Final Regs Defining Subpart F Income

 [4830-01-u]

[2] ACTION: Final regulations.

[3] SUMMARY: This document contains final regulations relating to the definitions of subpart F income and foreign personal holding company income of a controlled foreign corporation and the allocation of deficits for purposes of computing the deemed-paid foreign tax credit. These regulations are necessary to provide guidance that coordinates with previously published guidance under section 954. These regulations will affect United States shareholders of controlled foreign corporations.

[4] DATES: These regulations are effective January 2, 1997.

[5] For specific dates of applicability, see sections 1.952-1(f)(5), 1.952-2(c)(1), 1.954-2(b)(3) and 1.960-1(i)(6).

[6] FOR FURTHER INFORMATION CONTACT: Valerie Mark, (202) 622-3840 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

[7] On September 7, 1995, proposed regulations (IL-75-92) amending the Income Tax Regulations (26 CFR Part 1) under sections 952, 954(c) and 960 of the Internal Revenue Code (Code) were published in the Federal Register (60 FR 46548). In final regulations under section 954 (TD 8618), also published on that date (60 FR 46500), a provision relating to the treatment of tax-exempt interest under the foreign personal holding company income rules was reserved. The proposed regulations provided rules for the treatment of tax- exempt interest and also provided guidance under sections 952 and 960 to coordinate with the final regulations. No public hearing was requested or held. One written comment was received on the proposed regulations. After consideration of this comment, the proposed regulations are adopted as final regulations without amendment.

EXPLANATION OF PROVISIONS

Section 1.952-1(e) and (f) and 1.960-1(i)

[8] Sections 1.952-1(e) and (f) and 1.960-1(i) are unchanged from the proposed regulations.

Sections 1.952-2(c)(1) and 1.954-2(b)(3)

[9] Under section 1.954-2T(b)(6), interest income that was exempt from tax under section 103 was included in the foreign personal holding company income of the controlled foreign corporation. However, the net foreign base company income that was attributable to tax-exempt interest was treated as tax-exempt interest in the hands of the United States shareholder upon a deemed distribution under subpart F and therefore excluded for regular tax purposes but potentially subject to the alternative minimum tax. Section 1.954-2(b)(3), as proposed and finalized, amends the rule in the temporary regulations to provide that foreign personal holding company income includes interest income that is exempt from tax under section 103. The tax-exempt interest would not retain its character as such in the hands of the United States shareholder upon a deemed distribution under subpart F. As a result of the treatment of tax- exempt interest in these final regulations, Rev. Rul. 72-527 (1972-2 C.B. 456) is obsoleted.

[10] A commentator argued that treatment of tax-exempt interest in the proposed regulations was contrary to section 103. This comment was rejected. The Code does not specifically address how section 103 applies in the context of subpart F. Although section 1.952-2 provides that, in general, U.S. tax principles apply in computing subpart F income, this regulation makes certain Code provisions inapplicable when necessary to serve the purposes of subpart F. See section 1.952-2(c)(1).

Section 1.954-1(d)(4)(iii)

[11] The example in section 1.954-1(d)(4)(iii) is amended to correct a mathematical error.

Section 1.954-2(g)(2)

[12] The regulations are amended to clarify that income derived in the trade or business of trading foreign currency is not excluded from foreign personal holding company income under the business needs exception. A technical correction is made to section 1.954-2(g)(2)(ii)(B)(2).

Section 1.957-1(c)

[13] Technical corrections are made to section 1.957-1(c) Examples 8 and 9.

SPECIAL ANALYSES

[14] It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

[15] The principal authors of these regulations are Barbara Felker and Valerie Mark of the Office of the Associate Chief Counsel (International), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS IN 26 CFR PART 1

[16] Income taxes, Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

[17] Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read as follows:

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

Section 1.960-1 also issued under 26 U.S.C. 960(a). * * *

Par. 2. Section 1.952-1 is amended by adding paragraphs (e) and (f) to read as follows:

SECTION 1.952-1 SUBPART F INCOME DEFINED.

* * * * *

(e) APPLICATION OF CURRENT EARNINGS AND PROFITS LIMITATION -- (1) IN GENERAL. If the subpart F income (as defined in section 952(a)) of a controlled foreign corporation exceeds the foreign corporation's earnings and profits for the taxable year, the subpart F income includible in the income of the corporation's United States shareholders is reduced under section 952(c)(1)(A) in accordance with the following rules. The excess of subpart F income over current year earnings and profits shall --

(i) First, proportionately reduce subpart F income in each separate category of the controlled foreign corporation, as defined in section 1.904-5(a)(1), in which current earnings and profits are zero or less than zero;

(ii) Second, proportionately reduce subpart F income in each separate category in which subpart F income exceeds current earnings and profits; and

(iii) Third, proportionately reduce subpart F income in other separate categories.

(2) ALLOCATION TO A CATEGORY OF SUBPART F INCOME. An excess amount that is allocated under paragraph (e)(1) of this section to a separate category must be further allocated to a category of subpart F income if the separate category contains more than one category of subpart F income described in section 952(a) or, in the case of foreign base company income, described in section 1.954-1(c)(1)(iii)(A)(1) or (2). In such case, the excess amount that is allocated to the separate category must be allocated to the various categories of subpart F income within that separate category on a proportionate basis.

(3) RECAPTURE OF SUBPART F INCOME REDUCED BY OPERATION OF EARNINGS AND PROFITS LIMITATION. Any amount in a category of subpart F income described in section 952(a) or, in the case of foreign base company income, described in section 1.954-1(c)(1)(iii)(A)(1) or (2) that is reduced by operation of the current year earnings and profits limitation of section 952(c)(1)(A) and this paragraph (e) shall be subject to recapture in a subsequent year under the rules of section 952(c)(2) and paragraph (f) of this section.

(4) COORDINATION WITH SECTIONS 953 AND 954. The rules of this paragraph (e) shall be applied after the application of sections 953 and 954 and the regulations under those sections, except as provided in section 1.954-1(d)(4)(ii).

(5) EARNINGS AND DEFICITS RETAIN SEPARATE LIMITATION CHARACTER. The income reduction rules of paragraph (e)(1) of this section shall apply only for purposes of determining the amount of an inclusion under section 951(a)(1)(A) from each separate category as defined in section 1.904-5(a)(1) and the separate categories in which recapture accounts are established under section 952(c)(2) and paragraph (f) of this section. For rules applicable in computing post-1986 undistributed earnings, see generally section 902 and the regulations under that section. For rules relating to the allocation of deficits for purposes of computing foreign taxes deemed paid under section 960 with respect to an inclusion under section 951(a)(1)(A), see section 1.960-1(i).

(f) RECAPTURE OF SUBPART F INCOME IN SUBSEQUENT TAXABLE YEAR -- (1) IN GENERAL. If a controlled foreign corporation's subpart F income for a taxable year is reduced under the current year earnings and profits limitation of section 952(c)(1)(A) and paragraph (e) of this section, recapture accounts will be established and subject to recharacterization in any subsequent taxable year to the extent the recapture accounts were not previously recharacterized or distributed, as provided in paragraphs (f)(2) and (3) of this section.

(2) RULES OF RECAPTURE -- (i) RECAPTURE ACCOUNT. If a category of subpart F income described in section 952(a) or, in the case of foreign base company income, described in section 1.954-1(c)(1)(iii)(A)(1) or (2) is reduced under the current year earnings and profits limitation of section 952(c)(1)(A) and paragraph (e) of this section for a taxable year, the amount of such reduction shall constitute a recapture account.

(ii) RECAPTURE. Each recapture account of the controlled foreign corporation will be recharacterized, on a proportionate basis, as subpart F income in the same separate category (as defined in section 1.904-5(a)(1)) as the recapture account to the extent that current year earnings and profits exceed subpart F income in a taxable year. The United States shareholder must include his pro rata share (determined under the rules of section 1.951-1(e)) of each recharacterized amount in income as subpart F income in such separate category for the taxable year.

(iii) REDUCTION OF RECAPTURE ACCOUNT AND CORRESPONDING EARNINGS. Each recapture account, and post-1986 undistributed earnings in the separate category containing the recapture account, will be reduced in any taxable year by the amount which is recharacterized under paragraph (f)(2)(ii) of this section. In addition, each recapture account, and post-1986 undistributed earnings in the separate category containing the recapture account, will be reduced in the amount of any distribution out of that account (as determined under the ordering rules of section 959(c) and paragraph (f)(3)(ii) of this section).

(3) DISTRIBUTION ORDERING RULES -- (i) COORDINATION OF RECAPTURE AND DISTRIBUTION RULES. If a controlled foreign corporation distributes an amount out of earnings and profits described in section 959(c)(3) in a year in which current year earnings and profits exceed subpart F income and there is an amount in a recapture account for such year, the recapture rules will apply first.

(ii) DISTRIBUTIONS REDUCE RECAPTURE ACCOUNTS FIRST. Any distribution made by a controlled foreign corporation out of earnings and profits described in section 959(c)(3) shall be treated as made first on a proportionate basis out of the recapture accounts in each separate category to the extent thereof (even if the amount in the recapture account exceeds post-1986 undistributed earnings in the separate category containing the recapture account). Any remaining distribution shall be treated as made on a proportionate basis out of the remaining earnings and profits of the controlled foreign corporation in each separate category. See section 904(d)(3)(D).

(4) EXAMPLES. The application of paragraphs (e) and (f) of this section may be illustrated by the following examples:

 EXAMPLE 1. (i) A, a U.S. person, is the sole shareholder

Par. 3. In section 1.952-2, paragraph (c)(1) is revised to read as follows:

SECTION 1.952-2 DETERMINATION OF GROSS INCOME AND TAXABLE INCOME OF A FOREIGN CORPORATION.

* * * * *

(c) SPECIAL RULES FOR PURPOSES OF THIS SECTION -- (1) NONAPPLICATION OF CERTAIN PROVISIONS. Except where otherwise distinctly expressed, the provisions of subchapters F, G, H, L, M, N, S, and T of chapter 1 of the Internal Revenue Code shall not apply and, for taxable years of a controlled foreign corporation beginning after March 3, 1997, the provisions of section 103 of the Internal Revenue Code shall not apply.

* * * * *

Par. 4. In section 1.954-1, the Example in paragraph (d)(4)(iii) is revised to read as follows:

SECTION 1.954-1 FOREIGN BASE COMPANY INCOME.

* * * * *

(d) * * *

(4) * * *

(iii) * * *

 EXAMPLE. During its 1995 taxable year, CFC, a controlled

Par. 5. In section 1.954-2, paragraphs (b)(3), (g)(2)(ii)(B)(1)(i) and (g)(2)(ii)(B)(2) are revised to read as follows:

SECTION 1.954-2 FOREIGN PERSONAL HOLDING COMPANY INCOME.

* * * * *

(b) * * *

(3) TREATMENT OF TAX EXEMPT INTEREST. For taxable years of a controlled foreign corporation beginning after March 3, 1997, foreign personal holding company income includes all interest income, including interest that is described in section 103 (see section 1.952-2(c)(1)).

* * * * *

(g) * * *

(2) * * *

(ii) * * *

(B) * * *

(1) * * *

(i) Arises from a transaction (other than a hedging transaction) entered into, or property used or held for use, in the normal course of the controlled foreign corporation's trade or business, other than the trade or business of trading foreign currency;

* * * * *

(2) The foreign currency gain or loss arises from a bona fide hedging transaction, as defined in paragraph (a)(4)(ii) of this section, with respect to a transaction or property that satisfies the requirements of paragraphs (g)(2)(ii)(B)(1)(i) through (iii) of this section, provided that any gain or loss arising from such transaction or property that is attributable to changes in exchange rates is clearly determinable from the records of the CFC as being derived from such transaction or property. For purposes of this paragraph (g)(2)(ii)(B)(2), a hedging transaction will satisfy the aggregate hedging rules of section 1.1221-2(c)(7) only if all (or all but a de minimis amount) of the aggregate risk being hedged arises in connection with transactions or property that satisfy the requirements of paragraphs (g)(2)(ii)(B)(1)(i) through (iii) of this section, provided that any gain or loss arising from such transactions or property that is attributable to changes in exchange rates is clearly determinable from the records of the CFC as being derived from such transactions or property.

* * * * *

Par. 6. Section 1.957-1 is amended by:

1. Removing the last sentence of paragraph (c) Example 8 and adding two sentences in its place.

2. Revising the last sentence of paragraph (c) Example 9

The addition and revision read as follows:

SECTION 1.957-1 DEFINITION OF CONTROLLED FOREIGN CORPORATION.

* * * * *

(c) * * *

 EXAMPLE 8. * * * JV was a controlled foreign corporation on

Par. 7. In section 1.960-1, paragraph (i) is added to read as follows:

SECTION 1.960-1 FOREIGN TAX CREDIT WITH RESPECT TO TAXES PAID ON EARNINGS AND PROFITS OF CONTROLLED FOREIGN CORPORATIONS.

* * * * *

(i) COMPUTATION OF DEEMED-PAID TAXES IN POST-1986 TAXABLE YEARS -- (1) GENERAL RULE. If a domestic corporation is eligible to compute deemed-paid taxes under section 960(a)(1) with respect to an amount included in gross income under section 951(a), then, such domestic corporation shall be deemed to have paid a portion of the foreign corporation's post-1986 foreign income taxes determined under section 902 and the regulations under that section in the same manner as if the amount so included were a dividend paid by such foreign corporation (determined by applying section 902(c) in accordance with section 904(d)(3)(B)).

(2) ORDERING RULE FOR COMPUTING DEEMED-PAID TAXES UNDER SECTIONS 902 AND 960. If a domestic corporation computes deemed-paid taxes under both sections 902 and 960 in the same taxable year, section 960 shall be applied first. After the deemed-paid taxes are computed under section 960 with respect to a deemed income inclusion, post-1986 undistributed earnings and post-1986 foreign income taxes in each separate category shall be reduced by the appropriate amounts before deemed-paid taxes are computed under section 902 with respect to a dividend distribution.

(3) COMPUTATION OF POST-1986 UNDISTRIBUTED EARNINGS. Post-1986 undistributed earnings (or an accumulated deficit in post-1986 undistributed earnings) are computed under section 902 and the regulations under that section.

(4) ALLOCATION OF ACCUMULATED DEFICITS. For purposes of computing post-1986 undistributed earnings under sections 902 and 960, a post-1986 accumulated deficit in a separate category shall be allocated proportionately to reduce post-1986 undistributed earnings in the other separate categories. However, a deficit in any separate category shall not permanently reduce earnings in other separate categories, but after the deemed-paid taxes are computed the separate limitation deficit shall be carried forward in the same separate category in which it was incurred. In addition, because deemed-paid taxes may not exceed taxes paid or accrued by the controlled foreign corporation, in computing deemed-paid taxes with respect to an inclusion out of a separate category that exceeds post-1986 undistributed earnings in that separate category, the numerator of the deemed-paid credit fraction (deemed inclusion from the separate category) may not exceed the denominator (post-1986 undistributed earnings in the separate category).

(5) EXAMPLES. The application of this paragraph (i) may be illustrated by the following examples. See section 1.952-1(f)(4) for additional illustrations of these rules.

 EXAMPLE 1. (i) A, a U.S. person, is the sole shareholder