[Federal Register Volume 64, Number 6 (Monday, January 11, 1999)]
[Rules and Regulations]
[Pages 1505-1516]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-149]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8805]
RIN 1545-AQ43; 1545-AT41
Allocation of Loss With Respect to Stock and Other Personal
Property; Application of Section 904 to Income Subject to Separate
Limitations
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final and temporary regulations.
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[[Page 1506]]
SUMMARY: This document contains final and temporary Income Tax
Regulations relating to the allocation of loss recognized on the
disposition of stock and other personal property and the computation of
the foreign tax credit limitation. The loss allocation regulations
primarily will affect taxpayers that claim the foreign tax credit and
that incur losses with respect to personal property and are necessary
to modify existing guidance with respect to loss allocation. The
foreign tax credit limitation regulations will affect taxpayers
claiming foreign tax credits that have passive income or losses and are
necessary to modify existing guidance with respect to the computation
of the limitation.
DATES: Effective dates: These regulations are effective January 11,
1999, except that Sec. 1.904-4(c)(2)(ii) (A) and (B) are effective
March 12, 1999 and Sec. 1.904-4(c)(3)(iv) is effective December 31,
1998.
Dates of applicability: For dates of applicability of Secs. 1.865-
1T, 1.865-2, and 1.865-2T, see Secs. 1.865-1T(f), 1.865-2(e), and
1.865-2T(e), respectively. For dates of applicability of Sec. 1.904-
4(c), see Sec. 1.904-4(c)(2)(i).
FOR FURTHER INFORMATION CONTACT: Seth B. Goldstein, (202) 622-3810,
regarding section 865(j); and Rebecca Rosenberg, (202) 622-3850,
regarding section 904(d) (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
On May 14, 1992, the IRS published a notice of proposed rulemaking
in the Federal Register (REG-209527-92, formerly INTL-1-92 (1992-1 C.B.
1209), 57 FR 20660), proposing amendments to the Income Tax Regulations
(26 CFR part 1) under section 904(d). The regulations included proposed
amendments to the grouping rules under Sec. 1.904-4(c)(3) for purposes
of determining whether passive income is high taxed. The amendments
were proposed to be effective for taxable years beginning after
December 31, 1991. A public hearing was held on September 24, 1992, but
no written or oral comments were received with respect to these
provisions. These regulations are finalized as proposed. However, as
described below, the effective date of the regulations has been
modified.
On July 8, 1996, the IRS published proposed amendments (REG-209750-
95, formerly INTL-4-95 (1996-2 C.B. 484), 61 FR 35696) to the Income
Tax Regulations (26 CFR part 1) under sections 861, 865, and 904 of the
Internal Revenue Code in the Federal Register. The regulations
addressed the allocation of loss on the disposition of stock
(Sec. 1.865-2) and other personal property (Sec. 1.865-1) and also
contained proposed amendments to the grouping rules under Sec. 1.904-
4(c). The proposed regulations generally allocate loss with respect to
stock based upon the residence of the seller (reciprocal to gain), but
allocate loss on other personal property based upon the income
generated by the property. A public hearing was held on November 6,
1996, and several written comments were received. The written comments
endorsed the regulations' general approach with respect to the
allocation of stock loss. In addition, on June 18, 1997, the Tax Court
held in International Multifoods Corporation v. Commissioner, 108 T.C.
579 (1997), that loss on the disposition of stock is generally
allocated based on the residence of the seller, consistent with the
approach of the proposed regulations. After consideration of all the
comments, the regulations proposed by INTL-4-95 with respect to stock
loss and with respect to the grouping rules are adopted as amended by
this Treasury decision. The principal changes to these regulations, as
well as the major comments and suggestions, are discussed below. An
additional anti-abuse rule, not previously proposed, is issued as a
proposed and temporary regulation.
The written comments criticized the proposed regulation concerning
the allocation of loss on other personal property (Sec. 1.865-1). This
proposed regulation is withdrawn and replaced with a new proposed and
temporary regulation that is more consistent with the approach of the
stock loss allocation rules. The new rules are issued as a temporary
regulation because of the need for immediate guidance following the
International Multifoods opinion.
Explanation of Provisions
Section 1.861-8T(e)(8): Net Operating Loss
Section 1.861-8T(e)(8) clarifies that a net operating loss
deduction allowed under section 172 is allocated and apportioned in the
same manner as the deductions giving rise to the net operating loss
deduction.
Section 1.865-1T: Loss With Respect to Personal Property Other Than
Stock
Section 1.865-1T(a) provides the general rule that loss with
respect to personal property is allocated in the same manner in which
gain on the sale of the property would be sourced. Thus, for example,
loss on the sale or worthlessness of a foreign bond held by a U.S.
resident generally would be allocated against U.S. source income.
Notice 89-58 (1989-1 C.B. 699), which addressed the allocation of loss
with respect to certain bank loans, is revoked as inconsistent with
this approach. Taxpayers may rely on the Notice for loss recognized
prior to the effective date of the temporary regulations (see
discussion of effective dates, below). Following the general rule, loss
attributable to a foreign office of a U.S. resident is allocated
against foreign source income where gain would be foreign source under
the foreign branch rule of section 865(e)(1).
Section 1.865-1T(b) provides special rules of application. Loss on
depreciable property generally is allocated based upon the allocation
of depreciation deductions taken with respect to the property,
consistent with the depreciation-recapture source rule of section
865(c)(1). Similarly, loss with respect to a contingent payment debt
instrument subject to Reg. Sec. 1.1275-4(b) is allocated against
interest income because gain on the instrument generally is treated as
interest income.
Section 1.865-1T(c) provides exceptions from the reciprocal-to-gain
rule. The regulations do not apply to certain financial products (to be
addressed in a future guidance project), loss governed by section 988,
inventory (which is not governed by section 865), or trade receivables
and certain interest equivalents (which are governed by Sec. 1.861-
9T(b)). When Prop. Sec. 1.863-3(h) (the global dealing sourcing
regulation) is finalized, Sec. 1.865-1T will not apply to any loss
sourced under that regulation. Loss attributable to accrued-but-unpaid
interest income is allocated against interest income. Also, loss on a
debt instrument is allocated against interest income to the extent the
taxpayer did not amortize bond premium to the full extent permitted by
the Code. Anti-abuse exceptions are also provided. Section 1.865-
1T(c)(6)(i), which prevents taxpayers from manipulating loss allocation
through related-party transfers, reorganizations, or similar
transactions, and Sec. 1.865-1T(c)(6)(ii), which addresses offsetting
positions, are similar to the anti-abuse rules previously proposed with
respect to stock losses. In addition, section 1.865-1T(c)(6)(iii) has
been included to prevent taxpayers from accelerating foreign source
income with respect to property and claiming an offsetting U.S. loss.
The temporary regulations are effective for loss recognized on or
after January 11, 1999. A taxpayer may apply the regulations, however,
to loss
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recognized in any taxable year beginning on or after January 1, 1987,
subject to certain conditions.
Section 1.865-2: Stock Loss
The proposed regulations issued in 1996 provide that generally loss
with respect to stock is allocated to the residence of the seller, but
contain three major exceptions: an exclusion for dispositions of
portfolio stock and stock in regulated investment companies (RICs) and
S corporations, a dividend recapture rule, and a consistency rule for
certain dispositions of foreign affiliates. The final regulations
modify these exceptions. The principal comments and changes to the
regulations are discussed below.
Section 1.865-2(a): General Rule for Allocation of Stock Loss
Commentators criticized the exclusion of portfolio stock and RIC
stock from the general residence-based rule, arguing that the rationale
for residence-based allocation applies equally to these classes of
stock. The final regulations eliminate the exception for portfolio
stock and RIC stock.
In response to a comment, the final regulations clarify that
Sec. 1.865-2 does not apply to stock that constitutes inventory.
The proposed regulations allocate loss recognized on the ``sale or
other disposition'' of stock. Proposed Sec. 1.865-2(c)(2) provides that
worthlessness giving rise to a deduction under section 165(g)(3) with
respect to stock is treated as a disposition. Questions have been
raised as to whether the regulations apply to other recognized losses
that are not the result of a sale or disposition (for example, loss
recognized under the mark-to-market rules of section 475). The final
regulations are intended to apply to all recognized stock losses. To
avoid confusion, the reference to sales or other dispositions has been
deleted in the final regulations. The special reference to
worthlessness deductions is therefore unnecessary and also has been
deleted.
Section 1.865-2(b)(1): Dividend Recapture Exception
Some commentators questioned the dividend recapture rule of
Sec. 1.865-2(b)(1) and suggested that the rule should be limited to
cases in which the dividends were fully sheltered from U.S. tax by
foreign tax credits or the taxpayer did not meet a minimum holding
period. Others suggested that the two-year recapture period defined in
Sec. 1.865-2(d)(5) of the proposed regulations should be shortened.
Sections 1.865-2(b)(1)(i) and 1.865-2(d)(3) of the final regulations
retain the two-year rule.
Section 1.865-2(b)(1)(iii) of the final regulations provides an
exception from dividend recapture for passive-basket dividends. This
new exception will exempt most portfolio investors (other than
financial services entities) from the dividend recapture rule. The
rule, which will reduce administrative burdens, reflects the fact that
passive income is generally subject to residual U.S. tax and the high-
tax kick-out of section 904(d)(2)(A)(iii)(III) limits the potential for
cross-crediting in the passive basket, thus reducing the need for
recapture. In addition, allocation of loss to the passive basket may
lead to investment incentives that violate the policies underlying the
passive basket. For example, where a loss allocated to the passive
basket creates a separate limitation loss under section 904(f)(5) that
reduces high-taxed income in other baskets, this creates an incentive
in subsequent years for the taxpayer to earn low-taxed foreign passive
income to utilize the foreign tax credits in the high-taxed basket (due
to the recharacterization rules of section 904(f)(5)(C)).
Commentators also suggested alternatives to the de minimis rule of
Sec. 1.865-2(b)(1)(ii), which exempts from recapture dividends that are
less than 10 percent of the recognized loss. The proposed de minimis
rule is retained in the final regulations. The de minimis rule is
intended to exempt from recapture, as a matter of administrative
convenience, dividends that are relatively insignificant in comparison
to the loss.
Two commentators questioned why the dividend recapture rule and the
definition of the recapture period in Sec. 1.865-2(d)(5) of the
proposed regulations refer to realized, rather than recognized, loss.
The wording was intended to avoid confusion over the application of the
rule to loss that is deferred under section 267(f). The final
regulation refers to ``recognized'' loss, but examples have been added
in Sec. 1.865-2(b)(1)(iv) of the final regulations to illustrate the
application of the dividend recapture rule in the context of section
267(f) and how the result differs in the context of a consolidated
group.
Proposed Sec. 1.865-2(b)(2): Consistency Rule
Proposed Sec. 1.865-2(b)(2) requires a taxpayer to allocate loss on
the sale of a foreign affiliate to passive-basket foreign source income
if the taxpayer recognized foreign source gain under section 865(f) at
any time during the 5-year period preceding the loss sale. Commentators
criticized this rule as producing disproportionate results where the
foreign source gain is small in comparison to the subsequent loss.
Furthermore, even where the gain and loss are of similar magnitude, the
results may be disproportionate because sourcing the gain foreign may
provide the taxpayer with minimal tax benefits (because the gain is
assigned to the passive basket) but the loss may reduce (sometimes as a
separate limitation loss) income that is otherwise sheltered by foreign
tax credits. In addition, allocating loss to the passive basket raises
the policy concerns described above with respect to passive-basket
dividend recapture. After consideration of the comments, the
consistency rule has been eliminated from the final regulations.
Section 1.865-2(b)(2): Anti-Abuse Rules
The anti-abuse rules of Sec. 1.865-2(b)(3) of the proposed
regulations, finalized as Sec. 1.865-2(b)(4), have been refined and
modified. One commentator requested examples illustrating the anti-
abuse rules. Examples have been provided. An additional rule is
provided in Sec. 1.865-2T, discussed below.
Section 1.865-2(e): Effective Date and Retroactive Election
The proposed regulations are proposed to be effective for taxable
years beginning 61 days after final regulations are promulgated.
Because of the immediate need for guidance following the International
Multifoods opinion, the final regulations are effective for losses
recognized on or after January 11, 1999.
Several commentators requested that the regulations clarify the
scope of the retroactive election and reduce the administrative burden
of making the election. In response to these comments, Sec. 1.865-
2(e)(2) is amended to provide that a taxpayer need not make a formal
election to retroactively apply the regulations to losses recognized in
any post-1986 year and all subsequent pre-effective date years. An
amended return will be required only if retroactive application results
in a change in tax liability.
One commentator urged that the overall foreign loss transition rule
in Sec. 1.904(f)-12 be modified to provide that an overall foreign loss
account attributable to a stock loss recognized in a pre-1987 year be
recomputed under the new regulations in the first election year. This
suggestion was rejected because the allocation of a stock loss is
governed by the rules in effect in the year the loss is recognized, and
the
[[Page 1508]]
retroactive election is available only with respect to post-1986 years.
Section 1.865-2(e)(3) provides examples to illustrate the effect of the
retroactive application of the regulations on overall foreign loss
accounts, capital loss carryovers, and foreign tax credit carryovers.
Section 1.865-2T: Stock Loss Matching Rule
Section 1.865-2T(b)(4)(iii) provides a rule intended to prevent
taxpayers from avoiding the dividend recapture rule of Sec. 1.865-
2(b)(1) or from accelerating foreign source income and recognizing an
offsetting U.S. loss. This rule is substantially the same as the
matching rule of Sec. 1.865-1T(c)(6)(iii). The rule is promulgated as a
temporary regulation because it is necessary to prevent abuse of the
residence-based general allocation rule.
Section 1.904-4(c): Grouping Rules
The high-tax kick-out grouping rules of Sec. 1.904-4(c) provide
rules for determining when particular groups of passive income are
high-taxed and, therefore, treated as general limitation income under
sections 904(d)(2)(A)(iii)(III) and 904(d)(2)(F). As described above,
the proposed amendments to these rules that were proposed in 1992 are
finalized as proposed, but taxpayers are afforded some flexibility with
respect to the effective date. The amendments were proposed to be
effective for taxable years beginning after December 31, 1991. The
final regulations are effective for taxable years ending on or after
December 31, 1998, but taxpayers may apply the amended regulations to
any taxable year beginning after December 31, 1991 and all subsequent
years. An example is also added to clarify that foreign taxes that are
not creditable (e.g., under section 901(k)) are not withholding taxes
for purposes of the grouping rules.
The proposed amendments to the grouping rules that were proposed in
1996 are finalized with two clarifications. Proposed Sec. 1.904-
4(c)(2)(ii)(B) provides guidance where deductions allocated to a group
of passive income exceed the income in that group (i.e., a loss group).
A question has been raised as to the proper treatment of foreign taxes
in a group that has no taxable income or loss (either because the
deductions allocated to the group exactly equal the income in the group
or because the foreign taxes assigned to the group are imposed on U.S.
source income or income that is not currently taken into account under
U.S. tax principles). Consistent with the approach taken in the
proposed regulations with respect to loss groups, the final regulations
clarify that foreign taxes allocated to a group with no foreign source
income are ``kicked out'' and treated as related to general limitation
income.
Proposed Sec. 1.904-4(c)(2)(ii)(A) provides that foreign tax
imposed on sales that result in loss for U.S. tax purposes is allocated
to the group of passive income to which the loss is allocated. While
this correctly states the result where loss on the disposition of
property is allocated to passive income under a reciprocal-to-gain
rule, under the temporary and final regulations loss may be allocated
to reduce the group of passive income where income from the property
was assigned (for example, dividends or interest under the anti-abuse
rules or the accrued-but-unpaid interest rule) or a separate category
of income other than passive income. Accordingly, Sec. 1.904-
4(c)(2)(ii)(A) of the final regulations is clarified to state that
foreign tax imposed on a loss sale is allocated to the group of passive
income to which a gain would have been assigned. The examples in
Sec. 1.904-4(c)(8) of the final regulations are modified to reflect the
fact that the consistency rule of Sec. 1.865-2(b)(2) of the proposed
regulations has been deleted.
One commentator inquired whether the rule of Sec. 1.904-
4(c)(2)(ii)(A) allocating foreign tax on a loss sale to a group of
passive income is consistent with the tax allocation rule of
Sec. 1.904-6(a)(1)(iv). The latter rule provides that a foreign tax
imposed on an item of income that does not constitute income under U.S.
tax principles (a base difference) shall be treated as imposed with
respect to general limitation income, whereas a foreign tax imposed on
an item that would be income under U.S. tax principles in another year
(a timing difference) will be allocated to the appropriate separate
category as if the U.S. recognized the income in the same year.
Treasury and the Service believe that a base difference exists within
the meaning of Sec. 1.904-6(a)(1)(iv) only when a foreign country taxes
items that the United States would never treat as taxable income, for
example, gifts or life insurance proceeds. A sale that results in gain
under foreign law but in loss for U.S. tax purposes is attributable to
differences in basis calculations rather than to a difference in the
concept of taxable income and, therefore, does not constitute a base
difference. The tax allocation rule of Sec. 1.904-4(c)(2)(ii)(A),
allocating foreign taxes on a loss sale to the same group of passive
income to which gain would have been assigned had the United States
recognized gain on the sale, is conceptually consistent with the
treatment of timing differences in Sec. 1.904-6(a)(1)(iv).
Effect on Other Documents
The following document is obsolete as of January 11, 1999:
Notice 89-58, 1989-1 C.B. 699.
Special Analyses
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.
This Treasury Decision finalizes notices of proposed rulemaking
published May 14, 1992 (57 FR 20660) and July 8, 1996 (61 FR 35696). It
has been determined that section 553(b) of the Administrative Procedure
Act (5 U.S.C. chapter 5) does not apply to the final regulations issued
pursuant to the notice of proposed rulemaking published on May 14,
1992. Furthermore, the Regulatory Flexibility Act (5 U.S.C. chapter 6)
does not apply to those regulations, because the notice of proposed
rulemaking was issued prior to March 29, 1996.
It also has been determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to the
portion of the notice of proposed rulemaking published on July 8, 1996,
relating to section 904 of the Internal Revenue Code. Because the
regulation does not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply.
A final regulatory flexibility analysis under 5 U.S.C. Sec. 604 has
been prepared for the final regulations portion of this Treasury
Decision with respect to the regulations issued under section 865 of
the Internal Revenue Code. A summary of the analysis is set forth below
under the heading ``Summary of Regulatory Flexibility Analysis.''
Because no preceding notice of proposed rulemaking is required for the
temporary regulations portion of this Treasury Decision relating to
sections 861 and 865 of the Code, the provisions of the Regulatory
Flexibility Act do not apply. However, an initial Regulatory
Flexibility Analysis was prepared for the proposed regulations
published elsewhere in this issue of the Federal Register.
Pursuant to section 7805(f) of the Internal Revenue Code, the
notices of proposed rulemaking preceding these regulations were
submitted to the Small Business Administration for comment on their
impact on small business.
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Summary of Regulatory Flexibility Analysis
It has been determined that a final regulatory flexibility analysis
is required under 5 U.S.C. Sec. 604 with respect to the final
regulations portion of this Treasury Decision with respect to the
regulations issued under section 865 of the Internal Revenue Code.
These regulations will affect small entities such as small businesses
but not other small entities, such as local government or tax exempt
organizations, which do not pay taxes. The IRS and Treasury Department
are not aware of any federal rules that duplicate, overlap or conflict
with these regulations. The final regulations address the allocation of
loss with respect to stock. These regulations are necessary primarily
for the proper computation of the foreign tax credit limitation under
section 904 of the Internal Revenue Code. With respect to U.S. resident
taxpayers, the regulations generally allocate losses against U.S.
source income. Generally, this allocation simplifies the computation of
the foreign tax credit limitation. None of the significant alternatives
considered in drafting the regulations would have significantly altered
the economic impact of the regulations on small entities. There are no
alternative rules that are less burdensome to small entities but that
accomplish the purposes of the statute.
Drafting Information
The principal author of these regulations is Seth B. Goldstein, 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
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
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
entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.865-1T also issued under 26 U.S.C. 865(j)(1).
Section 1.865-2 also issued under 26 U.S.C. 865(j)(1).
Section 1.865-2T also issued under 26 U.S.C. 865(j)(1). * * *
Par. 2. Section 1.861-8 is amended by adding paragraph (e)(7)(iii)
and revising paragraph (e)(8) to read as follows:
Sec. 1.861-8 Computation of taxable income from sources within the
United States and from other sources and activities.
* * * * *
(e) * * *
(7) * * *
(iii) Allocation of loss recognized in taxable years after 1986.
See Secs. 1.865-1T, 1.865-2, and 1.865-2T for rules regarding the
allocation of certain loss recognized in taxable years beginning after
December 31, 1986.
(8) Net operating loss deduction. [Reserved.] For guidance, see
Sec. 1.861-8T(e)(8).
* * * * *
Par. 3. Section 1.861-8T is amended by adding paragraph (e)(8) and
a sentence at the end of paragraph (h) to read as follows:
Sec. 1.861-8T Computation of taxable income from sources within the
United States and from other sources and activities (Temporary).
* * * * *
(e) * * *
(8) Net operating loss deduction. A net operating loss deduction
allowed under section 172 shall be allocated and apportioned in the
same manner as the deductions giving rise to the net operating loss
deduction.
* * * * *
(h) * * * Paragraph (e)(8) of this section shall cease to be
effective January 8, 2002.
Par. 4. Section 1.865-1T is added immediately following Sec. 1.864-
8T, to read as follows:
Sec. 1.865-1T Loss with respect to personal property other than stock
(Temporary).
(a) General rules for allocation of loss--(1) Allocation against
gain. Except as otherwise provided in Secs. 1.865-2 and 1.865-2T and
paragraph (c) of this section, loss recognized with respect to personal
property shall be allocated to the class of gross income and, if
necessary, apportioned between the statutory grouping of gross income
(or among the statutory groupings) and the residual grouping of gross
income, with respect to which gain from a sale of such property would
give rise in the hands of the seller. Thus, for example, loss
recognized by a United States resident on the sale of a bond generally
is allocated to reduce United States source income.
(2) Loss attributable to foreign office. Except as otherwise
provided in Secs. 1.865-2 and 1.865-2T and paragraph (c) of this
section, and except with respect to loss subject to paragraph (b) of
this section, in the case of loss recognized by a United States
resident with respect to property that is attributable to an office or
other fixed place of business in a foreign country within the meaning
of section 865(e)(3), the loss shall be allocated to reduce foreign
source income if a gain on the sale of the property would have been
taxable by the foreign country and the highest marginal rate of tax
imposed on such gains in the foreign country is at least 10 percent.
However, paragraph (a)(1) of this section and not this paragraph (a)(2)
will apply if gain on the sale of such property would be sourced under
section 865(c), (d)(1)(B), or (d)(3).
(3) Loss recognized by United States citizen or resident alien with
foreign tax home. Except as otherwise provided in Secs. 1.865-2 and
1.865-2T and paragraph (c) of this section, and except with respect to
loss subject to paragraph (b) of this section, in the case of loss with
respect to property recognized by a United States citizen or resident
alien that has a tax home (as defined in section 911(d)(3)) in a
foreign country, the loss shall be allocated to reduce foreign source
income if a gain on the sale of such property would have been taxable
by a foreign country and the highest marginal rate of tax imposed on
such gains in the foreign country is at least 10 percent.
(4) Allocation for purposes of section 904. For purposes of section
904, loss recognized with respect to property that is allocated to
foreign source income under this paragraph (a) shall be allocated to
the separate category under section 904(d) to which gain on the sale of
the property would have been assigned (without regard to section
904(d)(2)(A)(iii)(III)). For purposes of Sec. 1.904-4(c)(2)(ii)(A), any
such loss allocated to passive income shall be allocated (prior to the
application of Sec. 1.904-4(c)(2)(ii)(B)) to the group of passive
income to which gain on a sale of the property would have been assigned
had a sale of the property resulted in the recognition of a gain under
the law of the relevant foreign jurisdiction or jurisdictions.
(5) Loss recognized by partnership. A partner's distributive share
of loss recognized by a partnership with respect to personal property
shall be allocated and apportioned in accordance with this section as
if the partner had recognized the loss. If loss is attributable to an
office or other fixed place of business of the partnership within the
meaning of section 865(e)(3), such office or fixed place of business
shall be considered to be an office of the partner for purposes of this
section.
[[Page 1510]]
(b) Special rules of application--(1) Depreciable property. In the
case of a loss recognized with respect to depreciable personal
property, the gain referred to in paragraph (a)(1) of this section is
the gain that would be sourced under section 865(c)(1) (depreciation
recapture).
(2) Contingent payment debt instrument. Except to the extent
provided in Sec. 1.1275-4(b)(9)(iv), loss recognized with respect to a
contingent payment debt instrument to which Sec. 1.1275-4(b) applies
(instruments issued for money or publicly traded property) shall be
allocated to the class of gross income and, if necessary, apportioned
between the statutory grouping of gross income (or among the statutory
groupings) and the residual grouping of gross income, with respect to
which interest income from the instrument (in the amount of the loss
subject to this paragraph (b)(2)) would give rise.
(c) Exceptions--(1) Foreign currency and certain financial
instruments. This section does not apply to loss governed by section
988 and loss recognized with respect to options contracts or derivative
financial instruments, including futures contracts, forward contracts,
notional principal contracts, or evidence of an interest in any of the
foregoing.
(2) Inventory. This section does not apply to loss recognized with
respect to property described in section 1221(1).
(3) Interest equivalents and trade receivables. Loss subject to
Sec. 1.861-9T(b) (loss equivalent to interest expense and loss on trade
receivables) shall be allocated and apportioned under the rules of
Sec. 1.861-9T and not under the rules of this section.
(4) Unamortized bond premium. To the extent a taxpayer recognizing
loss with respect to a bond (within the meaning of Sec. 1.171-1(b)) did
not amortize bond premium to the full extent permitted by Secs. 1.171-2
or 1.171-3 (or Sec. 1.171-1, as contained in the 26 CFR part 1 edition
revised as of April 1, 1997) (as applicable), loss recognized with
respect to the bond shall be allocated to the class of gross income
and, if necessary, apportioned between the statutory grouping of gross
income (or among the statutory groupings) and the residual grouping of
gross income, with respect to which interest income from the bond was
assigned.
(5) Accrued interest. Loss attributable to accrued but unpaid
interest on a debt obligation shall be allocated to the class of gross
income and, if necessary, apportioned between the statutory grouping of
gross income (or among the statutory groupings) and the residual
grouping of gross income, with respect to which interest income from
the obligation was assigned. For purposes of this section, whether loss
is attributable to accrued but unpaid interest (rather than to
principal) shall be determined under the principles of Secs. 1.61-7(d)
and 1.446-2(e).
(6) Anti-abuse rules--(i) Transactions involving built-in losses.
If one of the principal purposes of a transaction is to change the
allocation of a built-in loss with respect to personal property by
transferring the property to another person, qualified business unit,
office or other fixed place of business, or branch that subsequently
recognizes the loss, the loss shall be allocated by the transferee as
if it were recognized by the transferor immediately prior to the
transaction. If one of the principal purposes of a change of residence
is to change the allocation of a built-in loss with respect to personal
property, the loss shall be allocated as if the change of residence had
not occurred. If one of the principal purposes of a transaction is to
change the allocation of a built-in loss on the disposition of personal
property by converting the original property into other property and
subsequently recognizing loss with respect to such other property, the
loss shall be allocated as if it were recognized with respect to the
original property immediately prior to the transaction. Transactions
subject to this paragraph shall include, without limitation,
reorganizations within the meaning of section 368(a), liquidations
under section 332, transfers to a corporation under section 351,
transfers to a partnership under section 721, transfers to a trust,
distributions by a partnership, distributions by a trust, transfers to
or from a qualified business unit, office or other fixed place of
business, or branch, or exchanges under section 1031. A person may have
a principal purpose of affecting loss allocation even though this
purpose is outweighed by other purposes (taken together or separately).
(ii) Offsetting positions. If a taxpayer recognizes loss with
respect to personal property and the taxpayer (or any person described
in section 267(b) (after application of section 267(c), 267(e), 318 or
482 with respect to the taxpayer) holds (or held) offsetting positions
with respect to such property with a principal purpose of recognizing
foreign source income and United States source loss, the loss shall be
allocated and apportioned against such foreign source income. For
purposes of this paragraph (c)(6)(ii), positions are offsetting if the
risk of loss of holding one or more positions is substantially
diminished by holding one or more other positions.
(iii) Matching rule. To the extent a taxpayer (or a person
described in section 1059(c)(3)(C) with respect to the taxpayer)
recognizes foreign source income for tax purposes that results in the
creation of a corresponding loss with respect to personal property, the
loss shall be allocated and apportioned against such income. For
examples illustrating a similar rule with respect to stock loss, see
Examples 3 through 6 of Sec. 1.865-2T(b)(4)(iv).
(d) Definitions--(1) Contingent payment debt instrument. A
contingent payment debt instrument is any debt instrument that is
subject to Sec. 1.1275-4.
(2) Depreciable personal property. Depreciable personal property is
any property described in section 865(c)(4)(A).
(3) Terms defined in Sec. 1.861-8. See Sec. 1.861-8 for the meaning
of class of gross income, statutory grouping of gross income, and
residual grouping of gross income.
(e) Examples. The application of this section may be illustrated by
the following examples:
Example 1. On January 1, 1997, A, a domestic corporation,
purchases for $1,000 a machine that produces widgets, which A sells
in the United States and throughout the world. Throughout A's
holding period, the machine is located and used in Country X. During
A's holding period, A incurs depreciation deductions of $400 with
respect to the machine. Under Sec. 1.861-8, A allocates and
apportions depreciation deductions of $250 against foreign source
general limitation income and $150 against U.S. source income. On
December 12, 1999, A sells the machine and recognizes a loss of
$500. Because the machine was used predominantly outside the United
States, under section 865(c)(1)(B) and (c)(3)(B)(ii), gain on the
disposition of the machine would be foreign source general
limitation income to the extent of the depreciation adjustments.
Therefore, under paragraph (b)(1) of this section, the entire $500
loss is allocated against foreign source general limitation income.
Example 2. On January 1, 1997, A, a domestic corporation, loans
$2,000 to N, its wholly-owned controlled foreign corporation, in
exchange for a contingent payment debt instrument subject to
Sec. 1.1275-4(b). During 1997 through 1999, A accrues and receives
interest income of $630, $150 of which is foreign source general
limitation income and $480 of which is foreign source passive income
under section 904(d)(3). Assume there are no positive or negative
adjustments pursuant to Sec. 1.1275-4(b)(6) in 1997 through 1999. On
January 1, 2000, A disposes of the debt instrument and recognizes a
$770 loss. Under Sec. 1.1275-4(b)(8)(ii), $630 of the loss is
treated as ordinary loss and $140 is treated as capital loss. Assume
that $140 of interest income earned in 2000 with respect to the debt
[[Page 1511]]
instrument would be foreign source passive income under section
904(d)(3). Under Sec. 1.1275-4(b)(9)(iv), $150 of the ordinary loss
is allocated against foreign source general limitation income and
$480 of the ordinary loss is allocated against foreign source
passive income. Under paragraph (b)(2) of this section, the $140
capital loss is allocated against foreign source passive income.
Example 3. On January 1, 1997, A, a domestic corporation,
purchases for $1,000 a bond maturing January 1, 2009, with a stated
principal amount of $1,000, payable at maturity. The bond provides
for unconditional payments of interest of $100, payable December 31
of each year. The issuer of the bond is a foreign corporation and
interest on the bond is thus foreign source. Between 1997 and 2001,
A accrues and receives foreign source interest income of $500 with
respect to the bond. On January 1, 2002, A sells the bond and
recognizes a $500 loss. Under paragraph (a)(1) of this section, the
$500 loss is allocated against U.S. source income. Paragraph
(c)(6)(iii) of this section is not applicable because A's
recognition of the foreign source income did not result in the
creation of a corresponding loss with respect to the bond.
Example 4. On January 1, 1999, A, a domestic corporation on the
accrual method of accounting, purchases for $1,000 a bond maturing
January 1, 2009, with a stated principal amount of $1,000, payable
at maturity. The bond provides for unconditional payments of
interest of $100, payable December 31 of each year. The issuer of
the bond is a foreign corporation and interest on the bond is thus
foreign source. On June 10, 1999, after A has accrued $44 of
interest income, but before any interest has been paid, the issuer
suddenly becomes insolvent and declares bankruptcy. A sells the bond
(including the accrued interest) for $20. Assuming that A properly
accrued $44 interest income, A treats the $20 proceeds from the sale
of the bond as payment of interest previously accrued and recognizes
a $1000 loss with respect to the bond principal and a $24 loss with
respect to the accrued interest. See Sec. 1.61-7(d). Under paragraph
(a)(1) of this section, the $1000 loss with respect to the principal
is allocated against U.S. source income. Under paragraph (c)(5) of
this section, the $24 loss with respect to accrued but unpaid
interest is allocated against foreign source interest income.
(f) Effective date--(1) In general. Except as provided in paragraph
(f)(2) of this section, this section is effective for loss recognized
on or after January 11, 1999. For purposes of this paragraph (f), loss
that is recognized but deferred (for example, under section 267 or
1092) shall be treated as recognized at the time the loss is taken into
account. This section shall cease to be effective January 8, 2002.
(2) Application to prior periods. A taxpayer may apply the rules of
this section to losses recognized in any taxable year beginning on or
after January 1, 1987, and all subsequent years, provided that--
(i) The taxpayer's tax liability as shown on an original or amended
tax return is consistent with the rules of this section for each such
year for which the statute of limitations does not preclude the filing
of an amended return on June 30, 1999; and
(ii) The taxpayer makes appropriate adjustments to eliminate any
double benefit arising from the application of this section to years
that are not open for assessment.
(3) Examples. See Sec. 1.865-2(e)(3) for examples illustrating an
effective date provision similar to the effective date provided in this
paragraph (f).
Par. 5. Section 1.865-2 is added immediately after Sec. 1.865-1T,
to read as follows:
Sec. 1.865-2 Loss with respect to stock.
(a) General rules for allocation of loss with respect to stock--(1)
Allocation against gain. Except as otherwise provided in paragraph (b)
of this section, loss recognized with respect to stock shall be
allocated to the class of gross income and, if necessary, apportioned
between the statutory grouping of gross income (or among the statutory
groupings) and the residual grouping of gross income, with respect to
which gain (other than gain treated as a dividend under section
964(e)(1) or 1248) from a sale of such stock would give rise in the
hands of the seller (without regard to section 865(f)). Thus, for
example, loss recognized by a United States resident on the sale of
stock generally is allocated to reduce United States source income.
(2) Stock attributable to foreign office. Except as otherwise
provided in paragraph (b) of this section, in the case of loss
recognized by a United States resident with respect to stock that is
attributable to an office or other fixed place of business in a foreign
country within the meaning of section 865(e)(3), the loss shall be
allocated to reduce foreign source income if a gain on the sale of the
stock would have been taxable by the foreign country and the highest
marginal rate of tax imposed on such gains in the foreign country is at
least 10 percent.
(3) Loss recognized by United States citizen or resident alien with
foreign tax home--(i) In general. Except as otherwise provided in
paragraph (b) of this section, in the case of loss with respect to
stock that is recognized by a United States citizen or resident alien
that has a tax home (as defined in section 911(d)(3)) in a foreign
country, the loss shall be allocated to reduce foreign source income if
a gain on the sale of the stock would have been taxable by a foreign
country and the highest marginal rate of tax imposed on such gains in
the foreign country is at least 10 percent.
(ii) Bona fide residents of Puerto Rico. Except as otherwise
provided in paragraph (b) of this section, in the case of loss with
respect to stock in a corporation described in section 865(g)(3)
recognized by a United States citizen or resident alien that is a bona
fide resident of Puerto Rico during the entire taxable year, the loss
shall be allocated to reduce foreign source income.
(4) Stock constituting a United States real property interest. Loss
recognized by a nonresident alien individual or a foreign corporation
with respect to stock that constitutes a United States real property
interest shall be allocated to reduce United States source income. For
additional rules governing the treatment of such loss, see section 897
and the regulations thereunder.
(5) Allocation for purposes of section 904. For purposes of section
904, loss recognized with respect to stock that is allocated to foreign
source income under this paragraph (a) shall be allocated to the
separate category under section 904(d) to which gain on a sale of the
stock would have been assigned (without regard to section
904(d)(2)(A)(iii)(III)). For purposes of Sec. 1.904-4(c)(2)(ii)(A), any
such loss allocated to passive income shall be allocated (prior to the
application of Sec. 1.904-4(c)(2)(ii)(B)) to the group of passive
income to which gain on a sale of the stock would have been assigned
had a sale of the stock resulted in the recognition of a gain under the
law of the relevant foreign jurisdiction or jurisdictions.
(b) Exceptions--(1) Dividend recapture exception--(i) In general.
If a taxpayer recognizes a loss with respect to shares of stock, and
the taxpayer (or a person described in section 1059(c)(3)(C) with
respect to such shares) included in income a dividend recapture amount
(or amounts) with respect to such shares at any time during the
recapture period, then, to the extent of the dividend recapture amount
(or amounts), the loss shall be allocated and apportioned on a
proportionate basis to the class or classes of gross income or the
statutory or residual grouping or groupings of gross income to which
the dividend recapture amount was assigned.
(ii) Exception for de minimis amounts. Paragraph (b)(1)(i) of this
section shall not apply to a loss recognized by a taxpayer on the
disposition of stock if the sum of all dividend recapture amounts
(other than dividend recapture amounts eligible for
[[Page 1512]]
the exception described in paragraph (b)(1)(iii) of this section
(passive limitation dividends)) included in income by the taxpayer (or
a person described in section 1059(c)(3)(C)) with respect to such stock
during the recapture period is less than 10 percent of the recognized
loss.
(iii) Exception for passive limitation dividends. Paragraph
(b)(1)(i) of this section shall not apply to the extent of a dividend
recapture amount that is treated as income in the separate category for
passive income described in section 904(d)(2)(A) (without regard to
section 904(d)(2)(A)(iii)(III)). The exception provided for in this
paragraph (b)(1)(iii) shall not apply to any dividend recapture amount
that is treated as income in the separate category for financial
services income described in section 904(d)(2)(C).
(iv) Examples. The application of this paragraph (b)(1) may be
illustrated by the following examples:
Example 1. (i) P, a domestic corporation, is a United States
shareholder of N, a controlled foreign corporation. N has never had
any subpart F income and all of its earnings and profits are
described in section 959(c)(3). On May 5, 1998, N distributes a
dividend to P in the amount of $100. The dividend gives rise to a $5
foreign withholding tax, and P is deemed to have paid an additional
$45 of foreign income tax with respect to the dividend under section
902. Under the look-through rules of section 904(d)(3) the dividend
is general limitation income described in section 904(d)(1)(I).
(ii) On February 6, 2000, P sells its shares of N and recognizes
a $110 loss. In 2000, P has the following taxable income, excluding
the loss on the sale of N:
(A) $1,000 of foreign source income that is general limitation
income described in section 904(d)(1)(I);
(B) $1,000 of foreign source capital gain from the sale of stock
in a foreign affiliate that is sourced under section 865(f) and is
passive income described in section 904(d)(1)(A); and
(C) $1,000 of U.S. source income.
(iii) The $100 dividend paid in 1998 is a dividend recapture
amount that was included in P's income within the recapture period
preceding the disposition of the N stock. The de minimis exception
of paragraph (b)(1)(ii) of this section does not apply because the
$100 dividend recapture amount exceeds 10 percent of the $110 loss.
Therefore, to the extent of the $100 dividend recapture amount, the
loss must be allocated under paragraph (b)(1)(i) of this section to
the separate limitation category to which the dividend was assigned
(general limitation income).
(iv) P's remaining $10 loss on the disposition of the N stock is
allocated to U.S. source income under paragraph (a)(1) of this
section.
(v) After allocation of the stock loss, P's foreign source
taxable income in 2000 consists of $900 of foreign source general
limitation income and $1,000 of foreign source passive income.
Example 2. (i) P, a domestic corporation, owns all of the stock
of N1, which owns all of the stock of N2, which owns all of the
stock of N3. N1, N2, and N3 are controlled foreign corporations. All
of the corporations use the calendar year as their taxable year. On
February 5, 1997, N3 distributes a dividend to N2. The dividend is
foreign personal holding company income of N2 under section
954(c)(1)(A) that results in an inclusion of $100 in P's income
under section 951(a)(1)(A)(i) as of December 31, 1997. Under section
904(d)(3)(B) the inclusion is general limitation income described in
section 904(d)(1)(I). The income inclusion to P results in a
corresponding increase in P's basis in the stock of N1 under section
961(a).
(ii) On March 5, 1999, P sells its shares of N1 and recognizes a
$110 loss. The $100 1997 subpart F inclusion is a dividend recapture
amount that was included in P's income within the recapture period
preceding the disposition of the N1 stock. The de minimis exception
of paragraph (b)(1)(ii) of this section does not apply because the
$100 dividend recapture amount exceeds 10 percent of the $110 loss.
Therefore, to the extent of the $100 dividend recapture amount, the
loss must be allocated under paragraph (b)(1)(i) of this section to
the separate limitation category to which the dividend recapture
amount was assigned (general limitation income). The remaining $10
loss is allocated to U.S. source income under paragraph (a)(1) of
this section.
Example 3. (i) P, a domestic corporation, owns all of the stock
of N1, which owns all of the stock of N2. N1 and N2 are controlled
foreign corporations. All the corporations use the calendar year as
their taxable year and the U.S. dollar as their functional currency.
On May 5, 1998, N2 pays a dividend of $100 to N1 out of general
limitation earnings and profits.
(ii) On February 5, 2000, N1 sells its N2 stock to an unrelated
purchaser. The sale results in a loss to N1 of $110 for U.S. tax
purposes. In 2000, N1 has the following current earnings and
profits, excluding the loss on the sale of N2:
(A) $1,000 of non-subpart F foreign source general limitation
earnings and profits described in section 904(d)(1)(I);
(B) $1,000 of foreign source gain from the sale of stock that is
taken into account in determining foreign personal holding company
income under section 954(c)(1)(B)(i) and which is passive limitation
earnings and profits described in section 904(d)(1)(A);
(C) $1,000 of foreign source interest income received from an
unrelated person that is foreign personal holding company income
under section 954(c)(1)(A) and which is passive limitation earnings
and profits described in section 904(d)(1)(A).
(iii) The $100 dividend paid in 1998 is a dividend recapture
amount that was included in N1's income within the recapture period
preceding the disposition of the N2 stock. The de minimis exception
of paragraph (b)(1)(ii) of this section does not apply because the
$100 dividend recapture amount exceeds 10 percent of the $110 loss.
Therefore, to the extent of the $100 dividend recapture amount, the
loss must be allocated under paragraph (b)(1)(i) of this section to
the separate limitation category to which the dividend was assigned
(general limitation earnings and profits).
(iv) N1's remaining $10 loss on the disposition of the N2 stock
is allocated to foreign source passive limitation earnings and
profits under paragraph (a)(1) of this section.
(v) After allocation of the stock loss, N1's current earnings
and profits for 1998 consist of $900 of foreign source general
limitation earnings and profits and $1,990 of foreign source passive
limitation earnings and profits.
(vi) After allocation of the stock loss, N1's subpart F income
for 2000 consists of $1,000 of foreign source interest income that
is foreign personal holding company income under section
954(c)(1)(A) and $890 of foreign source net gain that is foreign
personal holding company income under section 954(c)(1)(B)(i). P
includes $1,890 in income under section 951(a)(1)(A)(i) as passive
income under sections 904(d)(1)(A) and 904(d)(3)(B).
Example 4. P, a foreign corporation, has two wholly-owned
subsidiaries, S, a domestic corporation, and B, a foreign
corporation. On January 1, 2000, S purchases a one-percent interest
in N, a foreign corporation, for $100. On January 2, 2000, N
distributes a $20 dividend to S. The $20 dividend is foreign source
financial services income. On January 3, 2000, S sells its N stock
to B for $80 and recognizes a $20 loss that is deferred under
section 267(f). On June 10, 2008, B sells its N stock to an
unrelated person for $55. Under section 267(f) and Sec. 1.267(f)-
1(c)(1), S's $20 loss is deferred until 2008. Under this paragraph
(b)(1), the $20 loss is allocated to reduce foreign source financial
services income in 2008 because the loss was recognized (albeit
deferred) within the 24-month recapture period following the receipt
of the dividend. See Secs. 1.267(f)-1(a)(2)(i)(B) and 1.267(f)-
1(c)(2).
Example 5. The facts are the same as in Example 4, except P, S,
and B are domestic corporations and members of the P consolidated
group. Under the matching rule of Sec. 1.1502-13(c)(1), the separate
entity attributes of S's intercompany items and B's corresponding
items are redetermined to the extent necessary to produce the same
effect on consolidated taxable income as if S and B were divisions
of a single corporation and the intercompany transaction was a
transaction between divisions. If S and B were divisions of a single
corporation, the transfer of N stock on January 3, 2000 would be
ignored for tax purposes, and the corporation would be treated as
selling that stock only in 2008. Thus, the corporation's entire $45
loss would have been allocated against U.S. source income under
paragraph (a)(1) of this section because a dividend recapture amount
was not received during the corporation's recapture period.
Accordingly, S's $20 loss and B's $25 loss are allocated to reduce
U.S. source income.
(2) Exception for inventory. This section does not apply to loss
[[Page 1513]]
recognized with respect to stock described in section 1221(1).
(3) Exception for stock in an S corporation. This section does not
apply to loss recognized with respect to stock in an S corporation (as
defined in section 1361).
(4) Anti-abuse rules--(i) Transactions involving built-in losses.
If one of the principal purposes of a transaction is to change the
allocation of a built-in loss with respect to stock by transferring the
stock to another person, qualified business unit (within the meaning of
section 989(a)), office or other fixed place of business, or branch
that subsequently recognizes the loss, the loss shall be allocated by
the transferee as if it were recognized with respect to the stock by
the transferor immediately prior to the transaction. If one of the
principal purposes of a change of residence is to change the allocation
of a built-in loss with respect to stock, the loss shall be allocated
as if the change of residence had not occurred. If one of the principal
purposes of a transaction is to change the allocation of a built-in
loss with respect to stock (or other personal property) by converting
the original property into other property and subsequently recognizing
loss with respect to such other property, the loss shall be allocated
as if it were recognized with respect to the original property
immediately prior to the transaction. Transactions subject to this
paragraph shall include, without limitation, reorganizations within the
meaning of section 368(a), liquidations under section 332, transfers to
a corporation under section 351, transfers to a partnership under
section 721, transfers to a trust, distributions by a partnership,
distributions by a trust, or transfers to or from a qualified business
unit, office or other fixed place of business. A person may have a
principal purpose of affecting loss allocation even though this purpose
is outweighed by other purposes (taken together or separately).
(ii) Offsetting positions. If a taxpayer recognizes loss with
respect to stock and the taxpayer (or any person described in section
267(b) (after application of section 267(c)), 267(e), 318 or 482 with
respect to the taxpayer) holds (or held) offsetting positions with
respect to such stock with a principal purpose of recognizing foreign
source income and United States source loss, the loss will be allocated
and apportioned against such foreign source income. For purposes of
this paragraph (b)(4)(ii), positions are offsetting if the risk of loss
of holding one or more positions is substantially diminished by holding
one or more other positions.
(iii) Matching rule. [Reserved] For further guidance, see
Sec. 1.865-2T(b)(4)(iii).
(iv) Examples. The application of this paragraph (b)(4) may be
illustrated by the following examples. No inference is intended
regarding the application of any other Internal Revenue Code section or
judicial doctrine that may apply to disallow or defer the recognition
of loss. The examples are as follows:
Example 1. (i) Facts. On January 1, 2000, P, a domestic
corporation, owns all of the stock of N1, a controlled foreign
corporation, which owns all of the stock of N2, a controlled foreign
corporation. N1's basis in the stock of N2 exceeds its fair market
value, and any loss recognized by N1 on the sale of N2 would be
allocated under paragraph (a)(1) of this section to reduce foreign
source passive limitation earnings and profits of N1. In
contemplation of the sale of N2 to an unrelated purchaser, P causes
N1 to liquidate with principal purposes of recognizing the loss on
the N2 stock and allocating the loss against U.S. source income. P
sells the N2 stock and P recognizes a loss.
(ii) Loss allocation. Because one of the principal purposes of
the liquidation was to transfer the stock to P in order to change
the allocation of the built-in loss on the N2 stock, under paragraph
(b)(4)(i) of this section the loss is allocated against P's foreign
source passive limitation income.
Example 2. (i) Facts. On January 1, 2000, P, a domestic
corporation, forms N and F, foreign corporations, and contributes
$1,000 to the capital of each. N and F enter into offsetting
positions in financial instruments that produce financial services
income. Holding the N stock substantially diminishes P's risk of
loss with respect to the F stock (and vice versa). P holds N and F
with a principal purpose of recognizing foreign source income and
U.S. source loss. On March 31, 2000, when the financial instrument
held by N is worth $1,200 and the financial instrument held by F is
worth $800, P sells its F stock and recognizes a $200 loss.
(ii) Loss allocation. Because P held an offsetting position with
respect to the F stock with a principal purpose of recognizing
foreign source income and U.S. source loss, the $200 loss is
allocated against foreign source financial services income under
paragraph (b)(4)(ii) of this section.
(c) Loss recognized by partnership. A partner's distributive share
of loss recognized by a partnership shall be allocated and apportioned
in accordance with this section as if the partner had recognized the
loss. If loss is attributable to an office or other fixed place of
business of the partnership within the meaning of section 865(e)(3),
such office or fixed place of business shall be considered to be an
office of the partner for purposes of this section.
(d) Definitions--(1) Terms defined in Sec. 1.861-8. See Sec. 1.861-
8 for the meaning of class of gross income, statutory grouping of gross
income, and residual grouping of gross income.
(2) Dividend recapture amount. A dividend recapture amount is a
dividend (except for an amount treated as a dividend under section 78),
an inclusion described in section 951(a)(1)(A)(i) (but only to the
extent attributable to a dividend (including a dividend under section
964(e)(1)) included in the earnings of a controlled foreign corporation
(held directly or indirectly by the person recognizing the loss) that
is included in foreign personal holding company income under section
954(c)(1)(A)) and an inclusion described in section 951(a)(1)(B).
(3) Recapture period. A recapture period is the 24-month period
preceding the date on which a taxpayer recognizes a loss with respect
to stock, increased by any period of time in which the taxpayer has
diminished its risk of loss in a manner described in section 246(c)(4)
and the regulations thereunder and by any period in which the assets of
the corporation are hedged against risk of loss with a principal
purpose of enabling the taxpayer to hold the stock without significant
risk of loss until the recapture period has expired.
(4) United States resident. See section 865(g) and the regulations
thereunder for the definition of United States resident.
(e) Effective date--(1) In general. This section is effective for
loss recognized on or after January 11, 1999. For purposes of this
paragraph (e), loss that is recognized but deferred (for example, under
section 267 or 1092) shall be treated as recognized at the time the
loss is taken into account.
(2) Application to prior periods. A taxpayer may apply the rules of
this section to losses recognized in any taxable year beginning on or
after January 1, 1987, and all subsequent years, provided that--
(i) The taxpayer's tax liability as shown on an original or amended
tax return is consistent with the rules of this section and Sec. 1.865-
2T for each such year for which the statute of limitations does not
preclude the filing of an amended return on June 30, 1999; and
(ii) The taxpayer makes appropriate adjustments to eliminate any
double benefit arising from the application of this section to years
that are not open for assessment.
(3) Examples. The rules of this paragraph (e) may be illustrated by
the following examples:
Example 1. (i) P, a domestic corporation, has a calendar taxable
year. On March 10, 1985, P recognizes a $100 capital loss on the
sale of N, a foreign corporation. Pursuant to sections 1211(a) and
1212(a), the loss is not allowed in 1985 and is carried over to the
1990 taxable year. The loss is allocated
[[Page 1514]]
against foreign source income under Sec. 1.861-8(e)(7). In 1999, P
chooses to apply this section to all losses recognized in its 1987
taxable year and in all subsequent years.
(ii) Allocation of the loss on the sale of N is not affected by
the rules of this section because the loss was recognized in a
taxable year that did not begin after December 31, 1986.
Example 2. (i) P, a domestic corporation, has a calendar taxable
year. On March 10, 1988, P recognizes a $100 capital loss on the
sale of N, a foreign corporation. Pursuant to sections 1211(a) and
1212(a), the loss is not allowed in 1988 and is carried back to the
1985 taxable year. The loss is allocated against foreign source
income under Sec. 1.861-8(e)(7) on P's federal income tax return for
1985 and increases an overall foreign loss account under
Sec. 1.904(f)-1.
(ii) In 1999, P chooses to apply this section to all losses
recognized in its 1987 taxable year and in all subsequent years.
Consequently, the loss on the sale of N is allocated against U.S.
source income under paragraph (a)(1) of this section. Allocation of
the loss against U.S. source income reduces P's overall foreign loss
account and increases P's tax liability in 2 years: 1990, a year
that will not be open for assessment on June 30, 1999, and 1997, a
year that will be open for assessment on June 30, 1999. Pursuant to
paragraph (e)(2)(i) of this section, P must file an amended federal
income tax return that reflects the rules of this section for 1997,
but not for 1990.
Example 3. (i) P, a domestic corporation, has a calendar taxable
year. On March 10, 1989, P recognizes a $100 capital loss on the
sale of N, a foreign corporation. The loss is allocated against
foreign source income under Sec. 1.861-8(e)(7) on P's federal income
tax return for 1989 and results in excess foreign tax credits for
that year. The excess credit is carried back to 1988, pursuant to
section 904(c). In 1999, P chooses to apply this section to all
losses recognized in its 1989 taxable year and in all subsequent
years. On June 30, 1999, P's 1988 taxable year is closed for
assessment, but P's 1989 taxable year is open with respect to claims
for refund.
(ii) Because P chooses to apply this section to its 1989 taxable
year, the loss on the sale of N is allocated against U.S. source
income under paragraph (a)(1) of this section. Allocation of the
loss against U.S. source income would have permitted the foreign tax
credit to be used in 1989, reducing P's tax liability in 1989.
Nevertheless, under paragraph (e)(2)(ii) of this section, because
the credit was carried back to 1988, P may not claim the foreign tax
credit in 1989.
Par. 6. Section 1.865-2T is added immediately after Sec. 1.865-2,
to read as follows:
Sec. 1.865-2T Loss with respect to stock (Temporary).
(a) through (b)(4)(ii) [Reserved] For further guidance, see
Sec. 1.865-2(a) through (b)(4)(ii).
(b)(4)(iii) Matching rule. To the extent a taxpayer (or a person
described in section 1059(c)(3)(C) with respect to the taxpayer)
recognizes foreign source income for tax purposes that results in the
creation of a corresponding loss with respect to stock, the loss shall
be allocated and apportioned against such income. This paragraph
(b)(4)(iii) shall not apply to the extent a loss is related to a
dividend recapture amount and Sec. 1.865-2(b)(1)(ii) (de minimis
exception) or (b)(1)(iii) (passive dividend exception) exempts the loss
from Sec. 1.865-2(b)(1)(i) (dividend recapture rule), unless the stock
is held with a principal purpose of producing foreign source income and
corresponding loss.
(iv) Examples. The application of this paragraph (b)(4) may be
illustrated by the following examples. No inference is intended
regarding the application of any other Internal Revenue Code section or
judicial doctrine that may apply to disallow or defer the recognition
of loss. The examples are as follows:
Examples 1 and 2. [Reserved] For further guidance, see
Sec. 1.865-2(b)(4)(iv).
Example 3. (i) Facts. On January 1, 1999, P and Q, domestic
corporations, form R, a domestic partnership. The corporations and
partnership use the calendar year as their taxable year. P
contributes $900 to R in exchange for a 90-percent partnership
interest and Q contributes $100 to R in exchange for a 10-percent
partnership interest. R purchases a dance studio in country X for
$1,000. On January 2, 1999, R enters into contracts to provide dance
lessons in Country X for a 5-year period beginning January 1, 2000.
These contracts are prepaid by the dance studio customers on
December 31, 1999, and R recognizes foreign source taxable income of
$500 from the prepayments (R's only income in 1999). P takes into
income its $450 distributive share of partnership taxable income. On
January 1, 2000, P's basis in its partnership interest is $1,350
($900 from its contribution under section 722, increased by its $450
distributive share of partnership income under section 705). On
September 22, 2000, P contributes its R partnership interest to S, a
newly-formed domestic corporation, in exchange for all the stock of
S. Under section 358, P's basis in S is $1,350. On December 1, 2000,
P sells S to an unrelated party for $1050 and recognizes a $300
loss.
(ii) Loss allocation. Because P recognized foreign source income
for tax purposes that resulted in the creation of a corresponding
loss with respect to the S stock, the $300 loss is allocated against
foreign source income under paragraph (b)(4)(iii) of this section.
Example 4. (i) Facts. On January 1, 2000, P, a domestic
corporation that uses the calendar year as its taxable year forms N,
a foreign corporation. P contributes $1,000 to the capital of N in
exchange for 100 shares of common stock. P contributes an additional
$1,000 to the capital of N in exchange for 100 shares of preferred
stock. Each preferred share is entitled to 15-percent dividend but
is redeemable by N on or after January 1, 2010, for $1. Prior to
January 10, 2005, P receives a total of $750 of distributions from N
with respect to its preferred shares, which P treats as foreign
source general limitation dividends. On January 10, 2005, P sells
its 100 preferred shares in N to an unrelated purchaser for $600.
Assume that this arrangement is not recharacterized under Notice 97-
21 (1997-1 C.B. 407).
(ii) Loss allocation. Because P recognized foreign source income
for tax purposes that resulted in the creation of a corresponding
loss with respect to the N stock, the $400 loss is allocated against
foreign source general limitation income under paragraph (b)(4)(iii)
of this section.
Example 5. (i) Facts. On January 1, 2000, P, a domestic
corporation that uses the calendar year as its taxable year, and F,
a newly-formed controlled foreign corporation wholly-owned by P,
form N, a foreign corporation. P contributes $1,000 to the capital
of N in exchange for 100 shares of common stock and $1,000 to the
capital of F in exchange for 100 shares of common stock. F
contributes LC1,000 to the capital of N in exchange for 100 shares
of preferred stock. Each preferred share is entitled to a 65-percent
LC dividend. At the time of the contributions, $1=LC1. The LC is
expected to depreciate significantly in relation to the U.S. dollar.
Prior to June 10, 2005, P receives a total of $1,900 of
distributions from F, which it treats as foreign source general
limitation dividends. On June 10, 2005, the N preferred stock has a
fair market value of $25 and P sells F for $25 to an unrelated
person. Assume that this arrangement is not recharacterized under
Notice 97-21 (1997-1 C.B. 407).
(ii) Loss allocation. Because P recognized foreign source income
for tax purposes that resulted in the creation of a corresponding
loss with respect to the F stock, the $975 loss is allocated against
foreign source general limitation income under paragraph (b)(4)(iii)
of this section.
Example 6. (i) Facts. On January 1, 1998, P, a domestic
corporation, purchases N, a foreign corporation, for $1000. On March
1, 1998, N sells its operating assets, distributes a $400 general
limitation dividend to P, and invests its remaining $600 in short
term government securities. N earns interest income from the
securities. The income constitutes subpart F income that is included
in P's income under section 951, increasing P's basis in the N stock
under section 961(a). On March 1, 2002, P sells N and recognizes a
$400 loss.
(ii) Loss allocation. The $400 dividend received by P resulted
in a $400 built-in loss in the N stock, which was locked in for P's
four-year holding period. Because P recognized foreign source income
for tax purposes that resulted in the creation of a corresponding
loss with respect to the N stock, under paragraph (b)(4)(iii) of
this section the $400 loss is allocated against foreign source
general limitation income.
(e) Effective date--(1) In general. This section is effective
for loss recognized on or after January 11, 1999. For purposes of
this paragraph (e), loss that is recognized but deferred (for
example, under section 267 or 1092) shall be treated as recognized
at the time the loss is taken into account. This
[[Page 1515]]
section shall cease to be effective January 8, 2002.
(2) Application to prior periods. A taxpayer may apply the rules
of this section to losses recognized in any taxable year beginning
on or after January 1, 1987, and all subsequent years, provided
that--
(i) The taxpayer's tax liability as shown on an original or
amended tax return is consistent with the rules of this section and
Sec. 1.865-2 for each such year for which the statute of limitations
does not preclude the filing of an amended return on June 30, 1999;
and
(ii) The taxpayer makes appropriate adjustments to eliminate any
double benefit arising from the application of this section to years
that are not open for assessment.
Par. 7. Section 1.904-0 is amended by revising the entry for
Sec. 1.904-4(c)(2)(i) and (ii) and adding entries for paragraphs
(c)(2)(i)(A), (c)(2)(i)(B), (c)(2)(ii)(A) and (c)(2)(ii)(B) to read
as follows:
Sec. 1.904-0 Outline of regulation provisions for section 904.
* * * * *
Sec. 1.904-4 Separate application of section 904 with respect to
certain categories of income.
* * * * *
(c) * * *
(2) * * *
(i) Effective dates.
(A) In general.
(B) Application to prior periods.
(ii) Grouping rules.
(A) Initial allocation and apportionment of deductions and
taxes.
(B) Reallocation of loss groups.
* * * * *
Par. 8. Section 1.904-4 is amended by:
1. Revising paragraphs (c)(1) and (c)(2),
2. Revising paragraph (c)(3)(iii),
3. Adding paragraph (c)(3)(iv), and
4. Amending paragraph (c)(8) by adding Example 11, Example 12 and
Example 13.
5. The additions and revisions read as follows:
Sec. 1.904-4 Separate application of section 904 with respect to
certain categories of income.
* * * * *
(c) High-taxed income--(1) In general. Income received or accrued
by a United States person that would otherwise be passive income shall
not be treated as passive income if the income is determined to be
high-taxed income. Income shall be considered to be high-taxed income
if, after allocating expenses, losses and other deductions of the
United States person to that income under paragraph (c)(2)(ii) of this
section, the sum of the foreign income taxes paid or accrued by the
United States person with respect to such income and the foreign taxes
deemed paid or accrued by the United States person with respect to such
income under section 902 or section 960 exceeds the highest rate of tax
specified in section 1 or 11, whichever applies (and with reference to
section 15 if applicable), multiplied by the amount of such income
(including the amount treated as a dividend under section 78). If,
after application of this paragraph (c), income that would otherwise be
passive income is determined to be high-taxed income, such income shall
be treated as general limitation income, and any taxes imposed on that
income shall be considered related to general limitation income under
Sec. 1.904-6. If, after application of this paragraph (c), passive
income is zero or less than zero, any taxes imposed on the passive
income shall be considered related to general limitation income. For
additional rules regarding losses related to passive income, see
paragraph (c)(2) of this section. Income and taxes shall be translated
at the appropriate rates, as determined under sections 986, 987 and 989
and the regulations under those sections, before application of this
paragraph (c). For purposes of allocating taxes to groups of income,
United States source passive income is treated as any other passive
income. In making the determination whether income is high-taxed,
however, only foreign source income, as determined under United States
tax principles, is relevant. See paragraph (c)(8) Examples 10 through
13 of this section for examples illustrating the application of this
paragraph (c)(1) and paragraph (c)(2) of this section.
(2) Grouping of items of income in order to determine whether
passive income is high-taxed income--(i) Effective dates--(A) In
general. For purposes of determining whether passive income is high-
taxed income, the grouping rules of paragraphs (c)(3)(i) and (ii),
(c)(4), and (c)(5) of this section apply to taxable years beginning
after December 31, 1987. Except as provided in paragraph (c)(2)(i)(B)
of this section, the rules of paragraph (c)(3)(iii) apply to taxable
years beginning after December 31, 1987, and ending before December 31,
1998, and the rules of paragraph (c)(3)(iv) apply to taxable years
ending on or after December 31, 1998. See Notice 87-6 (1987-1 C.B.417)
for the grouping rules applicable to taxable years beginning after
December 31, 1986 and before January 1, 1988. The fourth sentence of
paragraph (c)(2)(ii)(A) and paragraph (c)(2)(ii)(B) of this section are
effective for taxable years beginning after March 12, 1999.
(B) Application to prior periods. A taxpayer may apply the rules of
paragraph (c)(3)(iv) to any taxable year beginning after December 31,
1991, and all subsequent years, provided that--
(1) The taxpayer's tax liability as shown on an original or amended
tax return is consistent with the rules of this section for each such
year for which the statute of limitations does not preclude the filing
of an amended return on June 30, 1999; and
(2) The taxpayer makes appropriate adjustments to eliminate any
double benefit arising from the application of this section to years
that are not open for assessment.
(ii) Grouping rules--(A) Initial allocation and apportionment of
deductions and taxes. For purposes of determining whether passive
income is high-taxed, expenses, losses and other deductions shall be
allocated and apportioned initially to each of the groups of passive
income (described in paragraphs (c)(3), (4), and (5) of this section)
under the rules of Secs. 1.861-8 through 1.861-14T and 1.865-1T through
1.865-2T. Taxpayers that allocate and apportion interest expense on an
asset basis may nevertheless apportion passive interest expense among
the groups of passive income on a gross income basis. Foreign taxes are
allocated to groups under the rules of Sec. 1.904-6(a)(iii). If a loss
on a disposition of property gives rise to foreign tax (i.e., the
transaction giving rise to the loss is treated under foreign law as
having given rise to a gain), the foreign tax shall be allocated to the
group of passive income to which gain on the sale would have been
assigned under paragraph (c)(3) or (4) of this section. A determination
of whether passive income is high-taxed shall be made only after
application of paragraph (c)(2)(ii)(B) of this section (if applicable).
(B) Reallocation of loss groups. If, after allocation and
apportionment of expenses, losses and other deductions under paragraph
(c)(2)(ii)(A) of this section, the sum of the allocable deductions
exceeds the gross income in one or more groups, the excess deductions
shall proportionately reduce income in the other groups (but not below
zero).
(3) * * *
(iii) For taxable years ending before December 31, 1998 (except as
provided in paragraph (c)(2)(i)(B) of this section), all passive income
received during the taxable year that is subject to no withholding tax
shall be treated as one item of income.
[[Page 1516]]
(iv) For taxable years ending on or after December 31, 1998, all
passive income received during the taxable year that is subject to no
withholding tax or other foreign tax shall be treated as one item of
income, and all passive income received during the taxable year that is
subject to no withholding tax but is subject to a foreign tax other
than a withholding tax shall be treated as one item of income.
* * * * *
(8) * * *
Example 11. In 2001, P, a U.S. citizen with a tax home in
Country X, earns the following items of gross income: $400 of
foreign source, passive limitation interest income not subject to
foreign withholding tax but subject to Country X income tax of $100,
$200 of foreign source, passive limitation royalty income subject to
a 5 percent foreign withholding tax (foreign tax paid is $10),
$1,300 of foreign source, passive limitation rental income subject
to a 25 percent foreign withholding tax (foreign tax paid is $325),
$500 of foreign source, general limitation income that gives rise to
a $250 foreign tax, and $2,000 of U.S. source capital gain that is
not subject to any foreign tax. P has a $900 deduction allocable to
its passive rental income. P's only other deduction is a $700
capital loss on the sale of stock that is allocated to foreign
source passive limitation income under Sec. 1.865-2(a)(3)(i). The
$700 capital loss is initially allocated to the group of passive
income subject to no withholding tax but subject to foreign tax
other than withholding tax. The $300 amount by which the capital
loss exceeds the income in the group must be reapportioned to the
other groups under paragraph (c)(2)(ii)(B) of this section. The
royalty income is thus reduced by $100 to $100 ($200 - ($300 x
(200/600))) and the rental income is thus reduced by $200 to $200
($400 - ($300 x (400/600))). The $100 royalty income is not high-
taxed and remains passive income because the foreign taxes do not
exceed the highest United States rate of tax on that income. Under
the high-tax kick-out, the $200 of rental income and the $325 of
associated foreign tax are assigned to the general limitation
category.
Example 12. The facts are the same as in Example 11 except the
amount of the capital loss that is allocated under Sec. 1.865-
2(a)(3)(i) and paragraph (c)(2) of this section to the group of
foreign source passive income subject to no withholding tax but
subject to foreign tax other than withholding tax is $1,200. Under
paragraph (c)(2)(ii)(B) of this section, the excess deductions of
$800 must be reapportioned to the $200 of net royalty income subject
to a 5 percent withholding tax and the $400 of net rental income
subject to a 15 percent or greater withholding tax. The income in
each of these groups is reduced to zero, and the foreign taxes
imposed on the rental and royalty income are considered related to
general limitation income. The remaining loss of $200 constitutes a
separate limitation loss with respect to passive income.
Example 13. In 2001, P, a domestic corporation, earns a $100
dividend that is foreign source passive limitation income subject to
a 30-percent withholding tax. A foreign tax credit for the
withholding tax on the dividend is disallowed under section 901(k).
A deduction for the tax is allowed, however, under sections 164 and
901(k)(7). In determining whether P's passive income is high-taxed,
the $100 dividend and the $30 deduction are allocated to the first
group of income described in paragraph (c)(3)(iv) of this section
(passive income subject to no withholding tax or other foreign tax).
* * * * *
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
Approved: December 15, 1998.
Donald C. Lubick,
Assistant Secretary of the Treasury.
[FR Doc. 99-149 Filed 1-8-99; 8:45 am]
BILLING CODE 3830-01-U
