Transition Rules for Recapture of Overall Foreign Losses -- Final Regs Under Section 904(f)

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final Income Tax Regulations relating to transition rules for implementing the changes made to section 904(f) of the Internal Revenue Code of 1954 by the Tax Reform Act of 1986. These final regulations provide rules for the recapture of overall foreign losses incurred in taxable years beginning before January 1, 1987, and rules for the treatment of overall foreign losses that are part of net operating losses incurred in taxable years beginning after December 31, 1986, which are carried back to taxable years beginning before January 1, 1987.

 EFFECTIVE DATE: These regulations are effective for taxable years beginning after December 31, 1986. However, taxpayers may choose to apply the rules set forth in section 1.904(f)-13T for taxable years beginning before January 1, 1990.

 FOR FURTHER INFORMATION CONTACT: Willard W. Yates of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC 20224, Attention: CC:CORP:T:R(INTL-932-86) (202-566-3452, not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

On May 17, 1988, the Federal Register published temporary regulations (53 FR 17461) and proposed amendments (53 FR 17472) to the Income Tax Regulations (26 CFR Part 1) under new paragraph (5) of section 904(f), which was added to the Code by Section 1203 of the Tax Reform Act of 1986 [100 Stat. 2085]. Written comments responding to this notice were received. After consideration of all comments regarding the proposed amendments, those amendments are adopted by this Treasury Decision with revisions in response to those comments. The comments and revisions are discussed below.

EXPLANATION OF PROVISIONS

 The proposed and temporary regulations dealt with transition rules for implementing the changes made to section 904(f) of the Internal Revenue Code of 1954 by the Tax Reform Act of 1986. The comments received focused primarily on the rule of section 1.904(f)- 12(a)(2) that provides that, unless an exception applies, overall foreign losses incurred in the general limitation category in taxable years beginning before January 1, 1987 (pre-effective date years), and recaptured in taxable years beginning after December 31, 1986 (post-effective date years), are recaptured pro rata from general limitation income, financial services income, shipping income, and dividends from each noncontrolled section 902 corporation. Commentors asserted that this rule unfairly limits recapture of a pre-effective date general limitation overall foreign loss from post-effective date passive income or high withholding tax interest. They state that the rule is unfair because passive income and high withholding tax interest income may have been included in general limitation income in pre-effective date years. Accordingly, the commentors contend, taxpayers should be permitted to recapture pre-effective date general limitation overall foreign losses from post-effective date passive income and high withholding tax interest income as well as from general limitation income, financial services income, shipping income and dividends from each noncontrolled section 902 corporation.

 This suggestion was rejected because post-effective date passive income and high withholding tax interest income could include substantial amounts of income that would have been separate limitation interest in pre-effective date years. Thus, a general rule that permitted taxpayers to recapture pre-effective date overall foreign losses out of post-effective date passive income or high withholding tax interest income likely would result in taxpayers recapturing those losses out of income that the loss would not have been allowed to offset if the income had been earned in a pre- effective date year.

 In addition, it was decided not to permit taxpayers to divide their passive income and high withholding tax interest income into income that would have been separate limitation interest if earned in a pre-effective date year and income that would have been general limitation income if earned in a pre-effective date year. The reason for this decision was to avoid frequent, difficult audit and allocation issues and to limit the continuing application of the law as in effect for taxable years beginning before January 1, 1987. Because overall foreign losses do not expire but continue until fully recaptured, adoption of a rule that permitted or required taxpayers to divide their passive income and high withholding tax interest income earned in post-effective date years into income that would have been separate limitation interest income and income that would have been general limitation income if earned in pre-effective date years would have continued the application of old law rules indefinitely.

 Paragraph (a)(2)(ii) of section 1.904(f)-12 permits taxpayers to trace a pre-effective date overall foreign loss in the general limitation category to one or more specific post-effective date income categories if the taxpayer can demonstrate that the loss is attributable to one or more separate categories of section 904(d)(1), as in effect for post-effective date taxable years. Commentors suggested that an example be included in the regulations to illustrate the application of this tracing rule to the recapture of a pre-effective date overall foreign loss from post-effective date passive income and high withholding tax interest. It has been determined that an example illustrating the tracing rule would be too dependent on its particular facts and circumstances to be useful. However, the text of paragraph (a)(2)(ii) has been clarified to state that taxpayers may trace a pre-effective date overall foreign loss in the general limitation category to any post-effective date separate category including passive income or high withholding tax interest income.

 Commentors were also concerned that the general reference to section 904(f)(5) in the last sentence of section 1.904(f)- 12(a)(2)(i) that provides for the recapture of pre-effective date general limitation overall foreign losses after the application of section 904(f)(5) means that those losses will be recaptured after post-effective date separate limitation income is recharacterized pursuant to section 904(f)(5)(C). This interpretation is incorrect. Overall foreign losses, whether from pre-effective date or post- effective date years, will always be recaptured before the recharacterization of separate limitation income pursuant to section 904(f)(5)(C). Accordingly, paragraph (a)(2)(i) has been amended to provide that the recapture of pre-effective date losses shall be made after allocation of separate limitation losses and before the recharacterization of post-effective date separate limitation income. Section 1.904(f)-12(a)(3) provides that pre-effective date overall foreign losses shall be recaptured to the extent thereof before post- effective date overall foreign losses are recaptured.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. Chapter 5) and the Regulatory Flexibility Act (5 U.S.C. Chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required.

DRAFTING INFORMATION

 The principal author of this regulation is Willard W. Yates of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. Other personnel from offices of the IRS and Treasury Department participated in developing the regulations.

LIST OF SUBJECTS IN 26 CFR SECTIONS 1.861-1 THROUGH 1.997-1

 Income taxes, Corporate deductions, Aliens, Exports, DISC, Foreign investments in U.S., Foreign tax credit, FSC, Sources of income, U.S. investments abroad.

Treasury Decision 8306

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR Part 1 is amended as follows:

PART 1 -- INCOME TAX REGULATIONS

Paragraph 1. The authority for Part 1 continues to read in part:

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

Par. 2. Section 1.904(f)-13T is removed.

Par. 3. New section 1.904(f)-12 is added in the appropriate place to read as follows:

Section 1.904(f)-12 Transition rules.

(a) RECAPTURE IN YEARS BEGINNING AFTER DECEMBER 31, 1986, OF OVERALL FOREIGN LOSSES INCURRED IN TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1987 -- (1) IN GENERAL. If a taxpayer has a balance in an overall foreign loss account at the end of its last taxable year beginning before January 1, 1987 (pre-effective date years), the amount of that balance shall be recaptured in subsequent years by recharacterizing income received in the income category described in section 904(d) as in effect for taxable years beginning after December 31, 1986 (post-effective date years), that is analogous to the income category for which the overall foreign loss account was established, as follows:

(i) Interest income as defined in section 904(d)(1)(A) as in effect for pre-effective date taxable years is analogous to passive income as defined in section 904(d)(1)(A) as in effect for post- effective date years;

(ii) Dividends from a DISC or former DISC as defined in section 904(d)(1)(B) as in effect for pre-effective date taxable years is analogous to dividends from a DISC or former DISC as defined in section 904(d)(1)(F) as in effect for post-effective date taxable years;

(iii) Taxable income attributable to foreign trade income as defined in section 904(d)(1)(C) as in effect for pre-effective date taxable years is analogous to taxable income attributable to foreign trade income as defined in section 904(d)(1)(G) as in effect for post-effective date years;

(iv) Distributions from a FSC (or former FSC) as defined in section 904(d)(1)(D) as in effect for pre-effective date taxable years is analogous to distributions from a FSC (or former FSC) as defined in section 904(d)(1)(H) as in effect for post-effective date taxable years;

(v) For general limitation income as described in section 904(d)(1)(E) as in effect for pre-effective date taxable years, see the special rule in paragraph (a)(2) of this section.

(2) RULE FOR GENERAL LIMITATION LOSSES -- (i) IN GENERAL. Overall foreign losses incurred in the general limitation category of section 904(d)(1)(E), as in effect for pre-effective date taxable years, that are recaptured in post-effective date taxable years shall be recaptured from the taxpayer's general limitation income, financial services income, shipping income, and dividends from each noncontrolled section 902 corporation. If the sum of the taxpayer's general limitation income, financial services income, shipping income and dividends from each noncontrolled section 902 corporation for a taxable year subject to recapture exceeds the overall foreign loss to be recaptured, then the amount of each type of separate limitation income that will be treated as U.S. source income shall be determined as follows:

      Amount of income in each

(ii) EXCEPTION. If a taxpayer can demonstrate to the satisfaction of the district director that an overall foreign loss in the general limitation category of section 904(d)(1)(E), as in effect for pre-effective date taxable years, is attributable, in sums certain, to losses in one or more separate categories of section 904(d)(1) (including for this purpose the passive income category and the high withholding tax interest category), as in effect for post- effective date taxable years, then the taxpayer may recapture the loss (in the amounts demonstrated) from those separate categories only.

(3) PRIORITY OF RECAPTURE OF OVERALL FOREIGN LOSSES INCURRED IN PRE-EFFECTIVE DATE TAXABLE YEARS. An overall foreign loss incurred by a taxpayer in pre-effective date taxable years shall be recaptured to the extent thereof before the taxpayer recaptures an overall foreign loss incurred in a post-effective date taxable year.

(4) EXAMPLES. The following examples illustrate the application of this paragraph (a).

EXAMPLE (1). X corporation is a domestic corporation which operates a branch in Country Y. For its taxable year ending December 31, 1988, X has $800 of financial services income, $100 of general limitation income and $100 of shipping income. X has a balance of $100 in its general limitation overall foreign loss account which resulted from an overall foreign loss incurred during its 1986 taxable year. X is unable to demonstrate to which of the income categories set forth in section 904(d)(1) as in effect for post-effective date taxable years the loss is attributable. In addition, X has a balance of $100 in its shipping overall foreign loss account attributable to a shipping loss incurred during its 1987 taxable year. X has no other overall foreign loss accounts. Pursuant to section 904(f)(1), the full amount in each of X corporation's overall foreign loss accounts is subject to recapture since $200 (the sum of those amounts) is less than 50% of X's foreign source taxable income for its 1988 taxable year, or $500. X's overall foreign loss incurred during its 1986 taxable year is recaptured before the overall foreign loss incurred during its 1987 taxable year, as follows: $80 ($100 x 800/1000) of X's financial services income, $10 ($100 x 100/1000) of X's general limitation income, and $10 ($100 x 100/1000) of X's shipping income will be treated as U.S. source income. The remaining $90 of X corporation's 1988 shipping income will be treated as U.S. source income for the purpose of recapturing X's $100 overall foreign loss attributable to the shipping loss incurred in 1987. $10 remains in X's shipping overall foreign loss account for recapture in subsequent taxable years.

EXAMPLE (2). The facts are the same as in EXAMPLE (1) except that X has $800 of financial services income, $100 of general limitation income, a $100 dividend from a noncontrolled section 902 corporation and a ($100) shipping loss for its taxable year ending December 31, 1988. Separate limitation losses are allocated pursuant to the rules of section 904(f)(5) before the recapture of overall foreign losses. Therefore, the ($100) shipping loss incurred by X will be allocated to its separate limitation income as follows: $80 ($100 x 800/1000) will be allocated to X's financial services income, $10 ($100 x 100/1000) will be allocated to its general limitation income and $10 ($100 x 100/1000) will be allocated to X's dividend from the noncontrolled section 902 corporation. Accordingly, after allocation of the 1988 shipping loss, X has $720 of financial services income, $90 of general limitation income, and a $90 dividend from the noncontrolled section 902 corporation. Pursuant to section 904(f)(1), the full amount in each of X corporation's overall foreign loss accounts is subject to recapture since $200 (the sum of those amounts) is less than 50% of X's net foreign source taxable income for its 1988 taxable year, or $450. X's overall foreign loss incurred during its 1986 taxable year is recaptured as follows: $80 ($100 x 720/900) of X's financial services income, $10 ($100 x 90/900) of its general limitation income and $10 ($100 x 90/900) of its dividend from the noncontrolled section 902 corporation will be treated as U.S. source income. Accordingly, after application of section 904(f), X has $100 of U.S. source income, $640 of financial services income, $80 of general limitation income and a $80 dividend from the noncontrolled section 902 corporation for its 1988 taxable year. X must establish a separate limitation loss account for each portion of the 1988 shipping loss that was allocated to its financial services income, general limitation income and dividends from the noncontrolled section 902 corporation. X's overall foreign loss account for the 1986 general limitation loss is reduced to zero. X still has a $100 balance in its overall foreign loss account that resulted from the 1987 shipping loss.

EXAMPLE (3). Y is a domestic corporation which has a branch operation in Country Z. For its 1988 taxable year, Y has $5 of shipping income, $15 of general limitation income and $100 of financial services income. Y has a balance of $100 in its general limitation overall foreign loss account attributable to its 1986 taxable year. Y has no other overall foreign loss accounts. Pursuant to section 904(f)(1), $60 of the overall foreign loss is subject to recapture since 50% of Y's foreign source income for 1988 is less than the balance in its overall foreign loss account. Y can demonstrate that the entire $100 overall foreign loss was attributable to a shipping limitation loss incurred in 1986. Accordingly, only Y's $5 of shipping limitation income received in 1988 will be treated as U.S. source income. Because Y can demonstrate that the 1986 loss was entirely attributable to a shipping loss, none of Y's general limitation income or financial services income received in 1988 will be treated as U.S. source income.

EXAMPLE (4). The facts are the same as in EXAMPLE (3) except that Y can only demonstrate that $50 of the 1986 overall foreign loss account was attributable to a shipping loss incurred in 1986. Accordingly, Y's $5 of shipping limitation income received in 1988 will be treated as U.S. source income. The remaining $50 of the 1986 overall foreign loss that Y cannot trace to a particular separate limitation will be recaptured and treated as U.S. source income as follows: $43 ($50 x 100/115) of Y's financial services income will be treated as U.S. source income and $7 ($50 x 15/115) of Y's general limitation income will be treated as U.S. source income. Y has $45 remaining in its overall foreign loss account to be recaptured from shipping income in a future year.

(b) TREATMENT OF OVERALL FOREIGN LOSSES THAT ARE PART OF NET OPERATING LOSSES INCURRED IN PRE-EFFECTIVE DATE TAXABLE YEARS WHICH ARE CARRIED FORWARD TO POST-EFFECTIVE DATE TAXABLE YEARS -- (1) RULE. An overall foreign loss that is part of a net operating loss incurred in a pre-effective date taxable year which is carried forward, pursuant to section 172, to a post-effective date taxable year will be carried forward under the rules of section 904(f)(5) and the regulations under that section. See also Notice 89-3, 1989-1 C.B. 623. For this purpose the loss must be allocated to income in the category analogous to the income category set forth in section 904(d) as in effect for pre-effective date taxable years in which the loss occurred. The analogous category shall be determined under the rules of paragraph (a) of this section.

(2) EXAMPLE. The following example illustrates the rule of paragraph (b)(1) of this section.

EXAMPLE. Z is a domestic corporation which has a branch operation in Country D. For its taxable year ending December 31, 1988, Z has $100 of passive income and $200 of general limitation income. Z also has a $60 net operating loss which was carried forward pursuant to section 172 from its 1986 taxable year. The net operating loss resulted from an overall foreign loss attributable to the general limitation income category. Z can demonstrate that the loss is a shipping loss. Therefore, the net operating loss will be treated as a shipping loss for Z's 1988 taxable year. Pursuant to section 904(f)(5), the shipping loss will be allocated as follows: $20 ($60 x 100/300) will be allocated to Z's passive income and $40 ($60 x 200/300) will be allocated to Z's general limitation income. Accordingly, after application of section 904(f), Z has $80 of passive income and $160 of general limitation income for its 1988 taxable year. Although no addition to Z's overall foreign loss account for shipping income will result from the NOL carry forward, shipping income earned by Z in subsequent taxable years will be subject to recharacterization as passive income and general limitation income pursuant to the rules set forth in section 904(f)(5).

(c) TREATMENT OF OVERALL FOREIGN LOSSES THAT ARE PART OF NET OPERATING LOSSES INCURRED IN POST-EFFECTIVE DATE TAXABLE YEARS WHICH ARE CARRIED BACK TO PRE-EFFECTIVE DATE TAXABLE YEARS -- (1) ALLOCATION TO ANALOGOUS INCOME CATEGORY. An overall foreign loss that is part of a net operating loss incurred by the taxpayer in a post- effective date taxable year which is carried back, pursuant to section 172, to a pre-effective date taxable year shall be allocated first to income in the pre-effective date income category analogous to the income category set forth in section 904(d) as in effect for post-effective date taxable years in which the loss occurred. Except for the general limitation income category, the pre-effective date income category that is analogous to a post-effective date income category shall be determined under paragraphs (a)(1)(i) through (iv) of this section. The general limitation income category for pre- effective date years shall be treated as the income category that is analogous to the post-effective date categories for general limitation income, financial services income, shipping income, dividends from each noncontrolled section 902 corporation and high withholding tax interest income. If the net operating loss resulted from separate limitation losses in more than one post-effective date income category and more than one loss is carried back to pre- effective date general limitation income, then the losses shall be allocated to the pre-effective date general limitation income based on the following formula:

      Loss in each post-effective date

(3) ALLOCATION TO OTHER SEPARATE LIMITATION CATEGORIES. To the extent that an overall foreign loss that is carried back as part of a net operating loss exceeds the separate limitation income to which it is allocated and the U.S. source income of the taxpayer for the taxable year to which the loss is carried, the loss shall be allocated pro rata to other separate limitation income of the taxpayer for the taxable year. However, there shall be no recharacterization of separate limitation income pursuant to section 904(f)(5) as a result of the allocation of such a net operating loss to other separate limitation income of the taxpayer.

(4) EXAMPLES. The following examples illustrate the rules of paragraph (c) of this section.

EXAMPLE (1). X is a domestic corporation which has a branch operation in Country A. For its taxable year ending December 31, 1987, X has a $60 net operating loss which is carried back pursuant to section 172 to its taxable year ending December 31, 1985. The net operating loss resulted from a shipping loss; X had no U.S. source income in 1987. X had $20 of general limitation income, $40 of DISC limitation income and $10 of U.S. source income for its 1985 taxable year. The $60 NOL is allocated first to X's 1985 general limitation income to the extent thereof ($20) since the general limitation income category of section 904(d) as in effect for pre-effective date taxable years is the income category that is analogous to shipping income for post-effective date taxable years. Therefore, X has no general limitation income for its 1985 taxable year. Next, pursuant to section 904(f) as in effect for pre-effective date taxable years, the remaining $40 of the NOL is allocated first to X's $10 of U.S. source income and then to $30 of X's DISC limitation income for its 1985 taxable year. Accordingly, X has no U.S. source income and $10 of DISC limitation income for its 1985 taxable year after allocation of the NOL. X has a $10 balance in its shipping overall foreign loss account which is subject to recapture pursuant to section 904(f) as in effect for post-effective date taxable years. X will not be required to recharacterize, pursuant to section 904(f)(5), subsequent shipping income as DISC limitation income.

EXAMPLE (2). Y is a domestic corporation which has a branch operation in Country B. For its taxable year ending December 31, 1987, X has a $200 net operating loss which is carried back pursuant to section 172 to its taxable year ending December 31, 1986. The net operating loss resulted from a ($100) general limitation loss and a ($100) shipping loss. Y had $100 of general limitation income and $200 of U.S. source income for its taxable year ending December 31, 1986. The separate limitation losses for 1987 are allocated pro rata to Y's 1986 general limitation income as follows: $50 of the ($100) general limitation loss ($100 x 100/200) and $50 of the ($100) shipping loss ($100 x 100/200) is allocated to Y's $100 of 1986 general limitation income. The remaining $50 of Y's general limitation loss and the remaining $50 of Y's shipping loss are allocated to Y's 1986 U.S. source income. Accordingly, Y has no foreign source income and $100 of U.S. source income for its 1986 taxable year. Y has a $50 balance in its general limitation overall foreign loss account and a $50 balance in its shipping overall foreign loss account, both of which will be subject to recapture pursuant to section 904(f) as in effect for post- effective date taxable years.

(d) RECAPTURE OF FORI AND GENERAL LIMITATION OVERALL FOREIGN LOSSES INCURRED IN TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1983. For taxable years beginning after December 31, 1986, and before January 1, 1991, the rules set forth in section 1.904(f)-6 shall apply for purposes of recapturing general limitation and foreign oil related income (FORI) overall foreign losses incurred in taxable years beginning before January 1, 1983 (pre-1983). For taxable years beginning after December 31, 1990, the rules set forth in this section shall apply for purposes of recapturing pre-1983 general limitation and FORI overall foreign losses.

(e) RECAPTURE OF PRE-1983 OVERALL FOREIGN LOSSES DETERMINED ON A COMBINED BASIS. The rules set forth in paragraph (a)(2) of this section shall apply for purposes of recapturing overall foreign losses incurred in taxable years beginning before January 1, 1983, that were computed on a combined basis in accordance with section 1.904(f)-1(c)(1).

(f) TRANSITION RULES FOR TAXABLE YEARS BEGINNING BEFORE DECEMBER 31, 1990. For transition rules for taxable years beginning before January 1, 1990, see 26 CFR section 1.904(f)-13T as it appeared in the Code of Federal Regulations revised as of April 1, 1990.