determined under foreign law. However, Federal income tax law 
applies to characterize the item and the transaction or other 
realization event from which the item arose, and to assign it to a 
grouping. Except as provided in paragraph (d)(3) of this section, if a 
taxpayer pays or accrues a foreign income tax that is imposed on 
foreign taxable income that includes an item of foreign gross income in 
a U.S. taxable year in which the taxpayer also realizes, recognizes, or 
takes into account a corresponding U.S. item, then the item of foreign 
gross income is assigned to the grouping to which the corresponding 
U.S. item is assigned. If the corresponding U.S. item is a U.S. loss 
(or zero), the foreign gross income is assigned to the grouping to 
which a gain would be assigned had the transaction or other realization 
event given rise to a gain, rather than a U.S. loss (or zero), for 
Federal income tax purposes, and not (if different) to the grouping to 
which the U.S. loss is allocated and apportioned in computing U.S. 
taxable income. Paragraph (d)(3) of this section provides special rules 
regarding the assignment of the item of foreign gross income in 
particular circumstances.
    (2) Items of foreign gross income with no corresponding U.S. item. 
Except as provided in paragraph (d)(3) of this section, the rules in 
paragraphs (d)(2)(i) and (ii) of this section apply for purposes of 
characterizing an item of foreign gross income and assigning it to a 
grouping if the taxpayer does not realize, recognize, or take into 
account a corresponding U.S. item in the same U.S. taxable year in 
which the taxpayer pays or accrues foreign income tax that is imposed 
on foreign taxable income that includes the item of foreign gross 
income.
    (i) Foreign gross income from U.S. nonrecognition event, or U.S. 
recognition event that falls in a different U.S. taxable year. If a 
taxpayer recognizes an item of foreign gross income arising from a 
transaction or other foreign realization event that does not result in 
the recognition of gross income or loss under Federal income tax law in 
the same U.S. taxable year in which the foreign income tax is paid or 
accrued, then the item of foreign gross income is characterized and 
assigned to the grouping to which the corresponding U.S. item would be 
assigned if the event giving rise to the foreign gross income resulted 
in the recognition of gross income or loss under Federal income tax law 
in that U.S. taxable year. For example, if a foreign gross income item 
of gain arises from a distribution of property that is treated as a 
taxable disposition of the property under foreign law, and the 
realization event under foreign law does not cause the recognition of 
gain or loss under Federal income tax law, the foreign gross income 
item of gain is assigned to the grouping to which a corresponding U.S. 
item of gain or loss on a taxable disposition of the property would be 
assigned. However, foreign gross income arising from the receipt of the 
distribution is assigned under the rules of paragraphs (d)(3)(i) and 
(ii) of this section. As another example, if a taxpayer pays or accrues 
a foreign income tax that is imposed on foreign taxable income that 
includes an item of foreign gross income by reason of a transaction or 
other realization event that also gave rise to an item of U.S. gross 
income or U.S. loss, but the U.S. and foreign taxable years end on 
different dates and the event occurred in the last U.S. taxable year 
that ends before the end of the foreign taxable year, then the item of 
foreign gross income is characterized and assigned to the grouping to 
which the corresponding U.S. item would be assigned if the item of U.S. 
gross income or U.S. loss were taken into account under Federal income 
tax law in the U.S. taxable year in which the foreign income tax is 
paid or accrued.
    (ii) Foreign gross income of a type that is recognized but excluded 
from U.S. gross income--(A) In general. If a taxpayer recognizes an 
item of foreign gross income that is a type of recognized gross income 
that Federal income tax law excludes from U.S. gross income, then the 
item of foreign gross income is assigned to the grouping to which the 
item of gross income would be assigned if it were included in U.S. 
gross income. Notwithstanding the previous sentence, foreign gross 
income that is attributable to a base difference is assigned under 
paragraph (d)(2)(ii)(B) of this section.
    (B) Base differences. If a taxpayer recognizes an item of foreign 
gross income that is attributable to a base difference, then the item 
of foreign gross income is assigned to the residual grouping. But see 
Sec.  1.904-6(b)(1) (assigning foreign gross income attributable to a 
base difference to foreign source income in the separate category 
described in section 904(d)(2)(H)(i)) for purposes of applying section 
904 as the operative section). An item of foreign gross income is 
attributable to a base difference under this paragraph (d)(2)(ii)(B) 
only if it is one of the following items:
    (1) Death benefits described in section 101;
    (2) Gifts and inheritances described in section 102;
    (3) Contributions to capital described in section 118;
    (4) The receipt of money or other property in exchange for stock 
described in section 1032 (including by reason of a transfer described 
in section 351(a));

[[Page 69160]]

    (5) The receipt of money or other property in exchange for a 
partnership interest described in section 721;
    (6) The portion of a distribution of property by a corporation to 
its shareholder with respect to its stock that is described in section 
301(c)(2); and
    (7) A distribution to a partner described in section 733.
    (3) Special rules for assigning certain items of foreign gross 
income to a statutory or residual grouping--(i) Items of foreign gross 
income included by a taxpayer in its capacity as a shareholder--(A) 
Scope. The rules of this paragraph (d)(3)(i) apply to assign to a 
statutory or residual grouping an item of foreign gross income that a 
taxpayer includes in foreign taxable income in its capacity as a 
shareholder of a corporation as a result of a distribution, a foreign 
law distribution, an inclusion, or gain with respect to the stock of 
the corporation (as determined under foreign law).
    (B) Characterizing and assigning foreign gross income items that 
arise from a distribution--(1) In general. If there is a distribution 
by a corporation that is recognized for both foreign law and Federal 
income tax purposes, a taxpayer first applies the rules of paragraph 
(d)(3)(i)(B)(2) of this section, and then (if necessary) applies the 
rules of paragraph (d)(3)(i)(B)(3) of this section to determine the 
amount and the character of the items of foreign gross income that 
arise from the distribution. Foreign gross income arising from any 
portion of a distribution that is not recognized as a distribution for 
Federal income tax purposes is characterized under the rules for 
foreign law distributions in paragraph (d)(3)(i)(C) of this section. 
See Sec.  1.960-1(d)(3)(ii) for rules for assigning foreign gross 
income arising from a distribution described in this paragraph to 
income groups or PTEP groups for purposes of section 960 as the 
operative section.
    (2) Characterizing and assigning the foreign dividend amount. The 
foreign dividend amount is, to the extent of the U.S. dividend amount, 
assigned to the same statutory and residual groupings from which a 
distribution of the U.S. dividend amount is made under Federal income 
tax law. If the foreign dividend amount exceeds the U.S. dividend 
amount, the excess foreign dividend amount is an item of foreign gross 
income that is, to the extent of the U.S. return of capital amount, 
treated as attributable to a base difference described in paragraph 
(d)(2)(ii)(B)(6) of this section. Any additional excess of the foreign 
dividend amount over the sum of the U.S. dividend amount and the U.S. 
return of capital amount is an item of foreign gross income that is 
assigned to the statutory or residual grouping (or ratably to the 
groupings) to which the U.S. capital gain amount is assigned.
    (3) Characterizing and assigning the foreign capital gain amount. 
The foreign capital gain amount is, to the extent of the U.S. capital 
gain amount, assigned to the statutory and residual groupings to which 
the U.S. capital gain amount is assigned under Federal income tax law. 
If the foreign capital gain amount exceeds the U.S. capital gain 
amount, the excess is, to the extent of the U.S. return of capital 
amount, treated as attributable to a base difference described in 
paragraph (d)(2)(ii)(B)(6) of this section. Any additional excess of 
the foreign capital gain amount over the sum of the U.S. capital gain 
amount and the U.S. return of capital amount is assigned ratably to the 
statutory and residual groupings to which the U.S. dividend amount is 
assigned.
    (C) Foreign gross income items arising from a foreign law 
distribution. An item of foreign gross income that arises from an event 
that foreign law treats as a taxable distribution (other than by reason 
of a foreign law subpart F regime) but that Federal income tax law does 
not treat as a distribution of property (for example, a stock dividend 
described in section 305 or a foreign law consent dividend) (a foreign 
law distribution) is assigned under the rules of paragraph (d)(3)(i)(B) 
of this section to the same statutory or residual groupings to which 
the foreign gross income would be assigned if a distribution of 
property in the amount of the foreign law distribution were made for 
Federal income tax purposes in the U.S. taxable year in which the 
taxpayer paid or accrued the foreign income tax.
    (D) Foreign gross income from an inclusion under a foreign law 
subpart F regime. An item of foreign gross income that a taxpayer 
includes under foreign law in its capacity as a shareholder of a 
foreign law CFC under a foreign law subpart F regime is assigned to the 
same statutory and residual groupings as the item of foreign law 
subpart F income of the foreign law CFC that gives rise to the item of 
foreign gross income of the taxpayer. The assignment is made by 
treating the items of foreign gross income of the taxpayer attributable 
to the foreign law subpart F regime inclusion as the items of foreign 
gross income of the foreign law CFC and applying the rules in this 
paragraph (d) by treating the foreign law CFC as the taxpayer in its 
U.S. taxable year with or within which its foreign taxable year (under 
the law of the foreign jurisdiction imposing the shareholder-level tax) 
ends. See Sec.  1.904-6(f) for special rules with respect to items of 
foreign gross income relating to items of the foreign law CFC that give 
rise to inclusions under section 951A for purposes of applying section 
904 as the operative section.
    (ii) Tax imposed on disregarded payments--(A) Disregarded payments 
made by a foreign branch. Except as provided in paragraph (d)(3)(ii)(C) 
of this section, an item of foreign gross income that a taxpayer 
includes by reason of the receipt of a disregarded payment made by a 
disregarded entity or other foreign branch is assigned to the statutory 
or residual grouping to which the income out of which the payment is 
made is assigned. For purposes of this paragraph (d)(3)(ii), a 
disregarded payment is considered to be made ratably out of all of the 
accumulated after-tax income of the foreign branch, as computed for 
Federal income tax purposes. The accumulated after-tax income of the 
foreign branch is deemed to have arisen in the statutory and residual 
groupings in the same ratio as the tax book value of the assets of the 
branch in the groupings, determined in accordance with Sec.  1.987-
6(b)(2), unless the payment was made with a principal purpose of 
avoiding the purposes of an operative section, or results in a material 
distortion in the association of foreign income tax with U.S. gross 
income in the same statutory or residual grouping as the foreign gross 
income from the payment. For purposes of applying Sec.  1.987-6(b)(2) 
under this paragraph (d)(3)(ii), assets of the foreign branch include 
stock held by the foreign branch. But see Sec.  1.904-6(b)(2)(i) 
(assigning certain items based on the separate category to which the 
U.S. gross income to which the disregarded payment is allocable is 
assigned under Sec.  1.904-4(f)(2)(vi)(A) for purposes of applying 
section 904 as the operative section).
    (B) Disregarded payments made by an owner. Except as provided in 
paragraph (d)(3)(ii)(C) of this section, an item of foreign gross 
income that a taxpayer includes by reason of the receipt of a 
disregarded payment made to a foreign branch by a foreign branch owner 
is assigned to the residual grouping. But see Sec.  1.904-6(b)(2)(ii) 
(assigning certain items to the foreign branch category for purposes of 
applying section 904 as the operative section).
    (C) Disregarded payments in connection with disregarded sales or 
exchanges of property. An item of foreign gross income attributable to 
gain recognized under foreign law by reason of a disregarded payment 
received in

[[Page 69161]]

exchange for property is characterized and assigned under the rules of 
paragraph (d)(2)(i) of this section.
    (D) Definitions. For purposes of this paragraph (d)(3)(ii) and 
paragraph (g) of this section, the terms disregarded entity, 
disregarded payment, foreign branch, and foreign branch owner have the 
same meaning given to those terms in Sec.  1.904-4(f)(3). A foreign 
branch owner can include a foreign corporation. See Sec.  1.904-
4(f)(3)(viii).
    (iii) Reverse hybrids. An item of foreign gross income that a 
taxpayer includes in foreign taxable income in its capacity as the 
owner of a reverse hybrid is assigned to a statutory or residual 
grouping by treating the taxpayer's items of foreign gross income 
included from the reverse hybrid as the foreign gross income of the 
reverse hybrid, and applying the rules in this paragraph (d) by 
treating the reverse hybrid as the taxpayer in the reverse hybrid's 
U.S. taxable year with or within which its foreign taxable year (under 
the law of the foreign jurisdiction imposing the owner-level tax) ends. 
See Sec.  1.904-6(f) for special rules that apply for purposes of 
section 904 with respect to items of foreign gross income that under 
this paragraph (d)(3)(iii) would be assigned to a separate category 
that includes income that gives rise to inclusions under section 951A.
    (iv) Gain on sale of disregarded entity. An item of foreign gross 
income arising from gain recognized on the disposition of a disregarded 
entity that is characterized as a disposition of assets for Federal 
income tax purposes is assigned to statutory and residual groupings in 
the same proportion as the gain that would be treated as foreign gross 
income in each grouping if the transaction were treated as a 
disposition of assets for foreign tax law purposes.
    (e) Allocating and apportioning deductions (allowed under foreign 
law) to foreign gross income in a grouping--(1) Application of foreign 
law expense allocation rules. In order to determine foreign taxable 
income in each statutory grouping, or the residual grouping, foreign 
gross income in each grouping is reduced by deducting any expenses, 
losses, or other amounts that are deductible under foreign law that are 
specifically allocable to the items of foreign gross income in the 
grouping under the laws of that foreign country. If expenses are not 
specifically allocated under foreign law, then the expenses are 
allocated and apportioned among the groupings under the principles of 
foreign law. Thus, for example, if foreign law provides that expenses 
will be apportioned on a gross income basis, the foreign law deductions 
are apportioned on the basis of the relative amounts of foreign gross 
income assigned to each grouping.
    (2) Application of U.S. expense allocation rules in the absence of 
foreign law rules. If foreign law does not provide rules for the 
allocation or apportionment of expenses, losses or other deductions to 
particular items of foreign gross income, then the principles of the 
section 861 regulations (as defined in Sec.  1.861-8(a)(1)) apply in 
allocating and apportioning such expenses, losses, or other deductions 
to foreign gross income. For example, in the absence of foreign law 
expense allocation rules, the principles of the section 861 regulations 
apply to allocate definitely related expenses to particular categories 
of foreign gross income and provide the methods for apportioning 
foreign law expenses that are definitely related to more than one 
statutory grouping or that are not definitely related to any statutory 
grouping. For this purpose, the apportionment of expenses required to 
be made under the principles of the section 861 regulations need not be 
made on other than a separate company basis. If the taxpayer applies 
the principles of the section 861 regulations for purposes of 
allocating foreign law deductions under this paragraph (e), the 
taxpayer must apply the principles in the same manner as the taxpayer 
applies such principles in determining the income or earnings and 
profits for Federal income tax purposes of the taxpayer (or of the 
foreign branch, controlled foreign corporation, or other entity that 
paid or accrued the foreign taxes, as the case may be). For example, a 
taxpayer must use the modified gross income method under Sec.  1.861-9T 
when applying the principles of that section for purposes of this 
paragraph (e) to determine the amount of foreign taxable income in each 
grouping if the taxpayer applies the modified gross income method in 
determining the income and earnings and profits of a controlled foreign 
corporation for Federal income tax purposes.
    (f) Apportionment of foreign income tax among groupings. If foreign 
taxable income is assigned to more than one grouping, then the foreign 
income tax is apportioned among the statutory and residual groupings by 
multiplying the foreign income tax by a fraction, the numerator of 
which is the foreign taxable income in a grouping and the denominator 
of which is all foreign taxable income on which the foreign income tax 
is imposed. If foreign law, including by reason of an income tax 
convention, exempts certain types of income from tax, or if foreign 
taxable income is reduced to or below zero by foreign law deductions, 
then no foreign income tax is allocated and apportioned to that income. 
A withholding tax (as defined in section 901(k)(1)(B)) is allocated and 
apportioned to the foreign gross income from which it is withheld. If 
foreign law, including by reason of an income tax convention, provides 
for a specific rate of tax with respect to certain types of income (for 
example, capital gains), or allows credits only against tax on 
particular items or types of income (for example, credit for foreign 
withholding taxes), then such provisions are taken into account in 
determining the amount of foreign tax imposed on such foreign taxable 
income.
    (g) Examples. The following examples illustrate the application of 
this section and Sec.  1.904-6.
    (1) Presumed facts. Except as otherwise provided, the following 
facts are assumed for purposes of the examples:
    (i) USP and US2 are domestic corporations, which are unrelated;
    (ii) USP elects to claim a foreign tax credit under section 901;
    (iii) CFC, CFC1, and CFC2 are controlled foreign corporations 
organized in Country A, and are not reverse hybrids;
    (iv) All parties have a U.S. dollar functional currency and a U.S. 
taxable year and foreign taxable year that corresponds to the calendar 
year;
    (v) No party has expenses for Country A tax purposes or expenses 
for U.S. tax purposes (other than foreign income tax expense); and
    (vi) Section 904 is the operative section, and terms have the 
meaning provided in this section or Sec. Sec.  1.904-4 and 1.904-5.

    (2) Example 1: Corresponding U.S. item--(i) Facts. USP conducts 
business in Country A that gives rise to a foreign branch. In Year 
1, for Country A tax purposes, USP earns $600x of gross income from 
the sale of Asset X and incurs foreign income tax of $80x. Also in 
Year 1, for Federal income tax purposes, USP earns $800x of foreign 
branch category income from the sale of Asset X.
    (ii) Analysis. For purposes of allocating and apportioning the 
$80x of Country A foreign income tax, the $600x of Country A gross 
income from the sale of Asset X is first assigned to separate 
categories. The $800x of foreign branch category income from the 
sale of Asset X is the corresponding U.S. item to the Country A item 
of gross income. Under paragraph (d)(1) of this section, because USP 
recognizes a corresponding U.S. item with respect to the Country A 
item of gross income in the same U.S. taxable year, the $600x of 
Country A gross income is assigned to the same separate category as 
the corresponding U.S. item. This is the case even though the amount 
of gross income recognized for

[[Page 69162]]

Federal income tax purposes differs from the amount recognized for 
Country A tax purposes. Accordingly, the $600x of Country A gross 
income is assigned to the foreign branch category. Additionally, 
because all of the Country A taxable income is assigned to a single 
separate category, the $80x of Country A tax is also allocated to 
the foreign branch category. No apportionment of the $80x is 
necessary because the class of gross income to which the tax is 
allocated consists entirely of a single statutory grouping, foreign 
branch category income.
    (3) Example 2: Characterization of transactions--(i) Facts. USP 
owns all of the outstanding stock of CFC, which conducts business in 
Country A. In Year 1, USP sells all of the stock of CFC to US2. For 
Country A tax purposes, USP recognizes $800x of gain on which 
Country A imposes $80x of foreign income tax based on its rules for 
taxing capital gains of nonresidents. For Federal income tax 
purposes, USP recognizes $800x of gain on the sale of the stock of 
CFC, all of which is included in the gross income of USP as a 
dividend under section 1248(a). Under Sec. Sec.  1.904-4(d) and 
1.904-5(c)(4), the $800x is general category income to USP.
    (ii) Analysis. For purposes of allocating and apportioning the 
$80x of Country A foreign income tax, the $800x of Country A gross 
income from the sale of the stock of CFC is first assigned to 
separate categories. The $800x of general category income from the 
sale of the stock of CFC is the corresponding U.S. item to the 
Country A item of gross income. Under paragraph (d)(1) of this 
section, because USP recognizes a corresponding U.S. item with 
respect to the Country A gross income in the same U.S. taxable year, 
the $800x of Country A gross income is assigned to the same separate 
category as the corresponding U.S. item. Accordingly, the $800x of 
Country A gross income is assigned to the general category. This is 
the case even though for Country A tax purposes the $800x of Country 
A gross income is characterized as gain from the sale of stock, 
which would be passive category income under section 
904(d)(2)(B)(i), because the income is assigned to a separate 
category based on the characterization of the gain as a dividend 
under Federal income tax law. Additionally, because all of the 
Country A taxable income is assigned to a single separate category, 
the $80x of Country A tax is also allocated to the general category. 
No apportionment of the $80x is necessary because the class of gross 
income to which the deduction is allocated consists entirely of a 
single statutory grouping, general category income.
    (4) Example 3: No corresponding U.S. item because of a timing 
difference--(i) Facts. USP owns all of the outstanding stock of CFC, 
which conducts business in Country A. CFC sells Asset X. For Country 
A tax purposes, the sale of Asset X occurs in Year 1, CFC recognizes 
$400x of foreign gross income and incurs $80x of foreign income tax. 
For Federal income tax purposes, the sale of Asset X occurs in Year 
2 and CFC recognizes $500x of general category income.
    (ii) Analysis. For purposes of allocating and apportioning the 
$80x of Country A foreign income tax in Year 1, the $400x of Country 
A gross income from the sale of Asset X is first assigned to 
separate categories. There is no corresponding U.S. item because the 
U.S. gross income related to the sale is recognized in a different 
U.S. taxable year than the item of foreign gross income. Under 
paragraph (d)(2)(i) of this section, because there would be a 
corresponding U.S. item if the realization event occurred in the 
same U.S. taxable year for U.S. and foreign tax purposes, the item 
of foreign gross income (the $400x from the sale of Asset X) is 
characterized and assigned to the groupings to which the 
corresponding U.S. item would be assigned if it were recognized for 
Federal income tax purposes in the same U.S. taxable year in which 
the item of foreign gross income is recognized. This is the case 
even though the amount of gross income recognized for Federal income 
tax purposes differs from the amount recognized for Country A tax 
purposes. Accordingly, the $400x of Country A gross income is 
assigned to the general category. Additionally, because all of the 
Country A taxable income is assigned to a single separate category, 
the $80x of Country A tax is also allocated to the general category. 
No apportionment of the $80x is necessary because the class of gross 
income to which the deduction is allocated consists entirely of a 
single statutory grouping, general category income.
    (5) Example 4: No corresponding U.S. item because excluded from 
gross income--(i) Facts. USP conducts business in Country A. In Year 
1, USP earns $200x of interest income on a State or local bond. For 
Country A tax purposes, the $200x of income is included in gross 
income and incurs $10x of foreign income tax. For Federal income tax 
purposes, the $200x is excluded from gross income under section 103.
    (ii) Analysis. For purposes of allocating and apportioning the 
$10x of Country A foreign income tax, the $200x of Country A gross 
income is first assigned to separate categories. There is no 
corresponding U.S. item because the interest income is excluded from 
U.S. gross income. Thus, the rules of paragraph (d)(2) of this 
section apply to characterize and assign the foreign gross income to 
the groupings to which a corresponding U.S. item would be assigned 
if it were recognized under Federal income tax law in that U.S. 
taxable year. The interest income is excluded from U.S. gross 
income, but is otherwise described or identified by section 103. 
Accordingly, under paragraph (d)(2)(ii)(A) of this section, the 
$200x of Country A gross income is assigned to the separate category 
to which the interest income would be assigned under Federal income 
tax law if the income were included in gross income. Under section 
904(d)(2)(B)(i), the interest income would be passive category 
income. Accordingly, the $200x of Country A gross income is assigned 
to the passive category. Additionally, because all of the Country A 
taxable income is assigned to a single separate category, the $10x 
of Country A tax is also allocated to the passive category (subject 
to the rules in Sec.  1.904-4(c)). No apportionment of the $10x is 
necessary because the class of gross income to which the deduction 
is allocated consists entirely of a single statutory grouping, 
passive category income.
    (6) Example 5: Actual distribution--(1) Facts. USP owns all of 
the outstanding stock of CFC1, which in turn owns all of the 
outstanding stock of CFC2. CFC1 and CFC2 conduct business in Country 
A. In Year 1, CFC2 distributes $300x to CFC1. For Country A tax 
purposes, $100x of the distribution is the foreign dividend amount, 
$160x is treated as a nontaxable return of capital, and the 
remaining $40x is the foreign capital gain amount. CFC1 incurs $20x 
of foreign income tax with respect to the foreign dividend amount 
and $4x of foreign income tax with respect to the foreign capital 
gain amount. The $20x and $4x of foreign income tax are each a 
separate levy. For Federal income tax purposes, $150x of the 
distribution is the U.S. dividend amount, $100x is the U.S. return 
of capital amount, and the remaining $50x is the U.S. capital gain 
amount. Under section 904(d)(3)(D) and Sec. Sec.  1.904-4(d) and 
1.904-5(c)(4), the $150x of U.S. dividend amount consists solely of 
general category income in the hands of CFC1. Under section 
904(d)(2)(B)(i) and Sec.  1.904-4(b)(2)(i)(A), the $50x of U.S. 
capital gain amount is passive category income to CFC1.
    (ii) Analysis--(A) In general. Because the $20x of Country A 
foreign income tax and the $4x of Country A foreign income tax are 
separate levies, the taxes are allocated and apportioned separately. 
For purposes of allocating and apportioning each foreign income tax, 
the relevant item of Country A gross income (the foreign dividend 
amount or foreign capital gain amount) is first assigned to separate 
categories. The U.S. dividend amount and U.S. capital gain amount 
are corresponding U.S. items. However, paragraph (d)(3)(i)(B) of 
this section (and not paragraph (d)(1) of this section) applies to 
assign the items of foreign gross income arising from the 
distribution.
    (B) Foreign dividend amount. Under paragraph (d)(3)(i)(B)(2) of 
this section, the foreign dividend amount ($100x) is, to the extent 
of the U.S. dividend amount ($150x), assigned to the same separate 
category from which the distribution of the U.S. dividend amount is 
made under Federal income tax law. Thus, $100x of foreign gross 
income that is the foreign dividend amount is assigned to the 
general category. Additionally, because all of the Country A taxable 
income included in the base on which the $20x of foreign income tax 
is imposed is assigned to a single separate category, the $20x of 
Country A tax on the foreign dividend amount is also allocated to 
the general category. No apportionment of the $20x is necessary 
because the class of gross income to which the deduction is 
allocated consists entirely of a single statutory grouping, general 
category income.
    (C) Foreign capital gain amount. Under paragraph (d)(3)(i)(B)(3) 
of this section, the foreign capital gain amount ($40x) is, to the 
extent of the U.S. capital gain amount ($50x), assigned to the same 
separate category to which the U.S. capital gain is assigned under 
Federal income tax law. Thus, the $40x of foreign gross income that 
is the foreign capital gain amount is assigned to the passive 
category. Additionally, because all of the

[[Page 69163]]

Country A taxable income in the base on which the $4x of foreign 
income tax is imposed is assigned to a single separate category, the 
$4x of Country A tax on the foreign dividend amount is also 
allocated to the passive category. No apportionment of the $4x is 
necessary because the class of gross income to which the deduction 
is allocated consists entirely of a single statutory grouping, 
passive category income.
    (7) Example 6: Foreign law distribution--(i) Facts. USP owns all 
of the outstanding stock of CFC. In Year 1, for Country A tax 
purposes, CFC distributes $1,000x of its stock that is treated as a 
dividend to USP, and Country A imposes a withholding tax on USP of 
$150x with respect to the $1,000x of foreign gross income. For 
Federal income tax purposes, the distribution is treated as a stock 
dividend described in section 305(a) and USP recognizes no U.S. 
gross income. At the time of the distribution, CFC has $800x of 
section 965(a) PTEP (as defined in Sec.  1.960-3(c)(2)(vi)) in a 
single annual PTEP account (as defined in Sec.  1.960-3(c)(1)), and 
$500x of earnings and profits described in section 959(c)(3). 
Section 965(g) is the operative section for purposes of applying 
this section. See Sec.  1.965-5(b)(2). x
    (ii) Analysis. For purposes of allocating and apportioning the 
$150x of Country A foreign income tax, the $1,000x of Country A 
gross income is first assigned to the relevant statutory and 
residual groupings for purposes of applying section 965(g) as the 
operative section. Under Sec.  1.965-5(b)(2), the statutory grouping 
is the portion of the distribution that is attributable to section 
965(a) previously taxed earnings and profits and the residual 
grouping is the portion of the distribution attributable to other 
earnings and profits. There is no corresponding U.S. item because 
under section 305 USP recognizes no U.S. gross income with respect 
to the distribution. Under paragraph (d)(3)(i)(C) of this section, 
the item of foreign gross income (the $1,000x distribution) is 
assigned under the rules of paragraph (d)(3)(i)(B) of this section 
to the same statutory or residual groupings to which the foreign 
gross income would be assigned if a distribution of the same amount 
were made for Federal income tax purposes in Year 1. Under paragraph 
(d)(3)(i)(B)(2) of this section, the foreign dividend amount 
($1,000x) is, to the extent of the U.S. dividend amount ($1,000x), 
assigned to the same statutory or residual groupings from which a 
distribution of the U.S. dividend amount would be made under Federal 
income tax law. Thus, $800x of foreign gross income related to the 
foreign dividend amount is assigned to the statutory grouping for 
the portion of the distribution attributable to section 965(a) 
previously taxed earnings and profits and $200x of foreign gross 
income is assigned to the residual grouping. Under paragraph (f) of 
this section, $120x ($150x x $800x/$1,000x) of the Country A foreign 
income tax is apportioned to the statutory grouping and $30x ($150x 
x $200x/$1,000x) of the Country A foreign income tax is apportioned 
to the residual grouping. See section 965(g) and Sec.  1.965-5(b) 
for application of the applicable percentage (as defined in Sec.  
1.965-5(d)) to the foreign income tax allocated and apportioned to 
the statutory grouping.
    (8) Example 7: Foreign law subpart F regime, CFC shareholder--
(i) Facts. USP owns all of the outstanding stock of CFC1, which in 
turn owns all of the outstanding stock of CFC2. CFC2 is organized 
and conducts business in Country B. Country A has a foreign law 
subpart F regime that imposes a tax on CFC1 for certain earnings of 
CFC2, a foreign law CFC. In Year 1, CFC2 earns $400x of interest 
income and $200x of royalty income. CFC2 incurs no foreign income 
tax. For Country A tax purposes, the $400x of interest income and 
$200x of royalty income are each an item of foreign law subpart F 
income of CFC2 that are included in the gross income of CFC1. CFC1 
incurs $150x of Country A foreign income tax with respect to the 
foreign law subpart F income. For Federal income tax purposes, with 
respect to CFC2, the $400x of interest income is passive category 
income under section 904(d)(2)(B)(i) and the $200x of royalty income 
is general category income under Sec.  1.904-4(b)(2)(iii).
    (ii) Analysis. For purposes of allocating and apportioning 
CFC1's $150x of Country A foreign income tax, the $600x of Country A 
gross income is first assigned to separate categories. The $600x of 
foreign gross income is not included in the U.S. gross income of 
CFC1, and thus, there is no corresponding U.S. item. Under paragraph 
(d)(3)(i)(D) of this section, each item of foreign law subpart F 
income that is included in CFC1's foreign gross income is assigned 
to the same separate category as the item of foreign law subpart F 
income of CFC2. With respect to CFC2, the $400x of interest income 
and the $200x of royalty income would be corresponding U.S. items if 
CFC2 were the taxpayer. Accordingly, $400x of CFC1's foreign gross 
income is assigned to the passive category and $200x of CFC1's 
foreign gross income is assigned to the general category. Under 
paragraph (f) of this section, $100x ($150x x $400x/$600x) of the 
Country A foreign income tax is apportioned to the passive category 
and $50x ($150x x $200x/$600x) of the Country A foreign income tax 
is apportioned to the general category.
    (9) Example 8: Foreign law subpart F regime, U.S. shareholder--
(i) Facts. The facts are the same as in paragraph (g)(8)(i) of this 
section (the facts in Example 7), except that both CFC1 and CFC2 are 
organized and conduct business in Country B, all of the outstanding 
stock of CFC1 is owned by Individual X, a U.S. citizen resident in 
Country A, and Country A imposes tax of $150x on foreign gross 
income of $600x under its foreign law subpart F regime on Individual 
X, rather than on CFC1. For Federal income tax purposes, in the 
hands of CFC2, the $400x of interest income is passive category 
subpart F income and the $200x of royalty income is general category 
tested income (as defined in Sec.  1.951A-2(b)(1)). CFC2's $400x of 
interest income gives rise to a passive category subpart F inclusion 
under section 951(a)(1)(A), and its $200x of tested income gives 
rise to a GILTI inclusion amount (as defined in Sec.  1.951A-
1(c)(1)) of $200x, with respect to Individual X.
    (ii) Analysis. The analysis is the same as in paragraph 
(g)(8)(ii) of this section (the analysis in Example 7) except that 
under Sec.  1.904-6(f), because $50x of the Country A foreign income 
tax is allocated and apportioned under paragraph (d)(3)(i)(D) of 
this section to CFC2's general category tested income group to which 
Individual X's inclusion under section 951A is attributable, the 
$50x of Country A foreign income tax is allocated and apportioned in 
the hands of Individual X to the section 951A category.
    (10) Example 9: Disregarded payment--(i) Facts. USP owns all of 
the outstanding stock of CFC1. CFC1 owns all of the interests in 
FDE, a disregarded entity organized in Country A. FDE owns all of 
the outstanding stock of CFC2. In Year 1, FDE pays $400x of interest 
to CFC1. For Country A tax purposes, CFC1 includes the $400x of 
interest income in gross income and incurs foreign income tax of 
$80x. For Federal income tax purposes, the $400x payment is a 
disregarded payment and results in no income to CFC1. The tax book 
value of the assets of FDE, including the stock of CFC2, in each 
separate category (determined in accordance with Sec.  1.987-
6(b)(2)) is as follows: $750x of general category assets and $250x 
of passive category assets. The payment of the $400x of interest is 
not made with the principal purpose of avoiding the purposes of 
section 904, and does not result in a material distortion of the 
association of foreign income tax with U.S. gross income in a 
separate category.
    (ii) Analysis. For purposes of allocating and apportioning 
CFC1's $80x of foreign income tax, the $400x of Country A gross 
income is first assigned to separate categories. The $400x of 
foreign gross income is not included in the U.S. gross income of 
CFC1, and thus, there is no corresponding U.S. item. Under paragraph 
(d)(3)(ii)(A) of this section, the $400x payment is considered to be 
made ratably out of all of the accumulated after-tax income of FDE, 
which is deemed to have arisen in the separate categories in the 
same ratio of the tax book value of the assets in the separate 
categories (as determined under Sec.  1.987-6(b)(2)). Accordingly, 
$300x ($400x x $750x/$1,000x) of the Country A gross income is 
assigned to the general category and $100x ($400x x $250x/$1,000x) 
of the Country A gross income is assigned to the passive category. 
Under paragraph (f) of this section, $60x ($80x x $300x/$400x) of 
the Country A foreign income tax is apportioned to the general 
category and $20x ($80x x $100x/$400x) of the Country A foreign 
income tax is apportioned to the passive category.
    (11) Example 10: Disregarded transfer of built-in gain 
property--(i) Facts. USP owns FDE, a foreign branch operating in 
Country A. FDE transfers Asset F, equipment used in FDE's trade or 
business in Country A, for no consideration to USP in a transaction 
that is disregarded for Federal income tax purposes but treated as a 
distribution of Asset F from a foreign corporation to its U.S. 
shareholder for Country A tax purposes. Asset F has a fair market 
value of $250x at the time of transfer and an adjusted basis of 
$100x for both Federal income tax and Country A tax purposes. 
Country A imposes $30x of tax on FDE with respect to the $150x of 
built-in gain on a deemed sale of Asset F, which is recognized for 
Country A tax purposes by reason of the transfer to USP. If FDE had 
sold

[[Page 69164]]

Asset F for $250x in a transaction that was regarded for Federal 
income tax purposes, FDE would also have recognized gain of $150x 
for Federal income tax purposes, and that gain would have been 
characterized as foreign branch category income as defined in Sec.  
1.904-4(f). Country A also imposes $25x of withholding tax on USP by 
reason of the distribution of Asset F, valued at $250x, to USP.
    (ii) Analysis--(A) Net basis tax on built-in gain. For purposes 
of allocating and apportioning the $30x of Country A foreign income 
tax imposed on FDE by reason of the deemed sale of Asset F, the 
$150x of Country A gross income from the deemed sale of Asset F is 
first assigned to a separate category. Because the transaction is 
disregarded for Federal income tax purposes, there is no 
corresponding U.S. item. However, FDE would have recognized gain of 
$150x, which would have been a corresponding U.S. item, if the 
deemed sale had been recognized for Federal income tax purposes. 
Therefore, under paragraph (d)(2)(i) of this section the item of 
foreign gross income is characterized and assigned to the grouping 
to which such corresponding U.S. item would have been assigned if 
the deemed sale were recognized under Federal income tax law. 
Because the sale of Asset F in a regarded transaction would have 
resulted in foreign branch category income, the foreign gross income 
is characterized as foreign branch category income. Because all of 
the Country A foreign taxable income is assigned to a single 
separate category, the $30x of Country A tax is also allocated to 
the foreign branch category. No apportionment of the $30x is 
necessary because the class of gross income to which the tax is 
allocated consists entirely of a single statutory grouping, foreign 
branch category income.
    (B) Withholding tax on distribution. For purposes of allocating 
and apportioning the $25x of Country A withholding tax imposed on 
USP by reason of the transfer of Asset F, the $250x of Country A 
gross income from the distribution of Asset F is first assigned to a 
separate category. The transfer is a remittance from FDE to USP that 
is disregarded for Federal income tax purposes (as described in 
Sec.  1.904-4(f)(2)(vi)(C)(2) and Sec.  1.904-4(f)(3)(ix)) and thus 
there is no corresponding U.S. item. Under paragraph (d)(3)(ii)(A) 
of this section the item of foreign gross income is assigned to the 
groupings to which the income out of which the payment is made is 
assigned, and the payment is considered to be made ratably out of 
all of the accumulated after-tax income of FDE, as computed for 
Federal income tax purposes. The accumulated after-tax income of FDE 
is deemed to have arisen in the statutory and residual groupings in 
the same ratio as the tax book value of the FDE's assets in the 
groupings, determined in accordance with Sec.  1.987-6(b)(2). 
Because all of FDE's assets produce foreign branch category income, 
the foreign gross income is characterized as foreign branch category 
income. Because all of the Country A foreign taxable income from 
which the tax is withheld is assigned to a single separate category, 
under paragraph (f) of this section the $25x of Country A 
withholding tax is also allocated to the foreign branch category. No 
apportionment of the $25x is necessary because the class of gross 
income to which the tax is allocated consists entirely of a single 
statutory grouping, foreign branch category income.
    (12) Example 11: Sale of disregarded entity--(i) Facts. USP 
sells FDE, a disregarded entity that is organized and operates in 
Country A, for $500x. FDE owns Asset X and Asset Y, each having a 
fair market value of $250x. For Country A tax purposes, FDE has a 
basis in Asset X of $100x and a basis in Asset Y of $200x; USP's 
basis in FDE is $100x; and the sale is treated as a sale of stock. 
Country A imposes foreign income tax of $40x on USP on the Country A 
gross income of $400x resulting from the sale of FDE, based on its 
rules for taxing capital gains of nonresidents. For Federal income 
tax purposes, USP has a basis of $150x in Asset X, which produces 
passive category income, and a basis of $150x in Asset Y, which 
produces general category income that would not be foreign personal 
holding company income if earned by a CFC. For Federal income tax 
purposes USP recognizes $100x of passive category income and $100x 
of general category income from the sale of FDE.
    (ii) Analysis. For purposes of allocating and apportioning USP's 
$40x of Country A foreign income tax, the $400x of Country A gross 
income resulting from the sale of FDE is first assigned to separate 
categories. Under paragraph (d)(3)(iv) of this section, USP's $400x 
of Country A gross income is assigned among the statutory groupings 
in the same percentages as the foreign gross income in each category 
that would have resulted if the sale of FDE were treated as an asset 
sale for Country A tax purposes. Because for Country A tax purposes 
Asset X had a built-in gain of $150x and Asset Y had a built-in gain 
of $50x, $300x ($400x x $150x/$200x) of the Country A gross income 
is assigned to the passive category and $100x ($400x x $50x/$200x) 
is assigned to the general category. Under paragraph (f) of this 
section, $30x ($40x x $300x/$400x) of the Country A foreign income 
tax is apportioned to the passive category, and $10x ($40x x $100x/
$400x) of the Country A foreign income tax is apportioned to the 
general category.

    (h) Applicability date. This section applies to taxable years 
beginning after December 31, 2019.
0
Par. 13. Section 1.904-4 is amended by:
0
1. Revising paragraph (c)(7)(i).
0
2. Revising the third and fourth sentences of paragraph (c)(7)(ii).
0
3. Revising paragraph (c)(7)(iii).
0
4. Adding paragraphs (c)(8)(v) through (viii).
0
5. Revising paragraphs (e)(1)(ii) and (e)(2).
0
6. Removing paragraphs (e)(3) and (4).
0
7. Removing the language ``Sec.  1.904-6(b)'' in paragraph (o) and 
adding the language ``1.904-6(e)'' in its place.
0
8. Revising paragraph (q).
    The revisions and additions read as follows:


Sec.  1.904-4  Separate application of section 904 with respect to 
certain categories of income.

* * * * *
    (c) * * *
    (7) * * * (i) In general. If the effective rate of tax imposed by a 
foreign country on income of a foreign corporation that is included in 
a taxpayer's gross income is reduced under foreign law on distribution 
of such income, the rules of this paragraph (c) apply at the time that 
the income is included in the taxpayer's gross income, without regard 
to the possibility of a subsequent reduction of foreign tax on the 
distribution. If the inclusion is considered to be high-taxed income, 
then the taxpayer must initially treat the inclusion as general 
category income, section 951A category income or income in a specified 
separate category as provided in paragraph (c)(1) of this section. When 
the foreign corporation distributes the earnings and profits to which 
the inclusion was attributable and the foreign tax on the inclusion is 
reduced, then if a redetermination of U.S. tax liability is required 
under Sec.  1.905-3(b)(2), the taxpayer must redetermine whether the 
revised inclusion (if any) should be considered to be high-taxed 
income. See Sec.  1.905-3(b)(2)(ii) (requiring a redetermination of the 
amount of the inclusion, the application of the high-tax exception 
under section 954(b)(4), and the amount of foreign taxes deemed paid). 
If, taking into account the reduction in foreign tax, the inclusion 
would not have been considered high-taxed income, then the taxpayer, in 
redetermining its U.S. tax liability for the year or years affected, 
must treat the inclusion and the associated taxes (as reduced on the 
distribution) as passive category income and taxes. For this purpose, 
the foreign tax on an inclusion under section 951(a)(1) or 951A(a) is 
considered reduced on distribution of the earnings and profits 
associated with the inclusion if the total taxes paid and deemed paid 
on the inclusion and the distribution (taking into account any 
reductions in tax and any withholding taxes) is less than the total 
taxes deemed paid in the year of inclusion. Therefore, any foreign 
currency gain associated with the earnings and profits that are 
distributed with respect to the inclusion is not taken into account in 
determining whether there is a reduction of tax requiring a 
redetermination of whether the inclusion is high-taxed income.
    (ii) * * * 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

[[Page 69165]]

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 or tested income under section 
954(b)(4) or section 951A(c)(2)(A)(i)(III), and finally on a LIFO basis 
to foreign taxes associated with other earnings and profits. 
Furthermore, in applying the ordering rules of section 959(c), 
distributions shall be considered made on a LIFO basis first out of 
earnings described in section 959(c)(1) and (2), then on a LIFO basis 
out of earnings and profits associated with income that remains passive 
income under paragraph (c)(7)(iii) of this section but that was 
excluded from subpart F income or tested income under section 954(b)(4) 
or section 951A(c)(2)(A)(i)(III), and finally on a LIFO basis out of 
other earnings and profits. * * *
    (iii) Treatment of income excluded under section 954(b)(4) or 
section 951A(c)(2)(A)(i)(III). If the effective rate of tax imposed by 
a foreign country on income of a foreign corporation is reduced under 
foreign law on distribution of that income, the rules of section 
954(b)(4) (including for purposes of determining tested income under 
section 951A(c)(2)(A)(i)(III)) are applied in the year of inclusion 
without regard to the possibility of a subsequent reduction of foreign 
tax. See Sec.  1.954-1(d)(3)(iii) and Sec.  1.951A-2(c)(6)(iv). If a 
taxpayer excludes passive income from a controlled foreign 
corporation's foreign personal holding company income or tested income 
under section 954(b)(4) or section 951A(c)(2)(A)(i)(III), then, 
notwithstanding the general rule of Sec.  1.904-5(d)(2), the income is 
considered to be passive category income until distribution of that 
income. At that time, if after the redetermination of U.S. tax 
liability required under Sec.  1.905-3(b)(2) the taxpayer still elects 
to exclude the passive income under section 954(b)(4) or section 
951A(c)(2)(A)(i)(III), the rules of this paragraph (c)(7)(iii) apply to 
determine whether the income is high-taxed income upon distribution 
and, therefore, income in another separate category. For purposes of 
determining whether a reduction in tax is attributable to taxes on 
income excluded under section 954(b)(4) or section 
951A(c)(2)(A)(i)(III), the rules of paragraph (c)(7)(ii) of this 
section apply. The rules of paragraph (c)(7)(ii) of this section also 
apply for purposes of ordering distributions to determine whether such 
distributions are out of earnings and profits associated with such 
excluded income. For an example illustrating the operation of this 
paragraph (c)(7)(iii), see paragraph (c)(8)(vi) of this section 
(Example 6).
    (8) * * *

    (v) Example 5--CFC, a controlled foreign corporation, is a 
wholly-owned subsidiary of USP, a domestic corporation. USP and CFC 
are calendar year taxpayers. In Year 1, CFC's only earnings consist 
of $200x of pre-tax passive income that is foreign personal holding 
company income that is earned in foreign Country X. Under Country 
X's tax system, the corporate tax on particular earnings is reduced 
on distribution of those earnings and no withholding tax is imposed. 
In Year 1, CFC pays $100x of foreign tax with respect to its passive 
income. USP does not elect to exclude this income from subpart F 
under section 954(b)(4) and includes $200x in gross income ($100x of 
net foreign personal holding company income and $100x of the amount 
under section 78 (the ``section 78 dividend'')). At the time of the 
inclusion, the income is considered to be high-taxed income under 
paragraphs (c)(1) and (c)(6)(i) of this section and is general 
category income to USP ($100x > $42x (21% x $200x)). CFC does not 
distribute any of its earnings in Year 1. In Year 2, CFC has no 
additional earnings. On December 31, Year 2, CFC distributes the 
$100x of earnings from Year 1. At that time, CFC receives a $60x 
refund from Country X attributable to the reduction of the Country X 
corporate tax imposed on the Year 1 earnings. The refund is a 
foreign tax redetermination under Sec.  1.905-3(a) that under Sec.  
1.905-3(b)(2) and Sec.  1.954-1(d)(3)(iii) requires a 
redetermination of CFC's Year 1 subpart F income and the application 
of section 954(b)(4), as well as a redetermination of USP's Year 1 
inclusion under section 951(a)(1), its deemed paid taxes under 
section 960(a), and its Year 1 U.S. tax liability. As recomputed 
taking into account the $60x refund, CFC's Year 1 passive category 
net foreign personal holding company income is increased by $60x to 
$160x, CFC's foreign income taxes attributable to that income are 
reduced from $100x to $40x, and the income still qualifies to be 
excluded from CFC's subpart F income under section 954(b)(4) ($40x > 
$37.80x (90% x 21% x $200x)). Assuming USP does not change its Year 
1 election, USP's Year 1 inclusion under section 951(a)(1) is 
increased by $60x to $160x, and the associated deemed paid tax and 
section 78 dividend are reduced by $60x to $40x. Under paragraph 
(c)(7)(i) of this section, in connection with the adjustments 
required under section 905(c), USP must redetermine whether the 
adjusted Year 1 inclusion is high-taxed income of USP. Taking into 
account the $60x refund, the inclusion is not considered high-taxed 
income of USP ($40x < $42x (21% x $200x)). Therefore, USP must treat 
the $200x of income ($160x inclusion plus $40x section 78 amount) 
and the $40x of taxes associated with the inclusion in Year 1 as 
passive category income and taxes. USP must also follow the 
appropriate procedures under Sec.  1.905-4.
    (vi) Example 6. The facts are the same as in paragraph (c)(8)(v) 
of this section (the facts in Example 5), except that in Year 1, USP 
elects to apply section 954(b)(4) to exclude CFC's passive income 
from its subpart F income, both before and after the recomputation 
of CFC's Year 1 subpart F income and USP's Year 1 U.S. tax liability 
that is required by reason of the Year 2 $60x foreign tax 
redetermination. Although the income is not considered to be subpart 
F income, under paragraph (c)(7)(iii) of this section it remains 
passive category income until distribution. In Year 2, the $100x 
distribution is a dividend to USP, because CFC has $160x of 
accumulated earnings and profits described in section 959(c)(3) (the 
$100x of earnings in Year 1 increased by the $60x refund received in 
Year 2 that under Sec.  1.905-3(b)(2) is taken into account in Year 
1). Under paragraph (c)(7)(iii) of this section, USP must determine 
whether the dividend income is high-taxed income to USP in Year 2. 
The treatment of the dividend as passive category income may be 
relevant in determining deductions allocable or apportioned to such 
dividend income or related stock that are excluded in the 
computation of USP's foreign tax credit limitation under section 
904(a) in Year 2. See section 904(b)(4). Under paragraph (c)(1) of 
this section, the dividend income is passive category income to USP 
because the foreign taxes paid and deemed paid by USP ($0x) with 
respect to the dividend income do not exceed the highest U.S. tax 
rate on that income.
    (vii) Example 7. The facts are the same as in paragraph 
(c)(8)(v) of this section (the facts in Example 5), except that the 
distribution in Year 2 is subject to a withholding tax of $25x. 
Under paragraph (c)(7)(i) of this section, USP must redetermine 
whether its Year 1 inclusion should be considered high-taxed income 
of USP because there is a net $35x reduction ($60x refund of foreign 
corporate tax-$25x withholding tax) of foreign tax. By taking into 
account both the reduction in foreign corporate tax and the 
additional withholding tax, the inclusion continues to be considered 
high-taxed income of USP in Year 1 ($65x > $42x (21% x $200). USP 
must follow the appropriate section 905(c) procedures. USP must 
redetermine its U.S. tax liability for Year 1, but the Year 1 
inclusion and the $65x taxes ($40x of deemed paid tax in Year 1 and 
$25x withholding tax in Year 2) will continue to be treated as 
general category income and taxes.
    (viii) Example 8--(A) CFC, a controlled foreign corporation 
operating in Country G, is a wholly-owned subsidiary of USP, a 
domestic corporation. USP and CFC are calendar year taxpayers. 
Country G imposes a tax of 50% on CFC's earnings. Under Country G's 
system, the foreign corporate tax on particular earnings is reduced 
on distribution of those earnings to 30% and no withholding tax is 
imposed. Under Country G's law, distributions are treated as made 
out of a pool of undistributed earnings subject to the 50% tax rate. 
For Year 1, CFC's only earnings consist of passive income that is 
foreign personal holding company income that is earned in foreign 
Country G. CFC has taxable income of $110x for Federal income tax 
purposes and $100x for Country G

[[Page 69166]]

purposes. Country G, therefore, imposes a tax of $50x on the Year 1 
earnings of CFC. USP does not elect to exclude this income from 
subpart F under section 954(b)(4) and includes $110x in gross income 
($60x of net foreign personal holding company income under section 
951(a) and $50x of the section 78 dividend). The highest rate of tax 
under section 11 in Year 1 is 34%. Therefore, at the time of the 
section 951(a) inclusion, the income is considered to be high-taxed 
income under paragraph (c) of this section and is general category 
income to USP. CFC does not distribute any of its earnings in Year 
1.
    (B) In Year 2, CFC earns general category income that is not 
subpart F income or tested income. CFC again has $110x in taxable 
income for Federal income tax purposes and $100x in taxable income 
for Country G purposes, and CFC pays $50x of tax to foreign Country 
G. In Year 3, CFC has no taxable income or earnings. On December 31, 
Year 3, CFC distributes $60x of its total $120x of earnings and 
receives a refund of foreign tax of $24x. The $24x refund is a 
foreign tax redetermination under Sec.  1.905-3(a) that under Sec.  
1.905-3(b)(2) requires a redetermination of CFC's Year 1 subpart F 
income and USP's deemed paid taxes and Year 1 U.S. tax liability. 
Country G treats the distribution of earnings as out of the 50% tax 
rate pool of $200x of earnings accumulated in Year 1 and Year 2, as 
calculated for Country G tax purposes. However, under paragraph 
(c)(7)(ii) of this section, the distribution, and, therefore, the 
reduction of tax is treated as first attributable to the $60x of 
passive category earnings attributable to income previously taxed in 
Year 1, and none of the distribution is treated as made out of the 
$60x of earnings accumulated in Year 2 (which is not previously 
taxed). Because 40 percent (the reduction in tax rates from 50 
percent to 30 percent is a 40 percent reduction in the tax) of the 
$50x of foreign taxes attributable to the $60x of Year 1 passive 
income as calculated for Federal income tax purposes is refunded, 
$20x of the $24x foreign tax refund reduces foreign taxes on CFC's 
Year 1 passive income from $50x to $30x. The other $4x of the tax 
refund reduces the taxes imposed in Year 2 on CFC's general category 
income from $50x to $46x.
    (C) Under paragraph (c)(7) of this section, in connection with 
the section 905(c) adjustment USP must redetermine whether its Year 
1 subpart F inclusion should be considered high-taxed income. By 
taking into account the reduction in foreign tax, the inclusion is 
increased by $20x to $80x, the deemed paid taxes are reduced by $20x 
to $30x, and the inclusion is not considered high-taxed income ($30x 
< 34% x $110x). Therefore, USP must treat the revised section 951(a) 
inclusion and the taxes associated with the section 951(a) inclusion 
as passive category income and taxes in Year 1. USP must follow the 
appropriate procedures under Sec.  1.905-4.

* * * * *
    (e) * * * (1) * * *
    (ii) Definition of financial services income. The term financial 
services income means income derived by a financial services entity, as 
defined in paragraph (e)(2) of this section, that is:
    (A) Income derived in the active conduct of a banking, financing, 
or similar business under section 954(h)(3)(A)(i);
    (B) Income that is of a kind that would be insurance income as 
defined in section 953(a)(1) (including related person insurance income 
as defined in section 953(c)(2) and without regard to the exception in 
section 953(a)(2) for income that is exempt insurance income under 
section 953(e));
    (C) Income from the investment by an insurance company of its 
unearned premiums or reserves ordinary and necessary to the proper 
conduct of the insurance business; or
    (D) Passive income as defined in section 904(d)(2)(B) and paragraph 
(b) of this section as determined before the application of the 
exception for high-taxed income but after the application of the 
exception for export financing interest.
* * * * *
    (2) Financial services entities--(i) Definition of financial 
services entity--(A) In general. The term financial services entity 
means an individual or corporation that is predominantly engaged in the 
active conduct of a banking, insurance, financing, or similar business 
(active financing business) within the meaning of paragraphs 
(e)(2)(i)(A)(1) through (4) of this section for any taxable year. 
Except as provided in paragraph (e)(2)(ii) of this section, a 
determination of whether an individual or corporation is a financial 
services entity is done on an individual or entity-by-entity basis. An 
individual or corporation is predominantly engaged in the active 
financing business for any year if for that year:
    (1) It is predominantly engaged in the active conduct of a banking, 
financing, or similar business under section 954(h)(2)(B) (substituting 
the reference to ``controlled foreign corporation'' with ``individual 
or corporation'');
    (2) It is an insurance company meeting the requirements of section 
953(e)(3)(A) and (C) provided that the company's foreign personal 
holding company income does not exceed the amount that would be treated 
as derived in the active conduct of an insurance business under section 
954(i) if all of the insurance and annuity contracts issued or 
reinsured by the company had qualified as exempt contracts under 
section 953(e)(2);
    (3) It is a qualifying insurance corporation as defined in section 
1297(f) that is engaged in the active conduct of an insurance business 
under section 1297(b)(2)(B) (but without regard to whether the 
corporation is a foreign corporation); or
    (4) It is a domestic corporation, or a corporation that has elected 
to be treated as a domestic corporation under section 953(d), that is 
subject to Federal income tax under subchapter L on its net income and 
is subject to regulation as an insurance (or reinsurance) company in 
its jurisdiction of organization.
    (B) Certain gross income included and excluded. For purposes of 
applying the rules in paragraph (e)(2)(i)(A) of this section (including 
by reason of paragraph (e)(2)(ii) of this section), gross income 
includes interest on State and local bonds described in section 103(a), 
but does not include income from a distribution of previously taxed 
earnings and profits described in section 959(a) or (b).
    (C) Treatment of partnerships and other pass-through entities. For 
purposes of applying the rules in paragraph (e)(2)(i)(A) of this 
section (including by reason of paragraph (e)(2)(ii) of this section) 
with respect to an individual or corporation that is a direct or 
indirect partner in a partnership, the partner's distributive share of 
partnership income is characterized as if each partnership item of 
gross income were realized directly by the partner. For example, in 
applying section 954(h)(2)(B) under paragraph (e)(2)(i)(A) of this 
section, a customer with respect to a partnership is treated as a 
related person with respect to an individual or corporation that is a 
partner in the partnership if the customer is related to the individual 
or corporation under section 954(d)(3). Similar principles apply for an 
individual or corporation's share of income from any other pass-through 
entities.
    (ii) Financial services group. A corporation that is a member of a 
financial services group is deemed to be a financial services entity 
regardless of whether it is a financial services entity under paragraph 
(e)(2)(i) of this section. For purposes of this paragraph (e)(2)(ii), a 
financial services group means an affiliated group as defined in 
section 1504(a) (but determined without regard to paragraphs (2) or (3) 
of section 1504(b)) if the affiliated group as a whole meets the 
requirements of section 954(h)(2)(B)(i) (except that the reference to 
``controlled foreign corporation'' is substituted with ``affiliated 
group'' in section 954(h)(2)(B)(i)). For purposes of determining 
whether an affiliated group is a financial services group under the 
previous sentence, only the income of group members that are domestic

[[Page 69167]]

corporations or foreign corporations that are controlled foreign 
corporations in which U.S. members of the affiliated group own, 
directly or indirectly, at least 80 percent of the total voting power 
and value of the stock is included. In addition, indirect ownership is 
determined under section 318 and the regulations under that section, 
and the income of the group does not include any income from 
transactions with other members of the group.
    (iii) Examples. The following examples illustrate the application 
of paragraph (e)(2) of this section.

    (A) Example 1--(1) Facts. USP is a domestic corporation that is 
the parent of a consolidated group which includes B (a domestic 
corporation that is primarily engaged in a manufacturing business), 
C (a domestic corporation whose primary function is to manage the 
treasury operations of the consolidated group), and D (a domestic 
corporation that is engaged in the active and regular conduct of 
financing purchases by unrelated customers of B's products). USP 
also owns a 20% partnership interest in PS, a domestic partnership 
that is engaged in the active and regular conduct of making loans to 
customers that are not related persons with respect to it or USP. 
The other 80% of PS is owned by USX, a domestic corporation 
unrelated to USP (or any other member of the USP consolidated 
group). B has gross income of $170x consisting of income from its 
manufacturing operations. C has gross income of $20x consisting of 
interest income from loans to B. D has gross income of $100x 
consisting of interest income from making loans to unrelated 
customers that purchase B's products. PS has gross income of $50x 
consisting of interest on loans that it makes to customers in the 
ordinary course of its business, $10x of which is attributable to 
loans to C, $30x of which is attributable to loans to Z (a wholly 
owned subsidiary of USX), and $10 of which is attributable to loans 
to customers unrelated to either the USP or USX affiliated groups. 
USP, B, C, and D have no other items of gross income and no other 
intercompany transactions.
    (2) Analysis--(i) Entity test. Under paragraph (e)(2)(i)(A) of 
this section, B and C are not financial services entities because 
neither meets the requirements of being predominantly engaged in the 
active conduct of a banking, finance, insurance, or similar 
business. B does not meet the requirements because all of its income 
is derived from manufacturing. C does not meet the requirements 
because it lends solely to related persons. Under paragraph 
(e)(2)(i)(A)(1) of this section, D is a financial services entity 
because all of its gross income is derived from making loans to 
unrelated customers in the ordinary course of its lending business 
in a manner that meets the requirements of section 954(h)(2)(B)(i). 
Under paragraph (e)(2)(i)(C) of this section, USP's distributive 
share of partnership income from PS is characterized as if each item 
of PS's gross income were realized directly by USP. Thus, USP 
includes a $10x distributive share of income from PS, $2x of which 
is from related party loans to C and $8x of which is from loans to 
persons that are not related persons with respect to USP. Under 
paragraph (e)(2)(i)(A)(1) of this section, USP is a financial 
services entity because more than 70% of its gross income is derived 
from making loans to unrelated customers in the ordinary course of a 
lending business ($8x/$10x > 70% x $10x) and meets the requirements 
of section 954(h)(2)(B)(i).
    (ii) Affiliated group test. Under paragraph (e)(2)(ii) of this 
section, a corporation that is a member of a financial services 
group is deemed to be a financial services entity regardless of 
whether it is a financial services entity under paragraph (e)(2)(i) 
of this section. This would apply if the USP, B, C, and D affiliated 
group as a whole meets the requirements of section 954(h)(2)(B)(i). 
The USP affiliated group derives $108x ($100x by D and $8x by USP) 
from loans to unrelated customers and derives $278x of total gross 
income after making the adjustments provided in paragraph (e)(2)(ii) 
of this section ($300x total gross income minus $20x interest on 
intercompany loan from C to B and $2x interest on loan from PS to 
C). Because the gross income USP's affiliated group derives directly 
from the active and regular conduct of a lending or finance business 
from transactions with customers which are not related persons is 
39% ($108x divided by $278x), the USP affiliated group does not 
satisfy the more than 70% of gross income test of section 
954(h)(2)(B)(i), and the USP affiliated group is not a financial 
services group. USP and D are financial services entities under 
paragraph (e)(2)(i)(A) of this section. B and C are not financial 
services entities under either of paragraphs (e)(2)(i) or (ii) of 
this section.
    (B) Example 2--(1) Facts. The facts are the same as in paragraph 
(e)(2)(iii)(A)(1) of this section (the facts in Example 1) except 
that USX is the parent of a consolidated group, which includes Y (a 
domestic corporation that is a U.S. licensed bank), and Z (a 
domestic corporation that is a non-bank lender that is engaged in 
the active and regular conduct of making loans to customers 
unrelated to USX or its affiliates). Y has gross income of $200x, 
consisting of $190x from making loans to unrelated customers in the 
ordinary course of its banking business and $10x of other income not 
described in section 954(h)(4). Z has gross income of $160x, 
consisting of interest income from making loans to unrelated 
customers. USX, Y, and Z have no other items of gross income and no 
other intercompany transactions.
    (2) Analysis--(i) Entity test. Under paragraph (e)(2)(i)(A) of 
this section, Y and Z are financial services entities. Y is a 
financial services entity because it satisfies the requirements of 
section 954(h)(2)(B)(ii). Z is a financial services entity because 
all of its gross income is derived from making loans to unrelated 
customers in the ordinary course of its lending business in a manner 
that meets the requirements of section 954(h)(2)(B)(i). Under 
paragraph (e)(2)(i)(C) of this section, USX's distributive share of 
partnership income from PS is characterized as if each item of PS's 
gross income were realized directly by USX. Thus, USX includes a 
$40x distributive share of income from PS, $24x of which is from 
related party loans to Z and $16x of which is from loans to 
unrelated parties. Under paragraph (e)(2)(i)(A)(1) of this section, 
USX is not a financial services entity because only 60% ($24x 
divided by $40x) of its gross income is derived from making loans to 
unrelated customers in the ordinary course of a lending business 
and, therefore, USX does not meet the more than 70% of gross income 
test of section 954(h)(2)(B)(i).
    (ii) Affiliated group test. Under paragraph (e)(2)(ii) of this 
section, a corporation that is a member of a financial services 
group is deemed to be a financial services entity regardless of 
whether it is a financial services entity under paragraph (e)(2)(i) 
of this section. This would apply if the USX, Y, and Z affiliated 
group as a whole meets the requirements of section 954(h)(2)(B)(i). 
The USX affiliated group derives $366x ($190x by Y, $160x by Z, and 
$16x by USP) from loans to unrelated customers and derives $376x of 
total gross income after making the adjustments provided in 
paragraph (e)(2)(ii) of this section ($400x total gross income minus 
$24x interest on loans from PS to Z). Because the gross income USX's 
affiliated group derives directly from the active and regular 
conduct of a lending or finance business from transactions with 
customers which are not related persons is 97% ($366x divided by 
$376x), the USX affiliated group satisfies the more than 70% of 
gross income test of section 954(h)(2)(B)(i), and the USX affiliated 
group is a financial services group. Y and Z are financial services 
entities under paragraph (e)(2)(i)(A). USX is a financial services 
entity under paragraph (e)(2)(ii) of this section.

* * * * *
    (q) Applicability date--(1) Except as provided in paragraph (q)(2) 
and (3) of this section, this section applies for taxable years that 
both begin after December 31, 2017, and end on or after December 4, 
2018.
    (2) Paragraphs (c)(7)(i), (c)(7)(iii), (c)(8)(v) through (viii) 
apply to taxable years ending on or after December 16, 2019. For 
taxable years that both begin after December 31, 2017, and end on or 
after December 4, 2018, and also end before December 16, 2019, see 
Sec.  1.904-4(c)(7)(i) and (c)(7)(iii) as in effect on December 17, 
2019.
    (3) Paragraphs (e)(1)(ii) and (e)(2) of this section apply to 
taxable years ending on or after the date the final regulations are 
filed with the Federal Register. For taxable years that both begin 
after December 31, 2017, and end on or after December 4, 2018, and also 
end before the date the final regulations are filed with the Federal 
Register, see Sec.  1.904-4(e)(1)(i) and (e)(2) as in effect on 
December 17, 2019.
0
Par. 14. Sec.  1.904-6 is amended by:
0
1. Revising the section heading.
0
2. Revising paragraph (a).
0
3. Redesignating paragraph (b) as paragraph (e) and adding a new 
paragraph (b).

[[Page 69168]]

0
4. Adding paragraph (c) and revising paragraph (d).
0
5. Removing the language ``paragraph (b)(4)(ii)'' in newly-redesignated 
paragraph (e)(4)(i) and adding the language ``paragraph (e)(4)(ii)'' in 
its place.
0
6. Removing the language ``paragraph (b)(4)(ii)(B)'' in newly-
redesignated paragraph (e)(4)(ii)(C) and adding the language 
``paragraph (e)(4)(ii)(B)'' in its place.
0
7. Adding paragraphs (f) through (h).
    The revisions and additions read as follows:


Sec.  1.904-6  Allocation and apportionment of foreign income taxes.

    (a) In general. The amount of foreign income taxes paid or accrued 
with respect to a separate category (as defined in Sec.  1.904-
5(a)(4)(v)) of income (including U.S. source income assigned to the 
separate category) includes only those foreign income taxes that are 
allocated and apportioned to the separate category under the rules of 
Sec.  1.861-20 (as modified by this section). In applying the foreign 
tax credit limitation under sections 904(a) and (d) to general category 
income described in section 904(d)(2)(A)(ii) and Sec.  1.904-4(d), the 
general category is a statutory grouping. However, the general category 
income is the residual grouping of income for purposes of assigning 
foreign income taxes to separate categories. In addition, in 
determining the numerator of the foreign tax credit limitation under 
sections 904(a) and (d), where U.S. source income is the residual 
grouping, the amount of foreign income taxes paid or accrued for which 
a deduction is allowed, for example, under section 901(k)(7), with 
respect to foreign source income in a separate category includes only 
those foreign income taxes that are allocated and apportioned to 
foreign source income in the separate category under the rules of Sec.  
1.861-20 (as modified by this section). For purposes of this section, 
unless otherwise stated, terms have the same meaning as provided in 
Sec.  1.861-20(b).
    (b) Assigning an item of foreign gross income to a separate 
category. For purposes of assigning an item of foreign gross income to 
a separate category or categories (or foreign source income in a 
separate category) under Sec.  1.861-20, the rules of this paragraph 
(b) apply.
    (1) Base differences. Any item of foreign gross income that is 
attributable to a base difference described in Sec.  1.861-
20(d)(2)(ii)(B) is assigned to the separate category described in 
section 904(d)(2)(H)(i), and to foreign source income in that category.
    (2) Certain disregarded payments--(i) Certain disregarded payments 
made by a foreign branch. Except in the case of disregarded payments in 
exchange for property described in Sec.  1.861-20(d)(3)(ii)(C), if in 
connection with a disregarded payment made by a foreign branch to 
another foreign branch or to a foreign branch owner that is described 
in Sec.  1.861-20(d)(3)(ii)(A), U.S. gross income that would otherwise 
be attributable to a foreign branch is attributed to another foreign 
branch or to the foreign branch owner under Sec.  1.904-4(f)(2)(vi)(A) 
(including by reason of Sec.  1.904-4(f)(2)(vi)(D)), the item of 
foreign gross income that arises by reason of the disregarded payment 
is assigned to the same separate category as the reattributed U.S. 
gross income.
    (ii) Certain disregarded payments made by a foreign branch owner. 
Except in the case of disregarded payments in exchange for property 
described in Sec.  1.861-20(d)(3)(ii)(C), an item that a United States 
person includes in foreign gross income solely by reason of the receipt 
of a disregarded payment that is described in Sec.  1.861-
20(d)(3)(ii)(B) (payment to a foreign branch by a foreign branch owner) 
is assigned to the foreign branch category (or a specified separate 
category associated with the foreign branch category), or, in the case 
of a foreign branch owner that is a partnership, to the partnership's 
general category income that is attributable to the foreign branch. See 
Sec.  1.960-1(d)(3)(ii)(A) and (e) for rules providing that foreign 
income tax on a disregarded payment by a foreign branch owner that is a 
controlled foreign corporation is assigned to the residual grouping and 
cannot be deemed paid under section 960.
    (3) Disposition of property resulting in reattribution of U.S. 
gross income to or from a foreign branch. If a disposition of property 
results in the recognition of U.S. gross income that is reattributed 
under Sec.  1.904-4(f)(2)(vi)(A) by reason of a disregarded payment 
described in Sec.  1.904-4(f)(2)(vi)(B)(2) (or by reason of Sec.  
1.904-4(f)(2)(vi)(D)), any foreign gross income arising from that 
disposition of property under foreign law is assigned to a separate 
category under the rules in Sec.  1.861-20(d)(1) applied without regard 
to the reattribution of U.S. gross income under Sec.  1.904-
4(f)(2)(vi)(A).
    (c) Allocating and apportioning deductions. For purposes of 
applying Sec.  1.861-20(e) to allocate and apportion deductions allowed 
under foreign law to foreign gross income in the separate categories, 
before undertaking the steps outlined in Sec.  1.861-20(e), foreign 
gross income in the passive category is first reduced by any related 
person interest expense that is allocated to the income under the 
principles of section 954(b)(5) and Sec.  1.904-5(c)(2)(ii)(C). In 
allocating and apportioning expenses not specifically allocated under 
foreign law, the principles of foreign law are applied only after 
taking into account the reduction of passive income by the application 
of section 954(b)(5). In allocating and apportioning expenses when 
foreign law does not provide rules for the allocation or apportionment 
of expenses, losses or other deductions to particular items of foreign 
gross income, then the principles of section 954(b)(5), in addition to 
the principles of the section 861 regulations (as defined in Sec.  
1.861-8(a)(1)), apply to allocate and apportion expenses, losses or 
other foreign law deductions to foreign gross income after reduction of 
passive income by the amount of related person interest expense 
allocated to passive income under section 954(b)(5) and Sec.  1.904-
5(c)(2)(ii)(C).
    (d) Apportionment of taxes for purposes of applying the high-tax 
income tests. If taxes have been allocated and apportioned to passive 
income under the rules of paragraph (a) this section, the taxes must 
further be apportioned to the groups of income described in Sec.  
1.904-4(c)(3), (4) and (5) for purposes of determining if the group is 
high-taxed income that is recharacterized as income in another separate 
category under the rules of Sec.  1.904-4(c). See also Sec.  1.954-
1(c)(1)(iii)(B) (defining a single item of passive category foreign 
personal holding company income by reference to the grouping rules 
under Sec.  1.904-4(c)(3), (4) and (5)). Taxes are related to income in 
a particular group under the same rules as those in paragraph (a) of 
this section except that those rules are applied by apportioning 
foreign income taxes to the groups described in Sec.  1.904-4(c)(3), 
(4) and (5) instead of separate categories.
* * * * *
    (f) Treatment of certain foreign income taxes paid or accrued by 
United States shareholders. Some or all of the foreign gross income of 
a United States shareholder of a controlled foreign corporation that is 
a foreign law CFC described in Sec.  1.861-20(d)(3)(i)(D) or a reverse 
hybrid described in Sec.  1.861-20(d)(3)(iii) is assigned to the 
section 951A category if, were the controlled foreign corporation the 
taxpayer that recognizes the foreign gross income, the foreign gross 
income would be assigned to the controlled foreign corporation's tested 
income group (as defined in Sec.  1.960-1(b)(33)) within the general 
category to which an inclusion under

[[Page 69169]]

section 951A is attributable. The amount of the United States 
shareholder's foreign gross income that is assigned to the section 951A 
category (or a specified separate category associated with the section 
951A category) is based on the inclusion percentage (as defined in 
Sec.  1.960-2(c)(2)) of the United States shareholder. For example, if 
a United States shareholder has an inclusion percentage of 60 percent, 
then 60 percent of the foreign gross income of a United States 
shareholder that would be assigned (under Sec.  1.861-20(d)(3)(iii)) to 
the tested income group within the general category income of a reverse 
hybrid that is a controlled foreign corporation to which an inclusion 
under section 951A is attributable is assigned to the section 951A 
category or the specified separate category for income resourced under 
a tax treaty, and not to the general category.
    (g) Examples. For examples illustrating the application of this 
section, see Sec.  1.861-20(g).
    (h) Applicability date. This section applies to taxable years 
beginning after December 31, 2019. For taxable years that both begin 
after December 31, 2017, and end on or after December 4, 2018, and also 
begin before January 1, 2020, see Sec.  1.904-6 as in effect on 
December 17, 2019.
0
Par. 15. Section 1.904(b)-3 is amended by adding paragraph (d)(2) and 
revising paragraph (f) to read as follows:


Sec.  1.904(b)-3  Disregard of certain dividends and deductions under 
section 904(b)(4).

* * * * *
    (d) * * *
    (2) Net operating losses. If the taxpayer has a net operating loss 
in the current taxable year, then solely for purposes of determining 
the source and separate category of the net operating loss, the overall 
foreign loss rules in section 904(f) and the overall domestic loss 
rules in section 904(g) are applied without taking into account the 
adjustments required under section 904(b) and this section.
* * * * *
    (f) Applicability dates--(1) Except as provided in paragraph (f)(2) 
of this section, this section applies to taxable years beginning after 
December 31, 2017.
    (2) Paragraph (d)(2) of this section applies to taxable years 
ending on or after December 16, 2019.
0
Par. 16. Section 1.904(g)-3 is amended by:
0
1. Adding a sentence at the end of paragraph (b)(1).
0
2. Adding paragraph (j) and revising paragraph (l).
    The addition and revisions read as follows:


Sec.  1.904(g)-3  Ordering rules for the allocation of net operating 
losses, net capital losses, U.S. source losses, and separate limitation 
losses, and for the recapture of separate limitation losses, overall 
foreign losses, and overall domestic losses.

* * * * *
    (b) * * * (1) * * * See Sec. Sec.  1.861-8(e)(8), 1.904(b)-3(d)(2), 
and 1.1502-4(c)(1)(iii) for rules to determine the source and separate 
category components of a net operating loss.
* * * * *
    (j) Step Nine: Dispositions that result in additional income 
recognition under the branch loss recapture and dual consolidated loss 
recapture rules--(1) In general. If, after any gain is required to be 
recognized under section 904(f)(3) on a transaction that is otherwise a 
nonrecognition transaction, an additional amount of income is 
recognized under section 91(d), section 367(a)(3)(C) (as applicable to 
losses incurred before January 1, 2018), or Sec.  1.1503(d)-6, and that 
additional income amount is determined by taking into account an offset 
for the amount of gain recognized under section 904(f)(3) and so is not 
initially taken into account in applying paragraph (b) of this section, 
then paragraphs (b) through (h) of this section are applied to 
determine the allocation of any additional net operating loss deduction 
and other deductions or losses and the applicable increases in the 
taxpayer's overall foreign loss, separate limitation loss, and overall 
domestic loss accounts, as well as any additional recapture and 
reduction of the taxpayer's separate limitation loss, overall foreign 
loss, and overall domestic loss accounts.
    (2) Rules for additional recapture of loss accounts. For the 
purpose of recapturing and reducing loss accounts under paragraph 
(j)(1) of this section, the taxpayer also takes into account any 
creation of or addition to loss accounts that result from the 
application of paragraphs (b) through (i) of this section in the 
current tax year. If any of the additional income described in 
paragraph (j)(1) of this section is foreign source income in a separate 
category for which there is a remaining balance in an OFL account after 
applying paragraph (i) of this section, the section 904(f)(1) recapture 
amount under Sec.  1.904(f)-2(c) for that additional income is 
determined by first computing a hypothetical recapture amount as it 
would have been determined prior to the application of paragraph (i) of 
this section but taking into account the additional foreign source 
income described in this paragraph (j)(2) and then subtracting the 
actual OFL recapture determined prior to the application of paragraph 
(i) of this section (that did not take into account the additional 
foreign source income). The remainder is the OFL recapture amount with 
respect to the additional foreign source income described in this 
paragraph (j)(2).
* * * * *
    (l) Applicability date. This section applies to taxable years 
ending on or after the date the final regulations are filed with the 
Federal Register.
0
Par. 17. Section 1.905-3 is amended by:
0
1. Revising the section heading and the first sentence of paragraph 
(a).
0
2. Adding paragraphs (b)(2) and (3).
0
3. Revising paragraph (d).
    The revisions and additions read as follows:


Sec.  1.905-3  Adjustments to U.S. tax liability and to current 
earnings and profits as a result of a foreign tax redetermination.

    (a) * * * For purposes of this section and Sec.  1.905-4, the term 
foreign tax redetermination means a change in the liability for foreign 
income taxes, as defined in Sec.  1.960-1(b)(5), or certain other 
changes described in this paragraph (a) that may affect a taxpayer's 
U.S. tax liability, including by reason of a change in the amount of 
its foreign tax credit, the amount of its distributions or inclusions 
under sections 951, 951A, or 1293, the application of the high-tax 
exception described in section 954(b)(4) (including for purposes of 
determining tested income under section 951A(c)(2)(A)(i)(III)), or the 
amount of tax determined under sections 1291(c)(2) and 
1291(g)(1)(C)(ii). * * *
    (b) * * *
    (2) Foreign income taxes paid or accrued by foreign corporations--
(i) In general. A redetermination of U.S. tax liability is required to 
account for the effect of a redetermination of foreign income taxes 
taken into account by a foreign corporation in the year accrued, or a 
refund of foreign income taxes taken into account by the foreign 
corporation in the year paid.
    (ii) Required adjustments. If a redetermination of U.S. tax 
liability is required for any taxable year under paragraph (b)(2)(i) of 
this section, the foreign corporation's taxable income, earnings and 
profits, and current year taxes (as defined in Sec.  1.960-1(b)(4)) 
must be adjusted in the year to which the redetermined tax relates (or, 
in the case of a foreign corporation that

[[Page 69170]]

receives a refund of foreign income tax and uses the cash basis of 
accounting, in the year the tax was paid). The redetermination of U.S. 
tax liability is made by treating the redetermined amount of foreign 
tax as the amount of tax paid or accrued by the foreign corporation in 
such year. For example, in the case of a refund of foreign income taxes 
taken into account in the year accrued, the foreign corporation's 
subpart F income, tested income, and earnings and profits are 
increased, as appropriate, in the year to which the foreign tax relates 
to reflect the functional currency amount of the foreign income tax 
refund. The required redetermination of U.S. tax liability must account 
for the effect of the foreign tax redetermination on the 
characterization and amount of distributions or inclusions under 
sections 951, 951A, or 1293 taken into account by each of the foreign 
corporation's United States shareholders, on the application of the 
high-tax exception described in section 954(b)(4) (including for 
purposes of determining tested income under section 
951A(c)(2)(A)(i)(III)), and the amount of tax determined under sections 
1291(c)(2) and 1291(g)(1)(C)(ii), as well as on the amount of foreign 
taxes deemed paid under section 960 in such year, regardless of whether 
any such shareholder chooses to deduct or credit its foreign income 
taxes in any taxable year. In addition, a redetermination of U.S. tax 
liability is required for any subsequent taxable year in which the 
characterization or amount of a United States shareholder's 
distribution or inclusion from the foreign corporation is affected by 
the foreign tax redetermination, up to and including the taxable year 
in which the foreign tax redetermination occurs, as well as any year to 
which unused foreign taxes from such year were carried under section 
904(c).
    (iii) Reduction of corporate level tax on distribution of earnings 
and profits. If a United States shareholder of a controlled foreign 
corporation receives a distribution out of previously taxed earnings 
and profits described in section 959(c)(1) and (2) and a foreign 
country has imposed tax on the income of the controlled foreign 
corporation, which tax is reduced on distribution of the earnings and 
profits of the corporation (resulting in a foreign tax 
redetermination), then the United States shareholder must redetermine 
its U.S. tax liability for the year or years affected.
    (iv) Foreign tax redeterminations relating to taxable years 
beginning before January 1, 2018. In the case of a foreign tax 
redetermination of a foreign corporation that relates to a taxable year 
of the foreign corporation beginning before January 1, 2018, a 
redetermination of U.S. tax liability is required under the rules of 
Sec.  1.905-5.
    (v) Examples. The following examples illustrate the application of 
this paragraph (b)(2).
    (A) Presumed Facts. Except as otherwise provided, the following 
facts are assumed for purposes of the examples:
    (1) All parties are accrual basis taxpayers that use the calendar 
year as their taxable year both for Federal income tax purposes and for 
foreign tax purposes and use the average exchange rate to translate 
accrued foreign income taxes;
    (2) CFC, CFC1, and CFC2 are controlled foreign corporations 
organized in Country X that use the ``u'' as their functional currency;
    (3) No income adjustment is required to reflect exchange gain or 
loss (within the meaning of Sec.  1.988-1(e)) with respect to the 
disposition of nonfunctional currency attributable to a refund of 
foreign income taxes received by any CFC, because all foreign income 
taxes are denominated and paid in the CFC's functional currency;
    (4) The highest rate of U.S. tax in section 11 and the rate 
applicable to USP in all years is 21 percent; and
    (5) USP's foreign tax credit limitation under section 904(a) 
exceeds the amount of foreign income taxes it is deemed to pay.

    (B) Example 1: Refund of tested foreign income taxes--(1) Facts. 
CFC is a wholly-owned subsidiary of USP, a domestic corporation. In 
Year 1, CFC earns 3,660u of general category gross tested income and 
accrues and pays 300u of foreign income taxes with respect to that 
income. CFC has no allowable deductions other than the foreign 
income tax expense. Accordingly, CFC has tested income of 3,360u in 
Year 1. CFC has no qualified business asset investment (within the 
meaning of section 951A(d) and Sec.  1.951A-3(b)). In Year 1, no 
portion of USP's deduction under section 250 (``section 250 
deduction'') is reduced by reason of section 250(a)(2)(B)(ii). USP's 
inclusion percentage (as defined in Sec.  1.960-2(c)(2)) is 100%. In 
Year 1, USP earns no other income and has no other expenses. The 
average exchange rate used to translate USP's inclusion under 
section 951A and CFC's foreign income taxes into dollars for Year 1 
is $1x:1u. See section 989(b)(3) and Sec. Sec.  1.951A-1(d)(1) and 
1.986(a)-1(a)(1). Accordingly, for Year 1, USP's tested foreign 
income taxes (as defined in Sec.  1.960-2(c)(3)) with respect to CFC 
are $300x. In Year 3, CFC carries back a loss for foreign tax 
purposes and receives a refund of foreign tax of 100u that relates 
to Year 1.
    (2) Analysis--(i) Result in Year 1. In Year 1, CFC has tested 
income of 3,360u and tested foreign income taxes of $300x. Under 
section 951A(a) and Sec.  1.951A-1(c)(1), USP has a GILTI inclusion 
amount of $3,360x (3,360u translated at $1x:1u). Under section 
960(d) and Sec.  1.960-2(c), USP is deemed to have paid $240x (80% x 
100% x $300x) of foreign income taxes. Under section 78 and Sec.  
1.78-1(a), USP is treated as receiving a dividend of $300x (a 
``section 78 dividend''). USP's section 250 deduction is $1,830x 
(50% x ($3,360x + $300x)). Accordingly, for Year 1, USP has taxable 
income of $1,830x ($3,360x + $300x-$1,830x) and pre-credit U.S. tax 
liability of $384.3x (21% x $1,830x). Accordingly, USP pays U.S. tax 
of $144.3x ($384.3x-$240x).
    (ii) Result in Year 3. The refund of 100u to CFC in Year 3 is a 
foreign tax redetermination under paragraph (a) of this section. 
Under paragraph (b)(2)(ii) of this section, USP must account for the 
effect of the foreign tax redetermination on its GILTI inclusion 
amount and foreign taxes deemed paid in Year 1. In redetermining 
USP's U.S. tax liability for Year 1, USP must increase CFC's tested 
income and its earnings and profits in Year 1 by the refunded tax 
amount of 100u, must determine the effect of that increase on its 
GILTI inclusion amount, and must adjust the amount of foreign taxes 
deemed paid and the section 78 dividend to account for CFC's refund 
of foreign tax. Under Sec.  1.986(a)-1(c), the refund is translated 
into dollars at the exchange rate that was used to translate such 
amount when initially accrued. As a result of the foreign tax 
redetermination, for Year 1, CFC has tested income of 3,460u (3,360u 
+ 100u) and tested foreign income taxes of $200x ($300x-$100x). 
Under section 951A(a) and Sec.  1.951A-1(c)(1), USP has a 
redetermined GILTI inclusion amount of $3,460x (3,460u translated at 
$1x:1u). Under section 960(d) and Sec.  1.960-2(c), USP is deemed to 
have paid $160x (80% x 100% x $200x) of foreign income taxes. Under 
section 78 and Sec.  1.78-1(a), USP's section 78 dividend is $200x. 
USP's redetermined section 250 deduction is $1,830x (50% x ($3,460x 
+ $200x)). Accordingly, USP's redetermined taxable income is $1,830x 
($3,460x + $200x-$1,830x) and its pre-credit U.S. tax liability is 
$384.3x (21% x $1,830x). Therefore, USP's redetermined U.S. tax 
liability is $224.3x ($384.3x-$160x), an increase of $80x ($224.3x-
$144.3x).
    (C) Example 2: High tax exception election following a foreign 
tax redetermination--(1) Facts. CFC is a wholly-owned subsidiary of 
USP, a domestic corporation. In Year 1, CFC earns 1,000u of general 
category gross foreign base company sales income and accrues and 
pays 100u of foreign income taxes with respect to that income. CFC 
has no allowable deductions other than the foreign income tax 
expense. The average exchange rate used to translate USP's subpart F 
inclusion and CFC's foreign income taxes into dollars for Year 1 is 
$1x:1u. See section 989(b)(3) and Sec.  1.986(a)-1(a)(1). In Year 1, 
USP earns no other income and has no other expenses. In Year 5, 
pursuant to a Country X audit CFC accrues and pays additional 
foreign income tax of 80u with respect to its 1,000u of general 
category foreign base company sales income earned in Year 1. The 
spot rate (as

[[Page 69171]]

defined in Sec.  1.988-1(d)) on the date of payment of the tax in 
Year 5 is $1x:0.8u. The foreign income taxes accrued and paid in 
Year 1 and Year 5 are properly attributable to CFC's foreign base 
company sales income that is included in income by USP under section 
951(a)(1)(A) (``subpart F inclusion'') in Year 1 with respect to 
CFC.
    (2) Analysis--(i) Result in Year 1. In Year 1, CFC has subpart F 
income of 900u (1,000u - 100u). Accordingly, USP has a $900x (900u 
translated at $1x:1u) subpart F inclusion. Under section 960(a) and 
Sec.  1.960-2(b), USP is deemed to have paid $100x (100u translated 
at $1x:1u) of foreign income taxes. Under section 78 and Sec.  1.78-
1(a), USP's section 78 dividend is $100x. Accordingly, for Year 1, 
USP has taxable income of $1,000x ($900x + $100x) and pre-credit 
U.S. tax liability of $210x (21% x $1,000x). Accordingly, USP's U.S. 
tax liability is $110x ($210x -$100x).
    (ii) Result in Year 5. CFC's payment of 80u of additional 
foreign income tax in Year 5 with respect to Year 1 is a foreign tax 
redetermination as defined in paragraph (a) of this section. Under 
paragraph (b)(2)(ii) of this section, USP must reduce CFC's subpart 
F income and its earnings and profits in Year 1 by the additional 
tax amount of 80u. Further, USP must reduce its subpart F inclusion, 
adjust the amount of foreign taxes deemed paid, and adjust the 
amount of the section 78 dividend to account for CFC's additional 
payment of foreign tax. Under section 986(a)(1)(B)(i) and Sec.  
1.986(a)-1(a)(2)(i), because CFC's payment of additional tax occurs 
more than 24 months after the close of the taxable year to which it 
relates, the additional tax is translated into dollars at the spot 
rate on the date of payment ($1x:0.8u). Therefore, CFC has foreign 
income taxes of $200x (100u translated at $1x:1u plus 80u translated 
at $1x:0.8u) that are properly attributable to CFC's foreign base 
company sales income that gives rise to USP's subpart F inclusion in 
Year 1. As a result of the foreign tax redetermination, for Year 1, 
USP has a subpart F inclusion of $820x (1,000u-180u = 820u 
translated at $1x:1u). Under section 960(a) and Sec.  1.960-2(b), 
USP is deemed to have paid $200x of foreign income taxes. Under 
section 78 and Sec.  1.78-1(a), USP's section 78 dividend is $200x. 
For purposes of section 954(b)(4), the effective tax rate on the 
general category foreign base company sales income is determined by 
dividing $200x, the U.S. dollar amount of the foreign taxes deemed 
paid, by the U.S. dollar amount of the net item of foreign base 
company sales income ($820x) plus the amount of the foreign income 
tax ($200x). Thus, the effective rate imposed on the general 
category foreign base company sales income in Year 1 is 19.6% 
($200x/$1020x), which exceeds 18.9% (90% of 21%, the highest tax 
rate in section 11). Therefore, after the foreign tax 
redetermination, USP is eligible to elect to exclude the item of 
subpart F income under section 954(b)(4) and Sec.  1.954-1(d). If 
USP makes the election under Sec.  1.954-1(d), USP's taxable income, 
pre-credit U.S. tax liability, and allowable foreign tax credit is 
zero, resulting in a decrease in USP's U.S. tax liability of $110x. 
If USP does not make the election under Sec.  1.954-1(d), then USP's 
redetermined U.S. taxable income is $1020x ($820x + $200x) and its 
pre-credit U.S. tax liability is $214.2x (21% x $1020x). Therefore, 
USP's redetermined U.S. tax liability is $14.20x ($214.2x-$200x), a 
decrease of $95.80x ($110x-$14.20x). If USP makes a timely refund 
claim within the time period allowed by section 6511, USP will be 
entitled to a refund of any overpayment resulting from the 
redetermination of U.S. tax liability.
    (D) Example 3: Two-year rule--(1) Facts. CFC is a wholly-owned 
subsidiary of USP, a domestic corporation. In Year 1, CFC earns 
1,000u of general category gross foreign base company sales income 
and accrues 210u of foreign income taxes with respect to that 
income. In Year 1, USP earns no other income and has no other 
expenses. The average exchange rate used to translate USP's subpart 
F inclusion and CFC's foreign income taxes into dollars for Year 1 
is $1x:1u. See sections 989(b)(3) and 986(a)(1)(A) and Sec.  
1.986(a)-1(a)(1). USP does not elect to treat CFC's subpart F income 
as high taxed income under section 954(b)(4). CFC does not pay its 
foreign income taxes for Year 1 until September 1, Year 5, when the 
spot rate is $0.8x:1u. The foreign income taxes accrued and paid in 
Year 1 and Year 5, respectively, are properly attributable to CFC's 
foreign base company sales income that gives rise to USP's subpart F 
inclusion in Year 1 with respect to CFC.
    (2) Analysis--(i) Result in Year 1. In Year 1, CFC has subpart F 
income of 790u (1,000u - 210u). Accordingly, USP has a $790x (790u 
translated at $1x:1u) subpart F inclusion. Under section 960(a) and 
Sec.  1.960-2(b), USP is deemed to have paid $210x (210u translated 
at $1x:1u) of foreign income taxes. Under section 78 and Sec.  1.78-
1(a), USP's section 78 dividend is $210x. Accordingly, for Year 1, 
USP has taxable income of $1,000x ($790x + $210x) and pre-credit 
U.S. tax liability of $210x (21% x $1,000x). Accordingly, USP owes 
no U.S. tax ($210x - $210x = 0).
    (ii) Result in Year 3. CFC's failure to pay the tax by the end 
of Year 3 results in a foreign tax redetermination under paragraph 
(a) of this section. Because the taxes are not paid on or before the 
date 24 months after the close of the taxable year to which the tax 
relates, under paragraph (a) of this section CFC must account for 
the redetermination as if the unpaid 210u of taxes were refunded on 
the last day of Year 3. Under paragraph (b)(2)(ii) of this section, 
USP must increase CFC's subpart F income and its earnings and 
profits in Year 1 by the unpaid tax amount of 210u. Further, USP 
must increase its subpart F inclusion, and decrease the amount of 
foreign taxes deemed paid and the amount of the section 78 dividend 
to account for the unpaid taxes. As a result of the foreign tax 
redetermination, for Year 1, USP has a subpart F inclusion of 
$1,000x (1,000u translated at $1x:1u). Under section 960(a) and 
Sec.  1.960-2(b), USP is deemed to have paid no foreign income 
taxes. Under section 78 and Sec.  1.78-1(a), USP has no section 78 
dividend. Accordingly, USP's redetermined taxable income is $1,000x 
and its pre-credit U.S. tax liability is unchanged at $210x (21% x 
$1,000x). However, USP has no foreign tax credits. Therefore, USP's 
redetermined U.S. tax liability for Year 1 is $210x, an increase of 
$210x.
    (iii) Result in Year 5. CFC's payment of the Year 1 tax 
liability of 210u on September 1, Year 5, results in a second 
foreign tax redetermination under paragraph (a) of this section. 
Under paragraph (b)(2)(ii) of this section, USP must decrease CFC's 
subpart F income and its earnings and profits in Year 1 by the tax 
paid amount of 210u. Further, USP must reduce its subpart F 
inclusion, and increase the amount of foreign taxes deemed paid and 
the amount of the section 78 dividend to account for CFC's payment 
of foreign tax. Under section 986(a)(1)(B)(i) and Sec.  1.986(a)-
1(a)(2)(i), because the tax was paid more than 24 months after the 
close of the year to which the tax relates, CFC must translate the 
210u of tax at the spot rate on the date of payment of the foreign 
taxes in Year 5. Therefore, CFC has foreign income taxes of $168x 
(210u translated at $0.8x:1u) that are properly attributable to 
CFC's foreign base company sales income that gives rise to USP's 
subpart F inclusion in Year 1. As a result of the foreign tax 
redetermination, for Year 1, USP has a subpart F inclusion of $790x 
(1,000u - 210u = 790u translated at $1x:1u). Under section 960(a) 
and Sec.  1.960-2(b), USP is deemed to have paid $168x of foreign 
income taxes. Under section 78 and Sec.  1.78-1(a), USP's section 78 
dividend is $168x. Accordingly, USP's redetermined taxable income is 
$958x ($790x + $168x) and its pre-credit U.S. tax liability is 
$201.18x (21% x $958x). Under section 904(a), USP's foreign tax 
credit limitation is $201.18x ($201.18x x $958x/$958x) and exceeds 
the $168x of foreign income tax that USP is deemed to have paid. 
Therefore USP's redetermined U.S. tax liability is $33.18 ($201.18x 
- $168x), a decrease of $176.82x ($210x - $33.18x).
    (E) Example 4: Contested tax--(1) Facts. CFC is a wholly-owned 
subsidiary of USP, a domestic corporation. In Year 1, CFC earns 360u 
of general category gross tested income and accrues and pays 160u of 
current year taxes with respect to that income. CFC has no allowable 
deductions other than the foreign income tax expense. Accordingly, 
CFC has tested income of 200u in year 1. CFC has no qualified 
business asset investment (within the meaning of section 951A(d) and 
Sec.  1.951A-3(b)). In Year 1, no portion of USP's section 250 
deduction is reduced by reason of section 250(a)(2)(B)(ii). USP's 
inclusion percentage (as defined in Sec.  1.960-2(c)(2)) is 100%. In 
Year 1, USP earns no other income and has no other expenses. The 
average exchange rate used to translate USP's section 951A inclusion 
and CFC's foreign income taxes into dollars for Year 1 is $1x:1u. 
See section 989(b)(3) and Sec. Sec.  1.951A-1(d)(1) and 1.986(a)-
1(a)(1). Accordingly, for Year 1, USP's tested foreign income taxes 
(as defined in Sec.  1.960-2(c)(3)) with respect to CFC are $160x. 
In Year 3, Country X assessed an additional 30u of tax with respect 
to CFC's Year 1 income. CFC did not pay the additional 30u of tax 
and contested the assessment. After exhausting all effective and 
practical remedies to reduce, over time, its liability for foreign 
tax, CFC settled the

[[Page 69172]]

contest with Country X in Year 4 for 20u, which CFC did not pay 
until January 15, Year 5, when the spot rate was $1.1x:1u. CFC did 
not earn any other income or accrue any other foreign income taxes 
in Years 2 through 6 and made no distributions to USP. The 
additional taxes paid in Year 5 are also tested foreign income taxes 
of USP with respect to CFC.
    (2) Analysis--(i) Result in Year 1. In Year 1, CFC has tested 
income of 200u and tested foreign income taxes of $160x. Under 
section 951A(a) and Sec.  1.951A-1(c)(1), USP has a GILTI inclusion 
amount of $200x (200u translated at $1x:1u). Under section 960(d) 
and Sec.  1.960-2(c), USP is deemed to have paid $128x (80% x 100% x 
$160x) of foreign income taxes. Under section 78 and Sec.  1.78-
1(a), USP's section 78 dividend is $160x. USP's section 250 
deduction is $180x (50% x ($200x + $160x)). Accordingly, for Year 1, 
USP has taxable income of $180x ($200x + $160x - $180x) and a pre-
credit U.S. tax liability of $37.8x (21% $180x). Under section 
904(a), because all of USP's income is section 951A category income 
(see Sec.  1.904-4(g)), USP's foreign tax credit limitation is $37.8 
($37.8x x $180x/$180x), which is less than the $128x of foreign 
income tax that USP is deemed to have paid. Accordingly, USP owes no 
U.S. tax ($37.8x - $37.8x = 0).
    (ii) Result in Year 5. CFC's accrual and payment of the 
additional 20u of foreign income tax with respect to Year 1 is a 
foreign tax redetermination under paragraph (a) of this section. 
Under Sec.  1.461-4(g)(6)(iii)(B), the additional taxes accrue when 
the tax contest is resolved, that is, in Year 4. However, because 
the taxes, which relate to Year 1, were not paid on or before the 
date 24 months after close of CFC's taxable year to which the tax 
relates, that is, Year 1, under section 905(c)(2) and paragraph (a) 
of this section CFC cannot take these taxes into account when they 
accrue in Year 4. Instead, the taxes are taken into account when 
they are paid in Year 5. Under paragraph (b)(2)(ii) of this section, 
USP must decrease CFC's tested income and its earnings and profits 
in Year 1 by the additional tax amount of 20u. Further, USP must 
adjust its GILTI inclusion amount, the amount of foreign taxes 
deemed paid, and the amount of the section 78 dividend to account 
for CFC's additional payment of tax. Under section 986(a)(1)(B)(i) 
and Sec.  1.986(a)-1(a)(2)(i), because CFC's payment of additional 
tax occurs more than 24 months after the close of the taxable year 
to which it relates, the additional tax is translated into dollars 
at the spot rate on the date of payment ($1.1x:1u). Therefore, CFC 
has tested foreign income taxes of $182x (160u translated at $1x:1u 
plus 20u translated at $1.1x:1u). As a result of the foreign tax 
redetermination, for Year 1, CFC has tested income of 180u (200u-
20u). Under section 951A(a) and Sec.  1.951A-1(c)(1), USP has a 
redetermined GILTI inclusion amount of $180x (180u, translated at 
$1x:1u). Under section 960(d) and Sec.  1.960-2(c), USP is deemed to 
have paid $145.6x (80% x 100% x $182x) of foreign income taxes. 
Under section 78 and Sec.  1.78-1(a), USP's section 78 dividend is 
$182x. USP's redetermined section 250 deduction is $181x (50% x 
($180x + $182x)). Accordingly, USP's redetermined taxable income is 
$181x ($180x + $182x-$181x) and its pre-credit U.S. tax liability is 
$38.01x (21% x $181x). Under section 904(a), USP's foreign tax 
credit limitation is $38.01x ($38.01x x $181x/$181x), which is less 
than the $145.6x of foreign tax credits that USP is deemed to have 
paid. Therefore, USP's redetermined U.S. tax liability is zero 
($38.01x-$38.01x).
    (3) Foreign tax redeterminations of successors or transferees. If 
at the time of a foreign tax redetermination the person with legal 
liability for the tax (or in the case of a refund, the legal right to 
such refund) (the ``successor'') is a different person than the person 
that had legal liability for the tax in the year to which the 
redetermined tax relates (the ``original taxpayer''), the required 
redetermination of U.S. tax liability is made as if the foreign tax 
redetermination occurred in the hands of the original taxpayer. Federal 
income tax principles apply to determine the tax consequences if the 
successor remits (or receives a refund of) a tax that in the year to 
which the redetermined tax relates was the legal liability of, and thus 
under Sec.  1.901-2(f) is considered paid by, the original taxpayer.
* * * * *
    (d) Applicability dates. This section applies to foreign tax 
redeterminations occurring in taxable years ending on or after December 
16, 2019, and to foreign tax redeterminations of foreign corporations 
occurring in taxable years that end with or within a taxable year of a 
United States shareholder ending on or after December 16, 2019 and that 
relate to taxable years of foreign corporations beginning after 
December 31, 2017.
0
Par. 18. Section 1.905-4, as proposed to be added at 72 FR 62805 
(November 7, 2007), is further revised to read as follows:


Sec.  1.905-4   Notification of foreign tax redetermination.

    (a) Application of this section. The rules of this section apply 
if, as a result of a foreign tax redetermination (as defined in Sec.  
1.905-3(a)), a redetermination of U.S. tax liability is required under 
section 905(c) and Sec.  1.905-3(b).
    (b) Time and manner of notification--(1) Redetermination of U.S. 
tax liability--(i) In general. Except as provided in paragraphs 
(b)(1)(v) and (b)(2) through (b)(4) of this section, any taxpayer for 
which a redetermination of U.S. tax liability is required must notify 
the Internal Revenue Service (IRS) of the foreign tax redetermination 
by filing an amended return, Form 1118 (Foreign Tax Credit--
Corporations) or Form 1116 (Foreign Tax Credit), and the statement 
described in paragraph (c) of this section for the taxable year with 
respect to which a redetermination of U.S. tax liability is required. 
Such notification must be filed within the time prescribed by this 
paragraph (b) and contain the information described in paragraph (c) of 
this section. If a foreign tax redetermination requires an individual 
to redetermine the individual's U.S. tax liability, and if, after 
taking into account such foreign tax redetermination, the amount of 
creditable foreign taxes (as defined in section 904(j)(3)(B)) that are 
paid or accrued by such individual during the taxable year does not 
exceed the applicable dollar limitation in section 904(j), the 
individual is not required to file Form 1116 with the amended return 
for such taxable year if the individual satisfies the requirements of 
section 904(j).
    (ii) Increase in amount of U.S. tax liability. Except as provided 
in paragraphs (b)(1)(iv) and (b)(2) through (b)(4) of this section, for 
each taxable year of the taxpayer with respect to which a 
redetermination of U.S. tax liability is required by reason of a 
foreign tax redetermination that increases the amount of U.S. tax 
liability, for example, by reason of a downward adjustment to the 
amount of foreign income taxes paid or accrued by the taxpayer or a 
foreign corporation with respect to which the taxpayer computes an 
amount of foreign taxes deemed paid, the taxpayer must file a separate 
notification by the due date (with extensions) of the original return 
for the taxpayer's taxable year in which the foreign tax 
redetermination occurs.
    (iii) Decrease in amount of U.S. tax liability. Except as provided 
in paragraphs (b)(1)(iv) and (b)(2) through (b)(4) of this section, for 
each taxable year of the taxpayer with respect to which a 
redetermination of U.S. tax liability is required by reason of a 
foreign tax redetermination that decreases the amount of U.S. tax 
liability and results in an overpayment, for example, by reason of an 
increase in the amount of foreign income taxes paid or accrued by the 
taxpayer or a foreign corporation with respect to which the taxpayer 
computes an amount of foreign taxes deemed paid, the taxpayer must file 
a claim for refund with the IRS within the period provided in section 
6511. See section 6511(d)(3)(A) for the special refund period for 
refunds attributable to an increase in foreign tax credits.
    (iv) Multiple redeterminations of U.S. tax liability for same 
taxable year. The rules of this paragraph (b)(1)(iv) apply except as 
provided in paragraphs (b)(1)(v), (b)(2) through (b)(4) of this 
section. If more than one foreign tax

[[Page 69173]]

redetermination requires a redetermination of U.S. tax liability for 
the same affected taxable year of the taxpayer and those foreign tax 
redeterminations occur within the same taxable year or within two 
consecutive taxable years of the taxpayer, the taxpayer may file for 
the affected taxable year one amended return, Form 1118 or Form 1116, 
and the statement described in paragraph (c) of this section that 
reflects all such foreign tax redeterminations. If the taxpayer chooses 
to file one notification for such redeterminations, one or more of such 
redeterminations would increase the U.S. tax liability, and the net 
effect of all such redeterminations is to increase the U.S. tax 
liability for the affected taxable year, the taxpayer must file such 
notification by the due date (with extensions) of the original return 
for the taxpayer's taxable year in which the first foreign tax 
redetermination that would result in an increased U.S. tax liability 
occurred. If the taxpayer chooses to file one notification for such 
redeterminations, one or more of such redeterminations would decrease 
the U.S. tax liability, and the net effect of all such redeterminations 
is to decrease the total amount of U.S. tax liability for the affected 
taxable year, the taxpayer must file such notification as provided in 
paragraph (b)(1)(iii) of this section, within the period provided by 
section 6511. If a foreign tax redetermination with respect to the 
taxable year for which a redetermination of U.S. tax liability is 
required occurs after the date for providing such notification, more 
than one amended return may be required with respect to that taxable 
year.
    (v) Amended return required only if there is a change in amount of 
U.S. tax due. If a redetermination of U.S. tax liability is required by 
reason of a foreign tax redetermination, but does not change the amount 
of U.S. tax due for any taxable year, the taxpayer may, in lieu of 
applying the applicable rules of paragraphs (b)(1)(i) through (iv) of 
this section, notify the IRS of such redetermination by attaching a 
statement to the original return for the taxpayer's taxable year in 
which the foreign tax redetermination occurs. Such statement must be 
filed by the due date (with extensions) of the original return for the 
taxpayer's taxable year in which the foreign tax redetermination occurs 
and contain the information described in Sec.  1.904-2(f). If a 
redetermination of U.S. tax liability is required by reason of a 
foreign tax redetermination (either alone, or if the taxpayer chooses 
to apply paragraph (b)(1)(iv) of this section, in combination with 
other foreign tax redeterminations, as provided therein) and the 
redetermination of U.S. tax liability results in a change to the amount 
of U.S. tax due for a taxable year, but does not change the amount of 
U.S. tax due for other taxable years, for example, because of a 
carryback or carryover of an unused foreign tax under section 904(c), 
the notification requirements for such other taxable years are deemed 
to be satisfied if the taxpayer complies with the applicable rules of 
paragraphs (b)(1)(i) through (iv) of this section with respect to each 
taxable year for which the foreign tax redetermination changes the 
amount of U.S. tax due.
    (2) Notification with respect to a change in the amount of foreign 
tax reported to an owner by a pass-through entity--(i) In general. If a 
partnership, trust, or other pass-through entity that reports to its 
beneficial owners (or to any intermediary on behalf its beneficial 
owners), including partners, shareholders, beneficiaries, or similar 
persons, an amount of creditable foreign income taxes, such pass-
through entity must notify both the IRS and its owners of any foreign 
tax redetermination described in Sec.  1.905-3(a) with respect to the 
foreign tax so reported. For purposes of this paragraph (b)(2), whether 
or not a redetermination has occurred within the meaning of Sec.  
1.905-3(a) is determined as if the pass-through entity were a domestic 
corporation which had elected to and claimed foreign tax credits in the 
amount reported for the year to which such foreign taxes relate. The 
notification required under this paragraph (b)(2) must include the 
statement described in paragraph (c) of this section along with any 
information necessary for the owners to redetermine their U.S. tax 
liability.
    (ii) Partnerships subject to subchapter C of chapter 63. Except as 
provided in paragraph (b)(4) of this section, if a redetermination of 
U.S. tax liability that is required under Sec.  1.905-3(b) by reason of 
a foreign tax redetermination described in Sec.  1.905-3(a) would 
require a partnership adjustment as defined in Sec.  301.6241-1(a)(6) 
of this chapter, the partnership must file an administrative adjustment 
request under section 6227 and make any adjustments required under 
section 6227. See Sec.  301.6227-2 and Sec.  301.6227-3 of this chapter 
for procedures for making adjustments with respect to an administrative 
adjustment request. An administrative adjustment request required under 
this paragraph (b)(2)(ii) must be filed by the due date (with 
extensions) of the original return for the partnership's taxable year 
in which the foreign tax redetermination occurs, and the restrictions 
in section 6227(c) do not apply to such filing. However, unless the 
administrative adjustment request may otherwise be filed after applying 
the limitations contained in section 6227(c), such a request is limited 
to adjustments that are required to be made under section 905(c). The 
requirements of paragraph (b)(2)(i) of this section are deemed to be 
satisfied with respect to any item taken into account in an 
administrative adjustment request filed under this paragraph 
(b)(2)(ii).
    (3) Alternative notification requirements. An amended return and 
Form 1118 (Foreign Tax Credit--Corporations) or Form 1116 (Foreign Tax 
Credit), is not required to notify the IRS of the foreign tax 
redetermination and redetermination of U.S. tax liability if the 
taxpayer satisfies alternative notification requirements that may be 
prescribed by the IRS through forms, instructions, publications, or 
other guidance.
    (4) Taxpayers under examination within the jurisdiction of the 
Large Business and International Division--(i) In general. The 
alternative notification requirements of this paragraph (b)(4) apply if 
all of the following conditions are satisfied:
    (A) A foreign tax redetermination occurs while the taxpayer is 
under examination within the jurisdiction of the Large Business and 
International Division (or a successor division);
    (B) The foreign tax redetermination results in a downward 
adjustment to the amount of foreign income taxes paid or accrued by the 
taxpayer or a foreign corporation with respect to which the taxpayer 
computes an amount of foreign income taxes deemed paid;
    (C) The foreign tax redetermination requires a redetermination of 
U.S. tax liability and accordingly, but for this paragraph (b)(4), the 
taxpayer would be required to notify the IRS of such foreign tax 
redetermination under paragraph (b)(1)(ii) of this section (determined 
without regard to paragraphs (b)(1)(iv) and (v) of this section) or 
(b)(2)(ii) of this section;
    (D) The return for the taxable year for which a redetermination of 
U.S. tax liability is required is under examination; and
    (E) The due date specified in paragraph (b)(1)(ii) or (b)(2) of 
this section for providing notice of such foreign tax redetermination 
is not before the later of the opening conference or the hand-delivery 
or postmark date of the opening letter concerning an examination of the 
return for the taxable year for which a redetermination of U.S.

[[Page 69174]]

tax liability is required by reason of such foreign tax 
redetermination.
    (ii) Notification requirements--(A) Foreign tax redetermination 
occurring before commencement of the examination. If a foreign tax 
redetermination described in paragraph (b)(4)(i)(B) and (C) of this 
section occurs before the later of the opening conference or the hand-
delivery or postmark date of the opening letter and if the condition 
provided in paragraph (b)(4)(i)(E) of this section with respect to such 
foreign tax redetermination is met, the taxpayer, in lieu of applying 
the rules of paragraph (b)(1)(i) and (ii) of this section (requiring 
the filing of an amended return, Form 1118, and the statement described 
in paragraph (c) of this section) or (b)(2)(ii) of this section 
(requiring the filing of an administrative adjustment request), must 
notify the IRS of such redetermination by providing the statement 
described in paragraph (b)(4)(iii) of this section to the examiner no 
later than 120 days after the later of the date of the opening 
conference of the examination, or the hand-delivery or postmark date of 
the opening letter concerning the examination.
    (B) Foreign tax redetermination occurring within 180 days after 
commencement of the examination. If a foreign tax redetermination 
described in paragraph (b)(4)(i)(B) and (C) of this section occurs on 
or after the latest of the opening conference or the hand-delivery or 
postmark date of the opening letter and on or before the date that is 
180 days after the later of the opening conference or the hand-delivery 
or postmark date of the opening letter, the taxpayer, in lieu of 
applying the rules of paragraph (b)(1)(i) and (ii) of this section or 
(b)(2) of this section, must notify the IRS of such redetermination by 
providing the statement described in paragraph (b)(4)(iii) of this 
section to the examiner no later than 120 days after the date the 
foreign tax redetermination occurs.
    (C) Foreign tax redetermination occurring more than 180 days after 
commencement of the examination. If a foreign tax redetermination 
described in paragraphs (b)(4)(i)(B) and (C) of this section occurs 
after the date that is 180 days after the later of the opening 
conference or the hand-delivery or postmark date of the opening letter, 
the taxpayer must either apply the rules of paragraphs (b)(1)(i) and 
(ii) of this section or (b)(2) of this section, or, in lieu of applying 
paragraphs (b)(1)(i) and (ii) of this section or (b)(2) of this 
section, provide the statement described in paragraph (b)(4)(iii) of 
this section to the examiner within 120 days after the date the foreign 
tax redetermination occurs. However, the IRS, in its discretion, may 
either accept such statement or require the taxpayer to comply with the 
rules of paragraphs (b)(1)(i) and (ii) of this section or (b)(2) of 
this section, as applicable.
    (iii) Statement. The statement required by paragraphs (b)(4)(ii)(A) 
and (B) of this section must provide the original amount of foreign 
income taxes paid or accrued, the revised amount of foreign income 
taxes paid or accrued, and documentation with respect to the revisions, 
including exchange rates and dates of accrual or payment, and, if 
applicable, the information described in paragraph (c)(8) of this 
section. The statement must include the following declaration signed by 
a person authorized to sign the return of the taxpayer: ``Under 
penalties of perjury, I declare that I have examined this written 
statement, and to the best of my knowledge and belief, this written 
statement is true, correct, and complete.''
    (iv) Penalty for failure to file notice of a foreign tax 
redetermination. A taxpayer subject to the rules of this paragraph 
(b)(4) must satisfy the rules of paragraph (b)(4)(ii) of this section 
in order not to be subject to the penalty relating to the failure to 
file notice of a foreign tax redetermination under section 6689 and 
Sec.  301.6689-1 of this chapter.
    (5) Examples. The following examples illustrate the application of 
paragraph (b) of this section.

    (i) Example 1--(A) X, a domestic corporation, is an accrual 
basis taxpayer and uses the calendar year as its U.S. taxable year. 
X conducts business through a branch in Country M, the currency of 
which is the m, and also conducts business through a branch in 
Country N, the currency of which is the n. X uses the average 
exchange rate to translate foreign income taxes. Assume that X is 
able to claim a credit under section 901 for all foreign income 
taxes paid or accrued.
    (B) In Year 1, X accrued and paid 100m of Country M income taxes 
with respect to 400m of foreign source foreign branch category 
income. The average exchange rate for Year 1 was $1:1m. Also in Year 
1, X accrued and paid 50n of Country N income taxes with respect to 
150n of foreign source foreign branch category income. The average 
exchange rate for Year 1 was $1:1n. On its Year 1 Federal income tax 
return, X claimed a foreign tax credit under section 901 of $150 
($100 (100m translated at $1:1m) + $50 (50n translated at $1:1n)) 
with respect to its foreign source foreign branch category income. 
See Sec.  1.986(a)-1(a)(1).
    (C) In Year 2, X accrued and paid 100n of Country N income taxes 
with respect to 300n of foreign source foreign branch category 
income. The average exchange rate for Year 2 was $1.50:1n. On its 
Year 2 Federal income tax return X claimed a foreign tax credit 
under section 901 of $150 (100n translated at $1.5:1n). See Sec.  
1.986(a)-1(a)(1).
    (D) On June 15, Year 5, when the spot rate was $1.40:1n, X 
received a refund of 10n from Country N, and, on March 15, Year 6, 
when the spot rate was $1.20:1m, X was assessed by and paid Country 
M an additional 20m of tax. Both payments were with respect to X's 
foreign source foreign branch category income in Year 1. On May 15, 
Year 6, when the spot rate was $1.45:1n, X received a refund of 5n 
from Country N with respect to its foreign source foreign branch 
category income in Year 2.
    (E) Both the refunds and the assessment are foreign tax 
redeterminations under Sec.  1.905-3(a). Under Sec.  1.905-3(b)(1), 
X must redetermine its U.S. tax liability for both Year 1 and Year 
2. With respect to Year 1, under paragraph (b)(1)(ii) of this 
section, X must notify the IRS of the June 15, Year 5, refund of 10n 
from Country N that increased X's U.S. tax liability by filing an 
amended return, Form 1118, and the statement required in paragraph 
(c) of this section for Year 1 by the due date of the original 
return (with extensions) for Year 5. The amended return and Form 
1118 reduces the amount of foreign income taxes claimed as a credit 
under section 901 and increases X's U.S. tax liability by $10 (10n 
refund translated at the average exchange rate for Year 1, or $1:1n 
(see Sec.  1.986(a)-1(c)). With respect to the March 15, Year 6, 
additional assessment of 20m by Country M, under paragraph 
(b)(1)(iii) of this section, X must notify the IRS within the time 
period provided by section 6511, increasing the foreign income taxes 
available as a credit and reducing X's U.S. tax liability by $24 
(20m translated at the spot rate on the date of payment, or 
$1.20:1m). See sections 986(a)(1)(B)(i) and 986(a)(2)(A) and Sec.  
1.986(a)-1(a)(2)(i). X may so notify the IRS by filing a second 
amended return, Form 1118, and the statement described in paragraph 
(c) of this section for Year 1, within the time period provided by 
section 6511. Alternatively, under paragraph (b)(1)(iv) of this 
section, when X redetermines its U.S. tax liability for Year 1 to 
take into account the 10n refund from Country N that occurred in 
Year 5, X may also take into account the 20m additional assessment 
by Country M that occurred on March 15, Year 6. If X reflects both 
foreign tax redeterminations on the same amended return, Form 1118, 
and in the statement described in paragraph (c) of this section for 
Year 1, the amount of X's foreign income taxes available as a credit 
would be reduced by $10 (10n refund translated at $1:1n), and 
increased by $24 (20m additional assessment translated at the spot 
rate on the date of payment, March 15, Year 6, or $1.20:1m). The 
foreign income taxes available as a credit therefore would be 
increased by $14 ($24 (additional assessment)-$10 (refund)). Because 
the net effect of the foreign tax redeterminations is to increase 
the amount of foreign taxes paid or accrued and decrease X's U.S. 
tax liability, under paragraph (b)(1)(iv) of this section the Year 1 
amended return, Form 1118, and the statement required in paragraph 
(c) of this section reflecting foreign tax redeterminations in both 
years must be filed within the time period provided by section 6511.

[[Page 69175]]

    (F) With respect to Year 2, under paragraph (b)(1)(ii) of this 
section, X must notify the IRS by filing an amended return, Form 
1118, and the statement required in paragraph (c) of this section 
for Year 2 that is separate from that filed for Year 1. The amended 
return, Form 1118, and the statement required in paragraph (c) of 
this section for Year 2 must be filed by the due date (with 
extensions) of X's original return for Year 6. The amended return 
and Form 1118 reduces the amount of foreign income taxes claimed as 
a credit under section 901 and increases X's U.S. tax liability by 
$7.50 (5n refund translated at the average exchange rate for Year 2, 
or $1.50:1n).
    (ii) Example 2. X, a taxpayer within the jurisdiction of the 
Large Business and International Division, uses the calendar year as 
its U.S. taxable year. On November 15, Year 2, X receives a refund 
of foreign income taxes that constitutes a foreign tax 
redetermination and necessitates a redetermination of U.S. tax 
liability for X's Year 1 taxable year. Under paragraph (b)(1)(ii) of 
this section, X is required to notify the IRS of the foreign tax 
redetermination that increased its U.S. tax liability by filing an 
amended return, Form 1118, and the statement described in paragraph 
(c) of this section for its Year 1 taxable year by October 15, Year 
3 (the due date (with extensions) of the original return for X's 
Year 2 taxable year). On December 15, Year 3, the IRS hand delivers 
an opening letter concerning the examination of the return for X's 
Year 1 taxable year, and the opening conference for such examination 
is scheduled for January 15, Year 4. Because the date for notifying 
the IRS of the foreign tax redetermination under paragraph 
(b)(1)(ii) of this section (October 15, Year 3) is before the date 
of the opening conference concerning the examination of the return 
for X's Year 1 taxable year (January 15, Year 4), the condition of 
paragraph (b)(4)(i)(E) of this section is not met, and so paragraph 
(b)(4)(i) of this section does not apply. Accordingly, X must notify 
the IRS of the foreign tax redetermination by filing an amended 
return, Form 1118, and the statement described in paragraph (c) of 
this section for the Year 1 taxable year by October 15, Year 3.

    (c) Notification contents. The statement required by paragraphs 
(b)(1)(i) through (iv) of this section and (b)(2) of this section must 
contain information sufficient for the IRS to redetermine U.S. tax 
liability if such a redetermination is required under section 905(c). 
The information must be in a form that enables the IRS to verify and 
compare the original computation of U.S. tax liability, the revised 
computation resulting from the foreign tax redetermination, and the net 
changes resulting therefrom. The statement must include the following:
    (1) The taxpayer's name, address, identifying number, the taxable 
year or years of the taxpayer that are affected by the foreign tax 
redetermination, and, in the case of foreign taxes deemed paid, the 
name and identifying number, if any, of the foreign corporation;
    (2) The date or dates the foreign income taxes were accrued, if 
applicable; the date or dates the foreign income taxes were paid; the 
amount of foreign income taxes paid or accrued on each date (in foreign 
currency) and the exchange rate used to translate each such amount, as 
provided in Sec.  1.986(a)-1(a) or (b);
    (3) Information sufficient to determine any change to the 
characterization of a distribution, the amount of any inclusion under 
section 951(a), 951A, or 1293, or the deferred tax amount under section 
1291;
    (4) Information sufficient to determine any interest due from or 
owing to the taxpayer, including the amount of any interest paid by the 
foreign government to the taxpayer and the dates received;
    (5) In the case of any foreign income tax that is refunded in whole 
or in part, the taxpayer must provide the date of each such refund; the 
amount of such refund (in foreign currency); and the exchange rate that 
was used to translate such amount when originally claimed as a credit 
(as provided in Sec.  1.986(a)-1(c)) and the spot rate (as defined in 
Sec.  1.988-1(d)) for the date the refund was received (for purposes of 
computing foreign currency gain or loss under section 988);
    (6) In the case of any foreign income taxes that are not paid on or 
before the date that is 24 months after the close of the taxable year 
to which such taxes relate, the amount of such taxes in foreign 
currency, and the exchange rate that was used to translate such amount 
when originally claimed as a credit or added to PTEP group taxes (as 
defined in Sec.  1.960-3(d)(1));
    (7) If a redetermination of U.S. tax liability results in an amount 
of additional tax due, and the carryback or carryover of an unused 
foreign income tax under section 904(c) only partially eliminates such 
amount, the information required in Sec.  1.904-2(f); and
    (8) In the case of a pass-through entity, the name, address, and 
identifying number of each beneficial owner to which foreign taxes were 
reported for the taxable year or years to which the foreign tax 
redetermination relates, and the amount of foreign tax initially 
reported to each beneficial owner for each such year and the amount of 
foreign tax allocable to each beneficial owner for each such year after 
the foreign tax redetermination is taken into account.
    (d) Payment or refund of U.S. tax. The amount of tax, if any, due 
upon a redetermination of U.S. tax liability is paid by the taxpayer 
after notice and demand has been made by the IRS. Subchapter B of 
chapter 63 of the Internal Revenue Code (relating to deficiency 
procedures) does not apply with respect to the assessment of the amount 
due upon such redetermination. In accordance with sections 905(c) and 
6501(c)(5), the amount of additional tax due is assessed and collected 
without regard to the provisions of section 6501(a) (relating to 
limitations on assessment and collection). The amount of tax, if any, 
shown by a redetermination of U.S. tax liability to have been overpaid 
is credited or refunded to the taxpayer in accordance with subchapter B 
of chapter 66 (section 6511 et seq.).
    (e) Interest and penalties--(1) In general. If a redetermination of 
U.S. tax liability is required by reason of a foreign tax 
redetermination, interest is computed on the underpayment or 
overpayment in accordance with sections 6601 and 6611. No interest is 
assessed or collected on any underpayment resulting from a refund of 
foreign income taxes for any period before the receipt of the refund, 
except to the extent interest was paid by the foreign country or 
possession of the United States on the refund for the period before the 
receipt of the refund. See section 905(c)(5). In no case, however, will 
interest assessed and collected pursuant to the preceding sentence for 
any period before receipt of the refund exceed the amount that 
otherwise would have been assessed and collected under section 6601 for 
that period. Interest is assessed from the time the taxpayer (or the 
foreign corporation, partnership, trust, or other pass-through entity 
of which the taxpayer is a shareholder, partner, or beneficiary) 
receives a refund until the taxpayer pays the additional tax due the 
United States.
    (2) Imposition of penalty. Failure to comply with the provisions of 
this section subjects the taxpayer to the penalty provisions of section 
6689 and Sec.  301.6689-1 of this chapter.
    (f) Applicability date. This section applies to foreign tax 
redeterminations (as defined in Sec.  1.905-3(a)) occurring in taxable 
years ending on or after December 16, 2019, and to foreign tax 
redeterminations of foreign corporations occurring in taxable years 
that end with or within a taxable year of a United States shareholder 
ending on or after December 16, 2019.
0
Par. 19. Section 1.905-5, as proposed to be added at 72 FR 62805 
(November 7, 2007), is further revised to read as follows:

[[Page 69176]]

Sec.  1.905-5  Foreign tax redeterminations of foreign corporations 
that relate to taxable years of the foreign corporation beginning 
before January 1, 2018.

    (a) In general--(1) Effect of foreign tax redetermination of a 
foreign corporation. A foreign tax redetermination (as defined in Sec.  
1.905-3(a)) of a foreign corporation that relates to a taxable year of 
the foreign corporation beginning before January 1, 2018, and that may 
affect a taxpayer's foreign tax credit in any taxable year, must be 
accounted for by adjusting the foreign corporation's taxable income and 
earnings and profits, post-1986 undistributed earnings as defined in 
Sec.  1.902-1(a)(9), and post-1986 foreign income taxes as defined in 
Sec.  1.902-1(a)(8) (or its pre-1987 accumulated profits as defined in 
Sec.  1.902-1(a)(10)(i) and pre-1987 foreign income taxes as defined in 
Sec.  1.902-1(a)(10)(iii), as applicable) in the taxable year of the 
foreign corporation to which the foreign taxes relate.
    (2) Requirement of U.S. tax redetermination. A redetermination of 
U.S. tax liability is required to account for the effect of the foreign 
tax redetermination on the earnings and profits and taxable income of 
the foreign corporation, the taxable income of a United States 
shareholder, and the amount of foreign taxes deemed paid by the United 
States shareholder under section 902 or 960 (as in effect before 
December 22, 2017), in the year to which the redetermined foreign taxes 
relate. For example, in the case of a refund of foreign income taxes, 
the subpart F income, earnings and profits, and post-1986 undistributed 
earnings (or pre-1987 accumulated profits, as applicable) of the 
foreign corporation are increased in the year to which the foreign tax 
relates to reflect the functional currency amount of the foreign income 
tax refund. The required redetermination of U.S. tax liability must 
account for the effect of the foreign tax redetermination on the 
characterization and amount of distributions or inclusions under 
sections 951 or 1293 taken into account by each of the foreign 
corporation's United States shareholders and on the application of the 
high-tax exception described in section 954(b)(4), as well as on the 
amount of foreign income taxes deemed paid in such year. In addition, a 
redetermination of U.S. tax liability is required for any subsequent 
taxable year in which the United States shareholder received or accrued 
a distribution or inclusion from the foreign corporation, up to and 
including the taxable year in which the foreign tax redetermination 
occurs, as well as any year to which unused foreign taxes from such 
year were carried under section 904(c).
    (b) Notification requirements--(1) In general. The notification 
requirements of Sec.  1.905-4, as modified by paragraphs (b)(2) and (3) 
of this section, apply if a redetermination of U.S. tax liability is 
required under paragraph (a) of this section.
    (2) Notification relating to post-1986 undistributed earnings and 
post-1986 foreign income taxes. In the case of foreign tax 
redeterminations with respect to taxes included in post-1986 foreign 
income taxes, in addition to the information required by Sec.  1.905-
4(c), the taxpayer must provide the balances of the pools of post-1986 
undistributed earnings and post-1986 foreign income taxes before and 
after adjusting the pools, the dates and amounts of any dividend 
distributions or other inclusions made out of earnings and profits for 
the affected year or years, and the amount of earnings and profits from 
which such dividends were paid or such inclusions were made for the 
affected year or years.
    (3) Notification relating to pre-1987 accumulated profits and pre-
1987 foreign income taxes. In the case of foreign tax redeterminations 
with respect to pre-1987 accumulated profits, in addition to the 
information required by Sec.  1.905-4(c), the taxpayer must provide the 
following: The dates and amounts of any dividend distributions made out 
of earnings and profits for the affected year or years; the rate of 
exchange on the date of any such distribution; and the amount of 
earnings and profits from which such dividends were paid for the 
affected year or years.
    (c) Currency translation rules for adjustments to pre-1987 foreign 
income taxes. Foreign income taxes paid with respect to pre-1987 
accumulated profits that are deemed paid under section 960 (or under 
section 902 in the case of an amount treated as a dividend under 
section 1248) are translated into dollars at the spot rate for the date 
of the payment of the foreign income taxes, and refunds of such taxes 
are translated into dollars at the spot rate for the date of the 
refund. Foreign income taxes deemed paid by a taxpayer under section 
902 with respect to an actual distribution of pre-1987 accumulated 
profits and refunds of such taxes are translated into dollars at the 
spot rate for the date of the distribution of the earnings to which the 
foreign income taxes relate. See section 902(c)(6) (as in effect before 
December 22, 2017) and Sec.  1.902-1(a)(10)(iii). For purposes of this 
section, the term spot rate has the meaning provided in Sec.  1.988-
1(d).
    (d) Adjustments to pools of post-1986 foreign income taxes. The 
redetermination of U.S. tax liability required by paragraph (a) of this 
section is made in accordance with section 905(c) as in effect for 
those taxable years, without regard to rules that required prospective 
adjustments to a foreign corporation's pools of post-1986 undistributed 
earnings and post-1986 foreign income taxes in the year of the foreign 
tax redetermination in lieu of redeterminations of U.S. tax liability. 
No underpayment or overpayment of U.S. tax liability results from a 
foreign tax redetermination unless the required adjustments change the 
U.S. tax liability. Consequently, no interest is paid by or to a 
taxpayer as a result of adjustments, required by reason of a foreign 
tax redetermination, to a foreign corporation's pools of post-1986 
undistributed earnings and post-1986 foreign income taxes in the year 
to which the redetermined foreign tax relates that did not result in a 
change to U.S. tax liability, for example, because no foreign taxes 
were deemed paid in that year.
    (e) Applicability date. This section applies to foreign tax 
redeterminations (as defined in Sec.  1.905-3(a)) of foreign 
corporations occurring in taxable years that end with or within taxable 
years of a United States shareholder ending on or after December 16, 
2019, and that relate to taxable years of foreign corporations 
beginning before January 1, 2018.
0
Par. 20. Section 1.954-1 is amended by:
0
1. In paragraph (c)(1)(i)(C) removing the language ``reduced by related 
person'' and adding the language ``reduced (but not below zero) by 
related person'' in its place.
0
2. Adding two sentences to the end of paragraph (d)(3)(iii).
0
3. Revising paragraph (h)(1).
    The revisions and additions read as follows:


Sec.  1.954-1  Foreign base company income.

* * * * *
    (d) * * *
    (3) * * *
    (iii) * * * In addition, foreign income taxes that have not been 
paid or accrued because they are contingent on a future distribution of 
earnings are not taken into account for purposes of this paragraph 
(d)(3). If, pursuant to section 905(c) and Sec.  1.905-3(b)(2), a 
redetermination of U.S. tax liability is required to account for the 
effect of a foreign tax redetermination (as defined in Sec.  1.905-
3(a)), this paragraph (d) is applied in the adjusted year taking into

[[Page 69177]]

account the adjusted amount of the redetermined foreign tax.
* * * * *
    (h) * * * (1) Paragraph (d)(3) of this section. Paragraph (d)(3) of 
this section applies to taxable years of a controlled foreign 
corporation ending on or after December 16, 2019. For taxable years of 
a controlled foreign corporation ending on or after December 4, 2018, 
but ending before December 16, 2019, see Sec.  1.954-1(d)(3) as 
contained in 26 CFR part 1 revised as of April 1, 2019.
* * * * *
0
Par. 21. Section 1.954-2 is amended by:
0
1. Removing the text ``and'' from paragraph (h)(2)(i)(H).
0
2. Redesignating paragraph (h)(2)(i)(I) as paragraph (h)(2)(i)(J).
0
3. Adding a new paragraph (h)(2)(i)(I).
0
4. Adding a sentence to the end of paragraph (i)(2).
    The additions read as follows:


Sec.  1.954-2  Foreign personal holding company income.

* * * * *
    (h) * * * (2) * * * (i) * * *
    (I) Any guaranteed payments for the use of capital under section 
707(c); and
* * * * *
    (i) * * *
    (2) * * * Paragraph (h)(2)(i)(I) of this section applies to taxable 
years of controlled foreign corporations ending on or after December 
16, 2019, and to taxable years of United States shareholders in which 
or with which such taxable years end.
0
Par. 22. Section 1.960-1 is amended by:
0
1. Adding a sentence at the end of paragraph (c)(2).
0
2. Revising the first three sentences, and adding two new sentences 
after the third sentence, in paragraph (d)(3)(ii)(A).
0
3. Removing and reserving paragraph (d)(3)(ii)(B).
0
4. Revising the second, third, and seventh sentences of paragraph 
(d)(3)(ii)(C).
    The addition and revisions read as follows:


Sec.  1.960-1  Overview, definitions, and computational rules for 
determining foreign income taxes deemed paid under section 960(a), (b), 
and (d).

* * * * *
    (c) * * *
    (2) * * * An item of income with respect to a current taxable year 
does not include an amount included as subpart F income of a controlled 
foreign corporation by reason of the recharacterization of a recapture 
account established in a prior U.S. taxable year (and the corresponding 
earnings and profits) of the controlled foreign corporation under 
section 952(c)(2) and Sec.  1.952-1(f).
* * * * *
    (d) * * *
    (3) * * *
    (ii) * * *
    (A) * * * A current year tax is allocated and apportioned among the 
section 904 categories under the rules of Sec.  1.904-6. An amount of 
the current year tax that is allocated and apportioned to a section 904 
category is then allocated and apportioned among the income groups 
within the section 904 category under Sec.  1.861-20 (as modified by 
Sec.  1.904-6(c)) by treating each income group as a statutory grouping 
and treating the residual income group as the residual grouping. 
Therefore, the portion of a current year tax that is attributable to 
foreign taxable income arising from a transaction that does not result 
in the recognition of gross income or loss for Federal income tax 
purposes in the current taxable year is assigned under Sec.  1.861-
20(d)(2)(i) to the section 904 category and income group within a 
section 904 category to which the corresponding U.S. item would be 
assigned if the event giving rise to the foreign taxable income 
resulted in the recognition of income or loss under Federal income tax 
law in that year. Foreign gross income arising from the receipt of a 
disregarded payment made by a disregarded entity or other foreign 
branch to its foreign branch owner that is a controlled foreign 
corporation is assigned to the income group or groups from which the 
payment is considered to be made under Sec.  1.861-20(d)(3)(ii)(A). 
Foreign gross income attributable to a base difference, or resulting 
from the receipt of a disregarded payment made to a foreign branch, is 
assigned to the residual income grouping under Sec. Sec.  1.861-
20(d)(2)(ii)(B) and 1.861-20(d)(3)(ii)(B). * * *
* * * * *
    (C) * * * In such case, under Sec.  1.861-20, the portion of the 
foreign gross income (as defined in Sec.  1.861-20(b)(5)) that is 
characterized under Federal income tax principles as a distribution of 
previously taxed earnings and profits that results in the increase in 
the PTEP group in the current taxable year is assigned to that PTEP 
group. If a PTEP group is not treated as an income group under the 
first sentence of this paragraph (d)(3)(ii)(C), and the rules of Sec.  
1.861-20 would otherwise apply to assign foreign gross income to a PTEP 
group, that foreign gross income is instead assigned to the subpart F 
income group or tested income group to which the income that gave rise 
to the previously taxed earnings and profits would be assigned if the 
income were recognized by the recipient controlled foreign corporation 
under Federal income tax principles in the current taxable year. * * * 
That foreign gross income, however, may be assigned to a subpart F 
income group or tested income group.
0
Par. 23. Section 1.960-2 is amended by adding a sentence at the end of 
paragraph (b)(3)(iii) to read as follows:


Sec.  1.960-2   Foreign income taxes deemed paid under sections 960(a) 
and (d).

* * * * *
    (b) * * *
    (3) * * *
    (iii) * * * See Sec.  1.960-1(c)(2) for rule regarding the 
treatment of an increase in the subpart F income of a controlled 
foreign corporation by reason of the recharacterization of a recapture 
account and the corresponding accumulated earnings and profits under 
section 952(c) and Sec.  1.952-1(f).
0
Par. 24. Section 1.960-7 is revised to read as follows:


Sec.  1.960-7  Applicability dates.

    (a) Except as provided in paragraph (b) of this section, Sec. Sec.  
1.960-1 through 1.960-6 apply to each taxable year of a foreign 
corporation ending on or after December 4, 2018, and to each taxable 
year of a domestic corporation that is a United States shareholder of 
the foreign corporation in which or with which such taxable year of 
such foreign corporation ends.
    (b) Section 1.960-1(d)(3)(ii) applies to taxable years of a foreign 
corporation beginning after December 31, 2019, and to each taxable year 
of a domestic corporation that is a United States shareholder of the 
foreign corporation in which or with which such taxable year of such 
foreign corporation ends. For taxable years of a foreign corporation 
that end on or after December 4, 2018, and also begin before January 1, 
2020, see Sec.  1.960-1(d)(3)(ii) as in effect on December 17, 2019.
0
Par. 25. Amend Sec.  1.965-5 by:
0
1. Redesignating paragraph (b) as paragraph (b)(1).
0
2. Adding new introductory text for paragraph (b).
0
3. Revising the heading of newly redesignated paragraph (b)(1).
0
4. Adding paragraph (b)(2).
    The revision and additions read as follows:


Sec.  1.965-5  Allowance of a credit or deduction for foreign income 
taxes.

* * * * *

[[Page 69178]]

    (b) Rules for foreign income taxes paid or accrued--(1) In general. 
* * *
    (2) Attributing taxes to section 959(a) distributions of section 
965 previously taxed earnings and profits. For purposes of paragraph 
(b)(1) of this section, foreign income taxes are attributable to a 
distribution of section 965(a) previously taxed earnings and profits or 
section 965(b) previously taxed earnings and profits if such taxes 
would be allocated and apportioned to a distribution of such previously 
taxed earnings and profits under the principles of Sec.  1.904-
6(a)(1)(iv), regardless of whether an actual distribution is made or 
recognized for Federal income tax purposes. Therefore, for example, a 
credit or deduction for the applicable percentage of foreign income 
taxes imposed on a United States shareholder that pays foreign tax on a 
distribution that is not recognized for Federal income tax purposes 
(for example, in the case of a consent dividend or stock dividend upon 
which a withholding tax is imposed) is not allowed under paragraph 
(b)(1) of this section to the extent it is attributable to a 
distribution of section 965(a) previously taxed earnings and profits or 
section 965(b) previously taxed earnings and profits under the 
principles of Sec.  1.904-6(a)(1)(iv). For taxable years of foreign 
corporations beginning after December 31, 2019, in lieu of applying the 
principles of Sec.  1.904-6 under this paragraph (b)(2), the rules in 
Sec.  1.861-20 apply by treating the portion of a distribution 
attributable to section 965(a) previously taxed earnings and profits 
and the portion of a distribution attributable to section 965(b) 
previously taxed earnings and profits each as a statutory grouping, and 
the portion of the distribution that is attributable to other earnings 
and profits as the residual grouping. See Sec.  1.861-20(g)(7) (Example 
6).
* * * * *
0
Par. 26. Section 1.965-9 is amended by adding a sentence to the end of 
paragraph (c) to read as follows:


Sec.  1.965-9  Applicability dates.

* * * * *
    (c) * * * Section 1.965-5(b)(2) applies to taxable years of foreign 
corporations that end on or after December 16, 2019, and with respect 
to a United States person, to the taxable years in which or with which 
such taxable years of the foreign corporations end.
0
Par. 27. Section 1.1502-4 is revised to read as follows:


Sec.  1.1502-4  Consolidated foreign tax credit.

    (a) In general. The credit under section 901 for taxes paid or 
accrued to any foreign country or possession of the United States is 
allowed to the group only if the agent for the group (as defined in 
Sec.  1.1502-77(a)) chooses to use the credit in the computation of the 
consolidated tax liability of the group for the consolidated return 
year. If that choice is made, section 275(a)(4) provides that no 
deduction against taxable income may be taken on the consolidated 
return for foreign taxes paid or accrued by any member. However, if 
section 275(a)(4) does not apply, a deduction against consolidated 
taxable income may be allowed for certain taxes for which a credit is 
not allowed, even though the choice is made to claim a credit for other 
taxes. See, for example, sections 901(j)(3), 901(k)(7), 901(l)(4), 
901(m)(6), and 908(b).
    (b) Computation of foreign tax credit. The foreign tax credit for 
the consolidated return year is determined on a consolidated basis 
under the principles of sections 901 through 909 and 960. Taxes paid or 
accrued to all foreign countries and possessions by members of the 
group for the year (including those deemed paid under section 960 and 
paragraph (d) of this section) must be aggregated.
    (c) Computation of limitation on credit. For purposes of computing 
the group's limiting fraction under section 904, the following rules 
apply:
    (1) Computation of taxable income from foreign sources--(i) 
Separate categories. The group must compute a separate foreign tax 
credit limitation for income in each separate category (as defined in 
Sec.  1.904-5(a)(4)(v) for purposes of this section). The numerator of 
the limiting fraction in any separate category is the consolidated 
taxable income of the group determined in accordance with Sec.  1.1502-
11, taking into account adjustments required under section 904(b), if 
any, from sources without the United States in that category, 
determined in accordance with the rules of Sec.  1.904-4, 1.904-5, and 
the section 861 regulations (as defined in Sec.  1.861-8(a)(1)).
    (ii) Adjustments under sections 904(f) and (g). The rules for 
allocation and recapture of separate limitation losses and overall 
foreign losses under section 904(f) and Sec.  1.1502-9 apply to 
determine the foreign source and U.S. source taxable income in each 
separate category of the consolidated group. Similarly, the rules for 
allocation and recapture of overall domestic losses under section 
904(g) and Sec.  1.1502-9 apply to determine the foreign source and 
U.S. source taxable income in each separate category of the 
consolidated group. See Sec.  1.904(g)-3 for allocation rules under 
sections 904(f) and 904(g). The rules of sections 904(f) and 904(g) do 
not operate to recharacterize foreign income tax attributable to any 
separate category.
    (iii) Computation of consolidated net operating loss. The source 
and separate category of the group's consolidated net operating loss 
(``CNOL''), as that term is defined in Sec.  1.1502-21(e), for the 
taxable year, if any, is determined based on the amounts of any 
separate limitation losses and U.S. source loss that are not allocated 
to reduce U.S. source income or income in other separate categories 
under the rules of sections 904(f) and 904(g) in computing the group's 
consolidated foreign tax credit limitations for the taxable year under 
paragraphs (c)(1)(i) and (ii) of this section.
    (iv) Characterization of CNOL carried to a separate return year--
(A) In general. The total amount of CNOL attributable to a member that 
is carried to a separate return year is determined under the rules of 
Sec.  1.1502-21(b)(2). The source and separate category of the portion 
of the CNOL that is attributable to a member is determined under this 
paragraph (c)(1)(iv).
    (B) Tentative apportionment. For the portion of the CNOL that is 
attributable to the member described in paragraph (c)(1)(iv) of this 
section, the consolidated group determines a tentative allocation and 
apportionment to each statutory and residual grouping (as described in 
Sec.  1.861-8(a)(4) with respect to section 904 as the operative 
section) under the principles of Sec.  1.1502-9(c)(2)(i), (ii), (iv) 
and (v) by treating the portion of the group's CNOL in each statutory 
and residual grouping as if it were a CSLL account, as that term is 
described in Sec.  1.1502-9(b)(4). This determination is made as of the 
end of the taxable year of the consolidated group in which the CNOL 
arose or, if earlier and applicable, when the member leaves the 
consolidated group.
    (C) Adjustments--(1) If the total tentative apportionment for all 
statutory and residual groupings exceeds the portion of the CNOL 
attributable to the member described in paragraph (c)(1)(iv)(A) of this 
section (the ``excess amount''), then the tentative apportionment in 
each grouping is reduced by an amount equal to the excess amount 
multiplied by a fraction, the numerator of which is the tentative 
apportionment in that grouping, and the denominator of which is the 
total tentative apportionments in all groupings.

[[Page 69179]]

    (2) If the total tentative apportionment for all statutory and 
residual groupings is less than the total CNOL attributable to the 
member described in paragraph (c)(1)(iv)(A) (the ``deficiency''), then 
the tentative apportionment in each grouping is increased by an amount 
equal to the deficiency multiplied by a fraction, the numerator of 
which is the CNOL in that grouping that was not tentatively 
apportioned, and the denominator of which is the total CNOL in all 
groupings that was not tentatively apportioned.
    (v) Consolidated net capital losses. The principles of the rules in 
paragraphs (c)(1)(i) through (iv) of this section apply for purposes of 
determining the source and separate category of consolidated net 
capital losses described in Sec.  1.1502-22(e).
    (2) Computation of consolidated taxable income. The denominator of 
the limiting fraction in any separate category is the consolidated 
taxable income of the group determined in accordance with Sec.  1.1502-
11, taking into account adjustments required under section 904(b), if 
any.
    (3) Computation of tax against which credit is taken. The tax 
against which the limiting fraction under section 904(a) is applied 
will be the consolidated tax liability of the group determined under 
Sec.  1.1502-2, but without regard to Sec.  1.1502-2(a)(2), (3), (4), 
(8), and (9), and without regard to any credit against such liability. 
See sections 26(b) and 901(a).
    (d) Carryover and carryback of unused foreign tax--(1) Allowance of 
unused foreign tax as consolidated carryover or carryback. The 
consolidated group's carryovers and carrybacks of unused foreign tax 
(as defined in Sec.  1.904-2(c)(1)) to the taxable year is determined 
on a consolidated basis under the principles of section 904(c) and 
Sec.  1.904-2 and is deemed to be paid or accrued to a foreign country 
or possession for that year. The consolidated group's unused foreign 
tax carryovers and carrybacks to the taxable year consist of any unused 
foreign tax of the consolidated group, plus any unused foreign tax of 
members for separate return years, which may be carried over or back to 
the taxable year under the principles of section 904(c) and Sec.  
1.904-2. The consolidated group's unused foreign tax carryovers and 
carrybacks do not include any unused foreign taxes apportioned to a 
corporation for a separate return year pursuant to Sec.  1.1502-79(d). 
A consolidated group's unused foreign tax in each separate category is 
the excess of the foreign taxes paid, accrued or deemed paid under 
section 960 by the consolidated group over the limitation in the 
applicable separate category for the consolidated return year. See 
paragraph (c) of this section.
    (2) Absorption rules. For purposes of determining the amount, if 
any, of an unused foreign tax which can be carried to a taxable year 
(whether a consolidated or separate return year), the amount of the 
unused foreign tax that is absorbed in a prior consolidated return year 
under section 904(c) shall be determined by--
    (i) Applying all unused foreign taxes which can be carried to a 
prior year in the order of the taxable years in which those unused 
foreign taxes arose, beginning with the taxable year that ends 
earliest, and
    (ii) All the unused foreign taxes which can be carried to such 
prior year from taxable years ending on the same date on a pro rata 
basis.
    (e) Example. The following example illustrates the application of 
this section:
    (1) Facts--(i) Domestic corporation P is incorporated on January 1, 
Year 1. On that same day, P incorporates domestic corporations S and T 
as wholly owned subsidiaries. P, S, and T file consolidated returns for 
Years 1 and 2 on the basis of a calendar year. T engages in business 
solely through a qualified business unit in Country A. S engages in 
business solely through qualified business units in countries A and B. 
P does business solely in the United States. During Year 1, T sold an 
item of inventory to P at a gain of $2,000. Under Sec.  1.1502-13 the 
intercompany gain has not been taken into account as of the close of 
Year 1. The taxable income of each member for Year 1 from foreign and 
U.S. sources, and the foreign taxes paid on such foreign income, are as 
follows:

                                         Table 1 to Paragraph (e)(1)(i)
----------------------------------------------------------------------------------------------------------------
                                                           Foreign branch
                                         U.S. source      category foreign    Foreign branch     Total taxable
             Corporation                taxable income     source taxable    category foreign        income
                                                               income            tax paid
----------------------------------------------------------------------------------------------------------------
P...................................            $40,000  .................  .................            $40,000
T...................................  .................            $20,000            $12,000             20,000
S...................................  .................             20,000              9,000             20,000
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr
    Group...........................  .................  .................  .................             80,000
----------------------------------------------------------------------------------------------------------------

    (ii) The separate taxable income of each member was computed by 
taking into account the rules under Sec.  1.1502-12. Accordingly, 
T's intercompany gain of $2,000 is not included in T's taxable 
income for Year 1. The group's consolidated taxable income (computed 
in accordance with Sec.  1.1502-11) is $80,000. The consolidated tax 
liability against which the credit may be taken (computed in 
accordance with paragraph (c)(3) of this section) is $16,800.
    (2) Analysis. The aggregate taxes paid to all foreign countries 
with respect to the foreign branch category income of $21,000 
($12,000 + $9,000) is limited to $8,400 ($16,800 x $40,000/$80,000). 
Assuming P, as the agent for the group, chooses to use the foreign 
taxes paid as a credit, the group may claim a $8,400 foreign tax 
credit.

    (f) Applicability date. This section applies to taxable years for 
which the original consolidated Federal income tax return is due 
(without extensions) after December 17, 2019.
0
Par. 28. Section 1.1502-21 is amended by adding a sentence to the end 
of paragraph (b)(2)(iv)(B) to read as follows:


Sec.  1.1502-21.  Net operating losses.

* * * * *
    (b) * * *
    (2) * * *
    (iv) * * *
    (B) * * * The source and section 904(d) separate category of the 
CNOL attributable to a member is determined under Sec.  1.1502-
4(c)(1)(iii).
* * * * *

PART 301--PROCEDURE AND ADMINISTRATION

0
Par. 29. The authority citation for part 301 is amended by adding an 
entry for Sec.  301.6689-1, to read in part as follows:

    Authority: 26 U.S.C. 7805.

* * * * *

[[Page 69180]]

    Section 301.6689-1 also issued under 26 U.S.C. 6689(a), 26 
U.S.C. 6227(d), and 26 U.S.C. 6241(11).

* * * * *
0
Par. 30. Section 301.6227-1 is amended by adding paragraph (g) to read 
as follows:


Sec.  301.6227-1  Administrative adjustment request by partnership.

* * * * *
    (g) Notice requirement and partnership adjustments required as a 
result of a foreign tax redetermination. For special rules applicable 
when an adjustment to a partnership related item (as defined in section 
6241(2)) is required as part of a redetermination of U.S. tax liability 
under section 905(c) and Sec.  1.905-3(b) of this chapter as a result 
of a foreign tax redetermination (as defined in Sec.  1.905-3(a) of 
this chapter), see Sec.  1.905-4(b)(2)(ii) of this chapter.
* * * * *
0
Par. 31. Section 301.6689-1, as proposed to be added at 72 FR 62807 
(November 7, 2007), is further revised to read as follows:


Sec.  301.6689-1  Failure to file notice of redetermination of foreign 
income taxes.

    (a) Application of civil penalty. If a foreign tax redetermination 
occurs, and the taxpayer failed to notify the Internal Revenue Service 
(IRS) on or before the date and in the manner prescribed in Sec.  
1.905-4 of this chapter, or as required under section 404A(g)(2), for 
giving notice of a foreign tax redetermination, then, unless paragraph 
(d) of this section applies, there is added to the deficiency (or the 
imputed underpayment as determined under section 6225) attributable to 
such redetermination an amount determined under paragraph (b) of this 
section. Subchapter B of chapter 63 of the Internal Revenue Code 
(relating to deficiency proceedings) does not apply with respect to the 
assessment of the amount of the penalty.
    (b) Amount of the penalty. The amount of the penalty shall be equal 
to--
    (1) Five percent of the deficiency (or imputed underpayment) if the 
failure is for not more than one month, plus
    (2) An additional five percent of the deficiency (or imputed 
underpayment) for each month (or fraction thereof) during which the 
failure continues, but not to exceed in the aggregate twenty-five 
percent of the deficiency (or imputed underpayment).
    (c) Foreign tax redetermination defined. For purposes of this 
section, a foreign tax redetermination is any redetermination for which 
a notice is required under sections 905(c) or 404A(g)(2). See 
Sec. Sec.  1.905-3 through 1.905-5 of this chapter for rules relating 
to the notice requirement under section 905(c).
    (d) Reasonable cause. The penalty set forth in this section shall 
not apply if it is established to the satisfaction of the IRS that the 
failure to file the notification within the prescribed time was due to 
reasonable cause and not due to willful neglect. An affirmative showing 
of reasonable cause must be made in the form of a written statement 
that sets forth all the facts alleged as reasonable cause for the 
failure to file the notification on time and that contains a 
declaration by the taxpayer that the statement is made under the 
penalties of perjury. This statement must be filed with the Internal 
Revenue Service Center in which the notification was required to be 
filed. The taxpayer must file this statement with the notice required 
under section 905(c) or section 404A(g)(2). If the taxpayer exercised 
ordinary business care and prudence and was nevertheless unable to file 
the notification within the prescribed time, then the delay will be 
considered to be due to reasonable cause and not willful neglect.
    (e) Applicability date. This section applies to foreign tax 
redeterminations occurring in taxable years ending on or after December 
16, 2019, and to foreign tax redeterminations of foreign corporations 
occurring in taxable years that end with or within a taxable year of a 
United States shareholder ending on or December 16, 2019.

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2019-24847 Filed 12-16-19; 8:45 am]
 BILLING CODE 4830-01-P