Foreign Tax Credit Limitations for Foreign Oil and Gas Taxes-- Final Regulations Under Section 907

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final Income Tax Regulations relating to the amendments made to section 907 of the Internal Revenue Code by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). The amendments made by TEFRA require that foreign oil and gas extraction income (FOGEI) and losses from all foreign countries be aggregated before computing the limit on creditability of foreign taxes. The amendments also repeal the separate application of the foreign tax credit limitation to taxes on foreign oil related income (FORI). The amendments made by TAMRA remove dividends paid by a domestic corporation from inclusion within foreign oil related income.

 EFFECTIVE DATES: The amendments are effective for taxable years beginning after December 31, 1982, except as follows. The special rule at section 1.907(c)-2(d)(4) for determination on a facts and circumstances basis of the part of the section 907(c)(3)(C) amount that is attributable to FOGEI, FORI, and other income is effective for taxable years ending after January 23, 1989. The special rule provided at section 1.907(c)-2(d)(7) with respect to allocation of earnings and profits or deficits that arise in taxable years beginning after December 31, 1986, is effective after December 31, 1986. The special rules provided for determination of FORI and FOGEI tax with respect to dividends received and amounts includable in gross income under section 951(a) in taxable years beginning after December 31, 1986, at section 1.907(c)-3(b)(1) and (c), respectively, are effective after December 31, 1986.

 FOR FURTHER INFORMATION CONTACT: Richard L. Chewning of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC 20224, Attention: CC:CORP:T:R(INTL-152-86) (202-566-6285, not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

On January 23, 1989, the FEDERAL REGISTER published amendments (54 FR 3004) to the Income Tax Regulations (26 CFR Part 1) under section 907 of the Internal Revenue Code. These amendments conformed the regulations to changes made to section 907 by section 211 (96 Stat. 448) of TEFRA. Written comments responding to this notice were received. A public hearing was not requested and none was held. After consideration of all comments regarding the proposed amendments, those amendments are adopted by this Treasury Decision with revisions in response to those comments. This Treasury Decision also conforms the regulations to a change made to section 907(c)(3) by section 1012 of TAMRA (102 Stat. 3501).

EXPLANATION OF PROVISIONS

 These final regulations include only one principal change from the temporary regulations. The temporary regulations at section 1.907(b)-1T(b) set forth an objective safe harbor formula method for the determination of whether the foreign law imposing a FORI tax will be considered to be either structured in a manner, or to operate in a manner, so that the amount of tax imposed on FORI is generally materially greater than the tax imposed by the foreign law on income that is neither FORI nor FOGEI.

 Commenters criticized the temporary regulations on several grounds. First, in their view, the safe harbor method improperly reduces creditable FORI taxes even though there has not been a shifting of taxes away from taxes on FOGEI. They assert that this result is contrary to the intent of Congress. Second, in their view, the method disallows FORI tax credits regardless of whether the difference in tax burdens is materially greater over a reasonable period of time. In addition, they contend that the method is at odds with various treaty commitments which allow for the crediting of various taxes on FORI even though those taxes are imposed in addition to the general corporate tax.

 In light of the views expressed by the commenters, the safe harbor method has been replaced in the final regulations with a facts and circumstances test as suggested by the commenters. Under this test, the creditability of otherwise creditable FORI taxes will be limited only if there has been a shifting of tax from a tax on FOGEI to a tax on FORI. This determination will be made on a facts and circumstances basis.

 A commenter criticized section 1.907(c)-1T(c), which provides for the carry forward of a foreign oil and gas extraction loss to recharacterize FOGEI in future years as foreign-source income that is not FOGEI, because the rule in the regulations operates irrespective of whether the loss resulted in a tax benefit. The final regulations do not include a tax benefit rule because the Senate Finance Committee (S. Rep. No. 494, 97th Cong., 2d Sess. 151 (1982)), in explaining the rule, stated that recharacterization is to occur even though the taxpayer obtained no tax benefit from the loss.

 Section 1.907(c)-1(f)(4) has been revised to provide that for taxable years beginning after 1986, exchange gain or loss from a section 988 transaction may be FORI or FOGEI only if directly related to the business needs (under the principles of section 954(c)(1)(D)) attributable to the conduct of the section 907(c) activity.

 Section 1.907(c)-2(d)(3) has been revised in the final regulations to reflect that section 1012 of TAMRA amended section 907(c)(3) so that dividends paid after December 31, 1986, by a domestic corporation will no longer be FORI.

 In light of the Supreme Court decision in Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988), the temporary regulations at section 1.907(c)-1T(e)(3) (and as cross-referenced at 1.907(c)- 1A(d)(3)) provided that for all years, stock of any corporation will not be treated as an asset used by a person in section 907(c) activities. Therefore, income (or loss) from the sale of stock will never be FOGEI or FORI. One commenter suggested that the decision in Arkansas Best does not justify the position taken in the regulations. In addition, the commenter objected to applying the regulations on a retroactive basis. After further review, we think the position taken in the temporary regulations, on both a retroactive and prospective basis, was consistent with the Supreme Court's decision. Accordingly, the regulations provision has not been changed.

 Section 1.907(c)-2(f) has been revised to provide that for taxable years beginning after 1986, the principles of section 1.904-5(h) and (i) shall be applied to determine whether (and to what extent) a person's distributive share of the income of any partnership is FORI and FOGEI. Thus, for example, a less-than-10 percent corporate partner's share of income of the partnership would generally be treated as passive income to the partner, and not as FORI or FOGEI, unless an exception under section 1.904-5(h) and (i) applies.

 In response to commenters' suggestions, paragraphs (a) and (d)(7) of section 1.907(c)-2 and paragraph (b)(1) and (2)(iii) of section 1.907(c)-3 have been clarified.

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. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Administrator of the Small Business Administration (SBA) for comment on their impact on small business. The SBA did not comment on these regulations.

DRAFTING INFORMATION

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

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

 Aliens, Corporate deductions, DISC, Exports, Foreign investments in United States, Foreign tax credit, FSC, Income taxes, Sources of income, United States investments abroad, Petroleum, Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

Part 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 is amended by removing the citation for section 1.907(b)-1T and adding a new citation to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.907(b)-1 is also issued under 26 U.S.C. 907(b). * * *

Par. 2. Section 1.907-0 is revised to read as follows:

SECTION 1.907-0 OUTLINE OF REGULATION PROVISIONS FOR SECTION 907.

This section lists the paragraphs contained in sections 1.907(a)-0 through 1.907(f)-1A.

 REGULATIONS APPLICABLE TO TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1982

Par. 4. Sections 1.907(a)-0 through 1.907(f)-1 are added after the undesignated centerheading "REGULATIONS APPLICABLE TO TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1982" to read as follows:

SECTION 1.907(a)-0 INTRODUCTION (FOR TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1982).

(a) EFFECTIVE DATES. The provisions of sections 1.907(a)-0 through section 1.907(f)-1 apply to taxable years beginning after December 31, 1982. For provisions that apply to taxable years beginning before January 1, 1983, see sections 1.907(a)-0A through 1.907(f)-1A.

(b) KEY TERMS. For purposes of the regulations under section 907 --

(1) "FOGEI" means foreign oil and gas extraction income.

(2) "FORI" means foreign oil related income.

(3) "FOGEI taxes" mean foreign oil and gas extraction taxes as defined in section 907(c)(5).

(4) "FORI taxes" mean foreign taxes on foreign oil related income. See section 1.907(c)-3.

(c) FOGEI TAX LIMITATION. Section 907(a) limits the foreign tax credit for taxes paid or accrued on FOGEI. See section 1.907(a)-1.

(d) REDUCTION OF CREDITABLE FORI TAXES. Section 907(b) recharacterizes FORI taxes as non-creditable deductible expenses to the extent that the foreign law imposing the FORI taxes is structured, or in fact operates, so that the amount of tax imposed with respect to FORI will be materially greater, over a reasonable period of time, than the amount generally imposed on income that is neither FOGEI nor FORI. See section 1.907(b)-1.

(e) FOGEI AND FORI. FOGEI includes the taxable income from the extraction of minerals from oil or gas wells by a taxpayer (or another person) and from the sale or exchange of assets used in the extraction business. FORI includes taxable income from the activities of processing oil and gas into their primary products, transporting or distributing oil and gas and their primary products, and from the disposition of assets used in these activities. For this purpose, a disposition includes only a sale or exchange. FOGEI and FORI may also include taxable income from the performance of related services or from the lease of related property and certain dividends, interest, or amounts described in section 951(a). See sections 1.907(c)-1 through 1.907(c)-3.

(f) POSTED PRICES. Certain sales prices are disregarded when computing FOGEI for purposes of chapter 1 of the Code. See section 1.907(d)-1.

(g) TRANSITIONAL RULES. Section 907(e) provides rules for the carryover of unused FOGEI taxes from taxable years beginning before January 1, 1983, and carryback of FOGEI taxes arising in taxable years beginning after December 31, 1982. See section 1.907(e)-1.

(h) SECTION 907(f) CARRYBACKS AND CARRYOVERS. FOGEI taxes disallowed under section 907(a) may be carried back or forward to other taxable years. These FOGEI taxes may be absorbed in another taxable year to the extent of the lesser of the separate excess extraction limitation or the excess limitation in the general limitation category (section 904(d)(1)(I)) for the carryback or carryover year. See section 1.907(f)-1.

(i) STATUTES COVERED. The regulations under section 907 are issued as a result of the enactment of section 601 of the Tax Reduction Act of 1975, of section 1035 of the Tax Reform Act of 1976, of section 301(b)(14) of the Revenue Act of 1978, of section 211 of the Tax Equity and Fiscal Responsibility Act of 1982 and of section 1012(g)(6)(A)-(B) of the Technical and Miscellaneous Revenue Act of 1988.

SECTION 1.907(a)-1 REDUCTION IN TAXES PAID ON FOGEI (FOR TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1982).

(a) AMOUNT OF REDUCTION. FOGEI taxes are reduced by the amount by which they exceed a limitation level (as defined in paragraph (c) of this section).

(b) FOREIGN TAXES PAID OR ACCRUED. For purposes of the regulations under section 907 --

(1) FOREIGN TAXES. The term "foreign taxes" means income, war profits, or excess profits taxes of foreign countries or possessions of the United States otherwise creditable under section 901 (including those creditable by reason of section 903).

(2) FOREIGN TAXES PAID OR ACCRUED. The terms "foreign taxes paid or accrued," "FOGEI taxes paid or accrued," and "FORI taxes paid or accrued" include foreign taxes deemed paid under sections 902 and 960. Unless otherwise expressly provided, these terms do not include foreign taxes deemed paid by reason of sections 904(c) and 907(f).

(c) LIMITATION LEVEL -- (1) IN GENERAL. The limitation level is FOGEI for the taxable year multiplied by the limitation percentage for that year.

(2) LIMITATION PERCENTAGE FOR CORPORATIONS. A corporation's limitation percentage is the highest rate of tax specified in section 11(b) for the particular year.

(3) LIMITATION PERCENTAGE FOR INDIVIDUALS. Section 907(a)(2)(B) provides that the limitation percentage for individual taxpayers is the effective rate of tax for those taxpayers. The effective rate of tax is computed by dividing the entire tax, before the credit under section 901(a) is taken, by the taxpayer's entire taxable income.

(4) LOSSES. (i) For purposes of determining whether income is FOGEI, a taxpayer's FOGEI will be recharacterized as foreign source non-FOGEI to the extent that FOGEI losses for preceding taxable years beginning after December 31, 1982, exceed the amount of FOGEI already recharacterized. See section 1.907(c)-1(c). However, taxes that were paid or accrued on the recharacterized FOGEI will remain FOGEI taxes.

(ii) Taxes paid or accrued by a person to a foreign country may be FOGEI taxes even though that person has under U.S. law a net operating loss from sources within that country.

(iii) For purposes of determining whether income is FOGEI, a taxpayer's income will be treated as income from sources outside the United States even though all or a portion of that income may be resourced as income from sources within the United States under section 904(f)(1) and (4).

(5) PRIORITY. (i) Section 907(a) applies before section 908, relating to reduction of credit for participation in or cooperation with an international boycott.

(ii) Section 901(f) (relating to certain payments with respect to oil and gas not considered as taxes) applies before section 907.

(d) ILLUSTRATIONS. Paragraphs (a) through (c) of this section are illustrated by the following examples.

EXAMPLE 1. M, a U.S. corporation, uses the accrual method of accounting and the calendar year as its taxable year. For 1984, M has $20,000 of FOGEI, derived from operations in foreign countries X and Y, and has accrued $11,500 of foreign taxes with respect to FOGEI. The highest tax rate specified in section 11(b) for M's 1984 taxable year is 46 percent. Pursuant to section 907(a), M's FOGEI taxes limitation level for 1984 is $9,200 (46% x $20,000). The foreign taxes in excess of this limitation level ($2,300) may be carried back or forward. See section 907(f) and section 1.907(f)-1 and section 907(e) and section 1.907(e)-1.

EXAMPLE 2. The facts are the same as in Example 1 except that M is a partnership owned equally by U.S. citizens A and B who each file as unmarried individuals and do not itemize deductions. Pursuant to section 905(a), A and B have elected to credit foreign taxes in the year accrued. The total amount of foreign taxes accrued by A and B with respect to their distributive shares of M's FOGEI is $11,500 ($5,750 accrued by A and $5,750 accrued by B). A and B have no other FOGEI. A's only taxable income for 1984 is his 50% distributive share ($10,000) of M's FOGEI and A has a preliminary U.S. tax liability of $1,079. B has $112,130 of taxable income for 1984 (including his 50% distributive share ($10,000) of M's FOGEI) and has a preliminary U.S. tax liability of $44,000. Pursuant to section 907(a), A's FOGEI taxes limitation level for 1984 is $1,079 (($1,079/$10,000) x $10,000)) and B's FOGEI taxes limitation level for 1984 is $3,924 (($44,000/$112,130) x $10,000)).

(e) EFFECT ON OTHER PROVISIONS -- (1) DEDUCTION DENIED. If a credit is claimed under section 901, no deduction under section 164(a)(3) is allowed for the amount of the FOGEI taxes that exceed a taxpayer's limitation level for the taxable year. See section 275(a)(4)(A). Thus, FOGEI taxes disallowed under section 907(a) are not added to the cost or inventory amount of oil or gas.

(2) REDUCTION INAPPLICABLE. The reduction under section 907(a) does not apply to a taxpayer that deducts foreign taxes and does not claim the benefits of section 901 for a taxable year.

(3) SECTION 78 DIVIDEND. The reduction under section 907(a) has no effect on the amount of foreign taxes that are treated as dividends under section 78.

(f) SECTION 904 LIMITATION. FOGEI taxes as reduced under section 907(a) are creditable only to the extent permitted by the general limitation of section 904(d)(1)(I).

SECTION 1.907(b)-1 REDUCTION OF CREDITABLE FORI TAXES (FOR TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1982).

If the foreign law imposing a FORI tax (as defined in section 1.907(c)-3) is either structured in a manner, or operates in a manner, so that the amount of tax imposed on FORI is generally materially greater than the tax imposed by the foreign law on income that is neither FORI nor FOGEI ("described manner"), section 907(b) provides a special rule which limits the amount of FORI taxes paid or accrued by a person to a foreign country which will be considered income, war profits, or excess profits taxes. Section 907(b) will apply to a person regardless of whether that person is a dual capacity taxpayer as defined in section 1.901-2(a)(2)(ii)(A). (In general, a dual capacity taxpayer is a person who pays an amount to a foreign country part of which is attributable to an income tax and the remainder of which is a payment for a specific economic benefit derived from that country.) Foreign law imposing a tax on FORI will be considered either to be structured in or to operate in the described manner only if, under the facts and circumstances, there has been a shifting of tax by the foreign country from a tax on FOGEI to a tax on FORI.

SECTION 1.907(c)-1 DEFINITIONS RELATING TO FOGEI AND FORI (FOR TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1982).

(a) SCOPE. This section explains the meaning to be given certain terms and items in section 907(c)(1), (2), and (4). See also sections 1.907(a)-0(b) and 1.907(c)-2 for further definitions.

(b) FOGEI -- (1) GENERAL RULE. Under section 907(c)(1), FOGEI means taxable income (or loss) derived from sources outside the United States and its possessions from the extraction (by the taxpayer or any other person) of minerals from oil or gas wells located outside the United States and its possessions or from the sale or exchange of assets used by the taxpayer in the trade or business of extracting those minerals. Extraction of minerals from oil or gas wells will result in gross income from extraction in every case in which that person has an economic interest in the minerals in place. For other circumstances in which gross income from extraction may arise, see paragraph (b)(3) of this section. For determination of the amount of gross income from extraction, see paragraph (b)(2) of this section. For definition of the phrase "assets used by the taxpayer in the trade or business" and for rules relating to that type of FOGEI, see paragraph (e)(1) of this section. The term "minerals" is defined in paragraph (f)(1) of this section. For determination of taxable income, see paragraph (f)(2) of this section. FOGEI includes, in addition, items listed in section 907(c)(3) (relating to dividends, interest, partnership distributions, etc.) and explained in section 1.907(c)-2. For the reduction of what would otherwise be FOGEI by losses incurred in a prior year, see section 907(c)(4) and paragraph (c) of this section.

(2) AMOUNT. The gross income from extraction is determined by reference to the fair market value of the minerals in the immediate vicinity of the well. Fair market value is determined under paragraph (b)(6) of this section.

(3) OTHER CIRCUMSTANCES. Gross income from extraction or the sale or exchange of assets described in section 907(c)(1)(B) includes income from any arrangement, or a combination of arrangements or transactions, to the extent the income is in substance attributable to the extraction of minerals or such a sale or exchange. For instance, a person may have gross income from such a sale or exchange if the person purchased minerals from a foreign government at a discount and the discount reflects an arm's-length amount in consideration for the government's nationalization of assets that person owned and used in the extraction of minerals.

(4) INCOME DIRECTLY RELATED TO EXTRACTION. Gross income from extraction includes directly related income under paragraph (g) of this section.

(5) INCOME NOT INCLUDED. FOGEI as otherwise determined under this paragraph (b), nevertheless, does not include income to the extent attributable to marketing, distributing, processing or transporting minerals or primary products. Income from the purchase and sale of minerals is not ordinarily FOGEI. If the foreign taxes paid or accrued in connection with income from a purchase and sale are not creditable by reason of section 901(f), that income is not FOGEI. A taxpayer to whom section 901(f) applies is not a producer.

(6) FAIR MARKET VALUE. For purposes of this paragraph (b), the fair market value of oil or gas in the immediate vicinity of the well depends on all of the facts and circumstances as they exist relative to a party in any particular case. The facts and circumstances that may be taken into account include, but are not limited to, the following --

(i) The facts and circumstances pertaining to an independent market value (if any) in the immediate vicinity of the well,

(ii) The facts and circumstances pertaining to the relationships between the taxpayer and the foreign government. If an independent fair market value in the immediate vicinity of the well cannot be determined but fair market value at the port, or a similar point, in the foreign country can be determined (port price), an analysis of the arrangements between the taxpayer and the foreign government that retains a share of production could be evidence of the appropriate, arm's-length difference between the port price and the field price, and

(iii) The other facts and circumstances pertaining to any difference in the producing country between the field and port prices.

(7) ECONOMIC INTEREST. For purposes of this paragraph (b), the term "economic interest" means an economic interest as defined in section 1.611-1(b)(1), whether or not a deduction for depletion is allowable under section 611.

(c) CARRYOVER OF FOREIGN OIL EXTRACTION LOSSES -- (1) IN GENERAL. Pursuant to section 907(c)(4), the determination of FOGEI for a particular taxable year takes into account a foreign oil extraction loss incurred in prior taxable years beginning after December 31, 1982. There is no time limitation on this carryover of foreign oil extraction losses. Section 907(c)(4) does not provide for any carryback of these losses. Section 907(c)(4) operates solely for purposes of determining FOGEI and thus operates independently of section 904(f).

(2) REDUCTION. That portion of the income of the taxpayer for the taxable year which but for this paragraph (c) would be treated as FOGEI is reduced (but not below zero) by the excess of --

(i) The aggregate amount of foreign oil extraction losses for preceding taxable years beginning after December 31, 1982, over

(ii) The aggregate amount of reductions under this paragraph (c) for preceding taxable years beginning after December 31, 1982.

(3) FOREIGN OIL EXTRACTION LOSS DEFINED -- (i) IN GENERAL. For purposes of this paragraph (c), the term "foreign oil extraction loss" means the amount by which the gross income for the taxable year that is taken into account in determining FOGEI for that year is exceeded by the sum of the deductions properly allocated and apportioned to that gross income (as determined under paragraph (f)(2) of this section). A person can have a foreign oil extraction loss for a taxable year even if the person has not chosen the benefits of section 901 for that year.

(ii) ITEMS NOT TAKEN INTO ACCOUNT. For purposes of paragraph (c)(3)(i) of this section, the following items are not taken into account --

(A) The net operating loss deduction allowable for the taxable year under section 172(a),

(B) Any foreign expropriation loss (as defined in section 172(h)) for the taxable year, and

(C) Any loss for the taxable year which arises from fire, storm, shipwreck, or other casualty, or from theft.

A loss mentioned in paragraph (c)(3)(ii)(B) or (C) of this section is taken into account, however, to the extent compensation (for instance by insurance) for the loss is included in gross income.

(4) AFFILIATED GROUPS. The foreign oil extraction loss of an affiliated group of corporations (within the meaning of section 1504(a)) that files a consolidated return is determined on a group basis. If the group does not have a foreign oil extraction loss, the foreign oil extraction loss of a member of that group will not reduce on a separate basis that member's FOGEI for a later taxable year. For special rules affecting the foreign oil extraction loss in the case of certain related domestic corporations that are not members of the same affiliated group, see section 904(i).

(5) FOGEI TAXES. If FOGEI is reduced pursuant to this paragraph (c) (and thereby recharacterized as non-FOGEI income), any foreign taxes imposed on the FOGEI that is recharacterized as other income retain their character as FOGEI taxes. See section 907(c)(5).

(6) EXAMPLES. The provisions of this paragraph (c) may be illustrated by the following examples.

EXAMPLE 1 -- (i) FACTS. X, a U.S. corporation using the accrual method of accounting and the calendar year as its taxable year, is engaged in extraction activities in three foreign countries. X has only the following combined foreign tax items for the three countries (prior to the application of this paragraph (c)) for 1983, 1984, and 1985:

                                         1983    1984    1985

(iii) 1984. X's FOGEI for 1984, prior to the application of this paragraph (c), is $100. X has a foreign oil extraction loss for 1983 of $(500). This loss must be applied against X's preliminary FOGEI of $100 for 1984. Thus, X's FOGEI for 1984 is $0 and X has $(400) ($500-$100) of foreign oil extraction loss from 1983 to be carried to 1985. Since X's FOGEI for 1984 is $0, its section 907(a) limitation is $0 (.46 x $0). Therefore, none of the FOGEI taxes paid or accrued in 1984 ($60) can be credited in 1984. They can, however, be carried back pursuant to the provisions of section 907(e)(2) and section 1.907(e)-1 and carried forward pursuant to the provisions of section 907(f) and section 1.907(f)-1.

(iv) 1985. X's FOGEI for 1985, prior to the application of this paragraph (c), is $450. X's remaining foreign oil extraction loss carryover from 1983 is $(400) and this must be applied against X's preliminary FOGEI of $450 for 1985. Thus, X's FOGEI for 1984 is $50 ($450-$400). X's section 907(a) limitation is $23 (.46 x $50). Therefore, $23 of the FOGEI taxes paid or accrued in 1985, together with the other $230 of general limitation taxes, can be credited in 1985, subject to the general limitation of section 904(d)(1)(E) (as in effect prior to 1987). The excess of FOGEI taxes, $177 ($200-$23), can be carried back pursuant to the provisions of section 907(e)(2) and section 1.907(e)-1 and carried forward pursuant to the provisions of section 907(f) and section 1.907(f)-1.

EXAMPLE 2 -- (i) FACTS. The facts are the same as in Example 1 except that X's paragraph (c)(3)(ii) items for 1983 allocable to FOGEI are $(800) instead of $(200). FOGEI remains a loss of $(700). Thus, X does not have a foreign oil extraction loss for 1983 because it has $100 of FOGEI when its paragraph (c)(3)(ii) items are not taken into account ($(700) + $800).

(ii) 1983. The results are the same as in Example 1.

(iii) 1984. Although X had a FOGEI loss of $(700) in 1983, there is not a loss that can be carried forward after adjustment for paragraph (c)(3)(ii) items. Thus, X's FOGEI for 1984 is not reduced by the 1983 loss. X's section 907(a) limitation for 1984 is $46 (.46 x $100). Therefore, $46 of the FOGEI taxes paid or accrued in 1984, together with the other $90 of general limitation taxes, can be credited in 1984, subject to the general limitation of section 904(d)(1)(E)(as in effect prior to 1987). The excess of $14 ($60-$46) can be carried back to 1982 pursuant to the provisions of section 907(e)(2) and section 1.907(e)-1 and carried forward pursuant to the provisions of section 907(f) and section 1.907(f)-1.

(iv) 1985. Since there is no foreign oil extraction loss for either 1983 or 1984 to be applied in 1985, X's FOGEI for 1985 is $450. Thus, its section 907(a) limitation for 1985 is $207 (.46 x $450) and all of its FOGEI taxes paid or accrued in 1985 ($200), together with the other $230 of general limitation taxes, can be credited in 1985, subject to the general limitation of section 904(d)(1)(E)(as in effect prior to 1987). FOGEI taxes in the amount of $10 from 1983 and $14 from 1984 may be carried forward to 1985 if they have not been used in carryback years. However, because the excess section 907(a) limitation for 1985 is only $7, that is the maximum potential FOGEI taxes from 1983 or 1984 that may be used in 1985.

EXAMPLE 3 -- (i) FACTS. Y, a U.S. corporation using the accrual method of accounting and the calendar year as its taxable year, is engaged in extraction activities in three foreign countries. Y's only foreign taxable income is income subject to the general limitation of section 904(d)(1)(E)(as in effect prior to 1987). Y has no paragraph (c)(3)(ii) items. Y has the following foreign tax items for 1983 and 1984:

                                             1983       1984

(B) SECTION 904(d) FRACTION. Y has a foreign loss of $(150)($(400) + $250) for 1983. Thus, its fraction for purposes of determining its general limitation of section 904(d)(1)(E) is $0/$850.

(iii) 1984 -- (A) SECTION 907(a) LIMITATION. Y's foreign oil extraction loss for 1983 is $(400). Applying this loss to its preliminary FOGEI for 1984 ($300) eliminates all of Y's FOGEI for 1984. Because Y's FOGEI for 1984 is $0, its section 907(a) limitation is also $0. Thus, none of the FOGEI taxes paid or accrued in 1984 ($180) can be credited in 1984. They can, however, be carried back to 1982 pursuant to the provisions of section 907(e)(2) and section 1.907(e)-1 and carried forward pursuant to the provisions of section 907(f) and section 1.907(f)-1. Y has a remaining foreign oil extraction loss of $(100) from 1983 to be carried to 1985.

(B) SECTION 904(d) FRACTION. Y's preliminary foreign taxable income for purposes of determining its general limitation of section 904(d)(1)(E) is $500 ($300 + $200). However, Y has an overall foreign loss from 1983 of $(150)($(400) + $250) and thus, pursuant to section 904(f), Y must recharacterize $150 (lesser of $150 or 50% of $500) of its 1984 foreign taxable income as U.S. taxable income. Thus, Y's fraction for purposes of determining its general limitation of section 904(d)(1)(E) for 1984 is $350/$1,600.

EXAMPLE 4 -- (i) FACTS. Assume the same facts as in Example 3 except that Y has the following foreign tax items:

                                    1983      1984      1985

(iii) 1984. Because Y's FOGEI for 1984 is a loss of $(100), Y's section 907(a) limitation for 1984 is $0. Thus, none of the FOGEI taxes paid or accrued in 1984 ($10) can be credited in 1984. They can, however, be carried back under the provisions of section 907(e)(2) and Section 1.907(e)-1 and carried forward under the provisions of section 907(f) and section 1.907(f)-1.

(iv) 1985. Y's FOGEI loss of $(100) for 1984 is carried forward to 1985 and offsets FOGEI income in that amount in 1985. The entire section 904(d)(1)(E) overall foreign loss account of $50 is recaptured in 1985; therefore, Y has $75 of foreign source income and $50 of U.S. source income. However, Y has $125 of FOGEI since, for purposes of section 907(a), the $50 resourced by section 904(f) will be treated as income from sources outside the United States; see section 1.907(a)-1 (c)(4)(iii). Accordingly, Y's section 907(a) limitation is $57.50 (.46 x $125). Y's section 904(d)(1)(E) limitation is, however, only $34.50 (.46 x $75). Thus, Y may claim a foreign tax credit of $34.50 in 1985. Y may carry back or carry forward $23 ($57.50 - $34.50) and that amount is not subject to the section 907(a) limitation in the carry to year. In addition, $67.50 ($125 - $57.50) may be carried back pursuant to the provisions of section 907(e)(2) and section 1.907(e)-1 and carried forward pursuant to the provisions of section 907(f) and section 1.907(f)-1. This amount is subject to the section 907(a) limitation in the carry to year.

(d) FORI -- (1) IN GENERAL. Section 907(c)(2) defines FORI to include taxable income from the processing of oil and gas into their primary products, from the transportation or distribution and sale of oil and gas and their primary products, from the disposition of assets used in these activities and from the performance of any other related service. FORI may also include, under section 907(c)(3), certain dividends, interest, or amounts described in section 951(a). This paragraph (d) defines certain terms and items applicable to FORI.

(2) TRANSPORTATION. Gross income from transportation of minerals or primary products ("gross transportation income") is gross income arising from carrying minerals or primary products between two places (including time or voyage charter hires) by any means of transportation, such as a vessel, pipeline, truck, railroad, or aircraft. Except for directly related income under paragraphs (d)(7) and (g) of this section, gross transportation income does not include gross income received by a lessor from a bareboat charter hire of a means of transportation, certain other rental income, or income from the performance of certain services.

(3) DISTRIBUTION OR SALE. The term "distribution or sale" means the sale or exchange of minerals or primary products to processors, users who purchase, store, or use in bulk quantities, other persons for further distribution, retailers, or consumers. Gross income from distribution or sale includes interest income attributable to the distribution of minerals or primary products on credit.

(4) PROCESSING. The term "processing" means the destructive distillation, or a process similar in effect to destructive distillation, of crude oil and the processing of natural gas into their primary products including processes used to remove pollutants from crude oil or natural gas.

(5) PRIMARY PRODUCT FROM OIL. The term "primary product" (in the case of oil) means all products derived from the processing of crude oil, including volatile products, light oils (such as motor fuel and kerosene), distillates (such as naphtha), lubricating oils, greases and waxes, and residues (such as fuel oil).

(6) PRIMARY PRODUCT FROM GAS. The term "primary product" (in the case of gas) means all gas and associated hydrocarbon components from gas wells or oil wells, whether recovered at the lease or upon further processing, including natural gas, condensates, liquefiable petroleum gases (such as ethane, propane, and butane), and liquid products (such as natural gasoline).

(7) DIRECTLY RELATED INCOME. FORI also includes directly related income under paragraph (g) of this section.

(e) ASSETS USED IN A TRADE OR BUSINESS -- (1) IN GENERAL. The term "assets used by the taxpayer in the trade or business" in section 907(c)(1)(B) and (2)(D) means property primarily used in one or more of the trades or businesses that are section 907(c) activities. For purposes of this paragraph (e), assets used in a trade or business are assets described in section 1231(b) (applied without regard to any holding period or the character of the asset as being subject to the allowance for depreciation under section 167).

(2) SECTION 907(c) ACTIVITIES. Section 907(c) activities are those described in section 907(c)(1)(A) (for FOGEI) or (c)(2)(A) through (C) (for FORI). If an asset is used primarily in one or more section 907(c) activities, then the entire gain (or loss) will be considered attributable to those activities. For example, if a person uses a service station primarily to distribute primary products from oil, then all of the gain (or loss) on the sale of the station is FORI even though the person uses the station to distribute products that are not primary products (such as tires or batteries). If an asset is not primarily used in one or more section 907(c) activities, then the entire gain or loss will not be FOGEI or FORI.

(3) STOCK. Stock of any corporation (whether foreign or domestic) will not be treated as an asset used by a person in section 907(c) activities.

(4) LOSSES ON SALE OF STOCK. If, under section 1.861-8(e)(7), a loss on the sale, exchange, or disposition of stock is considered a deduction which is definitely related and allocable to FOGEI or FORI, then notwithstanding section 1.861-8(e)(7) and paragraph (f)(2) of this section, this loss shall be allocated and apportioned to the same class of income that would have been produced if there were capital gain from the sale, exchange or disposition.

(5) CHARACTER OF GAIN OR LOSS. Except in the case of stock, gain or loss from the sale, exchange or disposition of assets used in the trade or business may be FORI or FOGEI to the extent taken into account in computing taxable income for the taxable year, whether or not the gain or loss is ordinary income or ordinary loss.

(6) ALLOCATION OF AMOUNT REALIZED. The amount realized from the sale, exchange or disposition of several assets in one transaction is allocated among them in proportion to their respective fair market values. This allocation is made under the principles set forth in section 1.1245-1(a)(5)(relating to allocation between section 1245 property and non-section 1245 property).

(7) INTEREST. Gross income from the sale, exchange or disposition of an asset used in a section 907(c) activity includes interest income from such a sale, exchange or disposition.

(f) TERMS AND ITEMS COMMON TO FORI AND FOGEI -- (1) MINERALS. The term "minerals" means hydrocarbon minerals extracted from oil and gas wells, including crude oil or natural gas (as defined in section 613A(e)). The term includes incidental impurities from these wells, such as sulphur, nitrogen, or helium. The term does not include hydrocarbon minerals derived from shale oil or tar sands.

(2) TAXABLE INCOME. Deductions to be taken into account in computing taxable income or net operating loss attributable to FOGEI or FORI are determined under the principles of section 1.861-8. For an exception with regard to losses, see paragraph (e)(4) of this section.

(3) INTEREST ON WORKING CAPITAL. FORI and FOGEI may include interest on bank deposits or on any other temporary investment which is not in excess of funds reasonably necessary to meet the working capital requirements and the specifically anticipated business needs of the person that is engaged in the conduct of the activities described in section 907(c)(1) or (2).

(4) EXCHANGE GAIN OR LOSS. Exchange gain (and loss) may be FORI and FOGEI. For taxable years beginning after 1986, exchange gain or loss from a section 988 transaction may be FORI or FOGEI only if directly related to the business needs (under the principles of section 954(c)(1)(D)) attributable to the conduct of the section 907(c) activity.

(5) ALLOCATION. Interest income and exchange gain (or loss) described, respectively, in paragraph (f)(3) and (4) of this section are allocated among FORI, FOGEI, and any other class of income relevant for purposes of the foreign tax credit limitations under any reasonable method which is consistently applied from year-to-year.

(6) FACTS AND CIRCUMSTANCES. Income not described elsewhere in this section may be FOGEI or FORI if, under the facts and circumstances in the particular case, the income is in substance directly attributable to the activities described in section 907(c)(1) or (2). For example, assume that a producer in the North Sea suffers a casualty caused by an explosion, fire, and resulting destruction of a drilling platform. Insurance proceeds received for the platform's destruction in excess of the producer's basis is extraction income if the excess constitutes income from sources outside the United States. In addition, income from an insurance policy for business interruption may be extraction income to the extent the payments under the policy are geared directly to the loss of income from production and are treated as income from sources outside the United States. Also, if an oil company's oil concession or assets used in extraction activities described in section 907(c)(1)(A) and located outside the United States are nationalized or expropriated by a foreign government, or instrumentality thereof, income derived from that nationalization or expropriation (including interest on the income paid pursuant to the nationalization or expropriation) is FOGEI. Likewise, if a company's assets used in the activities described in section 907(c)(2)(A) through (C) and located outside the United States are nationalized or expropriated by a foreign government, or instrumentality thereof, income (including interest on the income paid pursuant to the nationalization or expropriation) derived from the nationalization or expropriation will be FORI. Nationalization or expropriation is deemed to be a sale or exchange for purposes of section 907(c)(1)(B) and a disposition for purposes of section 907(c)(2)(D). In further example, assume that an oil company has an exclusive right to buy all the oil in country X from Y, an instrumentality of the foreign sovereign which owns all of the oil in X. The oil company does not have an economic interest in any oil in country X. Y has a temporary cash-flow problem and demands that the oil company make advance deposits for the purchase of oil not yet delivered. In return, Y grants the oil company a discount on the price of the oil when delivered. Income represented by the discount on the later disposition of the oil is FORI described in section 907(c)(2)(C). The result would be the same if Y credited the oil company with interest on the advance deposits, which had to be used to purchase oil (the interest income would be FORI).

(g) DIRECTLY RELATED INCOME -- (1) IN GENERAL. Section 907(c)(2)(E) and this paragraph (g) include in FORI, and this paragraph (g) includes in FOGEI, income from the performance of directly related services (as defined in paragraph (g)(2) of this section). This paragraph (g) also includes in FORI and FOGEI income from the lease or license of related property (as defined in paragraph (g)(3) of this section). Section 907(c)(2)(E) with regard to FORI and this paragraph (g) with regard to both FORI and FOGEI do not apply to a person if --

(i) Neither that person nor a related person (as defined in paragraph (g)(4) of this section) has FOGEI described in paragraph (b) of this section (other than paragraph (b)(4) of this section relating to directly related income) or FORI described in paragraph (d) of this section (other than paragraph (d)(7) of this section relating to directly related income), or

(ii) Less than 50 percent of that person's gross income from sources outside the United States which is related exclusively to the performance of services and from the lease or license of property described in paragraph (g)(2) and (3) of this section, respectively, is attributable to services performed for (or on behalf of), leases to, or licenses with, related persons, but

(iii) Paragraph (g)(1)(ii) of this section will not apply to a person if 50 percent or more of that person's total gross income from sources outside the United States is FOGEI and FORI (as both are described in paragraph (g)(1)(i) of this section).

A person described in paragraph (g)(1)(i) or (ii) of this section will, however, have directly related services income which is FOGEI if the income is so classified by reason of the income based on output test set forth in paragraph (g)(2)(i)(B) of this section.

(2) DIRECTLY RELATED SERVICES -- (i) FOGEI. (A) Income from directly related services will be FOGEI, as that term is defined in paragraph (b)(1) and (3) of this section, if those services are directly related to the active conduct of extraction (including exploration) of minerals from oil and gas wells. Paragraph (b)(1) of this section provides that, in order to have extraction income, a person must have an economic interest in the minerals in place. However, paragraph (b)(3) of this section recognizes that income arising from "other circumstances" is extraction income if that income is in substance attributable to the extraction of minerals.

(B) An example of "other circumstances" under paragraph (b)(3) of this section is the "income based on output test." This income based on output test provides that, if the amount of compensation paid or credited to a person for services is dependent on the amount of minerals discovered or extracted, the income of the person from the performance of the services will be directly related services income which is FOGEI. This test will apply whether or not the person performing the services has, or had, an economic interest in the minerals discovered or extracted.

(ii) FORI. With regard to the determination of directly related services income which is FORI, directly related services are those services directly related to the active conduct of the operations described in section 907(c)(2)(A) through (C). Those services include, for example, services performed in relation to the distribution of minerals or primary products or in connection with the operation of a refinery, or the types of services described in section 1.954-6(d) (other than section 1.954-6(d)(4)) which relate to foreign base company shipping income.

(iii) RECIPIENT OF THE SERVICES. Directly related services described in paragraph (g)(2)(i) and (ii) of this section may be performed for any person without regard to whether that person is a related person.

(iv) EXCLUDED SERVICES -- (A) FOGEI. Directly related services which produce FOGEI do not include insurance, accounting or managerial services.

(B) FORI. Directly related services which produce FORI do not, generally, include insurance, accounting or managerial services. These services will, however, produce FORI if they are performed by the person performing the operations described in section 907(c)(2)(A) through (C). For these purposes, insurance income which is FORI means taxable income as defined in section 832 (a).

(3) LEASES AND LICENSES. A lease or license of related property is the lease or license of assets used (or held for use) by the lessor, licensor, or another person (including the lessee or a sublessee) in the active conduct of the activities described in section 907(c)(1)(A) or (c)(2)(A) through (C). The leases or licenses described in this paragraph (g)(3) include, for example, a lease of a means of transportation under a bareboat charter hire, of drilling equipment used in extraction operations, or the license of a patent, know-how, or similar intangible property used in extracting, transporting, distributing or processing minerals or primary products. This paragraph (g)(3) applies without regard to whether the parties are related persons.

(4) RELATED PERSON. A person will be treated as a related person for purposes of this paragraph (g) if that person would be so treated within the meaning of section 954(d)(3)(as applied by substituting the word "corporation" for the word "controlled foreign corporation") or that person is a partnership or partner described in section 707(b)(1).

(5) GROSS INCOME. A foreign corporation shall be treated as a domestic corporation for the purpose of applying the gross-income rules in paragraph (g)(1)(ii) and (iii) of this section.

(h) COORDINATION WITH OTHER PROVISIONS -- (1) CERTAIN ADJUSTMENTS. The character of income as FOGEI or FORI is determined before making any adjustment under section 482 or section 907(d). For example, assume that X and Y are related parties, Y's only income is from the sale of oil that Y purchased from X, and FOGEI from X is diverted to Y through an arrangement described in paragraph (b)(3) of this section. Accordingly, Y has FOGEI. If under section 482 the Commissioner reallocates the FOGEI from Y to X, then Y's remaining income represents only a profit from distributing the oil, and thus is FORI. If the foreign taxes paid by Y on this income are otherwise creditable under section 901, the foreign taxes that are not refunded to Y retain their characterization as FOGEI taxes.

(2) SECTION 901(f). Section 901(f) (relating to certain payments with respect to oil and gas not considered as taxes) applies before section 907. Taxes disallowed by section 901(f) are added to the cost or inventory amount of oil or gas.

SECTION 1.907(c)-2 SECTION 907(c)(3) ITEMS (FOR TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1982).

(a) SCOPE. This section provides rules relating to certain items listed in section 907(c)(3). The rules of this section are expressed in terms of FORI but apply for determining FOGEI by substituting "FOGEI" for "FORI" whenever appropriate. FOGEI does not include interest described in section 907(c)(3)(A). Dividends paid prior to January 1, 1987, and described in section 907(c)(3)(B), as in effect prior to amendment by the Technical and Miscellaneous Revenue Act of 1988, are included in FORI and not FOGEI.

(b) DIVIDEND -- (1) SECTION 1248 DIVIDEND. A section 1248 dividend is a dividend described in section 907(c)(3)(A). Except as otherwise provided in this paragraph (b)(1) gain (or loss) from the disposition of stock in any corporation is not FOGEI or FORI. See section 1.907(c)-1(e)(3) and (4).

(2) SECTION 78 DIVIDEND. A section 78 dividend is FORI to the extent it arises from a dividend described in section 907(c)(3)(A), or an amount described in section 907(c)(3)(C).

(c) TAXES DEEMED PAID -- (1) VOTING STOCK TEST. Items described in section 907(c)(3)(A) or (C) are FORI only if a deemed-paid-tax test is met under the criteria of section 902 or 960. The purpose of this test is to require minimum direct or indirect ownership by a domestic corporation in the voting stock of a foreign corporation as a prerequisite for the item to qualify as FORI in the hands of the domestic corporation. The test is whether a domestic corporation would be deemed to pay any taxes of a foreign corporation when a dividend or an amount described in section 907(c)(3)(A) or (C), respectively, is included in the domestic corporation's gross income. In the case of interest described in section 907(c)(3)(A), the test is whether any taxes would be deemed paid if there were a hypothetical dividend.

(2) DIVIDENDS AND INTEREST. For purposes of section 907(c)(3)(A), a domestic corporation is deemed under section 902 to pay taxes in respect of dividends and interest received from a foreign corporation whether or not the foreign corporation:

(i) Actually pays or is deemed to pay taxes, or

(ii) In the case of interest, actually pays dividends.

This paragraph (c)(2) also applies to dividends received by a foreign corporation from a second-tier or third-tier foreign corporation (as defined in section 1.902-1(a)(3)(i) and (4), respectively). In the case of interest received by a foreign corporation from another foreign corporation, this paragraph (c)(2) applies if the taxes of both foreign corporations would be deemed paid under section 902(a) or (b) for purposes of applying section 902(a) to the same taxpayer which is a domestic corporation. In the case of interest received by any corporation (whether foreign or domestic), all members of an affiliated group filing a consolidated return will be treated as the same taxpayer under section 907(c)(3)(A) if the foreign taxes of the payor and (if the recipient is a foreign corporation) the foreign taxes of the recipient would be deemed paid under section 902 by at least one member. The term "member" is defined in section 1.1502-1(b). Thus, for example, assume that P owns all of the stock of D1 and D2 and P, D1, and D2 are members of an affiliated group filing a consolidated return. Assume further that D1 owns all of the stock of F1 and D2 owns all of the stock of F2, where F1 and F2 are foreign corporations. Interest paid by F1 to P, D2, or F2 may be FORI.

(3) AMOUNTS INCLUDED UNDER SECTION 951(a). For purposes of section 907(c)(3)(C), a domestic corporation is deemed under section 960 to pay taxes in respect of a foreign corporation, whether or not the foreign corporation actually pays taxes on the amounts included in gross income under section 951(a).

(D) AMOUNT ATTRIBUTABLE TO CERTAIN ITEMS -- (1) CERTAIN DIVIDENDS -- (i) GENERAL RULE. The portion of a dividend described in section 907(c)(3)(A) that is FORI equals --

 Amount of dividend x a/b

 Amount of dividend x a/b

(2) INTEREST RECEIVED FROM CERTAIN FOREIGN CORPORATIONS. Interest described in section 907(c)(3)(A) is FORI to the extent the corresponding interest expense of the paying corporation is properly allocable and apportionable to the gross income of the paying corporation that would be FORI were that corporation a domestic corporation. This allocation and apportionment is made in a manner consistent with the rules of section 954(b)(5) and section 1.861-8(e)(2).

(3) DIVIDENDS FROM DOMESTIC CORPORATION. The amount of a dividend from a corporation described in section 907(c)(3)(B), as in effect prior to amendment by the Technical and Miscellaneous Revenue Act of 1988, paid in a taxable year of that corporation beginning before December 31, 1986, that is FORI is determined under the principles of paragraph (d)(1)(i) of this section with respect to its current earnings and profits under section 316(a)(2) or its accumulated earnings and profits under section 316(a)(1), as the case may be.

(4) AMOUNTS WITH RESPECT TO WHICH TAXES ARE DEEMED PAID UNDER SECTION 960(A) -- (i) PORTION ATTRIBUTABLE TO FORI. The portion of an amount described in section 907(c)(3)(C) that is FORI equals:

 A x B/C

(ii) EARNINGS AND PROFITS. Total earnings and profits are those of the foreign corporation for a taxable year under section 964 and the regulations under that section.

(5) SECTION 78 DIVIDEND. The portion of a section 78 dividend that will be considered FORI will equal the amount of taxes deemed paid under either section 902(a) or section 960(a)(1) with respect to the dividend to the extent the taxes deemed paid are FORI taxes under section 1.907(c)-3(b) or (c). See section 1.907(c)-3(a)(1).

(6) SPECIAL RULE. (i) No item in the formula described in paragraph (d)(1)(i) of this section includes amounts excluded from the gross income of a United States shareholder under section 959(a)(1).

(ii) With respect to a foreign corporation, earnings and profits in the formula described in paragraph (d)(4)(i) of this section do not include amounts excluded under section 959(b) from its gross income.

(7) DEFICITS -- (i) ALLOCATION OF DEFICITS WITHIN A SEPARATE CATEGORY. In a taxable year in which a foreign corporation described in section 907(c)(3)(A) pays a dividend or has income that is subject to inclusion under section 951, if the foreign corporation has positive post-1986 undistributed earnings in a separate category but within that separate category there is a deficit in post-1986 undistributed earnings attributable to earnings other than FOGEI and FORI, that deficit shall be allocated ratably between the FOGEI and FORI post-1986 undistributed earnings within that separate category. Any deficit in post-1986 undistributed earnings attributable to either FOGEI or FORI shall be allocated first to FOGEI or FORI post- 1986 undistributed earnings (as the case may be) to the extent thereof. Post-1986 undistributed FORI earnings are the post-1986 undistributed earnings (as defined in section 902 and the regulations under that section) attributable to FORI as defined in section 907(c)(2) and (3). Post-1986 undistributed FOGEI earnings are the post-1986 undistributed earnings (as defined in section 902 and the regulations under that section) attributable to FOGEI as defined in section 907(c)(1) and (3).

EXAMPLE. Foreign corporation X for years 1987 and 1988 had the following undistributed earnings (none of which is income that is subject to inclusion under section 951) and foreign taxes:

                              Earnings      Taxes

(ii) DEFICITS ALLOCATED AMONG SEPARATE CATEGORIES. If a deficit in a separate category ("first separate category") is allocated to another separate category ("second separate category") under sections 902 and 960 pursuant to Notice 88-71, 1988-2 CB 374 and the regulations under those sections, the following rules shall apply. Any deficit in post-1986 undistributed earnings attributable to either FOGEI (or FORI) from the first separate category shall be allocated to post-1986 undistributed earnings in the second separate category to the extent thereof in the following order:

(A) FOGEI (or FORI),

(B) FORI (or FOGEI), and

(C) Other income.

Any deficit in post-1986 undistributed earnings attributable to other income from the first separate category shall be allocated first to other post-1986 undistributed earnings and then ratably to FOGEI and FORI post-1986 undistributed earnings in the second separate category.

(iii) PRE-1987 DEFICITS. The amount of a dividend paid by a foreign corporation described in section 907(c)(3)(A) out of positive pre-1987 earnings that is attributable to FOGEI and FORI shall be determined in a manner similar to that used in paragraph (d)(7)(i) and (ii) of this section except that the determinations shall be made on an annual basis.

(8) ILLUSTRATIONS. The application of this paragraph (d) is illustrated by the following examples.

EXAMPLE 1. X, a domestic corporation, owns all of the stock of Y, a foreign corporation organized in country S. Y owns all of the stock of Z, a foreign corporation also organized in country S. Each corporation uses the calendar year as its taxable year. In 1983, Z has $150 of FOGEI earnings and profits and $250 of earnings and profits other than FOGEI or FORI. Assume that Z paid no taxes to S and X must include $100 in its gross income under section 951(a) with respect to Z. Under paragraph (d)(4)(i) of this section, $37.50 of the amount described in section 951(a) is FOGEI ($100 x $150/$400). The remaining $62.50 of the section 951(a) amount represents other income.

EXAMPLE 2. Assume the same facts as in Example 1 except that the taxable year in question is 1988. In addition, under the facts and circumstances, it is determined that of the $100 section 951(a) amount included in X's gross income, $30 is directly attributable to Z's FOGEI activity, $60 is directly attributable to Z's FORI activity and $10 is directly attributable to Z's other activity. Accordingly, under paragraph (d)(4)(i), $30 will be FOGEI and $60 will be FORI to X.

EXAMPLE 3. (i) Assume the same facts as in EXAMPLE 1. Assume further that, in 1983, Z distributes its entire earnings and profits ($400) to Y, which consists of a dividend of $300 and a section 959(a)(1) distribution of $100. Y has no other earnings and profits during 1983. Assume that the dividend and distribution are not foreign personal holding company income under section 954(c). Y pays no taxes to S. In 1983, Y distributes its entire earnings and profits to X.

(ii) Under paragraphs (c)(2) and (d)(1)(i) of this section, Y has FOGEI of $112.50, i.e., the amount of the dividend received by Y ($300) multiplied by the fraction described in paragraph (d)(1)(i). The numerator of the fraction is Z's FOGEI accumulated profits in excess of the FOGEI taxes paid ($112.50) and the denominator is Z's total accumulated profits in excess of total foreign taxes paid ($400) minus the amount excluded from Y's gross income under section 959(a)(1)($100). The rule of paragraph (d)(6)(ii) of this section does not apply since X does not include any amount in its gross income under section 951(a) with respect to Y. If Y paid taxes to S, this paragraph (d) would apply to characterize those taxes as FOGEI taxes or other taxes. See section 1.907(c)-3(a)(8) and EXAMPLE 2 (iii) under section 1.907(c)-3(e).

(iii) The distribution from Y to X is a dividend to the extent of $300, i.e., the amount of the distribution ($400) minus the amount excluded from X's gross income under section 959(a)(1) ($100). Under paragraph (d)(1)(i) and (6)(i) of this section, $112.50 of the dividend is FOGEI, i.e., the amount of the dividend ($300) multiplied by a fraction. The numerator of the fraction is $112.50, i.e., the FOGEI accumulated profits of Y in excess of FOGEI taxes paid ($150) minus the FOGEI accumulated profits of Y in excess of FOGEI taxes paid excluded from X's gross income under section 959(a)(1) ($37.50). The denominator of the fraction is $300, i.e., the total accumulated profits of Y in excess of taxes paid ($400) minus the amount excluded from X's gross income under section 959(a)(1) ($100).

EXAMPLE 4. Assume the same facts as in Example 1 with the following modifications: In 1983, Z's only earnings and profits are FORI earnings and profits which are included in X's gross income under section 951(a). Z distributes its entire earnings and profits to Y. In 1983, Y has total earnings and profits of $100 without regard to the dividend from Z, $60 of which are FORI earnings and profits. Y also has $40 which is included in X's gross income under section 951(a). Under paragraph (d)(6)(ii) of this section, the dividend from Z is disregarded for purposes of applying paragraph (d)(4)(i) of this section to the $40 included in X's gross income under section 951(a) with respect to Y. Accordingly, $24 of the amount described in section 951(a) is FORI ($40 x $60/$100). Had these circumstances existed in 1988, and if the $40 included in X's gross income under section 951(a) was directly attributable to FORI activity, all of that income would be FORI to X.

(e) DIVIDENDS, INTEREST, AND OTHER AMOUNTS FROM SOURCES WITHIN A POSSESSION. FORI includes the items listed in section 907(c)(3)(A) and (C) to the extent attributable to FORI of a corporation that is created or organized in or under the laws of a possession of the United States.

(f) INCOME FROM PARTNERSHIPS, TRUSTS, ETC. FORI and FOGEI include a person's distributive share (determined under the principles of section 704) of the income of any partnership and amounts included in income under subchapter J of chapter 1 of the Code (relating to the taxation of trusts, estates, and beneficiaries) to the extent the income and amounts are attributable to FORI and FOGEI. For taxable years beginning after 1986, the principles of section 1.904-5(h) and (i) shall be applied to determine whether (and to what extent) a person's distributive share is FORI and FOGEI. Thus, for example, a less-than-10 percent corporate partner's share of income of the partnership would generally be treated as passive income to the partner, and not as FORI or FOGEI, unless an exception under section 1.904-5(h) and (i) applies.

SECTION 1.907(c)-3 FOGEI AND FORI TAXES (FOR TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1982).

(a) TAX CHARACTERIZATION, ALLOCATION AND APPORTIONMENT -- (1) SCOPE. Paragraph (a)(2) through (6) of this section provides rules for the characterization, allocation, and apportionment of the income taxes (other than withholding taxes) paid or accrued to a foreign country among FOGEI, FORI, and other income relevant for purposes of sections 907 and 904. Some of the rules in this section are expressed in terms of FOGEI taxes but they apply to FORI taxes by substituting "FORI taxes" for "FOGEI taxes" whenever appropriate. For the treatment of withholding taxes, see paragraph (a)(8) of this section. FOGEI taxes are determined without any reduction under section 907(a). In addition, determination of FOGEI taxes will not be affected by recharacterization of FOGEI by section 907(c)(4). See section 1.907(c)-1(c)(5). Foreign taxes will not be characterized as creditable FORI taxes if section 907(b) and section 1.907(b)-1 apply.

(2) THREE CLASSES OF INCOME. There are three classes of income: FOGEI, FORI, and other income.

(3) MORE THAN ONE CLASS IN A FOREIGN TAX BASE. If more than one class of income is taxed under one tax base under the law of a foreign country, the amount of pre-credit foreign tax for each base must be determined. This amount is the foreign taxes paid or accrued to that country for the base as increased by the tax credits (if any) which reduced those taxes and were allowed in the country for that tax. More than one class of income is taxed under the same base, if, under a foreign country's law, deductions from one class of income may reduce the income of any other class and the classes are subject to foreign tax at the same rates.

(4) ALLOCATION OF TAX WITHIN A BASE. If more than one class of income is taxed under the same base under a foreign country's law, the pre-credit foreign tax for the base is apportioned to each class of income in proportion to the income of each class. Tax credits are then allocated (under paragraph (a)(6) of this section) to the apportioned pre-credit tax. Income of a class is the excess of modified gross income for a class over the deductions allowed under foreign law for, and which are attributable to, that class.

(5) MODIFIED GROSS INCOME. Modified gross income is not necessarily the same as gross income as defined for purposes of chapter 1 of the Internal Revenue Code. Modified gross income is determined with reference to the foreign tax base for gross income (or its equivalent). However, the characterization of the base as a particular class of income is governed by general principles of U.S. tax law. Thus, for example --

(i) Gross income from extraction is the fair market value of oil or gas in the immediate vicinity of the well (as determined under section 1.907(c)-1(b)(6) (without any deductions)).

(ii) Whether cost of goods sold (or any other deduction) is a deduction from modified gross income and the amount of such a deduction is determined under foreign law.

(iii) Modified gross income includes items that are part of the foreign tax base even though they are not gross income under U.S. law so long as the foreign taxes paid on the base constitute creditable taxes under section 901 (including taxes described in section 903). For example, if a foreign country imposes a tax (creditable under section 901) on a tax base that includes in small part a percentage of the value of a company's oil reserves in place, modified gross income from extraction includes such a percentage of value solely for purposes of making the tax allocation in paragraph (a)(4) of this section.

(iv) Modified gross income from extraction is increased for purposes of this paragraph (a)(5) by the entire excess of the posted price over fair market value if the foreign country uses a posted price system or other pricing arrangement described in section 907(d) in imposing its income tax.

(v) Modified gross income from FORI is that income attributable to the activities in section 907(c)(2)(A) through (C) and (E).

(vi) Modified gross income for any class may not include gross income that is not subject to taxation by the foreign country.

(6) ALLOCATION OF TAX CREDITS. The foreign taxes paid or accrued on a particular class of income equals the precredit tax on the class reduced (but not below zero) by the credits allowed under foreign law against the foreign tax on the particular class. Any tax credit attributable to a class that is not allocated to that class is allocated to the other class in the base or, if there are three classes in the base, is apportioned ratably among the taxes paid or accrued on the other two classes (as reduced in accordance with the preceding sentence).

(7) WITHHOLDING TAXES. Paragraph (a)(2) through (6) of this section does not apply to withholding taxes imposed by a foreign country. FOGEI taxes may include withholding taxes imposed with respect to a distribution from a corporation. The portion of the total withholding taxes on a distribution that constitutes FOGEI taxes is determined by the portion of the distribution that is FOGEI. In addition, FOGEI taxes may include taxes imposed on a distribution described in section 959(a)(1) or on amounts described in section 959(b). The portion of the total withholding taxes imposed on a distribution described in section 959(a)(1) or on amounts described in section 959(b) is determined by reference to the portion of the amount included in gross income under section 951(a) that was FOGEI.

(b) DIVIDENDS -- (1) IN GENERAL -- (i) FOGEI taxes deemed paid with respect to a dividend equal the total taxes deemed paid with respect to the dividend multiplied by the fraction:

 FOGEI taxes paid or accrued by the payor/

 Post-1986 FOGEI taxes as determined under the principles of

(A) For FOGEI taxes paid on FOGEI accumulated profits and total taxes paid on accumulated profits that arose in taxable years beginning before January 1, 1987, to which paragraph (b)(1)(i) of this section applies, and

(B) For FOGEI taxes paid on FOGEI accumulated profits and total taxes paid on accumulated profits that arose in taxable years beginning after December 31, 1986, to which paragraph (b)(1)(ii) of this section applies.

For purposes of these determinations, dividends are deemed to be paid first out of FOGEI and total accumulated profits that arose in taxable years beginning after December 31, 1986. See section 1.907(c)-2(d)(1)(i). See section 960(a)(3) and section 1.960-2 relating to distributions that are treated as dividends for purposes of section 902.

(2) SECTION 78 DIVIDEND. There are no FOGEI taxes with respect to section 78 dividends.

(c) INCLUDABLE AMOUNTS UNDER SECTION 951(a). (1) FOGEI taxes deemed paid with respect to an amount includable in gross income under section 951(a) equal the total taxes deemed paid with respect to that amount multiplied by the fraction:

 FOGEI taxes paid or accrued by the foreign

 Post-1986 FOGEI taxes as determined under the principles of

(d) PARTNERSHIPS. A partner's distributive share of the partnership's FOGEI taxes is determined under the principles of section 704.

(e) ILLUSTRATIONS. The application of this section may be illustrated by the following examples.

EXAMPLE 1. X, a domestic corporation, owns all of the stock of Y, a foreign corporation organized in country S. Y owns all of the stock of Z, a foreign corporation organized in country T. Each corporation used the calendar year as its taxable year. In 1983, X includes in its gross income an amount described in section 951(a) with respect to Z. Assume that the taxes deemed paid under section 902(a) by X by reason of such an inclusion is $70. Assume further that Z paid total taxes of $120, $80 of which is FOGEI tax. Under paragraph (c) of this section, the FOGEI tax deemed paid is $46.67 (i.e., $70 x $80/$120). This $46.57 is also FOGEI under section 1.907(c)-2(d)(5) because it must be included in X's gross income under section 78.

EXAMPLE 2. (i) Assume the same facts as in Example 1. Assume further that in 1983, Z distributes its entire earnings and profits to Y. Y has no earnings and profits during 1983 other than this dividend. y paid a tax of $50 to S. Assume that Y is deemed under section 902(b)(1) to pay $50 of the tax paid by Z which was not deemed paid by X under section 960(a)(1) in 1983. In 1983, Y distributes its entire earnings and profits to X. Assume that X is deemed under section 902(a) to pay $100 of the taxes actually paid, and deemed paid, by Y.

(ii) Paragraph (b)(1) of this section applies to characterize the $50 tax of Z that Y is deemed to pay under section 902(b)(1). Y is deemed to pay $33.33 of FOGEI tax, i.e., the amount of the tax deemed paid by Y ($50) multiplied by a fraction. The numerator of the fraction is the amount of Z's FOGEI tax ($80) and the denominator is the total taxes paid by Z ($120).

(iii) Under paragraph (a)(8) of this section, a portion of the $50 tax actually paid by Y on the earnings and profits received from Z is FOGEI tax. The amount of tax actually paid by Y that is FOGEI tax depends on the amount of the distribution from Z that is FOGEI (see section 1.907(c)-2(d)(1)(i) and Example (ii) under section 1.907(c)-2(d)(8)). This result does not depend upon whether a portion of the distribution from Z is described in section 959(b) and it follows even though a portion of Y's earnings and profits will be excluded from X's gross income under section 959(a)(1) when distributed by Y. Assume that $12.50 of the $50 tax actually paid by Y is FOGEI tax.

(iv) Under paragraph (b)(1) of this section, X is deemed to pay $45.83 of FOGEI tax by reason of the distribution from Y. This amount is determined by multiplying the total taxes deemed paid by X by reason of such distribution ($100) by a fraction. The numerator of the fraction is the FOGEI tax paid, and deemed paid, by Y ($45.83, i.e., $33.33 under paragraph (2)(ii) of this example plus $12.50 under paragraph (2)(iii) of this example). The denominator of the fraction is the total taxes paid, and deemed paid, by Y ($100). This $45.83 is FOGEI under section 1.907(c)-2(d)(5) because it is included in X's gross income as a section 78 dividend.

EXAMPLE 3. (i) X, a domestic corporation, has a concession with foreign country y that gives it the exclusive right to extract and export the crude oil and natural gas owned by Y. The concession agreement and location of the oil and gas wells mandate that X construct a system of pipelines to transport the minerals that are extracted to a port where they are loaded onto tankers for export. X owns the transportation facilities. Y has an income tax system under which income from mineral operations is subject to a 50 percent tax rate. The taxation by Y of the mineral operations is a separate tax base under paragraph (a)(3) of this section. Under this system, Y imposes the tax at the port prior to export and it establishes a posted price of $12 per barrel. Y also collects royalties of $1.44 per barrel (i.e., 12 percent of this posted price) which is deductible in computing the petroleum tax. Y also allows X deductible lifting costs of $.20 per barrel and deductible transporting costs of $.80 per barrel. Y does not allow any credits against the mineral tax. Assume that X does not have any income in Y other than the mineral income. (In 1983, X extracts, transports, and exports 10,000,000 barrels of crude oil, but for convenience, all computations are in terms of one barrel). X pays foreign taxes of $4.78 per barrel, computed as follows:

 Sales                               $12.00

(ii) The $4.78 foreign tax paid to Y is allocated to FOGEI and FORI in accordance with the rules in paragraph (a) (2) through (5) of this section.

(iii) Under paragraph (a)(3) of this section, FOGEI and FORI are subject to foreign taxation under one tax base. This foreign tax is allocated between FOGEI tax and FORI tax in accordance with paragraph (a)(4) and (5) of this section.

(iv) The modified gross income for FOGEI is $11, i.e., fair market value in the immediate vicinity of the well ($9) plus the excess at the port of posted price over fair market value ($2). The modified gross income for FORI is $1, i.e., value added to the oil beyond the wellhead which is part of Y's tax base ($10- $9).

(v) The royalty deductions are all directly attributable to FOGEI.

(vi) Under paragraph (a)(4) of this section, the income of each class is determined as follows:

                             FOGEI          FORI

 FOGEI tax = $4.78 x $9.36/$9.56 = $4.68

(viii) The allocation under paragraph (a)(4) of this section, rather than the direct application of stated foreign tax rates to foreign-law taxable income in each class of income (which would produce the same results in the facts of this example), is necessary when a foreign country taxes more than one class of income under a progressive rate structure. See Example 4 in this paragraph (e).

EXAMPLE 4. Assume the same facts as in Example 3 except that Y's tax is imposed at 40 percent for the first $20,000,000 of income and at 60 percent for all other income. The foreign taxes are allocated under paragraph (a)(4) of this section between FOGEI and FORI in the same manner as in paragraphs (vi) and (vii) of Example 8, as follows:

 (1) Taxable income                           $95,600,000

SECTION 1.907(d)-1 DISREGARD OF POSTED PRICES FOR PURPOSES OF CHAPTER 1 OF THE CODE (FOR TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1982).

(a) IN GENERAL -- (1) SCOPE. Section 907(d) applies if a person has FOGEI from the --

(i) Acquisition (other than from a foreign government) or

(ii) Disposition of minerals at a posted price that differs from the fair market value at the time of the transaction. Also, if a seller (other than a foreign government) derives FOGEI upon a disposition described in the preceding sentence, section 907(d) applies to the acquisition by the purchaser whether or not the purchaser has FOGEI. Thus, section 907(d) may apply in determining a person's FORI.

(2) INITIAL COMPUTATION REQUIREMENT. If section 907(d) applies to any person, income on the transaction as initially reflected on the person's return shall be computed as if the transaction were effected at fair market value. This requirement applies the first time a person has taxable income derived from either the transaction or an item (such as a dividend described in section 907(c)(3)(A)) determined with reference to that income.

(3) BURDEN OF PROOF. The taxpayer must be able to demonstrate the transaction as it actually occurred and the basis for reporting the transaction under the principles of paragraph (a) (2) of this section.

(4) RELATED PARTIES. Section 907(d) (as a rule of characterization) applies whether or not the parties to the transaction are related. Thus, the excess of the posted price over the fair market value may never be taken into account in determining a person's FOGEI under section 907(a) but may be taken into account in determining a person's FORI.

(b) ADJUSTMENTS. If a taxpayer does not comply with the initial requirement of paragraph (a)(2) of this section, adjustments under section 907(d) may be made only by the Commissioner in the same manner that section 482 is administered. Correlative and similar adjustments consistent with the substantive and procedural principles of section 482 and section 1.482-1(d) apply. However, section 907(d) is not a limitation on section 482. If a taxpayer disposing of minerals at a posted price does comply with the initial computation requirement of this section, adjustments and correlative and similar adjustments consistent with the substantive and procedural aspects of section 482 and section 1.482-1(d) shall apply, whether made on the return by the taxpayer or on a later audit. This paragraph (b) does not apply to an actual sale or exchange of minerals made between persons with respect to whom adjustments under section 482 would never apply (but see paragraph (a)(4) of this section).

(c) DEFINITIONS. For purposes of this section --

(1) FOREIGN GOVERNMENT. The term "foreign government" means only the integral parts or controlled entities of a foreign sovereign and political subdivisions of a foreign country.

(2) MINERALS. The term "minerals" has the same meaning as in section 1.907(c)-1(f)(1).

(3) POSTED PRICE. The term "posted price" means the price set by, or at the direction of, a foreign government to calculate income for purposes of its tax or at which minerals must be sold.

(4) OTHER PRICING ARRANGEMENT. The term "other pricing arrangement" in section 907(d) means a pricing arrangement having the effect of a posted price.

(5) FAIR MARKET VALUE. The term "fair market value," whether or not at the port prior to export, is determined in the same way that the wellhead price is determined under section 1.907(c)-1(b)(6).

SECTION 1.907(e)-1 TRANSITIONAL RULES (FOR AMOUNTS CARRIED BETWEEN A TAXABLE YEAR BEGINNING BEFORE JANUARY 1, 1983, AND A TAXABLE YEAR BEGINNING AFTER DECEMBER 31, 1982).

(a) GENERAL RULE. Section 907(e)(1) provides rules for carryovers of FOGEI and FORI taxes from taxable years beginning before January 1, 1983 (the general effective date of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)), to taxable years beginning after December 31, 1982. Section 907(e)(2) provides for carrybacks of those taxes from taxable years beginning after December 31, 1982, to taxable years beginning before January 1, 1983. Both the carryover and carryback amounts shall not exceed the lesser of the amount deemed paid or accrued which would have been deemed paid or accrued under the carryback and carryover rules of section 907(f) and section 1.907(f)-1 (covering carryback and carryover of taxes that both begin after December 31, 1982) or the amount which would have been deemed paid or accrued if --

(1) Pre-TEFRA section 907(b) (which provided for a separate section 904 limitation for FORI taxes),

(2) Pre-TEFRA section 907(f) (which limited the carryback and carryover of FOGEI taxes to 2% of FOGEI for the year of origin), and

(3) Pre-TEFRA section 904(f)(4) (which dealt with the determination of foreign oil related loss if section 907 applied)

had remained in effect for taxable years beginning after December 31, 1982.

(b) RULES FOR CARRYOVER OF FORI AND PRE-TEFRA NON-FORI TAXES -- (1) Under this section, in general --

(i) The amount of unused pre-TEFRA FORI taxes that may be carried forward to any carryover year may not exceed the excess section 907(b) limitation, as in effect prior to the general effective date of TEFRA, for that carryover year;

(ii) The amount of unused pre-TEFRA, non-FORI taxes that may be carried forward to any carryover year may not exceed the excess section 904(d) general limitation, as in effect before the general effective date of TEFRA for that carryover year; and

(iii) The total of the amounts carried forward under paragraph (b)(1)(i) and (ii) of this section to any carryover year may not exceed the excess section 904(d) general limitation, as in effect after the general effective date of TEFRA, for that carryover year.

(2) The amount of unused pre-TEFRA FORI taxes that may be carried forward to any succeeding carryover year is the total of those taxes, less the amount of those taxes deemed accrued in the carryover year after reduction in accordance with paragraph (b)(1)(i) of this section (if applicable).

(3) The amount of unused pre-TEFRA, non-FORI taxes that may be carried forward to any succeeding carryover year is the total of those taxes, less the amount of those taxes deemed accrued in the carryover year after reduction in accordance with paragraph (b)(1)(ii) of this section (if applicable).

(c) EXAMPLES. The provisions of section 907(e)(1) may be illustrated by the following examples. For purposes of these examples, assume the following:

(1) The corporation's preliminary U.S. tax liability is computed at an effective rate of 46%;

(2) A term modified by "old" refers to the meaning the term had prior to the general effective date of TEFRA;

(3) The only foreign source income which the corporation had prior to 1983 is old FORI (which included FOGEI and other FORI) and old section 904(d)(1)(C) income (i.e., income other than interest, DISC dividends and FORI); and

(4) The only foreign source income the corporation had during 1983 and 1984 was section 904(d)(1)(C) income (i.e., income other than interest and DISC dividends) as applicable during those years.

EXAMPLE 1 -- (i) FACTS. (A) X, a calendar year U.S. corporation organized on January 1, 1982, uses the accrual method of accounting. For 1982, X had the following relevant tax items:

                                    1982

                               TABLE I

                                TABLE II

(B) UNUSED FORI TAXES. X has $63 of unused old section 907(b) limitation FORI taxes available for carryover from 1982. Pursuant to section 907(e)(1), the amount of unused FORI taxes that may be carried over from 1982 to 1983 may not exceed the excess old section 907(b) limitation for 1983. Since the excess 1983 old section 907(b) limitation is $44 (Table II, 1983, line (o)), only that amount of the $63 of total unused 1982 FORI taxes (not including unused FOGEI taxes) may be carried over and deemed accrued in 1983. Therefore, X has unused 1982 old section 907(b) limitation FORI taxes (not including unused FOGEI taxes) in the amount of $19 ($63 less $44) available for carryover to 1984.

(C) UNUSED OTHER FOREIGN TAXES. X has $20 of unused old section 904(d)(1)(C) taxes available for carryover from 1982. However, only $6 may be deemed accrued in 1983 since for 1983 the excess old section 904(d)(1)(C) limitation was only $6 (Table II, 1983, line (p)). Therefore, X has unused 1982 old section 904(d)(1)(C) taxes in the amount of $14 ($20 less $6) available for carryover to 1984.

(iii) CARRYOVER FROM 1982 TO 1984 -- (A) UNUSED FOGEI TAXES. The unused FOGEI tax carryover from 1982 of $10 will be deemed accrued in 1984 since the limitations of both old and new section 907(f)(2) do not limit the deemed accrual. The $10 amount is not as great as the lesser of the excess extraction limitation under new section 907(f)(2)(A), $52 (Table I, 1984, line (1)) and the excess overall limitation under new section 907(f)(2)(B), $235 (Table I, 1984, line (m)). Likewise, the $10 amount is not as great as the lesser of the excess extraction limitation under old section 907(f)(2)(A), $52 (Table II, 1984, line (n)) and the excess oil related limitation under old section 907(f)(2)(B), $151 (Table II, 1984, line (o)).

(B) UNUSED FORI TAXES. The $29 of 1982 unused old section 907 (b) limitation FORI taxes (including $10 of unused FOGEI taxes) are deemed accrued in 1984 since they do not exceed the excess old section 907(b) limitation for 1984, $151 (Table II, 1984, line (o)).

(C) UNUSED OTHER FOREIGN TAXES. X's $14 of unused 1982 old section 904(d)(1)(C) taxes are deemed accrued in 1984 since they do not exceed the old section 904(d)(1)(C) limitation, $84 (Table II, 1984, line (p)).

EXAMPLE 2 -- (i) FACTS. Assume the same facts as in EXAMPLE 1 except that X's other foreign taxable income for 1983, line (c) in both tables in EXAMPLE 1, is $46. It is assumed that total taxable income remains the same as in EXAMPLE 1.

(ii) CARRYOVER FROM 1982 TO 1983 -- (A) UNUSED FOGEI TAXES. Same result as in EXAMPLE (1). None of the $10 of unused FOGEI taxes carried over from 1982 may be deemed accrued in 1983.

(B) UNUSED FORI AND OTHER FOREIGN TAXES. The old excess section 907(b) limitation for 1983 remains at $44 (Table II, 1983, line (o)). There is, however, no old excess section 904(d)(1)(C) limitation for 1983 (Table II, 1983, line (p)). The tentative carryovers are therefore $44 of FORI taxes and $0 of section 904(d)(1)(C) taxes. In addition, the excess section 904(d) overall limitation (Table I, 1983, line (m)) is now only $15. Accordingly, under paragraph (b)(1)(D) of this section, the maximum amount of FORI taxes and old section 904(d)(1)(C) taxes that may be carried forward to 1983 is $15. Therefore, $15 of the $63 of total unused 1982 FORI taxes (not including unused FOGEI taxes) may be carried over from 1982 and deemed accrued in 1983. X has unused 1982 old section 907(b) limitation FORI taxes (not including unused FOGEI taxes) in the amount of $48 available for carryover to 1984. X need not reduce the unused 1982 FORI taxes by the amount ($44) which would have been deemed accrued had the old excess section 907(b) limitation applied.

EXAMPLE 3 -- (i) FACTS. (A) Y, a U.S. corporation organized on January 1, 1982, uses the accrual method of accounting and the calendar year as its taxable year. For 1982, Y had the following tax items:

                               TABLE I

                              TABLE III

(B) UNUSED FORI TAXES. For 1982, Y has no unused old FORI taxes (Table I, 1982, line (o)) since the old FORI section 907(b) limitation, $529 (Table I, 1982, line (1)) exceeds old FORI taxes for 1982, $430 (Table I, 1982, line (i)).

(C) UNUSED OTHER FOREIGN TAXES. For 1982, Y has $78 of unused old section 904(d)(1)(C) taxes (Table I, 1982, line (p)). The unused old section 904(d)(1)(C) taxes from 1982 are deemed accrued in 1983 only to the extent of the excess old section 904(d)(1)(C) limitation for 1983, $32 (Table III, 1983, line (p)). Thus, $32 of the unused old section 904(d)(1)(C) taxes for 1982 are deemed accrued in 1983 and $46 are available for carryover to 1984.

(iii) CARRYBACK OF UNUSED FOGEI TAXES FROM 1984 TO 1982. Y has $198 of unused FOGEI taxes for 1984 (Table II, 1984, line (1)). These taxes are deemed accrued in 1982 only to the extent they would have been deemed accrued in 1982 had old section 907(f) remained in effect for 1984. Under old section 907(f), Y's carryback of unused FOGEI taxes would have been limited to $24, 2% of its FOGEI for 1984. All of the $24 is deemed accrued in 1982 because Y's excess section 907(a) limitation for 1982 is $114 (Table I, line (n)) and its excess old FORI section 907(b) limitation for 1982 is $99 (Table I, line (o)).

(iv) CARRYBACK OF UNUSED SECTION 904(d)(1)(C) TAXES FROM 1984 TO 1982. Y has $104 of unused section 904(d)(1)(C) taxes for 1984 (Table II, 1984, line (m)). Those taxes may be carried from 1984 to 1982 but only to the extent of the amount of unused old FORI taxes and unused old section 904(d)(1)(C) taxes from 1984 that would have been deemed accrued in 1982 had old sections 907(b) and (f) and 904(f)(4) remained in effect for 1984. The amount of unused old FORI taxes from 1984, $83 (Table III, 1984, line (o)), that would have been deemed accrued in 1982 is $75, the excess old FORI section 907(b) limitation for 1982, $99 (Table I, line (o)) less $24 of carryback of unused FOGEI taxes from paragraph (iii) of this example. Unused FOGEI taxes carried back to an excess limitation year are applied before unused other old FORI taxes. See section 1.907(b)- 2A(d)(1)(ii). Although Y has $21 of unused old section 904(d)(1)(C) taxes for 1984 (Table III, 1984, line (p)) none are deemed accrued in 1982 because there is no excess old section 904(d)(1)(C) limitation for 1982 (Table I, line (p)). Thus, only $75 of the $104 of unused section 904(d)(1)(C) taxes from 1984 are deemed accrued in 1982.

EXAMPLE 4 -- (i) FACTS. (A) X, a calendar year U.S. corporation, was organized on January 1, 1982. On that same day, X and Y, an unrelated foreign corporation, organized Z, a calendar year corporation, in country A. X and Y each received 50% of the stock of Z. During 1982, Z earned $1,000 of FOGEI and $800 of FORI. Z paid to A as taxes, $460 on its FOGEI and $400 on its FORI. During 1983, Z earned $1,000 of FOGEI and paid taxes of $460 on that income. Z did not earn any FORI in 1983. On December 31, 1983, X made a pro rata distribution of all of its accumulated earnings and profits ($1,480) to X and Y. X received a dividend from Z in the amount of $740 plus a section 78 dividend amount of $660.

(B) X's tax items for 1983 under the Code provisions applicable to those years were as follows:

                            TABLE I

                           TABLE II

SECTION 1.907(f)-1 CARRYBACK AND CARRYOVER OF CREDITS DISALLOWED BY SECTION 907(a) (FOR AMOUNTS CARRIED BETWEEN TAXABLE YEARS THAT EACH BEGIN AFTER DECEMBER 31, 1982).

(a) IN GENERAL. If a taxpayer chooses the benefits of section 901, any unused FOGEI tax paid or accrued in a taxable year beginning after December 31, 1982, may be carried to the taxable years specified in section 907(f) under the carryback and carryover principles of this section and section 1.904-2(b). See section 907(e) and section 1.907(e)-1 for transitional rules that apply to unused FOGEI taxes carried back or forward between a taxable year beginning before January 1, 1983, and a taxable year beginning after December 31, 1982.

(b) UNUSED FOGEI TAX -- (1) IN GENERAL. The "unused FOGEI tax" for purposes of this section is the excess of the FOGEI taxes for a taxable year (year of origin) over that year's limitation level (as defined in section 1.907(a)-1(b)).

(2) YEAR OF ORIGIN. The term "year of origin" in the regulations under section 904 corresponds to the term "unused credit year" under section 907(f).

(c) TAX DEEMED PAID OR ACCRUED. The unused FOGEI tax from a year of origin that may be deemed paid or accrued under section 907(f) in any preceding or succeeding taxable year ("excess limitation year") may not exceed the lesser of --

(1) The excess extraction limitation for the excess limitation year, or

(2) The excess general section 904 limitation for the excess limitation year.

(d) EXCESS EXTRACTION LIMITATION. Under section 907(f)(2)(A), the "excess extraction limitation" for an excess limitation year is the amount by which that year's section 907(a) extraction limitation exceeds the sum of --

(1) The FOGEI taxes paid or accrued, and

(2) The FOGEI taxes deemed paid or accrued in that year by reason of a section 907(f) carryback or carryover from preceding years of origin.

(e) EXCESS GENERAL SECTION 904 LIMITATION. Under section 907(f)(2)(B), the "excess general section 904 limitation" for an excess limitation year is the amount by which that year's section 904 general limitation exceeds the sum of --

(1) The general limitation taxes paid or accrued (or deemed to have been paid under section 902 or 960) to all foreign countries and possessions of the United States during the taxable year,

(2) The general limitation taxes deemed paid or accrued in such taxable year under section 904(c) and which are attributable to taxable years preceding the unused credit year, plus

(3) The FOGEI taxes deemed paid or accrued in that year by reason of a section 907(f) carryover (or carryback) from preceding years of origin.

(f) SECTION 907(f) PRIORITY. If a taxable year is a year of origin under both section 907(f) and section 904(c), section 907(f) applies first. See section 907(f)(3)(A).

(g) CROSS-REFERENCE. In computing the carryback and carryover of disallowed credits under section 907(f), the principles of section 1.904-2(d), (e), and (f) apply.

(h) EXAMPLE. The following example illustrates the application of section 907(f).

EXAMPLE. X, a U.S. corporation organized on January 1, 1983, uses the accrual method of accounting and the calendar year as its taxable year. X's only income is income which is not subject to a separate tax limitation under section 904(d). X's preliminary U.S. tax liability indicates an effective rate of 46% for taxable years 1983-1985. X has the following foreign tax items for 1983-1985:

                                           1983     1984    1985

Par. 5. Section 1.907(a)-0A is revised to read as follows:

SECTION 1.907(A)-OA INTRODUCTION (FOR TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1983).

(a) EFFECTIVE DATES. The provisions of sections 1.907(a)-OA through 1.907(f)-1A apply to taxable years beginning before January 1, 1983, and all references in these regulations to section 907 are to section 907 as it existed prior to the amendments made by section 211 of the Tax Equity and Fiscal Responsibility Act of 1982 (96 Stat. 448). For provisions that apply to taxable years beginning after December 31, 1982, see sections 1.907(a)-0 through 1.907(f)-1.

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Par. 6. Section 1.907(a)-OAT is removed.

Par. 7. Section 1.907(c)-1(d)(3) is revised to read as follows:

SECTION 1.907(c)-1A DEFINITIONS RELATING TO FORI AND FOGEI (FOR TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1983).

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(d) ASSETS USED IN A TRADE OR BUSINESS. * * *

(3) STOCK. Stock of any corporation (whether foreign or domestic) will not be treated as an asset used by a person in section 907(c) activities. This provision applies to taxable years beginning after December 31, 1974, and beginning before January 1, 1983.

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Par. 8. Section 1.907(c)-1AT is removed.