[Federal Register Volume 60, Number 173 (Thursday, September 7, 1995)]
[Rules and Regulations]
[Pages 46500-46530]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-21838]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1, 4 and 602
[TD 8618]
RIN 1545-AM15
Definition of a Controlled Foreign Corporation, Foreign Base
Company Income and Foreign Personal Holding Company Income of a
Controlled Foreign Corporation
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final Income Tax Regulations governing
the definition of a controlled foreign corporation and the definitions
of foreign base company income and foreign personal holding company
income of a controlled foreign corporation. These regulations are
necessary because of changes made to the prior law by the Tax Reform
Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the
Revenue Reconciliation Act of 1989, and the Omnibus Budget
Reconciliation Act of 1993. Certain conforming changes in the
regulations were necessary because of changes made by the Deficit
Reduction Act of 1984. The regulations will provide the public with the
guidance to comply with those acts and will affect United States
shareholders of controlled foreign corporations.
DATES: These regulations are effective September 7, 1995.
For dates of applicability, see Sec. 1.954-0(a).
FOR FURTHER INFORMATION CONTACT: Valerie Mark of the Office of
Associate Chief Counsel (International), within the Office of the Chief
Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW.,
Washington, DC 20224 (Attention CC:INTL:2 (INTL-0362-88). Telephone
(202) 622-3840 (not a toll-free call).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in these final regulations
has been reviewed and approved by the Office of Management and Budget
(OMB) in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C.
3504(h)) under control number 1545-1068. The estimated average burden
per respondent associated with the collection of information in this
regulation is one hour.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be directed to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP,
Washington, DC 20224, and to the Office of Management and Budget, Attn:
Desk Officer for the Department of the Treasury, Office of Information
and Regulatory Affairs, Washington, DC 20503.
Background
This document contains final regulations amending the Income Tax
Regulations (26 CFR Part 1) under sections 954(b), 954(c) and 957(a) of
the Internal Revenue Code (Code). Sections 954 and 957 were amended by
sections 1201, 1221, 1222 and 1223 of the Tax Reform Act of 1986 (Pub.
L. 99-514), by section 1012 of the Technical and Miscellaneous Revenue
Act of 1988 (Pub. L. 100-647), by section 7811 of the Revenue
Reconciliation Act of 1989 (Pub. L. 101-239) and by section 13233 of
the Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66). These
regulations are also issued under authority contained in section 7805
of the Code.
Temporary regulations (TD 8216) and a cross-referenced notice of
proposed rulemaking (INTL-362-88) under sections 954 and 957 of the
Code were published in the Federal Register on July 21, 1988 (53 FR
27489 and 53 FR 27532, respectively). Numerous written comments on the
proposed and temporary regulations were received from the public. As
explained below,
[[Page 46501]]
the comments were considered in the drafting of the final regulations.
Discussion of Major Comments and Changes to the Regulations
Section 1.954-1: Foreign Base Company Income
Section 1.954-1T(a)(3) and (5) (temporary regulations) apply the de
minimis and full inclusion tests of section 954(b)(3) before the high
tax exception of section 954(b)(4). Commenters have expressed concern
that, in certain cases, the only amounts required to be included in the
gross income of the United States shareholders of a controlled foreign
corporation may be full inclusion income. This result may occur when
subpart F income, other than full inclusion foreign base company
income, qualifies for the high tax exception. In response to these
comments, Sec. 1.954-1(d)(6) provides that an amount that otherwise
would be included as full inclusion foreign base company income,
pursuant to the operation of the full inclusion test of section
954(b)(3)(B), will be excluded from full inclusion foreign base company
income if more than 90 percent of the adjusted gross foreign base
company and adjusted gross insurance income qualifies for the high tax
exception described in section 954(b)(4) and the high tax election is
actually made.
Section 1.954-1T(a)(4) provides that in computing net foreign base
company income, foreign personal holding company income is reduced by
related person interest expense before allocating and apportioning
other expenses in accordance with Sec. 1.904(d)-5(c)(2). Commenters
understood this rule to be at variance with Sec. 1.904(d)-5(c)(2),
which requires related person interest expense to be allocated to
passive foreign personal holding company income after the allocation of
directly related expenses. In response to this comment, the rule
regarding allocation of related person interest expense was removed
from Sec. 1.954-1T(a)(4) and (c) was amended to clarify that foreign
base company income is reduced by directly related expenses before
passive foreign personal holding company income is reduced by related
person interest expense.
Section 1.954-1T(a)(7) treats amounts recharacterized as foreign
base company income or insurance income under section 952(c) as
adjusted net foreign base company income or adjusted net insurance
income. Thus, these amounts are not included in net foreign base
company income or net insurance income for purposes of applying the
high tax exception. Commenters argued that the rules of paragraph
(a)(7) should be amended to provide that amounts that are
recharacterized under section 952(c)(2) should not be treated as
adjusted net foreign base company income or adjusted net insurance
income if the amounts would have qualified for the high tax exception.
This comment was rejected because section 952(c)(2) does not
incorporate the exclusions and special rules of section 954(b)(4).
Additional rules regarding the coordination of sections 952(c) and 954
are being proposed under section 952 in a separate document published
elsewhere in this issue of the Federal Register.
Several comments were made concerning the anti-abuse rules of
Sec. 1.954-1T(b)(4), which require aggregation of gross income of
related controlled foreign corporations for purposes of the de minimis
and full inclusion tests. One comment suggested that the aggregation
rules of paragraph (b)(4) should be applied only if a purpose of first
importance (as opposed to a principal purpose) is to avoid the
application of the de minimis or full inclusion tests described in
section 954(b)(3). This comment was rejected because the standard
suggested is significantly more subjective than that of the regulations
and is therefore unadministrable. However, it was determined that it
was unnecessary to make the aggregation rules of paragraph (b)(4)
applicable to the full inclusion test, for which there is not the same
opportunity for tax avoidance.
One commenter suggested that the anti-abuse rules of Sec. 1.954-
1T(b)(4) should be amended to provide that the gross income of separate
controlled foreign corporations is aggregated only if a substantial
portion of the activities of the separate corporations would comprise a
single branch, and that the presumptions described in paragraph
(b)(4)(ii) should be eliminated. The commenter also suggested that the
definition of related person for purposes of these rules should refer
to the provisions of section 954(d)(3), rather than the broader
provisions of section 267. These comments were rejected because the
suggested amendments would unduly restrict the application of the anti-
abuse rules. The presumptions described in paragraph (b)(4)(ii) may be
rebutted, for example, by establishing reliance on the requirements of
foreign law. The anti-abuse rules are necessary to prevent the misuse
of the de minimis rule of section 954(b)(3), and do not impose a
significant limitation or burden on the activities of controlled
foreign corporations.
Section 1.954-1T(c) provides that in computing net foreign base
company income, the gross amount in each category of foreign base
company income may not be reduced below zero. Section 1.954-2T(e)
provides that the excess of losses over gains from the sale or exchange
of certain property may not be allocated to any other category of
foreign personal holding company income. Section 1.954-2T (f) and (g)
contain similar provisions with regard to excess losses from
commodities and foreign currency transactions, respectively. Because
the categories of foreign base company income described in section
954(a) and the categories of foreign personal holding company income
described in section 954(c)(1) (B), (C) and (D) are defined in terms of
net income, the temporary regulations interpreted the statutory scheme
as generally precluding the allocation of excess losses from categories
of foreign personal holding company income described in paragraph (e),
(f), or (g) against other foreign personal holding company income
categories. Commenters contended that by preventing any category of
subpart F income from being reduced below zero, paragraph (c) caused
inappropriate tax credit results and failed to harmonize the subpart F
provisions with section 904(f)(5). Commentators stated that paragraphs
(e), (f) and (g) should be amended to allow excess losses described in
those paragraphs to be allocated to other categories of foreign
personal holding company income.
Paragraph (c) has been amended to clarify that, in determining net
income, if the amount in any category of foreign base company income
(including any category of foreign personal holding company income) is
less than zero, the loss may not reduce any other categories of foreign
base company income (or foreign personal holding company income) except
by operation of the earnings and profits limitation. Proposed
regulations published elsewhere in this issue of the Federal Register
will provide rules concerning the application of the earnings and
profits limitation.
Section 1.954-1T(d) provides that the effective rate of foreign
income tax on an item of income is determined in a manner consistent
with the existing foreign tax credit regime under sections 904 and 960.
In some cases, the amount of an item of income for foreign law purposes
with respect to which foreign income tax is paid will be different from
the amount for United States tax purposes. As a result, the effective
rate of tax with respect to the item of income may be affected. In
addition, because
[[Page 46502]]
pursuant to section 960 the foreign income taxes of a controlled
foreign corporation more than three tiers below a United States
shareholder are not considered, the high tax exception will never apply
to items of income of such corporations.
Commenters suggested that certain foreign law accounting practices
should be considered in determining the effective rate of tax on an
item of income, for purposes of applying the high tax exception of
section 954(b)(4) and paragraph (d) of the regulations. Commenters also
contended that it is inappropriate to use section 960 to determine the
effective rate of foreign tax and thus prevent consideration of taxes
paid by controlled foreign corporations more than three tiers below the
United States shareholder.
The comment that the high tax exception should not be limited to
creditable taxes under section 960 was rejected. The high tax exception
is not intended to apply to the extent that an item of income would be
subject to residual United States tax if such item were included in the
gross income of the United States shareholder. The taxes paid with
respect to such item of income should be considered for purposes of the
high tax exception only to the extent they are otherwise considered for
United States taxing purposes. See Joint Committee on Taxation Staff,
General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess.
970-71 (1986).
The comment that foreign law accounting practices should be
considered in determining the effective rate of tax on an item of
income, for purposes of applying the high tax exception, was also
rejected. Such a rule would impose a significant burden on the IRS. It
would require the IRS to monitor and apply foreign tax and accounting
principles, and to reconcile their application with United States tax
and accounting principles, both in the current tax year and in later
tax years to prevent an item of income, deduction, credit, gain or loss
from being duplicated or omitted. Further, the IRS would have to
consider and identify the particular foreign tax and accounting
principles that could be taken into account for purposes of these
rules.
Section 1.954-1T(d)(4) defines the term item of income for purposes
of the high tax exception by reference to the foreign tax credit and
subpart F income categories to which the income relates. Thus, it is
possible that amounts attributable to separate transactions may be
included in the same item of income. If the income from the separate
transactions were subject to foreign income tax at different rates, the
effective rate of tax for the income item would reflect an average of
the two (or more) rates of tax. One commenter has suggested that
additional categories of income be created within the existing foreign
tax credit and subpart F income groups to limit the effect of this tax
rate blending.
The regulations rely on existing guidance under the foreign tax
credit and subpart F provisions generally to define item of income for
purposes of section 954(b)(4). To identify items of income on a
transaction-by-transaction basis is inconsistent with the separate
limitation categories of income described in section 904, and adds
complexity by requiring different computations for purposes of these
rules and the rules under the foreign tax credit provisions of the
Code. Moreover, there is no bias in the existing rules toward a
particular result.
Commenters suggested that the consistency rule of Sec. 1.954-
1T(d)(4)(ii)(B) be eliminated, to allow taxpayers to apply the high tax
exception on an item-by-item basis. The consistency rule prohibits a
taxpayer from selectively applying the high tax exception with respect
to foreign personal holding company income that is passive income under
section 904(d). Elimination of the consistency rule would provide a
result that is incompatible with the foreign tax credit provisions of
the Code, and thus the comment was rejected.
The final regulations clarify how the rules of paragraph (d)
coordinate with the earnings and profits limitation of section
952(c)(1). Under Sec. 1.954-1(d)(4)(ii), if the amount of income
included in subpart F income for the taxable year is reduced by the
earnings and profits limitation, the amount of income that is an item
of income, for purposes of paragraph (d), is determined after the
application of the rules of section 952(c)(1). An example was added to
illustrate this rule.
Section 1.954-1T(d)(5) provides that the election to apply the high
tax exception must be made by the controlling United States
shareholders and is binding on all United States shareholders of the
controlled foreign corporation. Commenters argued that the Secretary
does not have the authority to bind all United States shareholders to a
single election. This comment was rejected because it was determined
that section 954(b)(4) provides the authority. Further, allowing each
United States shareholder to separately elect the high tax exception
would add undue complexity to the operation of the foreign tax credit
rules.
Section 1.954-1(f) provides guidance on the definition of related
person under section 954(d)(3).
Section 1.954-2: Foreign Personal Holding Company Income
Section 1.954-2T(a)(2)(i) provides that amounts that fall within
the definition of income equivalent to interest, under paragraph (h),
will be so treated though such amounts may also fall within the
definition of gain from certain property transactions under paragraph
(e), gain from a commodities transaction under paragraph (f) or foreign
currency gain under paragraph (g). Paragraph (a)(2)(i) provides that
amounts will be treated as income equivalent to interest even if these
amounts are excluded from the computation of foreign personal holding
company income under paragraphs (e), (f), or (g) because they are
derived from certain qualifying business transactions. A commenter
suggested that paragraph (a)(2)(i) should not treat income from
qualifying business transactions excluded under paragraphs (e), (f), or
(g) as income equivalent to interest. This comment was rejected. The
rules regarding qualifying business transactions in paragraphs (e), (f)
and (g) do not operate to exclude interest income from characterization
as foreign personal holding company income. Income equivalent to
interest within the meaning of section 954(c)(1)(E) and paragraph (h)
generally should be treated like interest for purposes of subpart F.
Several commenters suggested that the test described in Sec. 1.954-
2T(a)(3) to determine the use for which property is held (for purposes
of determining the character of the income, gain or loss realized from
a disposition of such property) should not focus solely on the use of
the property immediately prior to its disposition, but instead should
consider the predominant use for which the property was held. This
comment was accepted. Section 1.954-2(a)(3) provides that the use for
which property is held is the use for which it was held for more than
one-half of the period during which the controlled foreign corporation
held the property. If there has been a change in use, however, and a
principal purpose for such change in use was to avoid characterizing
income or gain attributable to the property as foreign personal holding
company income, then the change in use will be disregarded.
Section 1.954-2T(a)(3)(ii), Examples 2 and 3 illustrate the rules
regarding change in use for which property is
[[Page 46503]]
held. The final regulations delete these examples because Example 1
sufficiently illustrated the rules of this paragraph. Examples 4 and 5
of paragraph (a)(3)(ii) illustrate the change in use rules with respect
to hedging transactions. The final regulations delete these examples
because the rules governing hedging transactions are now generally
contained in paragraph (a)(4)(ii).
Section 1.954-2T(a)(4)(i) lists some of the types of income that
are included in the term interest. To clarify that this list was not
meant to be exclusive, paragraph (a)(4)(i) has been amended to provide
that the term interest includes all amounts that are treated as
interest (including tax-exempt interest) under the Code and regulations
or any other provision of law. A new sentence illustrates the types of
income that would be treated as interest.
Section 1.954-2T(a)(4)(ii) provides that certain hedging
transactions that reduce the risk of price changes in the cost of
inventory and similar property are included within the definition of
inventory and similar property if certain requirements are met and if
they are so identified by the fifth day after which they are entered
into. Paragraphs (f)(4) and (g)(4) of the temporary regulations contain
definitions of the term qualified hedging transaction that have similar
five-day identification requirements. These several definitions of a
hedging transaction have been consolidated in Sec. 1.954-2(a)(4)(ii)
which contains a definition of bona fide hedging transaction and new
identification requirements for bona fide hedging transactions that
apply for purposes of computing foreign personal holding company income
under Sec. 1.954-2.
Section 1.954-2(a)(4)(ii)(A) generally defines a bona fide hedging
transaction as a transaction that meets the requirements of
Sec. 1.1221-2 (a) through (c) with two exceptions. First, the risk
being hedged may be with respect to ordinary property, section 1231
property or a section 988 transaction. Second, a transaction that
hedges the liabilities, inventory or other assets of a related person,
or that is entered into to assume or reduce risks of a related person,
will not be treated as a bona fide hedging transaction. Several
commenters had sought to expand the definition of qualified hedging
transactions to include hedging transactions conducted by a controlled
foreign corporation that is a currency coordination center, i.e., a
controlled foreign corporation that aggregates the currency exposures
of related controlled foreign corporations and hedges such exposures.
The statute provides, however, that a transaction must satisfy the
business needs of the particular controlled foreign corporation. See
also Joint Committee on Taxation Staff, General Explanation of the Tax
Reform Act of 1986, 99th Cong., 2d Sess. 976 (1986).
Section 1.954-2(a)(4)(ii)(B) provides identification requirements
for a bona fide hedging transaction. The same-day identification and
the recordkeeping requirements of Sec. 1.1221-2 apply for transactions
entered on or after March 7, 1996. For bona fide hedging transactions
entered into prior to this date and after July 22, 1988, the
transaction must be identified by the close of the fifth day after the
day on which it is entered into. For bona fide hedging transactions
entered into prior to July 22, 1988, the transaction must be identified
reasonably contemporaneously with the date it is entered into but no
later than within the normal period prescribed under the method of
accounting of the controlled foreign corporation used for financial
reporting purposes.
Section 1.954-2(a)(4)(ii)(C) describes the treatment of
transactions that are misidentified as hedging transactions, and
hedging transactions that the taxpayer fails to identify as such.
Paragraph (a)(4)(ii)(C) also provides relief for taxpayers that have
identified, or failed to identify, a hedging transaction due to
inadvertent error. These misidentification rules are substantially
similar to the rules in Sec. 1.1221-2(f), modified for purposes of the
subpart F regime.
Section 1.954-2T(a)(4)(iii) defines regular dealer, and states
that, ``purchasing and selling property through a regulated exchange or
off-exchange market (for example, engaging in futures transactions) is
not actively engaging as a merchant'' for purposes of these rules. This
provision was intended to mean that such purchasing and selling
activity alone, in the absence of other activities, will not qualify a
controlled foreign corporation as a regular dealer within the meaning
of paragraph (a)(4)(iii). Because commenters indicated that this
reference to purchasing and selling through a regular exchange or off-
exchange market was confusing, this provision was removed. Further, the
definition of regular dealer was amended. Section 1.954-2(a)(4)(iv)
provides that a controlled foreign corporation will be a regular dealer
if it regularly and actively offers to, and in fact does, engage in
certain specified activities with customers who are not related persons
(as defined in section 954(d)(3)) with respect to the CFC. Examples
were added to clarify that a controlled foreign corporation that
qualifies as a dealer under Sec. 1.954-2(a)(4)(iv) will not be
disqualified from being treated as a regular dealer because it also
engages in transactions with related persons.
The temporary regulations define dealer property as property held
by a controlled foreign corporation that is a regular dealer in
property of such kind in its capacity as a dealer. The temporary
regulations also state that property held for investment or speculation
is not dealer property. A commenter suggested that property should be
considered dealer property within the meaning of Sec. 1.954-
2T(a)(4)(iv) if the controlled foreign corporation holding the property
is a regular dealer in such property. This comment was rejected because
it proposes an unduly expansive definition of dealer property.
Paragraph (a)(4), therefore, generally continues to define dealer
property in the same manner as the temporary regulations.
The final regulations do clarify, however, that if a controlled
foreign corporation qualifies as a regular dealer, all of the property
held in a dealer capacity by that corporation is treated as dealer
property. Thus, dealer property includes property arising from a
transaction entered into with a related person, as long as the
controlled foreign corporation is a regular dealer and holds the
property in its capacity as a dealer, and not for investment or
speculation. The examples of Sec. 1.954-2(a)(4)(vi) illustrate this
rule. A rule has been added for licensed securities dealers under which
only securities identified as held for investment under section 475(b)
or 1236 will be treated as held for investment or speculation. Also, to
conform to amendments to section 954(c)(1)(B) made by the Technical and
Miscellaneous Revenue Act of 1988, Sec. 1.954-2(a)(4)(v)(C) provides
that a bona fide hedging transaction with respect to dealer property is
treated as a transaction in dealer property.
Section 954(c)(2)(B) and Sec. 1.954-2T(b)(2) exclude from foreign
personal holding company income export financing interest that is
derived in the active conduct of a banking business. A commenter
suggested that paragraph (b)(2) should treat a controlled foreign
corporation as engaged in the conduct of a banking business even if it
transfers the servicing of loans to related or unrelated parties. This
comment was rejected because servicing of loans is a fundamental
element of banking activity that gives rise to export financing
interest for which an exception from foreign personal holding company
income is intended.
[[Page 46504]]
Section 1.954-2T(b)(2) references the definition of export
financing interest contained in section 904(d)(2)(G). Under section
904(d)(2)(G), the property that is financed must be manufactured,
produced, grown or extracted in the United States by the taxpayer or a
related person. Section 1.954-2(b)(2) clarifies that Sec. 1.927(a)-
1T(c)(1) applies for purposes of determining whether property is
manufactured, produced, grown or extracted in the United States.
Section 1.954-2T(b)(2) also provides that the term export financing
interest does not include income from related party factoring that is
treated as interest under section 864(d)(1) or (6). The final
regulations contain examples that clarify that if amounts are not
treated as interest under section 864(d)(1) or (6) because the
exception under section 864(d)(7) applies, these amounts may be export
financing interest under paragraph (b)(2).
Section 954(c)(3)(A) and Sec. 1.954-2T(b) (3) and (4) provide that
certain dividend, interest, rent or royalty income received from
related corporate payors is not included in foreign personal holding
company income. To reflect amendments to section 954(c)(3)(A) by the
Revenue Reconciliation Act of 1989, the final regulations provide that
if a partnership with one or more corporate partners makes a payment of
interest, rent or royalties, the interest, rent or royalty payment will
be treated as paid by a corporate partner to the extent the payment
gives rise to a partnership item of deduction that is allocable to the
corporate partner or to the extent that a partnership item reasonably
related to the payment would be allocated to the corporate partner
under an existing allocation under the partnership agreement. To the
extent the payment is treated as made by the corporate partner, it will
be excluded from the foreign personal holding company income of the
recipient if the corporate partner otherwise satisfies the conditions
of section 954(c)(3)(A).
Under Sec. 1.954-2T(b)(3)(ii), interest may not be excluded from
foreign personal holding company income of the recipient to the extent
the deduction for interest is allocated to the payor's subpart F
income. To clarify how this rule is to be applied when a controlled
foreign corporation is both the recipient and payor of interest,
Sec. 1.954-2(b)(4)(ii)(B)(2) was added, which parallels the rule
contained in Sec. 1.904-5(k)(2).
Section 1.954-2T(b)(3) provides that, to exclude dividends and
interest received from related corporate payors from foreign personal
holding company income, a substantial part of the payor's assets must
be used in a trade or business in the payor's country of incorporation.
Section 1.954-2T(b)(3)(iv) provides that a substantial part of the
payor's assets will be considered to be used in a trade or business in
the payor's country of incorporation if, for each quarter of the
taxable year, the average value of its assets which are so used is over
50 percent of the average value of all of its assets (determined as of
the beginning and end of the quarter). To simplify the application of
this rule, Sec. 1.954-2(b)(4)(iv) provides that the average value of
assets is to be determined on a yearly rather than a quarterly basis by
averaging the values of assets as of the close of each quarter.
Section 1.954-2T(b)(3)(vi)(A) provides that for purposes of the
substantial assets test, tangible property (other than inventory) is
generally considered located where it is physically located. Paragraph
(b)(3)(vi)(B) contains an exception for property temporarily located
elsewhere for inspection or repair. A commenter suggested that, in
addition to this exception, the regulations should restore the
exception contained in prior regulations that treated purchased
property located abroad and intended for prompt shipment to the country
of incorporation as property located in the country of incorporation.
This comment was rejected because this provision would have been
inconsistent with the rule that property purchased for use in a trade
or business is not considered used in a trade or business until it is
placed in service.
Section 1.954-2T(b)(3)(vii)(A) provides that for purposes of the
substantial assets test, the location of intangible property is
determined based on the site of the activities conducted by the payor
during the taxable year in connection with the use or exploitation of
the property. The country in which services are performed is determined
under the principles of section 954(e) and Sec. 1.954-4(c). This rule
was amended to provide more comprehensive guidance to determine the
situs of activities in connection with the use or exploitation of
intangible property. Section 1.954-2(b)(4)(vii)(B) provides that the
country in which the activities connected to the use or exploitation of
property are conducted is the country in which the expenses associated
with these activities are incurred by the payor or its agent or an
independent contractor.
Section 1.954-2T(b)(3)(vii)(A) provides that the intangible
property is considered located in the payor's country of incorporation
during each quarter of the taxable year if the activities connected
with its use or exploitation are conducted in its country of
incorporation during the entire taxable year. A commenter argued that
this test is inconsistent with the quarterly determination required by
the substantial assets test of Sec. 1.954-2T(b)(3)(iv). Changes were
made to the location of property rules (Sec. 1.954-2(b)(4)(vi) through
(ix)) so that relevant determinations are made for each quarter
separately.
The final regulations continue to reserve on the provision of
special rules regarding the location of assets of banks and insurance
companies for purposes of the same-country exception. Comments are
invited regarding the need for special guidance on this issue.
Several comments questioned the application of the rules of
Sec. 1.954-2T(b)(6), pursuant to which interest income of a controlled
foreign corporation that is described in section 103 is included in
foreign personal holding company income but is characterized as tax-
exempt interest when included in the gross income of the United States
shareholders. The purpose of this rule was to prevent a person from
avoiding the consequences of the alternative minimum tax provisions by
investing in tax-exempt obligations described in section 103 through a
controlled foreign corporation.
The final regulations reserve on the treatment of tax-exempt
interest. The administrative complexity of applying the rule described
in the temporary regulations, and the potential for double taxation
that it creates, argue against its continued application. Proposed
regulations, published elsewhere in this issue of the Federal Register,
will provide rules regarding the treatment of tax-exempt interest. In
the interim, the rules of the temporary regulations continue to apply.
Section 1.954-2T(b)(5) provides that the determination whether
rents and royalties are derived from the active conduct of a trade or
business is made under the facts and circumstances of each case, and
refers to paragraphs (c) and (d) for the application of its provisions.
Commenters have asked whether only the facts and circumstances
described in paragraphs (c) and (d) may be considered. The final
regulations are clarified to reflect that whether rents or royalties
are derived in the active conduct of a trade or business is determined
solely under the provisions of paragraphs (c) and (d).
Section 1.954-2T(c)(2)(iii) defines active leasing expenses for
purposes of
[[Page 46505]]
determining whether rental income is derived in the active conduct of a
trade or business. A commenter suggested that paragraph (c)(2)(iii) be
amended to state that if a corporation sells property of the same type
as the property that is leased, the corporation's expenses that are of
the type described in that paragraph may be pro-rated on any reasonable
basis between the leasing and the sales function. It was determined
that the change requested by this commenter was unnecessary because
paragraph (c)(2)(iii) already defines active leasing expenses as
deductions properly allocable to rental income.
A commenter suggested that an example be added to Sec. 1.954-2T(c)
to illustrate that expenses such as payments to third parties for
insurance, utilities and repairs are considered active leasing expenses
and not amounts paid to agents or independent contractors. The
regulations were amended in response to this comment. Section 1.954-
2(c)(2)(iii)(D) provides that the term active leasing expenses does not
include payments to agents or independent contractors other than
payments for insurance, utilities and other expenses for like services
or capitalized property. A similar change was made to the definition of
the term adjusted leasing profit.
Section 954(c)(1)(B) and Sec. 1.954-2T(e) include in foreign
personal holding company income the excess of gains over losses from
certain property transactions. Section 1.954-2T(e)(1)(i) provides that
gain or loss that is treated as capital gain or loss under section
988(a)(1)(B) is not foreign currency gain or loss but rather gain or
loss from a property transaction under paragraph (e). A commenter
contended that gain or loss from transactions described in section
988(a)(1)(B) should be characterized as gain or loss described in
section 954(c)(1)(C) and Sec. 1.954-2T(f) rather than in section
954(c)(1)(B) and paragraph (e). This comment was rejected, because the
capital transactions described in section 988(a)(1)(B) are more
appropriately subject to the provisions of section 954(c)(1)(B) and
paragraph (e). This provision is now contained in Sec. 1.954-2(g)(5).
A commenter asked that gain from a disposition of stock of a
subsidiary be excluded from foreign personal holding company income to
the extent that gain from the subsidiary's disposition of its assets
would be so excluded. There is no statutory authority for the position
recommended by the commenter, however. In addition, the look-through
treatment proposed by the commenter is inconsistent with the treatment
prescribed for dispositions of interests in a partnership or trust
under section 954(c)(1)(B)(ii). For these reasons, the comment was
rejected.
Pursuant to Sec. 1.954-2T(e)(3)(vi), gain from a disposition of
non-depreciable intangible property or goodwill is characterized as
foreign personal holding company income unless the intangible property
is disposed of in connection with a disposition of the entire trade or
business of the controlled foreign corporation. Commenters have argued
that the gain should be excluded from foreign personal holding company
income if such property is used in the trade or business of the
controlled foreign corporation, without regard to whether an entire
trade or business of the controlled foreign corporation is sold.
The regulations were modified in response to this comment. Section
1.952-2(e)(3)(iv) excludes from foreign personal holding company income
any gain or loss of a controlled foreign corporation from a disposition
of intangible property, goodwill or going concern value to the extent
used or held for use in the trade or business of the controlled foreign
corporation.
Section 1.954-2T(e)(4) provides that gain or loss from the sale,
exchange or retirement of a debt instrument is included in the
computation of foreign personal holding company income under paragraph
(e) with certain exceptions. However, a loss on a debt instrument taken
in consideration for the sale or exchange of property is excluded from
foreign personal holding company income if the gain or loss from that
underlying sale or exchange is not includible in foreign base company
income. This rule was eliminated from the final regulations because it
was inconsistent to prevent a controlled foreign corporation from using
these losses to offset subpart F income when gain from such debt
instruments was not excepted from the general inclusion rule.
Section 1.954-2T(e)(5) provides that rights to acquire property,
other than certain property that is dealer property or inventory
property, are characterized as property that does not give rise to
income for purposes of section 954(c)(1)(B). One commenter has
suggested that such rights should not be characterized as property that
does not give rise to income. This comment was rejected because any
gain that may arise upon a disposition of an option, warrant, or other
right to acquire property, other than gain from a disposition of
inventory or dealer property, is income of the type intended to be
characterized as foreign personal holding company income for purposes
of section 954(c)(1)(B). The provisions of Sec. 1.954-2T(e)(5) are now
incorporated into the definition of property that does not give rise to
income under Sec. 1.954-2(e)(3). However, the final regulations clarify
that notional principal contracts are excluded from the definition of
property that does not give rise to income. (But see Sec. 1.954-2 (f),
(g) and (h).)
Section 954(c)(1)(C) and Sec. 1.954-2T(f) provide rules for
including the excess of gains over losses from commodities transactions
in foreign personal holding company income. Several commenters argued
that Sec. 1.954-2T(f)(2)(i) defines commodity too broadly, and that,
like sections 553 and 864, the regulations should apply only to
commodities that are actively traded on a regulated exchange. This
comment was rejected because the statute and its legislative history
make clear that section 954(c)(1)(C) is intended to apply broadly to
any commodity of a kind that is actively traded. Thus, there is no
reason to distinguish income from a disposition of a commodity actively
traded on a regulated exchange from income from a disposition of a
commodity of a kind that is otherwise actively traded.
Although Sec. 1.954-2(f)(2)(i) no longer explicitly provides that
nonfunctional currency is a commodity, nonfunctional currency continues
to fall within the general definition of commodity. Consequently,
foreign currency is still treated as a commodity if the currency is
actively traded or if contractual interests in the currency are
actively traded. Under the ordering rules of paragraph (a)(2), however,
paragraph (g) (foreign currency transactions) continues to apply before
paragraph (f). Thus, unless an election is made under section
988(c)(1)(D)(ii), a currency futures contract is treated as a
commodities transaction, while a currency forward contract is generally
treated as a foreign currency transaction.
Section 1.954-2T(f)(1) excludes gains and losses from qualified
active sales and qualified hedging transactions from the computation of
foreign personal holding company income under paragraph (f). In
defining qualified active sale, paragraph (f)(3) requires substantially
all of the controlled foreign corporation's business to be as an active
producer, processor, merchant or handler of commodities of like kind.
Commenters argued that by using the phrase ``of like kind,''
Sec. 1.954-2T(f)(3) defines qualified active sales too narrowly. The
``of like kind'' language was not intended to require that all of the
commodities be of one kind, but
[[Page 46506]]
rather that the controlled foreign corporation must be an active
producer, etc., with respect to each kind of commodity. To avoid
confusion, the ``of like kind'' language has been eliminated from the
definition of the term qualified active sale.
Section 1.954-2T(f)(3)(ii) defines the term sale of commodities.
Commenters questioned the requirement, incorporated in the definition
of this term, that the corporation hold the commodity in physical form.
This comment was accepted. The final regulations no longer require the
controlled foreign corporation to hold the commodity in physical form.
Section 1.954-2(f)(2)(iii)(B) requires only that the controlled foreign
corporation hold the commodity directly and not through an independent
contractor. The retention of this requirement is consistent with the
legislative history of section 954(c)(1)(C), which makes clear that the
exclusion from foreign personal holding company income was intended to
apply only with respect to commodities for which controlled foreign
corporations are active producers, processors, handlers or merchants.
Section 1.954-2(f)(2)(iii)(D) provides that activities of employees of
entities related to the controlled foreign corporation may be treated
as activities directly engaged in by the controlled foreign corporation
if the employees are paid and supervised by the controlled foreign
corporation.
Section 1.954-2(f)(2)(iii)(B) also amends the definition of the
term active conduct of a commodities business by clarifying that the
requirements specified in that paragraph must be satisfied with respect
to each commodity and that property may be held either as dealer
property or as inventory or similar property.
Section 954(c)(1)(C)(ii) and Sec. 1.954-2T(f) (1) and (3) exclude
income attributable to commodities transactions from foreign personal
holding company income if substantially all of the business of a
controlled foreign corporation is as an active producer, processor,
merchant or handler of commodities. Section 1.954-2T(f)(3)(iv) provides
that the controlled foreign corporation will satisfy the substantially
all requirement if 85 percent of its taxable income for the taxable
year is attributable to qualified active sales and qualified hedging
transactions. Several commenters argued that this test could fail to
reflect the nature of the controlled foreign corporation's business
accurately in some years because of the volatility of certain
commodities markets.
To accommodate this concern, Sec. 1.954-2(f)(2)(iii)(C) modifies
the definition of the term substantially all by applying the 85 percent
test to gross receipts rather than taxable income. To prevent
manipulation of this modified test, a provision was added under which
the District Director may disregard any sale or hedging transaction
that has as a principal purpose manipulation of the 85 percent test.
Section 1.954-2T(f)(4) defines the term qualified hedging
transaction as a bona fide hedging transaction that is entered into
primarily to reduce the risk of price change with respect to
commodities sold or to be sold in qualified active sales. A commenter
argued that a bona fide hedging transaction should not be required to
relate to a qualified active sale to be treated as a qualified hedging
transaction. This comment was rejected because this provision is based
on the statutory requirement that qualified hedging transactions must
arise out of the business of the controlled foreign corporation as an
active producer, processor, merchant or handler of commodities. Thus,
the rule of the temporary regulations is retained.
Section 954(c)(1)(D) and Sec. 1.954-2T(g) include in foreign
personal holding company income the net foreign currency gains
attributable to section 988 transactions. The rules in Sec. 1.954-
2T(g)(2)(i) governing the treatment of gain or loss attributable to
foreign currency transactions in hyperinflationary currencies have been
removed. Section 1.954-2(g)(5)(iii) provides that the applicable rules
of section 985 will apply to such transactions.
Section 1.954-2T(g)(2)(ii) excludes from foreign personal holding
company income gain or loss from qualified business transactions that
are separately identified, and gain or loss from qualified hedging
transactions that are identified with, or traced to, a qualified
business transaction. Many commenters argued that these rules are too
cumbersome to apply. They contended that a controlled foreign
corporation that has a large number of qualified business transactions
may not hedge such transactions individually, and that it is difficult
or impossible in such cases to relate a hedge to one or even several
qualified business transactions. The commenters also argued that the
alternative election to treat all currency gain (or loss) as foreign
personal holding company income (or loss allocable to foreign personal
holding company income) does not provide adequate relief for controlled
foreign corporations whose hedging activities relate to qualified
business transactions on a net basis but give rise to foreign currency
gain that is treated as foreign personal holding company income.
The regulations are modified in response to those comments. Section
1.954-2(g)(2)(ii) excludes from foreign personal holding company income
foreign currency gain or loss directly related to the business needs of
the controlled foreign corporation. Foreign currency gain or loss is
directly related to the business needs of the corporation, first, if it
can be clearly determined that it arises from a transaction entered
into or property used in the normal course of the corporation's trade
or business and the transaction or property does not itself give rise
to subpart F income (other than foreign currency gain or loss), or,
second, if it arises from a bona fide hedging transaction with respect
to such a transaction or property. To exclude gain or loss from a
hedging transaction from foreign personal holding company income under
this rule, corporations need not trace a hedging transaction to a
specific transaction or property if all (or all but a de minimis
amount) of the aggregate risks being hedged are within the business
needs exception and the hedging transaction otherwise satisfies the
requirements of section 1221, as modified for this purpose.
Section 1.954-2(g)(2)(ii)(C) provides a specific dealer exception
under which transactions described in section 988(c)(1)(B)(iii) and (C)
that are entered into by a regular dealer, in its capacity as a dealer,
are treated as directly related to its business needs for purposes of
the exclusion under Sec. 1.954-2(g)(2)(ii). Because a corporation's
borrowings support all of its activities, paragraph (g)(2)(iii)
provides that foreign currency gain or loss attributable to an
interest-bearing liability that is not covered by paragraph (g)(5)(iv)
is characterized as subpart F income and non-subpart F income on the
same basis as interest expense is allocated and apportioned. Thus, for
example, exchange gain or loss from an unhedged interest-bearing
liability may fall under this rule.
Section 1.954-2T(g)(3) provides that a transaction will not be
treated as a qualified business transaction if the foreign currency
gain or loss from the transaction is attributable to property or an
activity of a kind that gives rise to subpart F income. Commenters have
argued that this requirement is too restrictive because it may cause
the gain or loss from the underlying transaction, and the foreign
currency gain or loss attributable to the transaction, to be in
[[Page 46507]]
different separate categories for foreign tax credit purposes.
In response to this comment, a new election was added to paragraph
(g). Under Sec. 1.954-2(g)(3), the controlling United States
shareholders may elect to have the controlled foreign corporation
include foreign currency gain or loss that would otherwise be included
in foreign personal holding company income under paragraph (g) in the
category of subpart F income to which such gain or loss relates. This
election works in conjunction with the general rules of paragraph
(g)(2). Thus, for example, this election may apply to currency gain or
loss that would otherwise be treated as foreign personal holding
company income under paragraph (g) even if other currency gain or loss
is excluded under the business needs exception of paragraph (g)(2)(ii).
As described above, the temporary regulations permit taxpayers to
elect to treat all foreign currency gain or loss as foreign personal
holding company income. The final regulations retain this election,
with modifications. Under Sec. 1.954-2(g)(4), the controlling United
States shareholders of the controlled foreign corporation may elect to
include in the computation of foreign personal holding company income
net foreign currency gains or losses attributable to any section 988
transaction and any section 1256 contract that would be a section 988
transaction but for section 988(c)(1)(D). Shareholders are not
permitted to make separate elections for section 1256 contracts and
section 988 transactions. An election under paragraph (g)(4) supersedes
an election under paragraph (g)(3).
Section 1.954-2(g)(5)(iv) reserves on the treatment of gain or loss
allocated under Sec. 1.861-9. It is anticipated that when Sec. 1.861-9
is finalized, a provision will be added to this paragraph to indicate
that gain or loss that is allocated or apportioned under section 861 in
the same manner as interest expense is not foreign currency gain or
loss under paragraph (g).
Section 954(c)(1)(E) and Sec. 1.954-2T(h) include income equivalent
to interest in foreign personal holding company income. A commenter
argued that the term income equivalent to interest might be read to
include income from a wide range of interest rate sensitive
transactions entered into by a securities dealer or commodities
producer, processor, merchant or handler in the ordinary course of its
business. The commenter suggested that the regulations should be
modified to confirm that such income is not income equivalent to
interest.
The final regulations do not contain a general dealer exception
that applies to all income equivalent to interest because income
equivalent to interest is generally treated like interest, for which no
general dealer exception is provided. However, consistent with Notice
89-90 (1989-2 C.B. 407), Sec. 1.954-2(h)(3)(ii) provides a specific
dealer exception for income from notional principal contracts.
Section 1.954-2T(h)(1) provides that income equivalent to interest
does not include income attributable to notional principal contracts
except to the extent that such contracts are part of an integrated
transaction that gives rise to income equivalent to interest. Notice
89-90 stated, however, that final regulations would provide that income
equivalent to interest would include income from notional principal
contracts regardless of whether the notional principal contract is
integrated with an investment, because notional principal contracts
generally affect the all-in cost of interest-bearing liabilities or the
return on interest-bearing assets. Accordingly, Sec. 1.954-2(h)(3)
provides that income from notional principal contracts based solely on
interest rates or interest rate indices is income equivalent to
interest, and paragraph (h)(1)(ii) provides that income from a notional
principal contract covered by Sec. 1.861-9T is not income equivalent to
interest. Paragraph (f) continues to apply to notional principal
contracts based on commodities (or a commodities index), and paragraph
(g) continues to apply to notional principal contracts covered by
section 988.
Section 1.954-2T(h)(3) treats factoring income as income equivalent
to interest, with certain exceptions. Commenters have argued that
income realized by a credit card company from factoring its receivables
(which is attributable to the discount at which it acquires the
receivables from the business establishments honoring its credit card)
does not represent an interest equivalent amount, but instead
represents other types of income, such as compensation for services.
This comment was rejected. It is true that the income attributable
to the discount at which a controlled foreign corporation acquires a
receivable reflects not only the time value of money, but also certain
other elements (for example, collection risk and cost). However, the
factoring income derived by the controlled foreign corporation is
analogous to interest income derived from a loan made by a bank, which
reflects not only the time value of money, but also the other elements
of the discount income received in the factoring transaction described
above. The Tax Reform Act of 1986 repealed the exclusion from foreign
personal holding company income of such interest income derived by a
bank. The repeal of this provision indicates that interest income is
not intended to be excluded from foreign personal holding company
income merely because it may reflect more than the time value of money.
Income equivalent to interest should not be treated differently.
Some of the rules described in the final regulations are
inconsistent with provisions of Secs. 1.954-3 through 1.954-8, as well
as the regulations under other provisions of subpart F. In such cases,
these final regulations are intended to apply instead of the
regulations under other provisions of section 954 and of subpart F
generally. Section 1.952-3 is removed because the rules of that section
are replaced by Sec. 1.954-1. Other conforming changes are being
considered in a separate regulations project.
Many nonsubstantive structural and editorial changes were made to
these final regulations for clarity.
Drafting Information
The principal authors of these regulations are Valerie Mark and,
with respect to financial products, Elissa Shendalman of the Office of
the Associate Chief Counsel (International), IRS. However, personnel
from other offices of the IRS and Treasury Department participated in
developing the regulations.
List of Subjects
26 CFR Parts 1 and 4
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1, 4 and 602 are amended to read as
follows:
PART 1--INCOME TAXES
Paragraph 1. The authority for part 1 is amended by removing the
authority citation for ``Section 1.954-0T, 1.954-1T, 1.954-2T and
1.957-1T'' and adding the following citations in numerical order to
read as follows:
Authority: 26 U.S.C. 7805. * * *
Section 1.954-0 also issued under 26 U.S.C. 954 (b) and (c).
Section 1.954-1 also issued under 26 U.S.C. 954 (b) and (c).
[[Page 46508]]
Section 1.954-2 also issued under 26 U.S.C. 954 (b) and (c).
* * * * *
Section 1.957-1 also issued under 26 U.S.C. 957. * * *
Sec. 1.952-3 [Removed]
Par. 2. Section 1.952-3 is removed.
Par. 3. Sections 1.954-0, 1.954-1 and 1.954-2 are added to read as
follows:
Sec. 1.954-0 Introduction.
(a) Effective dates--(1) Final regulations--(i) In general. Except
as otherwise specifically provided, the provisions of Secs. 1.954-1 and
1.954-2 apply to taxable years of a controlled foreign corporation
beginning after November 6, 1995. If any of the rules described in
Secs. 1.954-1 and 1.954-2 are inconsistent with provisions of other
regulations under subpart F, these final regulations are intended to
apply instead of such other regulations.
(ii) Election to apply final regulations retroactively--(A) Scope
of election. An election may be made to apply the final regulations
retroactively with respect to any taxable year of the controlled
foreign corporation beginning on or after January 1, 1987. If such an
election is made, these final regulations must be applied in their
entirety for such taxable year and all subsequent taxable years. All
references to section 11 in the final regulations shall be deemed to
include section 15, where applicable.
(B) Manner of making election. An election under this paragraph
(a)(1)(ii) is binding on all United States shareholders of the
controlled foreign corporation and must be made--
(1) By the controlling United States shareholders, as defined in
Sec. 1.964-1(c)(5), by attaching a statement to such effect with their
original or amended income tax returns for the taxable year of such
United States shareholders in which or with which the taxable year of
the CFC ends, and including any additional information required by
applicable administrative pronouncements, or
(2) In such other manner as may be prescribed in applicable
administrative pronouncements.
(C) Time for making election. An election may be made under this
paragraph (a)(1)(ii) with respect to a taxable year of the controlled
foreign corporation beginning on or after January 1, 1987 only if the
time for filing a return or claim for refund has not expired for the
taxable year of any United States shareholder of the controlled foreign
corporation in which or with which such taxable year of the controlled
foreign corporation ends.
(D) Revocation of election. An election made under this paragraph
(a)(1)(ii) may not be revoked.
(2) Temporary regulations. The provisions of Secs. 4.954-1 and
4.954-2 of this chapter apply to taxable years of a controlled foreign
corporation beginning after December 31, 1986 and on or before November
6, 1995. However, the provisions of Sec. 4.954-2(b)(6) of this chapter
continue to apply. For transactions entered into on or before October
10, 1995, taxpayers may rely on Notice 89-90, 1989-2 C.B. 407, in
applying the temporary regulations.
(3) Secs. 1.954A-1 and 1.954A-2. The provisions of Secs. 1.954A-1
and 1.954A-2 (as contained in 26 CFR part 1 edition revised April 1,
1995) apply to taxable years of a controlled foreign corporation
beginning before January 1, 1987. All references therein to sections of
the Code are to the Internal Revenue Code of 1954 prior to the
amendments made by the Tax Reform Act of 1986.
(b) Outline of regulation provisions for sections 954(b)(3),
954(b)(4), 954(b)(5) and 954(c) of the Internal Revenue Code.
Sec. 1.954-0 Introduction.
(a) Effective dates.
(1) Final regulations.
(i) In general.
(ii) Election to apply final regulations retroactively.
(A) Scope of election.
(B) Manner of making election.
(C) Time for making election.
(D) Revocation of election.
(2) Temporary regulations.
(3) Secs. 1.954A-1 and 1.954A-2.
(b) Outline of regulation provisions for sections 954(b)(3),
954(b)(4), 954(b)(5) and 954(c) of the Internal Revenue Code.
Sec. 1.954-1 Foreign base company income.
(a) In general.
(1) Purpose and scope.
(2) Gross foreign base company income.
(3) Adjusted gross foreign base company income.
(4) Net foreign base company income.
(5) Adjusted net foreign base company income.
(6) Insurance income.
(7) Additional items of adjusted net foreign base company income
or adjusted net insurance income by reason of section 952(c).
(b) Computation of adjusted gross foreign base company income
and adjusted gross insurance income.
(1) De minimis and full inclusion tests.
(i) De minimis test.
(A) In general.
(B) Currency translation.
(C) Coordination with sections 864(d) and 881(c).
(ii) Seventy percent full inclusion test.
(2) Character of gross income included in adjusted gross foreign
base company income.
(3) Coordination with section 952(c).
(4) Anti-abuse rule.
(i) In general.
(ii) Presumption.
(iii) Related persons.
(iv) Example.
(c) Computation of net foreign base company income.
(1) General rule.
(i) Deductions against gross foreign base company income.
(ii) Losses reduce subpart F income by operation of earnings and
profits limitation.
(iii) Items of income.
(A) Income other than passive foreign personal holding company
income.
(B) Passive foreign personal holding company income.
(2) Computation of net foreign base company income derived from
same country insurance income.
(d) Computation of adjusted net foreign base company income or
adjusted net insurance income.
(1) Application of high tax exception.
(2) Effective rate at which taxes are imposed.
(3) Taxes paid or accrued with respect to an item of income.
(i) Income other than passive foreign personal holding company
income.
(ii) Passive foreign personal holding company income.
(4) Special rules.
(i) Consistency rule.
(ii) Coordination with earnings and profits limitation.
(iii) Example.
(5) Procedure.
(6) Coordination of full inclusion and high tax exception rules.
(7) Examples.
(e) Character of income.
(1) Substance of the transaction.
(2) Separable character.
(3) Predominant character.
(4) Coordination of categories of gross foreign base company
income or gross insurance income.
(i) In general.
(ii) Income excluded from other categories of gross foreign base
company income.
(f) Definition of related person.
(1) Persons related to controlled foreign corporation.
(i) Individuals.
(ii) Other persons.
(2) Control.
(i) Corporations.
(ii) Partnerships.
(iii) Trusts and estates.
(iv) Direct or indirect ownership.
Sec. 1.954-2 Foreign personal holding company income.
(a) Computation of foreign personal holding company income.
(1) Categories of foreign personal holding company income.
(2) Coordination of overlapping categories under foreign
personal holding company provisions.
(i) In general.
(ii) Priority of categories.
(3) Changes in the use or purpose for which property is held.
(i) In general.
(ii) Special rules.
[[Page 46509]]
(A) Anti-abuse rule.
(B) Hedging transactions.
(iii) Example.
(4) Definitions and special rules.
(i) Interest.
(ii) Bona fide hedging transaction.
(A) Definition.
(B) Identification.
(C) Effect of identification and non-identification.
(1) Transactions identified.
(2) Inadvertent identification.
(3) Transactions not identified.
(4) Inadvertent error.
(5) Anti-abuse rule.
(iii) Inventory and similar property.
(A) Definition.
(B) Hedging transactions.
(iv) Regular dealer.
(v) Dealer property.
(A) Definition.
(B) Securities dealers.
(C) Hedging transactions.
(vi) Examples.
(vii) Debt instrument.
(b) Dividends, interest, rents, royalties and annuities.
(1) In general.
(2) Exclusion of certain export financing interest.
(i) In general.
(ii) Exceptions.
(iii) Conduct of a banking business.
(iv) Examples.
(3) Treatment of tax-exempt interest. [RESERVED.]
(4) Exclusion of dividends or interest from related persons.
(i) In general.
(A) Corporate payor.
(B) Payment by a partnership.
(ii) Exceptions.
(A) Dividends.
(B) Interest paid out of adjusted foreign base company income or
insurance income.
(1) In general.
(2) Rule for corporations that are both recipients and payors of
interest.
(C) Coordination with sections 864(d) and 881(c).
(iii) Trade or business requirement.
(iv) Substantial assets test.
(v) Valuation of assets.
(vi) Location of tangible property.
(A) In general.
(B) Exception.
(vii) Location of intangible property.
(A) In general.
(B) Exception for property located in part in the payor's
country of incorporation.
(viii) Location of inventory and dealer property.
(A) In general.
(B) Inventory and dealer property located in part in the payor's
country of incorporation.
(ix) Location of debt instruments.
(x) Treatment of certain stock interests.
(xi) Treatment of banks and insurance companies. [Reserved]
(5) Exclusion of rents and royalties derived from related
persons.
(i) In general.
(A) Corporate payor.
(B) Payment by a partnership.
(ii) Exceptions.
(A) Rents or royalties paid out of adjusted foreign base company
income or insurance income.
(B) Property used in part in the controlled foreign
corporation's country of incorporation.
(6) Exclusion of rents and royalties derived in the active
conduct of a trade or business.
(c) Excluded rents.
(1) Active conduct of a trade or business.
(2) Special rules.
(i) Adding substantial value.
(ii) Substantiality of foreign organization.
(iii) Active leasing expenses.
(iv) Adjusted leasing profit.
(3) Examples.
(d) Excluded royalties.
(1) Active conduct of a trade or business.
(2) Special rules.
(i) Adding substantial value.
(ii) Substantiality of foreign organization.
(iii) Active licensing expenses.
(iv) Adjusted licensing profit.
(3) Examples.
(e) Certain property transactions.
(1) In general.
(i) Inclusions.
(ii) Exceptions.
(iii) Treatment of losses.
(iv) Dual character property.
(2) Property that gives rise to certain income.
(i) In general.
(ii) Gain or loss from the disposition of a debt instrument.
(3) Property that does not give rise to income.
(f) Commodities transactions.
(1) In general.
(i) Inclusion in foreign personal holding company income.
(ii) Exception.
(iii) Treatment of losses.
(2) Definitions.
(i) Commodity.
(ii) Commodities transaction.
(iii) Qualified active sale.
(A) In general.
(B) Active conduct of a commodities business.
(C) Substantially all.
(D) Activities of employees of a related entity.
(E) Financial activities.
(iv) Qualified hedging transaction.
(A) In general.
(B) Exception.
(g) Foreign currency gain or loss.
(1) Scope and purpose.
(2) In general.
(i) Inclusion.
(ii) Exclusion for business needs.
(A) General rule.
(B) Business needs.
(C) Regular dealers.
(D) Example.
(iii) Special rule for foreign currency gain or loss from an
interest-bearing liability.
(3) Election to characterize foreign currency gain or loss that
arises from a specific category of subpart F income as gain or loss
in that category.
(i) In general.
(ii) Time and manner of election.
(iii) Revocation of election.
(iv) Example.
(4) Election to treat all foreign currency gains or losses as
foreign personal holding company income.
(i) In general.
(ii) Time and manner of election.
(iii) Revocation of election.
(5) Gains and losses not subject to this paragraph.
(i) Capital gains and losses.
(ii) Income not subject to section 988.
(iii) Qualified business units using the dollar approximate
separate transactions method.
(iv) Gain or loss allocated under Sec. 1.861-9. [Reserved]
(h) Income equivalent to interest.
(1) In general.
(i) Inclusion in foreign personal holding company income.
(ii) Exceptions.
(A) Liability hedging transactions.
(B) Interest.
(2) Definition of income equivalent to interest.
(i) In general.
(ii) Income from the sale of property.
(3) Notional principal contracts.
(i) In general.
(ii) Regular dealers.
(4) Income equivalent to interest from factoring.
(i) General rule.
(ii) Exceptions.
(iii) Factored receivable.
(iv) Examples.
(5) Receivables arising from performance of services.
(6) Examples.
Sec. 1.954-1 Foreign base company income.
(a) In general--(1) Purpose and scope. Section 954 and Secs. 1.954-
1 and 1.954-2 provide rules for computing the foreign base company
income of a controlled foreign corporation. Foreign base company income
is included in the subpart F income of a controlled foreign corporation
under the rules of section 952. Subpart F income is included in the
gross income of a United States shareholder of a controlled foreign
corporation under the rules of section 951 and thus is subject to
current taxation under section 1, 11 or 55 of the Internal Revenue
Code. The determination of whether a foreign corporation is a
controlled foreign corporation, the subpart F income of which is
included currently in the gross income of its United States
shareholders, is made under the rules of section 957.
(2) Gross foreign base company income. The gross foreign base
company income of a controlled foreign corporation consists of the
following categories of gross income (determined after the application
of section 952(b))--
(i) Foreign personal holding company income, as defined in section
954(c);
[[Page 46510]]
(ii) Foreign base company sales income, as defined in section
954(d);
(iii) Foreign base company services income, as defined in section
954(e);
(iv) Foreign base company shipping income, as defined in section
954(f); and
(v) Foreign base company oil related income, as defined in section
954(g).
(3) Adjusted gross foreign base company income. The term adjusted
gross foreign base company income means the gross foreign base company
income of a controlled foreign corporation as adjusted by the de
minimis and full inclusion rules of paragraph (b) of this section.
(4) Net foreign base company income. The term net foreign base
company income means the adjusted gross foreign base company income of
a controlled foreign corporation reduced so as to take account of
deductions (including taxes) properly allocable or apportionable to
such income under the rules of section 954(b)(5) and paragraph (c) of
this section.
(5) Adjusted net foreign base company income. The term adjusted net
foreign base company income means the net foreign base company income
of a controlled foreign corporation reduced, first, by any items of net
foreign base company income excluded from subpart F income pursuant to
section 952(c) and, second, by any items excluded from subpart F income
pursuant to the high tax exception of section 954(b). See paragraph
(d)(4)(ii) of this section. The term foreign base company income as
used in the Internal Revenue Code and elsewhere in the Income Tax
Regulations means adjusted net foreign base company income, unless
otherwise provided.
(6) Insurance income. The term gross insurance income includes all
gross income taken into account in determining insurance income under
section 953. The term adjusted gross insurance income means gross
insurance income as adjusted by the de minimis and full inclusion rules
of paragraph (b) of this section. The term net insurance income means
adjusted gross insurance income reduced under section 953 so as to take
into account deductions (including taxes) properly allocable or
apportionable to such income. The term adjusted net insurance income
means net insurance income reduced by any items of net insurance income
that are excluded from subpart F income pursuant to section 952(b) or
pursuant to the high tax exception of section 954(b). The term
insurance income as used in subpart F of the Internal Revenue Code and
in the regulations under that subpart means adjusted net insurance
income, unless otherwise provided.
(7) Additional items of adjusted net foreign base company income or
adjusted net insurance income by reason of section 952(c). Earnings and
profits of the controlled foreign corporation that are recharacterized
as foreign base company income or insurance income under section 952(c)
are items of adjusted net foreign base company income or adjusted net
insurance income, respectively. Amounts subject to recharacterization
under section 952(c) are determined after adjusted net foreign base
company income and adjusted net insurance income are otherwise
determined under subpart F and are not again subject to any exceptions
or special rules that would affect the amount of subpart F income.
Thus, for example, items of gross foreign base company income or gross
insurance income that are excluded from adjusted gross foreign base
company income or adjusted gross insurance income because the de
minimis test is met are subject to recharacterization under section
952(c). Further, the de minimis and full inclusion tests of paragraph
(b) of this section, and the high tax exception of paragraph (d) of
this section, for example, do not apply to such amounts.
(b) Computation of adjusted gross foreign base company income and
adjusted gross insurance income--(1) De minimis and full inclusion
tests--(i) De minimis test--(A) In general. Except as provided in
paragraph (b)(1)(i)(C) of this section, adjusted gross foreign base
company income and adjusted gross insurance income are equal to zero if
the sum of the gross foreign base company income and the gross
insurance income of a controlled foreign corporation is less than the
lesser of--
(1) 5 percent of gross income; or
(2) $1,000,000.
(B) Currency translation. Controlled foreign corporations having a
functional currency other than the United States dollar shall translate
the $1,000,000 threshold using the exchange rate provided under section
989(b)(3) for amounts included in income under section 951(a).
(C) Coordination with sections 864(d) and 881(c). Adjusted gross
foreign base company income or adjusted gross insurance income of a
controlled foreign corporation always includes income from trade or
service receivables described in section 864(d) (1) or (6), and
portfolio interest described in section 881(c), even if the de minimis
test of this paragraph (b)(1)(i) is otherwise satisfied.
(ii) Seventy percent full inclusion test. Except as provided in
section 953, adjusted gross foreign base company income consists of all
gross income of the controlled foreign corporation other than gross
insurance income and amounts described in section 952(b), and adjusted
gross insurance income consists of all gross insurance income other
than amounts described in section 952(b), if the sum of the gross
foreign base company income and the gross insurance income for the
taxable year exceeds 70 percent of gross income. See paragraph (d)(6)
of this section, under which certain items of full inclusion foreign
base company income may nevertheless be excluded from subpart F income.
(2) Character of gross income included in adjusted gross foreign
base company income. The gross income included in the adjusted gross
foreign base company income of a controlled foreign corporation
generally retains its character as foreign personal holding company
income, foreign base company sales income, foreign base company
services income, foreign base company shipping income, or foreign base
company oil related income. However, gross income included in adjusted
gross foreign base company income because the full inclusion test of
paragraph (b)(1)(ii) of this section is met is termed full inclusion
foreign base company income, and constitutes a separate category of
adjusted gross foreign base company income for purposes of allocating
and apportioning deductions under paragraph (c) of this section.
(3) Coordination with section 952(c). Income that is included in
subpart F income because the full inclusion test of paragraph
(b)(1)(ii) of this section is met does not reduce amounts that, under
section 952(c), are subject to recharacterization.
(4) Anti-abuse rule--(i) In general. For purposes of applying the
de minimis test of paragraph (b)(1)(i) of this section, the income of
two or more controlled foreign corporations shall be aggregated and
treated as the income of a single corporation if a principal purpose
for separately organizing, acquiring, or maintaining such multiple
corporations is to prevent income from being treated as foreign base
company income or insurance income under the de minimis test. A purpose
may be a principal purpose even though it is outweighed by other
purposes (taken together or separately).
(ii) Presumption. Two or more controlled foreign corporations are
presumed to have been organized, acquired or maintained to prevent
income from being treated as foreign
[[Page 46511]]
base company income or insurance income under the de minimis test of
paragraph (b)(1)(i) of this section if the corporations are related
persons, as defined in paragraph (b)(4)(iii) of this section, and the
corporations are described in paragraph (b)(4)(ii)(A), (B), or (C) of
this section. This presumption may be rebutted by proof to the
contrary.
(A) The activities carried on by the controlled foreign
corporations, or the assets used in those activities, are substantially
the same activities that were previously carried on, or assets that
were previously held, by a single controlled foreign corporation.
Further, the United States shareholders of the controlled foreign
corporations or related persons (as determined under paragraph
(b)(4)(iii) of this section) are substantially the same as the United
States shareholders of the one controlled foreign corporation in a
prior taxable year. A presumption made in connection with the
requirements of this paragraph (b)(4)(ii)(A) may be rebutted by proof
that the activities carried on by each controlled foreign corporation
would constitute a separate branch under the principles of
Sec. 1.367(a)-6T(g)(2) if carried on directly by a United States
person.
(B) The controlled foreign corporations carry on a business,
financial operation, or venture as partners directly or indirectly in a
partnership (as defined in section 7701(a)(2) and Sec. 301.7701-3 of
this chapter) that is a related person (as defined in paragraph
(b)(4)(iii) of this section) with respect to each such controlled
foreign corporation.
(C) The activities carried on by the controlled foreign
corporations would constitute a single branch operation under
Sec. 1.367(a)-6T(g)(2) if carried on directly by a United States
person.
(iii) Related persons. For purposes of this paragraph (b), two or
more persons are related persons if they are in a relationship
described in section 267(b). In determining for purposes of this
paragraph (b) whether two or more corporations are members of the same
controlled group under section 267(b)(3), a person is considered to own
stock owned directly by such person, stock owned with the application
of section 1563(e)(1), and stock owned with the application of section
267(c). In determining for purposes of this paragraph (b) whether a
corporation is related to a partnership under section 267(b)(10), a
person is considered to own the partnership interest owned directly by
such person and the partnership interest owned with the application of
section 267(e)(3).
(iv) Example. The following example illustrates the application of
this paragraph (b)(4).
Example. (i)(1) USP is the sole United States shareholder of
three controlled foreign corporations: CFC1, CFC2 and CFC3. The
three controlled foreign corporations all have the same taxable
year. The three controlled foreign corporations are partners in FP,
a foreign entity classified as a partnership under section
7701(a)(2) and Sec. 301.7701-3 of the regulations. For their current
taxable years, each of the controlled foreign corporations derives
all of its income other than foreign base company income from
activities conducted through FP, and its foreign base company income
from activities conducted both jointly through FP and separately
without FP. Based on the facts in the table below, the foreign base
company income derived by each controlled foreign corporation for
its current taxable year, including income derived from FP, is less
than five percent of the gross income of each controlled foreign
corporation and is less than $1,000,000:
------------------------------------------------------------------------
CFC1 CFC2 CFC3
------------------------------------------------------------------------
Gross income............ $4,000,000 $8,000,000 $12,000,000
Five percent of gross
income................. 200,000 400,000 600,000
Foreign base company
income................. 199,000 398,000 597,000
------------------------------------------------------------------------
(2) Thus, without the application of the anti-abuse rule of this
paragraph (b)(4), each controlled foreign corporation would be
treated as having no foreign base company income after the
application of the de minimis test of section 954(b)(3)(A) and
paragraph (b)(1)(i) of this section.
(ii) However, under these facts, the requirements of paragraph
(b)(4)(i) of this section are met unless the presumption of
paragraph (b)(4)(ii) of this section is successfully rebutted. The
sum of the foreign base company income of the controlled foreign
corporations is $1,194,000. Thus, the amount of gross foreign base
company income of each controlled foreign corporation will not be
reduced by reason of the de minimis rule of section 954(b)(3)(A) and
this paragraph (b).
(c) Computation of net foreign base company income--(1) General
rule. The net foreign base company income of a controlled foreign
corporation (as defined in paragraph (a)(4) of this section) is
computed under the rules of this paragraph (c)(1). The principles of
Sec. 1.904-5(k) shall apply where payments are made between controlled
foreign corporations that are related persons (within the meaning of
section 954(d)(3)). Consistent with these principles, only payments
described in Sec. 1.954-2(b)(4)(ii)(B)(2) may be offset as provided in
Sec. 1.904-5(k)(2).
(i) Deductions against gross foreign base company income. The net
foreign base company income of a controlled foreign corporation is
computed first by taking into account deductions in the following
manner:
(A) First, the gross amount of each item of income described in
paragraph (c)(1)(iii) of this section is determined.
(B) Second, any expenses definitely related to less than all gross
income as a class shall be allocated and apportioned under the
principles of sections 861, 864 and 904(d) to the gross income
described in paragraph (c)(1)(i)(A) of this section.
(C) Third, foreign personal holding company income that is passive
within the meaning of section 904 (determined before the application of
the high-taxed income rule of Sec. 1.904-4(c)) is reduced by related
person interest expense allocable to passive income under Sec. 1.904-
5(c)(2); such interest must be further allocated and apportioned to
items described in paragraph (c)(1)(iii)(B) of this section.
(D) Fourth, the amount of each item of income described in
paragraph (c)(1)(iii) of this section is reduced by other expenses
allocable and apportionable to such income under the principles of
sections 861, 864 and 904(d).
(ii) Losses reduce subpart F income by operation of earnings and
profits limitation. Except as otherwise provided in Sec. 1.954-2(g)(4),
if after applying the rules of paragraph (c)(1)(i) of this section, the
amount remaining in any category of foreign base company income or
foreign personal holding company income is less than zero, the loss in
that category may not reduce any other category of foreign base company
income or foreign personal holding company income except by operation
of the earnings and profits limitation of section 952(c)(1).
(iii) Items of income--(A) Income other than passive foreign
personal holding company income. A single item of income (other than
foreign personal holding company income that is
[[Page 46512]]
passive) is the aggregate amount from all transactions that falls
within a single separate category (as defined in Sec. 1.904-5(a)(1)),
and either--
(1) Falls within a single category of foreign personal holding
company income as--
(i) Dividends, interest, rents, royalties and annuities;
(ii) Gain from certain property transactions;
(iii) Gain from commodities transactions;
(iv) Foreign currency gain; or
(v) Income equivalent to interest; or
(2) Falls within a single category of foreign base company income,
other than foreign personal holding company income, as--
(i) Foreign base company sales income;
(ii) Foreign base company services income;
(iii) Foreign base company shipping income;
(iv) Foreign base company oil related income; or
(v) Full inclusion foreign base company income.
(B) Passive foreign personal holding company income. A single item
of foreign personal holding company income that is passive is an amount
of income that falls within a single group of passive income under the
grouping rules of Sec. 1.904-4(c) (3), (4) and (5) and a single
category of foreign personal holding company income described in
paragraphs (c)(1)(iii)(A)(1) (i) through (v).
(2) Computation of net foreign base company income derived from
same country insurance income. Deductions relating to foreign base
company income attributable to the issuing (or reinsuring) of any
insurance or annuity contract in connection with risks located in the
country under the laws of which the controlled foreign corporation is
created or organized shall be allocated and apportioned in accordance
with the rules set forth in section 953.
(d) Computation of adjusted net foreign base company income or
adjusted net insurance income--(1) Application of high tax exception.
Adjusted net foreign base company income (or adjusted net insurance
income) equals the net foreign base company income (or net insurance
income) of a controlled foreign corporation, reduced by any net item of
such income that qualifies for the high tax exception provided by
section 954(b)(4) and this paragraph (d). Any item of income that is
foreign base company oil related income, as defined in section 954(g),
or portfolio interest, as described in section 881(c), does not qualify
for the high tax exception. See paragraph (c)(1)(iii) of this section
for the definition of the term item of income. For rules concerning the
treatment for foreign tax credit purposes of amounts excluded from
subpart F under section 954(b)(4), see Sec. 1.904-4(c). A net item of
income qualifies for the high tax exception only if--
(i) An election is made under section 954(b)(4) and paragraph
(d)(5) of this section to exclude the income from the computation of
subpart F income; and
(ii) It is established that the net item of income was subject to
foreign income taxes imposed by a foreign country or countries at an
effective rate that is greater than 90 percent of the maximum rate of
tax specified in section 11 for the taxable year of the controlled
foreign corporation.
(2) Effective rate at which taxes are imposed. The effective rate
with respect to a net item of income shall be determined separately for
each controlled foreign corporation in a chain of corporations through
which a distribution is made. The effective rate at which taxes are
imposed on a net item of income is--
(i) The United States dollar amount of foreign income taxes paid or
accrued (or deemed paid or accrued) with respect to the net item of
income, determined under paragraph (d)(3) of this section; divided by
(ii) The United States dollar amount of the net item of foreign
base company income or insurance income, described in paragraph
(c)(1)(iii) of this section, increased by the amount of foreign income
taxes referred to in paragraph (d)(2)(i) of this section.
(3) Taxes paid or accrued with respect to an item of income--(i)
Income other than passive foreign personal holding company income. The
amount of foreign income taxes paid or accrued with respect to a net
item of income (other than an item of foreign personal holding company
income that is passive) for purposes of section 954(b)(4) and this
paragraph (d) is the United States dollar amount of foreign income
taxes that would be deemed paid under section 960 with respect to that
item if that item were included in the gross income of a United States
shareholder under section 951(a)(1)(A) (determined, in the case of a
United States shareholder that is an individual, as if an election
under section 962 has been made, whether or not such election is
actually made). For this purpose, in accordance with the regulations
under section 960, the amounts that would be deemed paid under section
960 shall be determined separately with respect to each controlled
foreign corporation and without regard to the limitation applicable
under section 904(a). The amount of foreign income taxes paid or
accrued with respect to a net item of income, determined in the manner
provided in this paragraph (d), will not be affected by a subsequent
reduction in foreign income taxes attributable to a distribution to
shareholders of all or part of such income.
(ii) Passive foreign personal holding company income. The amount of
income taxes paid or accrued with respect to a net item of foreign
personal holding company income that is passive for purposes of section
954(b)(4) and this paragraph (d) is the United States dollar amount of
foreign income taxes that would be deemed paid under section 960 and
that would be taken into account for purposes applying the provisions
of Sec. 1.904-4(c) with respect to that net item of income.
(4) Special rules--(i) Consistency rule. An election to exclude
income from the computation of subpart F income for a taxable year must
be made consistently with respect to all items of passive foreign
personal holding company income eligible to be excluded for the taxable
year. Thus, high-taxed passive foreign personal holding company income
of a controlled foreign corporation must either be excluded in its
entirety, or remain subject to subpart F in its entirety.
(ii) Coordination with earnings and profits limitation. If the
amount of income included in subpart F income for the taxable year is
reduced by the earnings and profits limitation of section 952(c)(1),
the amount of income that is a net item of income, within the meaning
of paragraph (c)(1)(iii) of this section, is determined after the
application of the rules of section 952(c)(1).
(iii) Example. The following example illustrates the provisions of
paragraph (d)(4)(ii) of this section. All of the taxes referred to in
the following example are foreign income taxes. For simplicity, this
example assumes that the amount of taxes that are taken into account as
a deduction under section 954(b)(5) and the amount of the gross-up
required under sections 960 and 78 are equal. Therefore, this example
does not separately illustrate the deduction for taxes and gross-up.
Example. During its 1995 taxable year, CFC, a controlled foreign
corporation, earns $100 of royalty income that is foreign personal
holding company income. CFC has no expenses associated with this
royalty income. CFC pays $20 of foreign income taxes with respect to
the royalty income. For 1995, CFC has current earnings and profits
of $50. CFC's subpart F income, as determined
[[Page 46513]]
prior to the application of this paragraph (d), exceeds its current
earnings and profits. Thus, under paragraph (d)(4)(ii) of this
section, the amount of CFC's only net item of income, the royalty
income, will be limited to $50. The remaining $50 will be subject to
recharacterization in a subsequent taxable year under section
952(c)(2). Because the amount of foreign income taxes paid with
respect to this net item of income is $20, the effective rate of tax
on the item, for purposes of this paragraph (d), is 40 percent.
Accordingly, an election under paragraph (d)(5) of this section may
be made to exclude the item of income from the computation of
subpart F income.
(5) Procedure. An election made under the procedure provided by
this paragraph (d)(5) is binding on all United States shareholders of
the controlled foreign corporation and must be made--
(i) By the controlling United States shareholders, as defined in
Sec. 1.964-1(c)(5), by attaching a statement to such effect with their
original or amended income tax returns, and including any additional
information required by applicable administrative pronouncements; or
(ii) In such other manner as may be prescribed in applicable
administrative pronouncements.
(6) Coordination of full inclusion and high tax exception rules.
Notwithstanding paragraph (b)(1)(ii) of this section, full inclusion
foreign base company income will be excluded from subpart F income if
more than 90 percent of the adjusted gross foreign base company income
and adjusted gross insurance company income of a controlled foreign
corporation (determined without regard to the full inclusion test of
paragraph (b)(1) of this section) is attributable to net amounts
excluded from subpart F income pursuant to an election to have the high
tax exception described in section 954(b)(4) and this paragraph (d)
apply.
(7) Examples. (i) The following examples illustrate the rules of
this paragraph (d). All of the taxes referred to in the following
examples are foreign income taxes. For simplicity, these examples
assume that the amount of taxes that are taken into account as a
deduction under section 954(b)(5) and the amount of the gross-up
required under sections 960 and 78 are equal. Therefore, these examples
do not separately illustrate the deduction for taxes and gross-up.
Except as otherwise stated, these examples assume there are no
earnings, deficits, or foreign income taxes in the post-1986 pools of
earnings and profits or foreign income taxes.
Example 1. (i) Items of income. During its 1995 taxable year,
controlled foreign corporation CFC earns from outside its country of
operation portfolio dividend income of $100 and interest income, net
of taxes, of $100 (consisting of a gross payment of $150 reduced by
a third-country withholding tax of $50). For purposes of
illustration, assume that CFC incurs no expenses. None of the income
is taxed in CFC's country of operation. The dividend income was not
subject to third-country withholding taxes. Pursuant to the
operation of section 904, the interest income is high withholding
tax interest and the dividend income is passive income. Accordingly,
pursuant to paragraph (c)(1)(iii) of this section, CFC has two net
items of income--
(1) $100 of foreign personal holding company (FPHC)/passive
income (the dividends); and
(2) $100 of FPHC/high withholding tax income (the interest).
(ii) Effective rates of tax. No foreign tax would be deemed paid
under section 960 with respect to the net item of income described
in paragraph (i)(1) of this Example 1. Therefore, the effective rate
of foreign tax is 0, and the item may not be excluded from subpart F
under the rules of this paragraph (d). Foreign tax of $50 would be
deemed paid under section 960 with respect to the net item of income
described in paragraph (i)(2) of this Example 1. Therefore, the
effective rate of foreign tax is 33 percent ($50 of creditable taxes
paid, divided by $150, consisting of the net item of foreign base
company income ($100) plus creditable taxes paid thereon ($50)). The
highest rate of tax specified in section 11 for the 1995 taxable
year is 34 percent. Accordingly, the net item of income described in
paragraph (i)(2) of this Example 1 may be excluded from subpart F
income if an election under paragraph (d)(5) of this section is
made, since it is subject to foreign tax at an effective rate that
is greater than 30.6 percent (90 percent of 34 percent). However,
for purposes of section 904(d), it remains high withholding tax
interest.
Example 2. (i) The facts are the same as in Example 1, except
that CFC's country of operation imposes a tax of $50 with respect to
CFC's dividend income (and thus CFC earns portfolio dividend income,
net of taxes, of only $50). The interest income is still high
withholding tax interest. The dividend income is still passive
income (without regard to the possible applicability of the high tax
exception of section 904(d)(2)). Accordingly, CFC has two items of
income for purposes of this paragraph (d)--
(1) $50 of FPHC/passive income (net of the $50 foreign tax); and
(2) $100 of FPHC/high withholding tax interest income.
(ii) Each item is taxed at an effective rate greater than 30.6
percent. The net item of income described in paragraph (i)(1) of
this Example 2: foreign tax ($50) divided by sum ($100) of net item
of income ($50) plus creditable tax thereon ($50) equals 50 percent.
The net item of income described in paragraph (i)(2) of this Example
2: foreign tax ($50) divided by sum ($150) of income item ($100)
plus creditable tax thereon ($50) equals 33 percent. Accordingly, an
election may be made under paragraph (d)(5) of this section to
exclude either or both of the net items of income described in
paragraphs (i) (1) and (2) of this Example 2 from subpart F income.
If no election is made the items would be included in the subpart F
income of CFC.
Example 3. (i) The facts are the same as in Example 1, except
that the $100 of portfolio dividend income is subject to a third-
country withholding tax of $50, and the $150 of interest income is
from sources within CFC's country of operation, is subject to a $10
income tax therein, and is not subject to a withholding tax.
Although the interest income and the dividend income are both
passive income, under paragraph (c)(1)(iii)(B) of this section they
constitute separate items of income pursuant to the application of
the grouping rules of Sec. 1.904-4(c). Accordingly, CFC has two net
items of income for purposes of this paragraph (d)--
(1) $50 (net of $50 tax) of FPHC/non-country of operation/
greater than 15 percent withholding tax income; and
(2) $140 (net of $10 tax) of FPHC/country of operation income.
(ii) The item described in paragraph (i)(1) of this Example 3 is
taxed at an effective rate greater than 30.6 percent, but Item 2 is
not. The net item of income described in paragraph (i)(1) of this
Example 3: Foreign tax ($50) divided by sum ($100) of net item of
income ($50) plus creditable tax thereon ($50) equals 50 percent.
The net item of income described in paragraph (i)(2) of this Example
3: Foreign tax ($10) divided by sum ($150) of net item of income
($140) plus creditable tax thereon ($10) equals 6.67 percent.
Therefore, an election may be made under paragraph (d)(5) of this
section to exclude the net item of income described in paragraph
(i)(1) of this Example 3 but not the net item of income described in
paragraph (i)(2) of this Example 3 from subpart F income.
Example 4. The facts are the same as in Example 3, except that
the $150 of interest income is subject to an income tax of $50 in
CFC's country of operation. Accordingly, CFC's items of income are
the same as in Example 3, but both items are taxed at an effective
rate greater than 30.6 percent. The net item of income described in
paragraph (i)(1) of Example 3: Foreign tax ($50) divided by sum
($100) of net item of income ($50) plus creditable tax thereon ($50)
equals 50 percent. The net item of income described in paragraph
(i)(2) of Example 3: Foreign tax ($50) divided by sum ($150) of net
item of income ($100) plus creditable tax thereon ($50) equals 33
percent. Pursuant to the consistency rule of paragraph (d)(4)(i) of
this section, an election made by CFC's controlling United States
shareholders must exclude from subpart F income both items of FPHC
income under the high tax exception of section 954(b)(4) and this
paragraph (d). The election may not be made only with respect to one
item.
Example 5. The facts are the same as in Example 1, except that
CFC earns $5 of portfolio dividend income and $150 of interest
income. In addition, CFC earns $45 for performing consulting
services within its country of operation for unrelated persons.
CFC's gross foreign base company income for 1995 of $155 ($150 of
gross interest income and $5 of portfolio dividend income) is
[[Page 46514]]
greater than 70 percent of its gross income of $200. Therefore, under
the full inclusion test of paragraph (b)(1)(ii) of this section,
CFC's adjusted gross foreign base company income is $200, and under
paragraph (b)(2) of this section, the $45 of consulting income is
full inclusion foreign base company income. If CFC elects, under
paragraph (d)(5) of this section, to exclude the interest income
from subpart F income pursuant to the high tax exception, the $45 of
full inclusion foreign base company income will be excluded from
subpart F income under paragraph (d)(6) of this section because the
$150 of gross interest income excluded under the high tax exception
is more than 90 percent of CFC's adjusted gross foreign base company
income of $155.
(ii) The following examples generally illustrate the application of
paragraph (c) of this section and this paragraph (d). Example 1
illustrates the order of computations. Example 2 illustrates the
computations required by sections 952 and 954 and this Sec. 1.954-1 if
the full inclusion test of paragraph (b)(1)(ii) of this section is met
and the income is not excluded from subpart F income under section
952(b). Computations in these examples involving the operation of
section 952(c) are included for purposes of illustration only and do
not provide substantive rules concerning the operation of that section.
For simplicity, these examples assume that the amount of taxes that are
taken into account as a deduction under section 954(b)(5) and the
amount of the gross-up required under sections 960 and 78 are equal.
Therefore, these examples do not separately illustrate the deduction
for taxes and gross-up.
Example 1. (i) Gross income. CFC, a controlled foreign
corporation, has gross income of $1000 for the current taxable year.
Of that $1000 of income, $100 is interest income that is included in
the definition of foreign personal holding company income under
section 954(c)(1)(A) and Sec. 1.954-2(b)(1)(ii), is not income from
a trade or service receivable described in section 864(d)(1) or (6),
or portfolio interest described in section 881(c), and is not
excluded from foreign personal holding company income under any
provision of section 952(b) or section 954(c). Another $50 is
foreign base company sales income under section 954(d). The
remaining $850 of gross income is not included in the definition of
foreign base company income or insurance income under sections 954
(c), (d), (e), (f) or (g) or 953, and is foreign source general
limitation income described in section 904(d)(1)(I).
(ii) Expenses. For the current taxable year, CFC has expenses
of $500. This amount includes $8 of interest paid to a related
person that is allocable to foreign personal holding company income
under section 904, and $2 of other expense that is directly related
to foreign personal holding company income. Another $20 of expense
is directly related to foreign base company sales. The remaining
$470 of expenses is allocable to general limitation income that is
not foreign base company income or insurance income.
(iii) Earnings and losses. CFC has earnings and profits for the
current taxable year of $500. In the prior taxable year, CFC had
losses with respect to income other than gross foreign base company
income or gross insurance income. By reason of the limitation
provided under section 952(c)(1)(A), those losses reduced the
subpart F income (consisting entirely of foreign source general
limitation income) of CFC by $600 for the prior taxable year.
(iv) Taxes. Foreign income tax of $30 is considered imposed on
the interest income under the rules of section 954(b)(4), this
paragraph (d), and Sec. 1.904-6. Foreign income tax of $14 is
considered imposed on the foreign base company sales income under
the rules of section 954(b)(4), paragraph (d) of this section, and
Sec. 1.904-6. Foreign income tax of $177 is considered imposed on
the remaining foreign source general limitation income under the
rules of section 954(b)(4), this paragraph (d), and Sec. 1.904-6.
For the taxable year of CFC, the maximum United States rate of
taxation under section 11 is 34 percent.
(v) Conclusion. Based on these facts, if CFC elects to exclude
all items of income subject to a high foreign tax under section
954(b)(4) and this paragraph (d), it will have $500 of subpart F
income as defined in section 952(a) (consisting entirely of foreign
source general limitation income) determined as follows:
Step 1--Determine gross income:
(1) Gross income............................................. $1000
Step 2--Determine gross foreign base company income and gross
insurance income:
(2) Interest income included in gross foreign personal
holding company income under section 954(c)................. 100
(3) Gross foreign base company sales income under section
954(d)...................................................... 50
(4) Total gross foreign base company income and gross
insurance income as defined in sections 954 (c), (d), (e),
(f) and (g) and 953 (line (2) plus line (3))................ 150
Step 3--Compute adjusted gross foreign base company income and
adjusted gross insurance income:
(5) Five percent of gross income (.05 x line (1)).......... 50
(6) Seventy percent of gross income (.70 x line (1))....... 700
(7) Adjusted gross foreign base company income and adjusted
gross insurance income after the application of the de
minimis test of paragraph (b) (line (4), or zero if line (4)
is less than the lesser of line (5) or $1,000,000) (if the
amount on this line 7 is zero, proceed to Step 8)........... 150
(8) Adjusted gross foreign base company income and adjusted
gross insurance income after the application of the full
inclusion test of paragraph (b) (line (4), or line (1) if
line (4) is greater than line (6)).......................... 150
Step 4--Compute net foreign base company income:
(9) Expenses directly related to adjusted gross foreign base
company sales income........................................ 20
(10) Expenses (other than related person interest expense)
directly related to adjusted gross foreign personal holding
company income.............................................. 2
(11) Related person interest expense allocable to adjusted
gross foreign personal holding company income under section
904......................................................... 8
(12) Net foreign personal holding company income after
allocating deductions under section 954(b)(5) and paragraph
(c) of this section (line (2) reduced by lines (10) and
(11))....................................................... 90
(13) Net foreign base company sales income after allocating
deductions under section 954(b)(5) and paragraph (c) of this
section (line (3) reduced by line (9))...................... 30
(14) Total net foreign base company income after allocating
deductions under section 954(b)(5) and paragraph (c) of this
section (line (12) plus line (13)).......................... 120
Step 5--Compute net insurance income:
(15) Net insurance income under section 953.................. 0
Step 6--Compute adjusted net foreign base company income:
(16) Foreign income tax imposed on net foreign personal
holding company income (as determined under section
954(b)(4) and this paragraph (d))........................... 30
(17) Foreign income tax imposed on net foreign base company
sales income (as determined under section 954(b)(4) and this
paragraph (d)).............................................. 14
(18) Ninety percent of the maximum United States corporate
tax rate.................................................... 30.6%
(19) Effective rate of foreign income tax imposed on net
foreign personal holding company income ($90 of interest)
under section 954(b)(4) and this paragraph (d) (line (16)
divided by line (12))....................................... 33%
(20) Effective rate of foreign income tax imposed on $30 of
net foreign base company sales income under section
954(b)(4) and this paragraph (d) (line (17) divided by line
(13))....................................................... 47%
[[Page 46515]]
(21) Net foreign personal holding company income subject to a
high foreign tax under section 954(b)(4) and this paragraph
(d) (zero, or line (12) if line (19) is greater than line
(18))....................................................... 90
(22) Net foreign base company sales income subject to a high
foreign tax under section 954(b)(4) and this paragraph (d)
(zero, or line (13) if line (20) is greater than line (18)). 30
(23) Adjusted net foreign base company income after applying
section 954(b)(4) and this paragraph (d) (line (14), reduced
by the sum of line (21) and line (22))...................... 0
Step 7--Compute adjusted net insurance income:
(24) Adjusted net insurance income........................... 0
Step 8--Additions to or reduction of adjusted net foreign base
company income by reason of section 952(c):
(25) Earnings and profits for the current year............... 500
(26) Amount subject to being recharacterized as subpart F
income under section 952(c)(2) (excess of line (25) over the
sum of lines (23) and (24)); if there is a deficit, then the
limitation of section 952(c)(1) may apply for the current
year........................................................ 500
(27) Amount of reduction in subpart F income for prior
taxable years by reason of the limitation of section
952(c)(1)................................................... 600
(28) Subpart F income as defined in section 952(a), assuming
section 952(a)(3), (4), and (5) do not apply (the sum of
line (23), line (24), and the lesser of line (26) or line
(27))....................................................... 500
(29) Amount of prior year's deficit to be recharacterized as
subpart F income in later years under section 952(c) (excess
of line (27) over line (26)................................. 100
Example 2. (i) Gross income. CFC, a controlled foreign
corporation, has gross income of $1000 for the current taxable year.
Of that $1000 of income, $720 is interest income that is included in
the definition of foreign personal holding company income under
section 954(c) (1)(A) and Sec. 1.954-2(b)(1)(ii), is not income from
trade or service receivables described in section 864(d)(1) or (6),
or portfolio interest described in section 881(c), and is not
excluded from foreign personal holding company income under any
provision of section 954(c) and Sec. 1.954-2 or section 952(b). The
remaining $280 is services income that is not included in the
definition of foreign base company income or insurance income under
sections 954 (c), (d), (e), (f), or (g) or 953, and is foreign
source general limitation income for purposes of section
904(d)(1)(I).
(ii) Expenses. For the current taxable year, CFC has expenses of
$650. This amount includes $350 of interest paid to related persons
that is allocable to foreign personal holding company income under
section 904, and $50 of other expense that is directly related to
foreign personal holding company income. The remaining $250 of
expenses is allocable to services income other than foreign base
company income or insurance income.
(iii) Earnings and losses. CFC has earnings and profits for the
current taxable year of $350. In the prior taxable year, CFC had
losses with respect to income other than foreign base company income
or insurance income. By reason of the limitation provided under
section 952(c)(1)(A), those losses reduced the subpart F income of
CFC (consisting entirely of foreign source general limitation
income) by $600 for the prior taxable year.
(iv) Taxes. Foreign income tax of $120 is considered imposed on
the $720 of interest income under the rules of section 954(b)(4),
paragraph (d) of this section, and Sec. 1.904-6. Foreign income tax
of $2 is considered imposed on the services income under the rules
of section 954(b)(4), paragraph (d) of this section, and Sec. 1.904-
6. For the taxable year of CFC, the maximum United States rate of
taxation under section 11 is 34 percent.
(v) Conclusion. Based on these facts, if CFC elects to exclude
all items of income subject to a high foreign tax under section
954(b)(4) and this paragraph (d), it will have $350 of subpart F
income as defined in section 952(a), determined as follows.
Step 1--Determine gross income:
(1) Gross income............................................. $1000
Step 2--Determine gross foreign base company income and gross
insurance income:
(2) Gross foreign base company income and gross insurance
income as defined in sections 954 (c), (d), (e), (f) and (g)
and 953 (interest income)................................... 720
Step 3--Compute adjusted gross foreign base company income and
adjusted gross insurance income:
(3) Seventy percent of gross income (.70 x line (1))....... 700
(4) Adjusted gross foreign base company income and adjusted
gross insurance income after the application of the full
inclusion rule of this paragraph (b)(1) (line (2), or line
(1) if line (2) is greater than line (3))................... 1000
(5) Full inclusion foreign base company income under
paragraph (b)(1)(ii) (line (4) minus line (2)).............. 280
Step 4--Compute net foreign base company income:
(6) Expenses (other than related person interest expense)
directly related to adjusted gross foreign personal holding
company income.............................................. 50
(7) Related person interest expense allocable to adjusted
gross foreign personal holding company income under section
904......................................................... 350
(8) Deductions allocable to full inclusion foreign base
company income under section 954(b)(5) and paragraph (c) of
this section................................................ 250
(9) Net foreign personal holding company income after
allocating deductions under section 954(b)(5) and paragraph
(c) of this section (line (2) reduced by line (6) and line
(7))........................................................ 320
(10) Full inclusion foreign base company income after
allocating deductions under section 954(b)(5) and paragraph
(c) of this section (line (5) reduced by line (8)).......... 30
(11) Total net foreign base company income after allocating
deductions under section 954(b)(5) and paragraph (c) of this
section (line (9) plus line (10))........................... 350
Step 5--Compute net insurance income:
(12) Net insurance income under section 953.................. 0
Step 6--Compute adjusted net foreign base company income:
(13) Foreign income tax imposed on net foreign personal
holding company income (interest)........................... 120
(14) Foreign income tax imposed on net full inclusion foreign
base company income......................................... 2
(15) Ninety percent of the maximum United States corporate
tax rate.................................................... 30.6%
(16) Effective rate of foreign income tax imposed on $320 of
net foreign personal holding company income under section
954(b)(4) and this paragraph (d) (line (13) divided by line
(9))........................................................ 38%
(17) Effective rate of foreign income tax imposed on $30 of
net full inclusion foreign base company income under section
954(b)(4) and this paragraph (d) (line (14) divided by line
(10))....................................................... 7%
(18) Net foreign personal holding company income subject to a
high foreign tax under section 954(b)(4) and this paragraph
(d) (zero, or line (9) if line (16) is greater than line
(15))....................................................... 320
(19) Net full inclusion foreign base company income subject
to a high foreign tax under section 954(b)(4) and this
paragraph (d) (zero, or line (10) if line (17) is greater
than line (15))............................................. 0
(20) Adjusted net foreign base company income after applying
section 954(b)(4) and this paragraph (d) (line (11) reduced
by the sum of line (18) and line (19))...................... 30
Step 7--Compute adjusted net insurance income:
(21) Adjusted net insurance income........................... 0
[[Page 46516]]
Step 8--Reduction of adjusted net foreign base company income
or adjusted net insurance income by reason of paragraph (d)(6)
of this section:
(22) Adjusted gross foreign base company income and adjusted
gross insurance income (determined without regard to the
full inclusion test of paragraph (b)(1) of this section)
(line (4) reduced by line (5)).............................. 720
(23) Ninety percent of adjusted gross foreign base company
income and adjusted gross insurance income (determined
without regard to the full inclusion test of paragraph
(b)(1)(ii) of this section) (90% of the amount on line (22)) 648
(24) Net foreign base company income and net insurance income
excluded from subpart F income under section 954(b)(4),
increased by the amount of expenses that reduced this income
under section 954(b)(5) and paragraph (c) of this section
(line (18) increased by the sum of line (6) and line (7))... 720
(25) Adjusted net full inclusion foreign base company income
excluded from subpart F income under paragraph (d)(6) of
this section (zero, or line (10) reduced by line (19) if
line (24) is greater than line (23))........................ 30
(26) Adjusted net foreign base company income after
application of paragraph (d)(6) of this section (line (20)
reduced by line (25))....................................... 0
Step 9--Additions to or reduction of subpart F income by reason
of section 952(c):
(27) Earnings and profits for the current year............... 350
(28) Amount subject to being recharacterized as subpart F
income under section 952(c)(2) (excess of line (27) over the
sum of line (21) and line (26)); if there is a deficit, then
the limitation of 952(c)(1) may apply for the current year.. 350
(29) Amount of reduction in subpart F income for prior
taxable years by reason of the limitation of section
952(c)(1)................................................... 600
(30) Subpart F income as defined in section 952(a), assuming
section 952(a) (3), (4), and (5) do not apply (the sum of
line (21) and line (26) plus the lesser of line (28) or line
(29))....................................................... 350
(31) Amount of prior years' deficit remaining to be
recharacterized as subpart F income in later years under
section 952(c) (excess of line (29) over line (28))......... 250
(e) Character of income--(1) Substance of the transaction. For
purposes of section 954, income shall be characterized in accordance
with the substance of the transaction, and not in accordance with the
designation applied by the parties to the transaction. For example, an
amount that is designated as rent by the taxpayer but actually
constitutes income from the sale of property, royalties, or income from
services shall not be characterized as rent but shall be characterized
as income from the sale of property, royalties or income from services,
as the case may be. Local law shall not be controlling in
characterizing income.
(2) Separable character. To the extent the definitional provisions
of section 953 or 954 describe the income or gain derived from a
transaction, or any portion or portions thereof, that income or gain,
or portion or portions thereof, is so characterized for purposes of
subpart F. Thus, a single transaction may give rise to income in more
than one category of foreign base company income described in paragraph
(a)(2) of this section. For example, if a controlled foreign
corporation, in its business of purchasing personal property and
selling it to related persons outside its country of incorporation,
also performs services outside its country of incorporation with
respect to the property it sells, the sales income will be treated as
foreign base company sales income and the services income will be
treated as foreign base company services income for purposes of these
rules.
(3) Predominant character. The portion of income or gain derived
from a transaction that is included in the computation of foreign
personal holding company income is always separately determinable and
thus must always be segregated from other income and separately
classified under paragraph (e)(2) of this section. However, the portion
of income or gain derived from a transaction that would meet a
particular definitional provision under section 954 or 953 (other than
the definition of foreign personal holding company income) in unusual
circumstances may not be separately determinable. If such portion is
not separately determinable, it must be classified in accordance with
the predominant character of the transaction. For example, if a
controlled foreign corporation engineers, fabricates, and installs a
fixed offshore drilling platform as part of an integrated transaction,
and the portion of income that relates to services is not accounted for
separately from the portion that relates to sales, and is otherwise not
separately determinable, then the classification of income from the
transaction shall be made in accordance with the predominant character
of the arrangement.
(4) Coordination of categories of gross foreign base company
income or gross insurance income--(i) In general. The computations of
gross foreign base company income and gross insurance income are
limited by the following rules:
(A) If income is foreign base company shipping income, pursuant to
section 954(f), it shall not be considered insurance income or income
in any other category of foreign base company income.
(B) If income is foreign base company oil related income, pursuant
to section 954(g), it shall not be considered insurance income or
income in any other category of foreign base company income, except as
provided in paragraph (e)(4)(i)(A) of this section.
(C) If income is insurance income, pursuant to section 953, it
shall not be considered income in any category of foreign base company
income except as provided in paragraph (e)(4)(i) (A) or (B) of this
section.
(D) If income is foreign personal holding company income, pursuant
to section 954(c), it shall not be considered income in any other
category of foreign base company income, other than as provided in
paragraph (e)(4)(i) (A), (B) or (C) of this section.
(ii) Income excluded from other categories of gross foreign base
company income. Income shall not be excluded from a category of gross
foreign base company income or gross insurance income under this
paragraph (e)(4) by reason of being included in another category of
gross foreign base company income or gross insurance income, if the
income is excluded from that other category by a more specific
provision of section 953 or 954. For example, income derived from a
commodity transaction that is excluded from foreign personal holding
company income under Sec. 1.954-2(f) as income from a qualified active
sale may be included in gross foreign base company income if it also
meets the definition of foreign base company sales income. See
Sec. 1.954-2(a)(2) for the coordination of overlapping categories
within the definition of foreign personal holding company income.
(f) Definition of related person--(1) Persons related to controlled
foreign corporation. Unless otherwise provided, for purposes of section
954 and Secs. 1.954-1 through 1.954-8 inclusive, the following persons
are considered under section 954(d)(3) to be related persons with
respect to a controlled foreign corporation:
[[Page 46517]]
(i) Individuals. An individual, whether or not a citizen or
resident of the United States, who controls the controlled foreign
corporation.
(ii) Other persons. A foreign or domestic corporation, partnership,
trust or estate that controls or is controlled by the controlled
foreign corporation, or is controlled by the same person or persons
that control the controlled foreign corporation.
(2) Control--(i) Corporations. With respect to a corporation,
control means the ownership, directly or indirectly, of stock
possessing more than 50 percent of the total voting power of all
classes of stock entitled to vote or of the total value of the stock of
the corporation.
(ii) Partnerships. With respect to a partnership, control means the
ownership, directly or indirectly, of more than 50 percent (by value)
of the capital or profits interest in the partnership.
(iii) Trusts and estates. With respect to a trust or estate,
control means the ownership, directly or indirectly, of more than 50
percent (by value) of the beneficial interest in the trust or estate.
(iv) Direct or indirect ownership. For purposes of this paragraph
(f), to determine direct or indirect ownership, the principles of
section 958(a) shall be applied without regard to whether a
corporation, partnership, trust or estate is foreign or domestic or
whether or not an individual is a citizen or resident of the United
States.
Sec. 1.954-2 Foreign personal holding company income.
(a) Computation of foreign personal holding company income--(1)
Categories of foreign personal holding company income. For purposes of
subpart F and the regulations under that subpart, foreign personal
holding company income consists of the following categories of income--
(i) Dividends, interest, rents, royalties, and annuities as
described in paragraph (b) of this section;
(ii) Gain from certain property transactions as described in
paragraph (e) of this section;
(iii) Gain from commodities transactions as described in paragraph
(f) of this section;
(iv) Foreign currency gain as described in paragraph (g) of this
section; and
(v) Income equivalent to interest as described in paragraph (h) of
this section.
(2) Coordination of overlapping categories under foreign personal
holding company provisions--(i) In general. If any portion of income,
gain or loss from a transaction is described in more than one category
of foreign personal holding company income (as described in paragraph
(a)(2)(ii) of this section), that portion of income, gain or loss is
treated solely as income, gain or loss from the category of foreign
personal holding company income with the highest priority.
(ii) Priority of categories. The categories of foreign personal
holding company income, listed from highest priority (paragraph
(a)(2)(ii)(A) of this section) to lowest priority (paragraph
(a)(2)(ii)(E) of this section), are--
(A) Dividends, interest, rents, royalties, and annuities, as
described in paragraph (b) of this section;
(B) Income equivalent to interest, as described in paragraph (h) of
this section without regard to the exceptions in paragraph
(h)(1)(ii)(A) of this section;
(C) Foreign currency gain or loss, as described in paragraph (g) of
this section without regard to the exclusion in paragraph (g)(2)(ii) of
this section;
(D) Gain or loss from commodities transactions, as described in
paragraph (f) of this section without regard to the exclusion in
paragraph (f)(1)(ii) of this section; and
(E) Gain or loss from certain property transactions, as described
in paragraph (e) of this section without regard to the exceptions in
paragraph (e)(1)(ii) of this section.
(3) Changes in the use or purpose for which property is held--(i)
In general. Under paragraphs (e), (f), (g) and (h) of this section,
transactions in certain property give rise to gain or loss included in
the computation of foreign personal holding company income if the
controlled foreign corporation holds that property for a particular use
or purpose. The use or purpose for which property is held is that use
or purpose for which it was held for more than one- half of the period
during which the controlled foreign corporation held the property prior
to the disposition.
(ii) Special rules--(A) Anti-abuse rule. If a principal purpose of
a change in use or purpose of property was to avoid including gain or
loss in the computation of foreign personal holding company income, all
the gain or loss from the disposition of the property is treated as
foreign personal holding company income. A purpose may be a principal
purpose even though it is outweighed by other purposes (taken together
or separately).
(B) Hedging transactions. The provisions of paragraph (a)(3)(i) of
this section shall not apply to bona fide hedging transactions, as
defined in paragraph (a)(4)(ii) of this section. A transaction will be
treated as a bona fide hedging transaction only so long as it satisfies
the requirements of paragraph (a)(4)(ii) of this section.
(iii) Example. The following example illustrates the application of
this paragraph (a)(3).
Example. At the beginning of taxable year 1, CFC, a controlled
foreign corporation, purchases a building for investment. During
taxable years 1 and 2, CFC derives rents from the building that are
included in the computation of foreign personal holding company
income under paragraph (b)(1)(iii) of this section. At the beginning
of taxable year 3, CFC changes the use of the building by
terminating all leases and using it in an active trade or business.
At the beginning of taxable year 4, CFC sells the building at a
gain. The building was not used in an active trade or business of
CFC for more than one-half of the period during which it was held by
CFC. Therefore, the building is considered to be property that gives
rise to rents, as described in paragraph (e)(2) of this section, and
gain from the sale is included in the computation of CFC's foreign
personal holding company income under paragraph (e) of this section.
(4) Definitions and special rules. The following definitions and
special rules apply for purposes of computing foreign personal holding
company income under this section.
(i) Interest. The term interest includes all amounts that are
treated as interest income (including interest on a tax-exempt
obligation) by reason of the Internal Revenue Code or Income Tax
Regulations or any other provision of law. For example, interest
includes stated interest, acquisition discount, original issue
discount, de minimis original issue discount, market discount, de
minimis market discount, and unstated interest, as adjusted by any
amortizable bond premium or acquisition premium.
(ii) Bona fide hedging transaction--(A) Definition. The term bona
fide hedging transaction means a transaction that meets the
requirements of Sec. 1.1221-2 (a) through (c) and that is identified in
accordance with the requirements of paragraph (a)(4)(ii)(B) of this
section, except that in applying Sec. 1.1221-2(b)(1), the risk being
hedged may be with respect to ordinary property, section 1231 property,
or a section 988 transaction. A transaction that hedges the
liabilities, inventory or other assets of a related person (as defined
in section 954(d)(3)), that is entered into to assume or reduce risks
of a related person, or that is entered into by a person other than a
person acting in its capacity as a regular dealer (as defined in
paragraph (a)(4)(iv) of this section) to reduce risks assumed from a
related person, will not be treated as a bona fide hedging transaction.
For an illustration of how this rule applies with respect to foreign
[[Page 46518]]
currency transactions, see paragraph (g)(2)(ii)(D) of this section.
(B) Identification. The identification requirements of this section
shall be satisfied if the taxpayer meets the identification and
recordkeeping requirements of Sec. 1.1221-2(e). However, for bona fide
hedging transactions entered into prior to March 7, 1996 the
identification and recordkeeping requirements of Sec. 1.1221-2 shall
not apply. Rather, for bona fide hedging transactions entered into on
or after July 22, 1988 and prior to March 7, 1996 the identification
and recordkeeping requirements shall be satisfied if such transactions
are identified by the close of the fifth day after the day on which
they are entered into. For bona fide hedging transactions entered into
prior to July 22, 1988, the identification and recordkeeping
requirements shall be satisfied if such transactions are identified
reasonably contemporaneously with the date they are entered into, but
no later than within the normal period prescribed under the method of
accounting of the controlled foreign corporation used for financial
reporting purposes.
(C) Effect of identification and non-identification--(1)
Transactions identified. If a taxpayer identifies a transaction as a
bona fide hedging transaction for purposes of this section, the
identification is binding with respect to any loss arising from such
transaction whether or not all of the requirements of paragraph
(a)(4)(ii)(A) of this section are satisfied. Accordingly, such loss
will be allocated against income that is not subpart F income (or, in
the case of an election under paragraph (g)(3) of this section, against
the category of subpart F income to which it relates) and apportioned
among the categories of income described in section 904(d)(1). If the
transaction is not in fact a bona fide hedging transaction described in
paragraph (a)(4)(ii)(A) of this section, however, then any gain
realized with respect to such transaction shall not be considered as
gain from a bona fide hedging transaction. Accordingly, such gain shall
be treated as gain from the appropriate category of foreign personal
holding company income. Thus, the taxpayer's identification of the
transaction as a hedging transaction does not itself operate to exclude
gain from the appropriate category of foreign personal holding company
income.
(2) Inadvertent identification. Notwithstanding paragraph
(a)(4)(ii)(C)(1) of this section, if the taxpayer identifies a
transaction as a bona fide hedging transaction for purposes of this
section, the characterization of the loss is determined as if the
transaction had not been identified as a bona fide hedging transaction
if--
(i) The transaction is not a bona fide hedging transaction (as
defined in paragraph (a)(4)(ii)(A) of this section);
(ii) The identification of the transaction as a bona fide hedging
transaction was due to inadvertent error; and
(iii) All of the taxpayer's transactions in all open years are
being treated on either original or, if necessary, amended returns in a
manner consistent with the principles of this section.
(3) Transactions not identified. Except as provided in paragraphs
(a)(4)(ii)(C) (4) and (5) of this section, the absence of an
identification that satisfies the requirements of paragraph
(a)(4)(ii)(B) of this section is binding and establishes that a
transaction is not a bona fide hedging transaction. Thus, subject to
the exceptions, the characterization of gain or loss is determined
without reference to whether the transaction is a bona fide hedging
transaction.
(4) Inadvertent error. If a taxpayer does not make an
identification that satisfies the requirements of paragraph
(a)(4)(ii)(B) of this section, the taxpayer may treat gain or loss from
the transaction as gain or loss from a bona fide hedging transaction
if--
(i) The transaction is a bona fide hedging transaction (as defined
in paragraph (a)(4)(ii)(A) of this section);
(ii) The failure to identify the transaction was due to inadvertent
error; and
(iii) All of the taxpayer's bona fide hedging transactions in all
open years are being treated on either original or, if necessary,
amended returns as bona fide hedging transactions in accordance with
the rules of this section.
(5) Anti-abuse rule. If a taxpayer does not make an identification
that satisfies all the requirements of paragraph (a)(4)(ii)(B) of this
section but the taxpayer has no reasonable grounds for treating the
transaction as other than a bona fide hedging transaction, then loss
from the transaction shall be treated as realized with respect to a
bona fide hedging transaction. Thus, a taxpayer may not elect to
exclude loss from its proper characterization as a bona fide hedging
transaction. The reasonableness of the taxpayer's failure to identify a
transaction is determined by taking into consideration not only the
requirements of paragraph (a)(4)(ii)(A) of this section but also the
taxpayer's treatment of the transaction for financial accounting or
other purposes and the taxpayer's identification of similar
transactions as hedging transactions.
(iii) Inventory and similar property--(A) Definition. The term
inventory and similar property (or inventory or similar property) means
property that is stock in trade of the controlled foreign corporation
or other property of a kind that would properly be included in the
inventory of the controlled foreign corporation if on hand at the close
of the taxable year (if the controlled foreign corporation were a
domestic corporation), or property held by the controlled foreign
corporation primarily for sale to customers in the ordinary course of
its trade or business.
(B) Hedging transactions. A bona fide hedging transaction with
respect to inventory or similar property (other than a transaction
described in section 988(c)(1) without regard to section
988(c)(1)(D)(i)) shall be treated as a transaction in inventory or
similar property.
(iv) Regular dealer. The term regular dealer means a controlled
foreign corporation that--
(A) Regularly and actively offers to, and in fact does, purchase
property from and sell property to customers who are not related
persons (as defined in section 954(d)(3)) with respect to the
controlled foreign corporation in the ordinary course of a trade or
business; or
(B) Regularly and actively offers to, and in fact does, enter into,
assume, offset, assign or otherwise terminate positions in property
with customers who are not related persons (as defined in section
954(d)(3)) with respect to the controlled foreign corporation in the
ordinary course of a trade or business.
(v) Dealer property--(A) Definition. Property held by a controlled
foreign corporation is dealer property if--
(1) The controlled foreign corporation is a regular dealer in
property of such kind (determined under paragraph (a)(4)(iv) of this
section); and
(2) The property is held by the controlled foreign corporation in
its capacity as a dealer in property of such kind without regard to
whether the property arises from a transaction with a related person
(as defined in section 954(d)(3)) with respect to the controlled
foreign corporation. The property is not held by the controlled foreign
corporation in its capacity as a dealer if the property is held for
investment or speculation on its own behalf or on behalf of a related
person (as defined in section 954(d)(3)).
(B) Securities dealers. If a controlled foreign corporation is a
licensed securities dealer, only the securities that it has identified
as held for investment in accordance with the provisions of section
475(b) or section 1236 will be
[[Page 46519]]
considered to be property held for investment or speculation under this
section. A licensed securities dealer is a controlled foreign
corporation that is both a securities dealer, as defined in section
475, and a regular dealer, as defined in paragraph (a)(4)(iv) of this
section, and that is either--
(1) registered as a securities dealer under section 15(a) of the
Securities Exchange Act of 1934 or as a Government securities dealer
under section 15C(a) of such Act; or
(2) licensed or authorized in the country in which it is chartered,
incorporated, or organized to purchase and sell securities from or to
customers who are residents of that country. The conduct of such
securities activities must be subject to bona fide regulation,
including appropriate reporting, monitoring, and prudential (including
capital adequacy) requirements, by a securities regulatory authority in
that country that regularly enforces compliance with such requirements
and prudential standards.
(C) Hedging transactions. A bona fide hedging transaction with
respect to dealer property shall be treated as a transaction in dealer
property.
(vi) Examples. The following examples illustrate the application of
paragraphs (a)(4)(ii), (iv) and (v) of this section.
Example 1. (i) CFC1 and CFC2 are related controlled foreign
corporations (within the meaning of section 954(d)(3)) located in
Countries F and G, respectively. CFC1 and CFC2 regularly purchase
securities from and sell securities to customers who are not related
persons with respect to CFC1 or CFC2 (within the meaning of section
954(d)(3)) in the ordinary course of their businesses and regularly
and actively hold themselves out as being willing to, and in fact
do, enter into either side of options, forward contracts, or other
financial instruments. CFC1 uses securities that are traded in
securities markets in Country G to hedge positions that it enters
into with customers located in Country F. CFC1 is not a member of a
securities exchange in Country G, so it purchases such securities
from CFC2 and unrelated persons that are registered as securities
dealers in Country G and that are members of Country G securities
exchanges. Such hedging transactions qualify as bona fide hedging
transactions under paragraph (a)(4)(ii) of this section.
(ii) Transactions that CFC1 and CFC2 enter into with each other
do not affect the determination of whether they are regular dealers.
Because CFC1 and CFC2 regularly purchase securities from and sell
securities to customers who are not related persons within the
meaning of section 954(d)(3) in the ordinary course of their
businesses and regularly and actively hold themselves out as being
willing to, and in fact do, enter into either side of options,
forward contracts, or other financial instruments, however, they
qualify as regular dealers in such property within the meaning of
paragraph (a)(4)(iv) of this section. Moreover, because CFC1
purchases securities from CFC2 as bona fide hedging transactions
with respect to dealer property, the securities are dealer property
under paragraph (a)(4)(v)(C) of this section. Similarly, because
CFC2 sells securities to CFC1 in the ordinary course of its business
as a dealer, the securities are dealer property under paragraph
(a)(4)(v)(A) of this section.
Example 2. (i) CFC is a controlled foreign corporation located
in Country B. CFC serves as the currency coordination center for the
controlled group, aggregating currency risks incurred by the group
and entering into hedging transactions that transfer those risks
outside of the group. CFC regularly and actively holds itself out as
being willing to, and in fact does, enter into either side of
options, forward contracts, or other financial instruments with
other members of the same controlled group. CFC hedges risks arising
from such transactions by entering into transactions with persons
who are not related persons (within the meaning of section
954(d)(3)) with respect to CFC. However, CFC does not regularly and
actively hold itself out as being willing to, and does not, enter
into either side of transactions with unrelated persons.
(ii) CFC is not a regular dealer in property under paragraph
(a)(4)(iv) of this section and its options, forwards, and other
financial instruments are not dealer property within the meaning of
paragraph (a)(4)(v) of this section.
(vii) Debt instrument. The term debt instrument includes bonds,
debentures, notes, certificates, accounts receivable, and other
evidences of indebtedness.
(b) Dividends, interest, rents, royalties, and annuities--(1) In
general. Foreign personal holding company income includes--
(i) Dividends, except certain dividends from related persons as
described in paragraph (b)(4) of this section and distributions of
previously taxed income under section 959(b);
(ii) Interest, except export financing interest as defined in
paragraph (b)(2) of this section and certain interest received from
related persons as described in paragraph (b)(4) of this section;
(iii) Rents and royalties, except certain rents and royalties
received from related persons as described in paragraph (b)(5) of this
section and rents and royalties derived in the active conduct of a
trade or business as defined in paragraph (b)(6) of this section; and
(iv) Annuities.
(2) Exclusion of certain export financing interest--(i) In general.
Foreign personal holding company income does not include interest that
is export financing interest. The term export financing interest means
interest that is derived in the conduct of a banking business and is
export financing interest as defined in section 904(d)(2)(G). Solely
for purposes of determining whether interest is export financing
interest, property is treated as manufactured, produced, grown, or
extracted in the United States if it is so treated under Sec. 1.927(a)-
1T(c).
(ii) Exceptions. Export financing interest does not include income
from related party factoring that is treated as interest under section
864(d) (1) or (6) after the application of section 864(d)(7).
(iii) Conduct of a banking business. For purposes of this section,
export financing interest is considered derived in the conduct of a
banking business if, in connection with the financing from which the
interest is derived, the corporation, through its own officers or staff
of employees, engages in all the activities in which banks customarily
engage in issuing and servicing a loan.
(iv) Examples. The following examples illustrate the application of
this paragraph (b)(2).
Example 1. (i) DS, a domestic corporation, manufactures property
in the United States. In addition to selling inventory (property
described in section 1221(1)), DS occasionally sells depreciable
equipment it manufactures for use in its trade or business, which is
property described in section 1221(2). Less than 50 percent of the
fair market value, determined in accordance with section
904(d)(2)(G), of each item of inventory or equipment sold by DS is
attributable to products imported into the United States. CFC, a
controlled foreign corporation with respect to which DS is a related
person (within the meaning of section 954(d)(3)), provides loans
described in section 864(d)(6) to unrelated persons for the purchase
of property from DS. This property is purchased exclusively for use
or consumption outside the United States and outside CFC's country
of incorporation.
(ii) If, in issuing and servicing loans made with respect to
purchases from DS of depreciable equipment used in its trade or
business, which is property described in section 1221(2) in the
hands of DS, CFC engages in all the activities in which banks
customarily engage in issuing and servicing loans, the interest
accrued from these loans would be export financing interest meeting
the requirements of this paragraph (b)(2) and, thus, not included in
foreign personal holding company income. However, interest from the
loans made with respect to purchases from DS of property that is
inventory in the hands of DS cannot be export financing interest
because it is treated as income from a trade or service receivable
under section 864(d)(6) and the exception under section 864(d)(7)
does not apply. Thus the interest from loans made with respect to
this inventory is included in foreign personal holding company
income under paragraph (b)(1)(ii) of this section.
Example 2. (i) DS, a domestic corporation manufactures property
in the United States. DS wholly owns two controlled foreign
[[Page 46520]]
corporations organized in Country A, CFC1 and CFC2. CFC1 has a
substantial part of its assets used in its trade or business in
Country A. CFC1 purchases the property that DS manufactures and
sells it without further manufacture for use or consumption within
Country A. This property is inventory property, as described in
section 1221(1), in the hands of CFC1. Less than 50 percent of the
fair market value, determined in accordance with section
904(d)(2)(G), of each item of inventory sold by CFC1 is attributable
to products imported into the United States. CFC2 provides loans
described in section 864(d)(6) to unrelated persons in Country A for
the purchase of the property from CFC1.
(ii) If, in issuing and servicing loans made with respect to
purchases from CFC1 of the inventory property, CFC2 engages in all
the activities in which banks customarily engage in issuing and
servicing loans, the interest accrued from these loans would be
export financing interest meeting the requirements of paragraph
(b)(2) of this section. It is not treated as income from a trade or
service receivable under section 864(d)(6) because the exception
under section 864(d)(7) applies. Thus the interest is excluded from
foreign personal holding company income.
Example 3. The facts are the same as in Example 2 except that
the property sold by CFC1 is manufactured by CFC1 in Country A from
component parts that were manufactured by DS in the United States.
The interest accrued from the loans by CFC2 is not export financing
interest as defined in section 904(d)(2)(G) because the property is
not manufactured in the United States under Sec. 1.927(a)-1T(c). No
portion of the interest is export financing interest as defined in
this paragraph (b)(2). The full amount of the interest is,
therefore, included in foreign personal holding company income under
paragraph (b)(1)(ii) of this section.
(3) Treatment of tax-exempt interest. [Reserved] For guidance, see
Sec. 4.954-2(b)(6) of this chapter.
(4) Exclusion of dividends or interest from related persons--(i) In
general--(A) Corporate payor. Foreign personal holding company income
received by a controlled foreign corporation does not include dividends
or interest if the payor--
(1) Is a corporation that is a related person with respect to the
controlled foreign corporation, as defined in section 954(d)(3);
(2) Is created or organized under the laws of the same foreign
country (the country of incorporation) as is the controlled foreign
corporation; and
(3) Uses a substantial part of its assets in a trade or business in
its country of incorporation, as determined under this paragraph
(b)(4).
(B) Payment by a partnership. For purposes of this paragraph
(b)(4), if a partnership with one or more corporate partners makes a
payment of interest, a corporate partner will be treated as the payor
of the interest--
(1) If the interest payment gives rise to a partnership item of
deduction under the Internal Revenue Code or Income Tax Regulations, to
the extent that the item of deduction is allocable to the corporate
partner under section 704(b); or
(2) If the interest payment does not give rise to a partnership
item of deduction under the Internal Revenue Code or Income Tax
Regulations, to the extent that a partnership item reasonably related
to the payment would be allocated to that partner under an existing
allocation under the partnership agreement (made pursuant to section
704(b)).
(ii) Exceptions--(A) Dividends. Dividends are excluded from foreign
personal holding company income under this paragraph (b)(4) only to the
extent that they are paid out of earnings and profits that are earned
or accumulated during a period in which--
(1) The stock on which dividends are paid with respect to which the
exclusion is claimed was owned by the recipient controlled foreign
corporation directly, or indirectly through a chain of one or more
subsidiaries each of which meets the requirements of paragraph
(b)(4)(i)(A) of this section; and
(2) Each of the requirements of paragraph (b)(4)(i)(A) of this
section is satisfied or, to the extent earned or accumulated during a
taxable year of the related foreign corporation ending on or before
December 31, 1962, during a period in which the payor was a related
corporation as to the controlled foreign corporation and the other
requirements of paragraph (b)(4)(i)(A) of this section were
substantially satisfied.
(3) This paragraph (b)(4)(ii)(A) is illustrated by the following
example:
Example. A, a domestic corporation, owns all of the stock of B,
a corporation created and organized under the laws of Country Y, and
C, a corporation created and organized under the laws of Country X.
The taxable year of each of the corporations is the calendar year.
In Year 1, B earns $100 of income from the sale of products in
Country Y that it manufactured in Country Y. C had no earnings and
profits in Year 1. On January 1 of Year 2, A contributes all of the
stock of B and C to Newco, a Country Y corporation, in exchange for
all of the stock of Newco. Neither B nor C earns any income in Year
2, but at the end of Year 2 B distributes the $100 accumulated
earnings and profits to Newco. Newco's income from the distribution,
$100, is foreign personal holding company income because the
earnings and profits distributed by B were not earned or accumulated
during a period in which the stock of B was owned by Newco and in
which each of the requirements of paragraph (b)(4)(i)(A) of this
section was satisfied.
(B) Interest paid out of adjusted foreign base company income or
insurance income--(1) In general. Interest may not be excluded from the
foreign personal holding company income of the recipient under this
paragraph (b)(4) to the extent that the deduction for the interest is
allocated under Sec. 1.954-1(a)(4) and (c) to the payor's adjusted
gross foreign base company income (as defined in Sec. 1.954-1(a)(3)),
adjusted gross insurance income (as defined in Sec. 1.954-1(a)(6)), or
any other category of income included in the computation of subpart F
income under section 952(a).
(2) Rule for corporations that are both recipients and payors of
interest. If a controlled foreign corporation is both a recipient and
payor of interest, the interest that is received will be characterized
before the interest that is paid. In addition, the amount of interest
paid or accrued, directly or indirectly, by the controlled foreign
corporation to a related person (as defined in section 954(d)(3)) shall
be offset against and eliminate any interest received or accrued,
directly or indirectly, by the controlled foreign corporation from that
related person. In a case in which the controlled foreign corporation
pays or accrues interest to a related person, as defined in section
954(d)(3), and also receives or accrues interest indirectly from the
related person, the smallest interest payment is eliminated and the
amounts of all other interest payments are reduced by the amount of the
smallest interest payment.
(C) Coordination with sections 864(d) and 881(c). Income of a
controlled foreign corporation that is treated as interest under
section 864(d) (1) or (6), or that is portfolio interest, as defined by
section 881(c), is not excluded from foreign personal holding company
income under section 954(c)(3)(A)(i) and this paragraph (b)(4).
(iii) Trade or business requirement. Except as otherwise provided
under this paragraph (b)(4), the principles of section 367(a) apply for
purposes of determining whether the payor has a trade or business in
its country of incorporation and whether its assets are used in that
trade or business. Property purchased or produced for use in a trade or
business is not considered used in a trade or business before it is
placed in service or after it is retired from service as determined in
accordance with the principles of sections 167 and 168.
(iv) Substantial assets test. A substantial part of the assets of
the payor will be considered to be used in a trade or business located
in the payor's country of incorporation for a taxable year only if the
average value of the payor's assets for such year that are used in the
trade or business and are
[[Page 46521]]
located in such country equals more than 50 percent of the average
value of all the assets of the payor (including assets not used in a
trade or business). The average value of assets for the taxable year is
determined by averaging the values of assets at the close of each
quarter of the taxable year. The value of assets is determined under
paragraph (b)(4)(v) of this section, and the location of assets used in
a trade or business of the payor is determined under paragraphs (b)(4)
(vi) through (xi) of this section.
(v) Valuation of assets. For purposes of determining whether a
substantial part of the assets of the payor are used in a trade or
business in its country of incorporation, the value of assets shall be
their fair market value (not reduced by liabilities), which, in the
absence of affirmative evidence to the contrary, shall be deemed to be
their adjusted basis.
(vi) Location of tangible property--(A) In general. Tangible
property (other than inventory and similar property as defined in
paragraph (a)(4)(iii) of this section, and dealer property as defined
in paragraph (a)(4)(v) of this section) used in a trade or business is
considered located in the country in which it is physically located.
(B) Exception. An item of tangible personal property that is used
in the trade or business of a payor in the payor's country of
incorporation is considered located within the payor's country of
incorporation while it is temporarily located elsewhere for inspection
or repair if the property is not placed in service in a country other
than the payor's country of incorporation and is not to be so placed in
service following the inspection or repair.
(vii) Location of intangible property--(A) In general. Intangible
property (other than inventory and similar property as defined in
paragraph (a)(4)(iii) of this section, dealer property as defined in
paragraph (a)(4)(v) of this section, and debt instruments) is
considered located entirely in the payor's country of incorporation for
a quarter of the taxable year only if the payor conducts all of its
activities in connection with the use or exploitation of the property
in that country during that entire quarter. For this purpose, the
country in which the activities connected to the use or exploitation of
the property are conducted is the country in which the expenses
associated with these activities are incurred. Expenses incurred in
connection with the use or exploitation of an item of intangible
property are included in the computation provided by this paragraph
(b)(4) if they would be deductible under section 162 or includible in
inventory costs or the cost of goods sold if the payor were a domestic
corporation. If the payor conducts such activities through an agent or
independent contractor, then the expenses incurred by the payor with
respect to the agent or independent contractor shall be deemed to be
incurred by the payor in the country in which the expenses of the agent
or independent contractor were incurred by the agent or independent
contractor.
(B) Exception for property located in part in the payor's country
of incorporation. If the payor conducts its activities in connection
with the use or exploitation of an item of intangible property,
including goodwill (other than inventory and similar property, dealer
property and debt instruments) during a quarter of the taxable year
both in its country of incorporation and elsewhere, then the value of
the intangible considered located in the payor's country of
incorporation during that quarter is a percentage of the value of the
item as of the close of the quarter. That percentage equals the ratio
that the expenses incurred by the payor (described in paragraph
(b)(4)(vii)(A) of this section) during the entire quarter by reason of
activities that are connected with the use or exploitation of the item
of intangible property and are conducted in the payor's country of
incorporation bear to all expenses incurred by the payor during the
entire quarter by reason of all such activities worldwide.
(viii) Location of inventory and dealer property--(A) In general.
Inventory and similar property, as defined in paragraph (a)(4)(iii) of
this section, and dealer property, as defined in paragraph (a)(4)(v) of
this section, are considered located entirely in the payor's country of
incorporation for a quarter of the taxable year only if the payor
conducts all of its activities in connection with the production and
sale, or purchase and resale, of such property in its country of
incorporation during that entire quarter. If the payor conducts such
activities through an agent or independent contractor, then the
location of such activities is the place in which they are conducted by
the agent or independent contractor.
(B) Inventory and dealer property located in part in the payor's
country of incorporation. If the payor conducts its activities in
connection with the production and sale, or purchase and resale, of
inventory or similar property or dealer property during a quarter of
the taxable year both in its country of incorporation and elsewhere,
then the value of the inventory or similar property or dealer property
considered located in the payor's country of incorporation during each
quarter is a percentage of the value of the inventory or similar
property or dealer property as of the close of the quarter. That
percentage equals the ratio that the costs and expenses incurred by the
payor during the entire quarter by reason of activities connected with
the production and sale, or purchase and resale, of inventory or
similar property or dealer property that are conducted in the payor's
country of incorporation bear to all costs or expenses incurred by the
payor during the entire quarter by reason of all such activities
worldwide. A cost incurred in connection with the production and sale
or purchase and resale of inventory or similar property or dealer
property is included in this computation if it--
(1) Would be included in inventory costs or otherwise capitalized
with respect to inventory or similar property or dealer property under
section 61, 263A, 471, or 472 if the payor were a domestic corporation;
or
(2) Would be deductible under section 162 if the payor were a
domestic corporation and is definitely related to gross income derived
from such property (but not to all classes of gross income derived by
the payor) under the principles of Sec. 1.861-8.
(ix) Location of debt instruments. For purposes of this paragraph
(b)(4), debt instruments, other than debt instruments that are
inventory or similar property (as defined in paragraph (a)(4)(iii) of
this section) or dealer property (as defined in paragraph (a)(4)(v) of
this section) are considered to be used in a trade or business only if
they arise from the sale of inventory or similar property or dealer
property by the payor or from the rendition of services by the payor in
the ordinary course of a trade or business of the payor, and only until
such time as interest is required to be charged under section 482. Debt
instruments that arise from the sale of inventory or similar property
or dealer property during a quarter are treated as having the same
location, proportionately, as the inventory or similar property or
dealer property held during that quarter. Debt instruments arising from
the rendition of services in the ordinary course of a trade or business
are considered located on a proportionate basis in the countries in
which the services to which they relate are performed.
(x) Treatment of certain stock interests. Stock in a controlled
foreign corporation (lower-tier corporation) that is incorporated in
the same country as the payor and related to the payor
[[Page 46522]]
within the meaning of section 954(d)(3) shall be considered located in
the payor's country of incorporation in proportion to the value of the
assets of the lower-tier corporation. The location of assets used in a
trade or business of the lower-tier corporation shall be determined
under the rules of this paragraph (b)(4).
(xi) Treatment of banks and insurance companies. [Reserved]
(5) Exclusion of rents and royalties derived from related persons--
(i) In general--(A) Corporate payor. Foreign personal holding company
income received by a controlled foreign corporation does not include
rents or royalties if--
(1) The payor is a corporation that is a related person with
respect to the controlled foreign corporation, as defined in section
954(d)(3); and
(2) The rents or royalties are for the use of, or the privilege of
using, property within the country under the laws of which the
controlled foreign corporation receiving the payments is created or
organized (the country of incorporation).
(B) Payment by a partnership. For purposes of this paragraph
(b)(5), if a partnership with one or more corporate partners makes a
payment of rents or royalties, a corporate partner will be treated as
the payor of the rents or royalties--
(1) If the rent or royalty payment gives rise to a partnership item
of deduction under the Internal Revenue Code or Income Tax Regulations,
to the extent the item of deduction is allocable to the corporate
partner under section 704(b); or
(2) If the rent or royalty payment does not give rise to a
partnership item of deduction under the Internal Revenue Code or Income
Tax Regulations, to the extent that a partnership item reasonably
related to the payment would be allocated to that partner under an
existing allocation under the partnership agreement (made pursuant to
section 704(b)).
(ii) Exceptions--(A) Rents or royalties paid out of adjusted
foreign base company income or insurance income. Rents or royalties may
not be excluded from the foreign personal holding company income of the
recipient under this paragraph (b)(5) to the extent that deductions for
the payments are allocated under section 954(b)(5) and Sec. 1.954-
1(a)(4) and (c) to the payor's adjusted gross foreign base company
income (as defined in Sec. 1.954-1(a)(3)), adjusted gross insurance
income (as defined in Sec. 1.954-1(a)(6)), or any other category of
income included in the computation of subpart F income under section
952(a).
(B) Property used in part in the controlled foreign corporation's
country of incorporation. If the payor uses the property both in the
controlled foreign corporation's country of incorporation and
elsewhere, the part of the rent or royalty attributable (determined
under the principles of section 482) to the use of, or the privilege of
using, the property outside such country of incorporation is included
in the computation of foreign personal holding company income under
this paragraph (b).
(6) Exclusion of rents and royalties derived in the active conduct
of a trade or business. Foreign personal holding company income shall
not include rents or royalties that are derived in the active conduct
of a trade or business and received from a person that is not a related
person (as defined in section 954(d)(3)) with respect to the controlled
foreign corporation. For purposes of this section, rents or royalties
are derived in the active conduct of a trade or business only if the
provisions of paragraph (c) or (d) of this section are satisfied.
(c) Excluded rents--(1) Active conduct of a trade or business.
Rents will be considered for purposes of paragraph (b)(6) of this
section to be derived in the active conduct of a trade or business if
such rents are derived by the controlled foreign corporation (the
lessor) from leasing any of the following--
(i) Property that the lessor has manufactured or produced, or has
acquired and added substantial value to, but only if the lessor is
regularly engaged in the manufacture or production of, or in the
acquisition and addition of substantial value to, property of such
kind;
(ii) Real property with respect to which the lessor, through its
own officers or staff of employees, regularly performs active and
substantial management and operational functions while the property is
leased;
(iii) Personal property ordinarily used by the lessor in the active
conduct of a trade or business, leased temporarily during a period when
the property would, but for such leasing, be idle; or
(iv) Property that is leased as a result of the performance of
marketing functions by such lessor if the lessor, through its own
officers or staff of employees located in a foreign country, maintains
and operates an organization in such country that is regularly engaged
in the business of marketing, or of marketing and servicing, the leased
property and that is substantial in relation to the amount of rents
derived from the leasing of such property.
(2) Special rules--(i) Adding substantial value. For purposes of
paragraph (c)(1)(i) of this section, the performance of marketing
functions will not be considered to add substantial value to property.
(ii) Substantiality of foreign organization. For purposes of
paragraph (c)(1)(iv) of this section, whether an organization in a
foreign country is substantial in relation to the amount of rents is
determined based on all of the facts and circumstances. However, such
an organization will be considered substantial in relation to the
amount of rents if active leasing expenses, as defined in paragraph
(c)(2)(iii) of this section, equal or exceed 25 percent of the adjusted
leasing profit, as defined in paragraph (c)(2)(iv) of this section.
(iii) Active leasing expenses. The term active leasing expenses
means the deductions incurred by an organization of the lessor in a
foreign country that are properly allocable to rental income and that
would be allowable under section 162 to the lessor if it were a
domestic corporation, other than--
(A) Deductions for compensation for personal services rendered by
shareholders of, or related persons (as defined in section 954(d)(3))
with respect to, the lessor;
(B) Deductions for rents paid or accrued;
(C) Deductions that, although generally allowable under section
162, would be specifically allowable to the lessor (if the lessor were
a domestic corporation) under any section of the Internal Revenue Code
other than section 162; and
(D) Deductions for payments made to agents or independent
contractors with respect to the leased property other than payments for
insurance, utilities and other expenses for like services, or for
capitalized repairs.
(iv) Adjusted leasing profit. The term adjusted leasing profit
means the gross income of the lessor from rents, reduced by the sum
of--
(A) The rents paid or incurred by the lessor with respect to such
rental income;
(B) The amounts that would be allowable to such lessor (if the
lessor were a domestic corporation) as deductions under sections 167 or
168 with respect to such rental income; and
(C) The amounts paid by the lessor to agents or independent
contractors with respect to such rental income other than payments for
insurance, utilities and other expenses for like services, or for
capitalized repairs.
(3) Examples. The application of this paragraph (c) is illustrated
by the following examples.
[[Page 46523]]
Example 1. Controlled foreign corporation A is regularly engaged
in the production of office machines which it sells or leases to
others and services. Under paragraph (c)(1)(i) of this section, the
rental income of Corporation A from these leases is derived in the
active conduct of a trade or business for purposes of section
954(c)(2)(A).
Example 2. Controlled foreign corporation D purchases motor
vehicles which it leases to others. In the conduct of its short-term
leasing of such vehicles in foreign country X, Corporation D owns a
large number of motor vehicles in country X which it services and
repairs, leases motor vehicles to customers on an hourly, daily, or
weekly basis, maintains offices and service facilities in country X
from which to lease and service such vehicles, and maintains therein
a sizable staff of its own administrative, sales, and service
personnel. Corporation D also leases in country X on a long-term
basis, generally for a term of one year, motor vehicles that it
owns. Under the terms of the long-term leases, Corporation D is
required to repair and service, during the term of the lease, the
leased motor vehicles without cost to the lessee. By the maintenance
in country X of office, sales, and service facilities and its
complete staff of administrative, sales, and service personnel,
Corporation D maintains and operates an organization therein that is
regularly engaged in the business of marketing and servicing the
motor vehicles that are leased. The deductions incurred by such
organization satisfy the 25-percent test of paragraph (c)(2)(ii) of
this section; thus, such organization is substantial in relation to
the rents Corporation D receives from leasing the motor vehicles.
Therefore, under paragraph (c)(1)(iv) of this section, such rents
are derived in the active conduct of a trade or business for
purposes of section 954(c)(2)(A).
Example 3. Controlled foreign corporation E owns a complex of
apartment buildings that it has acquired by purchase. Corporation E
engages a real estate management firm to lease the apartments,
manage the buildings and pay over the net rents to Corporation E.
The rental income of Corporation E from such leases is not derived
in the active conduct of a trade or business for purposes of section
954(c)(2)(A).
Example 4. Controlled foreign corporation F acquired by purchase
a twenty-story office building in a foreign country, three floors of
which it occupies and the rest of which it leases. Corporation F
acts as rental agent for the leasing of offices in the building and
employs a substantial staff to perform other management and
maintenance functions. Under paragraph (c)(1)(ii) of this section,
the rents received by Corporation F from such leasing operations are
derived in the active conduct of a trade or business for purposes of
section 954(c)(2)(A).
Example 5. Controlled foreign corporation G owns equipment that
it ordinarily uses to perform contracts in foreign countries to
drill oil wells. For occasional brief and irregular periods it is
unable to obtain contracts requiring immediate performance
sufficient to employ all such equipment. During such a period it
sometimes leases such idle equipment temporarily. After the
expiration of such temporary leasing of the property, Corporation G
continues the use of such equipment in the performance of its own
drilling contracts. Under paragraph (c)(1)(iii) of this section,
rents Corporation G receives from such leasing of idle equipment are
derived in the active conduct of a trade or business for purposes of
section 954(c)(2)(A).
(d) Excluded royalties--(1) Active conduct of a trade or business.
Royalties will be considered for purposes of paragraph (b)(6) of this
section to be derived in the active conduct of a trade or business if
such royalties are derived by the controlled foreign corporation (the
licensor) from licensing--
(i) Property that the licensor has developed, created, or produced,
or has acquired and added substantial value to, but only so long as the
licensor is regularly engaged in the development, creation, or
production of, or in the acquisition of and addition of substantial
value to, property of such kind; or
(ii) Property that is licensed as a result of the performance of
marketing functions by such licensor if the licensor, through its own
officers or staff of employees located in a foreign country, maintains
and operates an organization in such country that is regularly engaged
in the business of marketing, or of marketing and servicing, the
licensed property and that is substantial in relation to the amount of
royalties derived from the licensing of such property.
(2) Special rules--(i) Adding substantial value. For purposes of
paragraph (d)(1)(i) of this section, the performance of marketing
functions will not be considered to add substantial value to property.
(ii) Substantiality of foreign organization. For purposes of
paragraph (d)(1)(ii) of this section, whether an organization in a
foreign country is substantial in relation to the amount of royalties
is determined based on all of the facts and circumstances. However,
such an organization will be considered substantial in relation to the
amount of royalties if active licensing expenses, as defined in
paragraph (d)(2)(iii) of this section, equal or exceed 25 percent of
the adjusted licensing profit, as defined in paragraph (d)(2)(iv) of
this section.
(iii) Active licensing expenses. The term active licensing expenses
means the deductions incurred by an organization of the licensor in a
foreign country that are properly allocable to royalty income and that
would be allowable under section 162 to the licensor if it were a
domestic corporation, other than--
(A) Deductions for compensation for personal services rendered by
shareholders of, or related persons (as defined in section 954(d)(3))
with respect to, the licensor;
(B) Deductions for royalties paid or incurred;
(C) Deductions that, although generally allowable under section
162, would be specifically allowable to the licensor (if the controlled
foreign corporation were a domestic corporation) under any section of
the Internal Revenue Code other than section 162; and
(D) Deductions for payments made to agents or independent
contractors with respect to the licensed property.
(iv) Adjusted licensing profit. The term adjusted licensing profit
means the gross income of the licensor from royalties, reduced by the
sum of--
(A) The royalties paid or incurred by the licensor with respect to
such royalty income;
(B) The amounts that would be allowable to such licensor as
deductions under section 167 or 197 (if the licensor were a domestic
corporation) with respect to such royalty income; and
(C) The amounts paid by the licensor to agents or independent
contractors with respect to such royalty income.
(3) Examples. The application of this paragraph (d) is illustrated
by the following examples.
Example 1. Controlled foreign corporation A, through its own
staff of employees, owns and operates a research facility in foreign
country X. At the research facility employees of Corporation A who
are scientists, engineers, and technicians regularly perform
experiments, tests, and other technical activities, that ultimately
result in the issuance of patents that it sells or licenses. Under
paragraph (d)(1)(i) of this section, royalties received by
Corporation A for the privilege of using patented rights that it
develops as a result of such research activity are derived in the
active conduct of a trade or business for purposes of section
954(c)(2)(A), but only so long as the licensor is regularly engaged
in the development, creation, or production of, or in the
acquisition of and addition of substantial value to, property of
such kind.
Example 2. Assume that Corporation A in Example 1, in addition
to receiving royalties for the use of patents that it develops,
receives royalties for the use of patents that it acquires by
purchase and licenses to others without adding any value thereto.
Corporation A generally consummates royalty agreements on such
purchased patents as the result of inquiries received by it from
prospective licensees when the fact becomes known in the business
community, as a result of the filing of a patent, advertisements in
trade journals, announcements, and contacts by employees of
Corporation A, that Corporation A has acquired rights under a patent
and is interested in licensing its rights. Corporation A does not,
however, maintain and operate
[[Page 46524]]
an organization in a foreign country that is regularly engaged in the
business of marketing the purchased patents. The royalties received
by Corporation A for the use of the purchased patents are not
derived in the active conduct of a trade or business for purposes of
section 954(c)(2)(A).
Example 3. Controlled foreign corporation B receives royalties
for the use of patents that it acquires by purchase. The primary
business of Corporation B, operated on a regular basis, consists of
licensing patents that it has purchased raw from inventors and,
through the efforts of a substantial staff of employees consisting
of scientists, engineers, and technicians, made susceptible to
commercial application. For example, Corporation B, after purchasing
patent rights covering a chemical process, designs specialized
production equipment required for the commercial adaptation of the
process and, by so doing, substantially increases the value of the
patent. Under paragraph (d)(1)(i) of this section, royalties
received by Corporation B from the use of such patent are derived in
the active conduct of a trade or business for purposes of section
954(c)(2)(A).
Example 4. Controlled foreign corporation C receives royalties
for the use of a patent that it developed through its own staff of
employees at its facility in country X. Corporation C has developed
no other patents. It does not regularly employ a staff of
scientists, engineers or technicians to create new products to be
patented. Further, it does not purchase and license patents
developed by others to which it has added substantial value. The
royalties received by Corporation C are not derived from the active
conduct of a trade or business for purposes of section 954(c)(2)(A).
Example 5. Controlled foreign corporation D finances independent
persons in the development of patented items in return for an
ownership interest in such items from which it derives a percentage
of royalty income, if any, subsequently derived from the use by
others of the protected right. Corporation D also attempts to
increase its royalty income from such patents by contacting
prospective licensees and rendering to licensees advice that is
intended to promote the use of the patented property. Corporation D
does not, however, maintain and operate an organization in a foreign
country that is regularly engaged in the business of marketing the
patents. Royalties received by Corporation D for the use of such
patents are not derived in the active conduct of a trade or business
for purposes of section 954(c)(2)(A).
(e) Certain property transactions--(1) In general--(i) Inclusions.
Gain from certain property transactions described in section
954(c)(1)(B) includes the excess of gains over losses from the sale or
exchange of--
(A) Property that gives rise to dividends, interest, rents,
royalties or annuities, as described in paragraph (e)(2) of this
section;
(B) Property that is an interest in a partnership, trust or REMIC;
and
(C) Property that does not give rise to income, as described in
paragraph (e)(3) of this section.
(ii) Exceptions. Gain or loss from certain property transactions
described in section 954(c)(1)(B) and paragraph (e)(1)(i) of this
section does not include gain or loss from the sale or exchange of--
(A) Inventory or similar property, as defined in paragraph
(a)(4)(iii) of this section;
(B) Dealer property, as defined in paragraph (a)(4)(v) of this
section; or
(C) Property that gives rise to rents or royalties described in
paragraph (b)(6) of this section that are derived in the active conduct
of a trade or business from persons that are not related persons (as
defined in section 954(d)(3)) with respect to the controlled foreign
corporation.
(iii) Treatment of losses. Section 1.954-1(c)(1)(ii) provides for
the treatment of losses in excess of gains from the sale or exchange of
property described in paragraph (e)(1)(i) of this section.
(iv) Dual character property. Property may, in part, constitute
property that gives rise to certain income as described in paragraph
(e)(2) of this section or, in part, constitute property that does not
give rise to any income as described in paragraph (e)(3) of this
section. However, property that is described in paragraph (e)(1)(i)(B)
of this section cannot be dual character property. Dual character
property must be treated as two separate properties for purposes of
paragraph (e)(2) or (3) of this section. Accordingly, the sale or
exchange of such dual character property will give rise to gain or loss
that in part must be included in the computation of foreign personal
holding company income under paragraph (e)(2) or (3) of this section,
and in part is excluded from such computation. Gain or loss from the
disposition of dual character property must be bifurcated under this
paragraph (e)(1)(iv) pursuant to the method that most reasonably
reflects the relative uses of the property. Reasonable methods may
include comparisons in terms of gross income generated or the physical
division of the property. In the case of real property, the physical
division of the property will in most cases be the most reasonable
method available. For example, if a controlled foreign corporation owns
an office building, uses 60 percent of the building in its trade or
business, and rents out the other 40 percent, then 40 percent of the
gain recognized on the disposition of the property would reasonably be
treated as gain that is included in the computation of foreign personal
holding company income under this paragraph (e)(1). This paragraph
(e)(1)(iv) addresses the contemporaneous use of property for dual
purposes. For rules concerning changes in the use of property affecting
its classification for purposes of this paragraph (e), see paragraph
(a)(3) of this section.
(2) Property that gives rise to certain income--(i) In general.
Property the sale or exchange of which gives rise to foreign personal
holding company income under this paragraph (e)(2) includes property
that gives rise to dividends, interest, rents, royalties or annuities
described in paragraph (b) of this section, including--
(A) Property that gives rise to export financing interest described
in paragraph (b)(2) of this section; and
(B) Property that gives rise to income from related persons
described in paragraph (b) (4) or (5) of this section.
(ii) Gain or loss from the disposition of a debt instrument. Gain
or loss from the sale, exchange, or retirement of a debt instrument is
included in the computation of foreign personal holding company income
under this paragraph (e) unless--
(A) In the case of gain--
(1) It is interest (as defined in paragraph (a)(4)(i) of this
section); or
(2) It is income equivalent to interest (as described in paragraph
(h) of this section); and
(B) In the case of loss--
(1) It is directly allocated to, or treated as an adjustment to,
interest income (as described in paragraph (a)(4)(i) of this section)
or income equivalent to interest (as defined in paragraph (h) of this
section) under any provision of the Internal Revenue Code or Income Tax
Regulations; or
(2) It is required to be apportioned in the same manner as interest
expense under section 864(e) or any other provision of the Internal
Revenue Code or Income Tax Regulations.
(3) Property that does not give rise to income. Except as otherwise
provided in this paragraph (e)(3), for purposes of this section, the
term property that does not give rise to income includes all rights and
interests in property (whether or not a capital asset) including, for
example, forwards, futures and options. Property that does not give
rise to income shall not include--
(i) Property that gives rise to dividends, interest, rents,
royalties or annuities described in paragraph (e)(2) of this section;
(ii) Tangible property (other than real property) used or held for
use in the controlled foreign corporation's trade or business that is
of a character that would be subject to the allowance for
[[Page 46525]]
depreciation under section 167 or 168 and the regulations under those
sections (including tangible property described in Sec. 1.167(a)-2);
(iii) Real property that does not give rise to rental or similar
income, to the extent used or held for use in the controlled foreign
corporation's trade or business;
(iv) Intangible property (as defined in section 936(h)(3)(B)),
goodwill or going concern value, to the extent used or held for use in
the controlled foreign corporation's trade or business;
(v) Notional principal contracts (but see paragraphs (f)(2), (g)(2)
and (h)(3) of this section for rules that include income from certain
notional principal contracts in gains from commodities transactions,
foreign currency gains and income equivalent to interest,
respectively); or
(vi) Other property that is excepted from the general rule of this
paragraph (e)(3) by the Commissioner in published guidance. See
Sec. 601.601(d)(2) of this chapter.
(f) Commodities transactions--(1) In general--(i) Inclusion in
foreign personal holding company income. Foreign personal holding
company income includes the excess of gains over losses from
commodities transactions.
(ii) Exception. Gains and losses from qualified active sales and
qualified hedging transactions are excluded from the computation of
foreign personal holding company income under this paragraph (f).
(iii) Treatment of losses. Section 1.954-1(c)(1)(ii) provides for
the treatment of losses in excess of gains from commodities
transactions.
(2) Definitions--(i) Commodity. For purposes of this section, the
term commodity includes tangible personal property of a kind that is
actively traded or with respect to which contractual interests are
actively traded.
(ii) Commodities transaction. The term commodities transaction
means the purchase or sale of a commodity for immediate (spot) delivery
or deferred (forward) delivery, or the right to purchase, sell,
receive, or transfer a commodity, or any other right or obligation with
respect to a commodity accomplished through a cash or off-exchange
market, an interbank market, an organized exchange or board of trade,
or an over-the-counter market, or in a transaction effected between
private parties outside of any market. Commodities transactions
include, but are not limited to--
(A) A futures or forward contract in a commodity;
(B) A leverage contract in a commodity purchased from a leverage
transaction merchant;
(C) An exchange of futures for physical transaction;
(D) A transaction, including a notional principal contract, in
which the income or loss to the parties is measured by reference to the
price of a commodity, a pool of commodities, or an index of
commodities;
(E) The purchase or sale of an option or other right to acquire or
transfer a commodity, a futures contract in a commodity, or an index of
commodities; and
(F) The delivery of one commodity in exchange for the delivery of
another commodity, the same commodity at another time, cash, or
nonfunctional currency.
(iii) Qualified active sale--(A) In general. The term qualified
active sale means the sale of commodities in the active conduct of a
commodities business as a producer, processor, merchant, or handler of
commodities if substantially all of the controlled foreign
corporation's business is as an active producer, processor, merchant or
handler of commodities. The sale of commodities held by a controlled
foreign corporation other than in its capacity as an active producer,
processor, merchant or handler of commodities is not a qualified active
sale. For example, the sale by a controlled foreign corporation of
commodities that were held for investment or speculation would not be a
qualified active sale.
(B) Active conduct of a commodities business. For purposes of this
paragraph, a controlled foreign corporation is engaged in the active
conduct of a commodities business as a producer, processor, merchant,
or handler of commodities only with respect to commodities for which
each of the following conditions is satisfied--
(1) It holds the commodities directly, and not through an agent or
independent contractor, as inventory or similar property (as defined in
paragraph (a)(4)(iii) of this section) or as dealer property (as
defined in paragraph (a)(4)(v) of this section); and
(2) With respect to such commodities, it incurs substantial
expenses in the ordinary course of a commodities business from engaging
in one or more of the following activities directly, and not through an
independent contractor--
(i) Substantial activities in the production of the commodities,
including planting, tending or harvesting crops, raising or
slaughtering livestock, or extracting minerals;
(ii) Substantial processing activities prior to the sale of the
commodities, including the blending and drying of agricultural
commodities, or the concentrating, refining, mixing, crushing, aerating
or milling of commodities; or
(iii) Significant activities as described in paragraph
(f)(2)(iii)(B)(3) of this section.
(3) For purposes of paragraph (f)(2)(iii)(B)(2)(iii) of this
section, the significant activities must relate to--
(i) The physical movement, handling and storage of the commodities,
including preparation of contracts and invoices, arranging freight,
insurance and credit, arranging for receipt, transfer or negotiation of
shipping documents, arranging storage or warehousing, and dealing with
quality claims;
(ii) Owning and operating facilities for storage or warehousing; or
(iii) Owning or chartering vessels or vehicles for the
transportation of the commodities.
(C) Substantially all. Substantially all of the controlled foreign
corporation's business is as an active producer, processor, merchant,
or handler of commodities if the sum of its gross receipts from all of
its qualified active sales (as defined in this paragraph (f)(2)(iii)
without regard to the substantially all requirement) of commodities and
its gross receipts from all of its qualified hedging transactions (as
defined in paragraph (f)(2)(iv) of this section, applied without regard
to the substantially all requirement of this paragraph (f)(2)(iii)(C))
equals or exceeds 85 percent of its total gross receipts for the
taxable year (computed as though the corporation were a domestic
corporation). In computing gross receipts, the District Director may
disregard any sale or hedging transaction that has as a principal
purpose manipulation of the 85 percent gross receipts test. A purpose
may be a principal purpose even though it is outweighed by other
purposes (taken together or separately).
(D) Activities of employees of a related entity. For purposes of
this paragraph (f), activities of employees of an entity related to the
controlled foreign corporation, who are made available to and
supervised on a day-to-day basis by, and whose salaries are paid by (or
reimbursed to the related entity by), the controlled foreign
corporation, are treated as activities engaged in directly by the
controlled foreign corporation.
(E) Financial activities. For purposes of this paragraph (f), a
corporation is not engaged in a commodities business as a producer,
processor, merchant, or
[[Page 46526]]
handler of commodities if its business is primarily financial. For
example, the business of a controlled foreign corporation is primarily
financial if its principal business is making a market in notional
principal contracts based on a commodities index.
(iv) Qualified hedging transaction--(A) In general. The term
qualified hedging transaction means a bona fide hedging transaction, as
defined in paragraph (a)(4)(ii) of this section, with respect to
qualified active sales (other than transactions described in section
988(c)(1) without regard to section 988(c)(1)(D)(i)).
(B) Exception. The term qualified hedging transaction does not
include transactions that are not reasonably necessary to the conduct
of business of the controlled foreign corporation as a producer,
processor, merchant or handler of a commodity in the manner in which
such business is customarily and usually conducted by others.
(g) Foreign currency gain or loss--(1) Scope and purpose. This
paragraph (g) provides rules for the treatment of foreign currency
gains and losses. Paragraph (g)(2) of this section provides the general
rule. Paragraph (g)(3) of this section provides an election to include
foreign currency gains or losses that would otherwise be treated as
foreign personal holding company income under this paragraph (g) in the
computation of another category of subpart F income. Paragraph (g)(4)
of this section provides an alternative election to treat any net
foreign currency gain or loss as foreign personal holding company
income. Paragraph (g)(5) of this section provides rules for certain
gains and losses not subject to this paragraph (g).
(2) In general--(i) Inclusion. Except as otherwise provided in this
paragraph (g), foreign personal holding company income includes the
excess of foreign currency gains over foreign currency losses
attributable to any section 988 transactions (foreign currency gain or
loss). Section 1.954-1(c)(1)(ii) provides rules for the treatment of
foreign currency losses in excess of foreign currency gains. However,
if an election is made under paragraph (g)(4) of this section, the
excess of foreign currency losses over foreign currency gains to which
the election would apply may be apportioned to, and offset, other
categories of foreign personal holding company income.
(ii) Exclusion for business needs--(A) General Rule. Foreign
currency gain or loss directly related to the business needs of the
controlled foreign corporation is excluded from foreign personal
holding company income.
(B) Business needs. Foreign currency gain or loss is directly
related to the business needs of a controlled foreign corporation if--
(1) The foreign currency gain or loss--
(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;
(ii) Arises from a transaction or property that does not itself
(and could not reasonably be expected to) give rise to subpart F income
other than foreign currency gain or loss;
(iii) Does not arise from a transaction described in section
988(c)(1)(B)(iii); and
(iv) Is clearly determinable from the records of the controlled
foreign corporation as being derived from such transaction or property;
or
(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 paragraph (g)(2)(ii)(B)(1)of this section. For purposes
of this paragraph (g)(2)(ii)(B)(2), a hedging transaction will satisfy
the aggregate hedging rules of Sec. 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 that satisfy the requirements of paragraph
(g)(2)(ii)(B)(1) of this section.
(C) Regular dealers. Transactions in dealer property (as defined in
paragraph (a)(4)(v) of this section) described in section 988(c)(1) (B)
or (C) that are entered into by a controlled foreign corporation that
is a regular dealer (as defined in paragraph (a)(4)(iv) of this
section) in such property in its capacity as a dealer will be treated
as directly related to the business needs of the controlled foreign
corporation under paragraph (g)(2)(ii)(A) of this section.
(D) Example. The following example illustrates the provisions of
this paragraph (g)(2).
Example. (i) CFC1 and CFC2 are controlled foreign corporations
located in Country B, and are members of the same controlled group.
CFC1 is engaged in the active conduct of a trade or business that
does not produce any subpart F income. CFC2 serves as the currency
coordination center for the controlled group, aggregating currency
risks incurred by the group and entering into hedging transactions
that transfer those risks outside of the group. Pursuant to this
arrangement, and to hedge the currency risk on a non-interest
bearing receivable incurred by CFC1 in the normal course of its
business, on Day 1 CFC1 enters into a forward contract to sell
Japanese Yen to CFC2 in 30 days. Also on Day 1, CFC2 enters into a
forward contract to sell Yen to unrelated Bank X on Day 30. CFC2 is
not a regular dealer in Yen spot and forward contracts, and the Yen
is not the functional currency for either CFC1 or CFC2.
(ii) Because the forward contract entered into by CFC1 to sell
Yen hedges a transaction entered into in the normal course of CFC1's
business that does not give rise to subpart F income, it qualifies
as a bona fide hedging transaction as defined in paragraph
(a)(4)(ii) of this section. Therefore, CFC1's foreign exchange gain
or loss from that forward contract will not be treated as foreign
personal holding company income or loss under this paragraph (g).
(iii) Because the forward contract to purchase Yen was entered
into by CFC2 in order to assume currency risks incurred by CFC1 it
does not qualify as a bona fide hedging transaction, as defined in
paragraph (a)(4)(ii) of this section. Thus, foreign exchange gain or
loss recognized by CFC2 from that forward contract will be foreign
personal holding company income. Because CFC2 entered into the
forward contract to sell Yen in order to hedge currency risks of
CFC1, that forward contract also does not qualify as a bona fide
hedging transaction. Thus, CFC2's foreign currency gain or loss
arising from that forward contract will be foreign personal holding
company income.
(iii) Special rule for foreign currency gain or loss from an
interest-bearing liability. Except as provided in paragraph (g)(5)(iv)
of this section, foreign currency gain or loss arising from an
interest-bearing liability is characterized as subpart F income and
non-subpart F income in the same manner that interest expense
associated with the liability would be allocated and apportioned
between subpart F income and non-subpart F income under Secs. 1.861-9T
and 1.861-12T.
(3) Election to characterize foreign currency gain or loss that
arises from a specific category of subpart F income as gain or loss in
that category--(i) In general. For taxable years of a controlled
foreign corporation beginning on or after November 6, 1995, the
controlling United States shareholders of the controlled foreign
corporation may elect, under this paragraph (g)(3), to exclude foreign
currency gain or loss otherwise includible in the computation of
foreign personal holding company income under this paragraph (g) from
the computation of foreign personal holding company income under this
paragraph (g) and include such foreign currency gain or loss in the
category (or categories) of subpart F income (described in section
952(a), or, in the case of foreign base company income, described in
Sec. 1.954-1(c)(1)(iii)(A) (1) or (2)) to which such gain or loss
relates. If an election is made under this paragraph (g)(3) with
respect to a category (or categories) of subpart F income described in
section 952(a), or,
[[Page 46527]]
in the case of foreign base company income, described in Sec. 1.954-
1(c)(1)(iii)(A) (1) or (2), the election shall apply to all foreign
currency gain or loss that arises from--
(A) 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 that gives rise to
income in that category (or categories) and that is clearly
determinable from the records of the controlled foreign corporation as
being derived from such transaction or property; and
(B) A bona fide hedging transaction, as defined in paragraph
(a)(4)(ii) of this section, with respect to a transaction or property
described in paragraph (g)(3)(i)(A) of this section. For purposes of
this paragraph (g)(3)(i)(B), a hedging transaction will satisfy the
aggregate hedging rules of Sec. 1.1221-2(c)(7) only if all (or all but
a de minimus amount) of the aggregate risk being hedged arises in
connection with transactions or property that generate the same
category of subpart F income described in section 952(a), or, in the
case of foreign base company income, described in Sec. 1.954-
1(c)(1)(iii)(A) (1) or (2).
(ii) Time and manner of election. The controlling United States
shareholders, as defined in Sec. 1.954-1(c)(5), make the election on
behalf of the controlled foreign corporation by filing a statement with
their original income tax returns for the taxable year of such United
States shareholders ending with or within the taxable year of the
controlled foreign corporation for which the election is made, clearly
indicating that such election has been made. If the controlling United
States shareholders elect to apply these regulations retroactively,
under Sec. 1.954-0(a)(1)(ii), the election under this paragraph (g)(3)
may be made by the amended return filed pursuant to the election under
Sec. 1.954-0(a)(1)(ii). The controlling United States shareholders
filing the election statement described in this paragraph (g)(3)(ii)
must provide copies of the election statement to all other United
States shareholders of the electing controlled foreign corporation.
Failure to provide copies of such statement will not cause an election
under this paragraph (g)(3) to be voidable by the controlled foreign
corporation or the controlling United States shareholders. However, the
District Director has discretion to void the election if it is
determined that three was no reasonable cause for the failure to
provide copies of such statement. The statement shall include the
following information--
(A) The name, address, taxpayer identification number, and taxable
year of such United States shareholder;
(B) The name, address, and taxable year of the controlled foreign
corporation for which the election is effective; and
(C) Any additional information required by the Commission by
administrative pronouncement.
(iii) Revocation of election. This election is effective for the
taxable year of the controlled foreign corporation for which it is made
and all subsequent taxable years of such corporation unless revoked by
or with the consent of the Commissioner.
(iv) Example. The following example illustrates the provisions of
this paragraph (g)(3).
Example. (i) CFC, a controlled foreign corporation, is a sales
company that earns foreign base company sales income under section
954(d). CFC makes an election under this paragraph (g)(3) to treat
foreign currency gains or losses that arise from a specific category
(or categories) of subpart F income (as described in section 952(a),
or, in the case of foreign base company income, as described in
Sec. 1.954-1(c)(1)(iii)(A) (1) or (2)) as that type of income. CFC
aggregates the currency risk on all of its transactions that
generate foreign base company sales income and hedges this net
currency exposure.
(ii) Assuming no more than a de minimus amount of risk in the
pool of risks being hedged arises from transactions or property that
generate income other than foreign base company sales income,
pursuant to its election under (g)(3), CFC's net foreign currency
gain from the pool and the hedging transactions will be treated as
foreign base company sales income under section 954(d), rather than
as foreign personal holding company income under section
954(c)(1)(D). If the pool of risks and the hedging transactions
generate a net foreign currency loss, however, CFC must apply the
rules of Sec. 1.954-1(c)(1)(ii).
(4) Election to treat all foreign currency gains or losses as
foreign personal holding company income--(i) In general. If the
controlling United States shareholders make an election under this
paragraph (g)(4), the controlled foreign corporation shall include in
its computation of foreign personal holding company income the excess
of foreign currency gains over losses or the excess of foreign currency
losses over gains attributable to any section 988 transaction (except
those described in paragraph (g)(5) of this section) and any section
1256 contract that would be a section 988 transaction but for section
988(c)(1)(D). Separate elections for section 1256 contracts and section
988 transactions are not permitted. An election under this paragraph
(g)(4) supersedes an election under paragraph (g)(3) of this section.
(ii) Time and manner of election. The controlling United States
shareholders, as defined in Sec. 1.964-1(c)(5), make the election on
behalf of the controlled foreign corporation in the same time and
manner as provided in paragraph (g)(3)(ii) of this section.
(iii) Revocation of election. This election is effective for the
taxable year of the controlled foreign corporation for which it is made
and all subsequent taxable years of such corporation unless revoked by
or with the consent of the Commissioner.
(5) Gains and losses not subject to this paragraph--(i) Capital
gains and losses. Gain or loss that is treated as capital gain or loss
under section 988(a)(1)(B) is not foreign currency gain or loss for
purposes of this paragraph (g). Such gain or loss is treated as gain or
loss from the sale or exchange of property that is included in the
computation of foreign personal holding company income under paragraph
(e)(1) of this section. Paragraph (a)(2) of this section provides other
rules concerning income described in more than one category of foreign
personal holding company income.
(ii) Income not subject to section 988. Gain or loss that is not
treated as foreign currency gain or loss by reason of section 988
(a)(2) or (d) is not foreign currency gain or loss for purposes of this
paragraph (g). However, such gain or loss may be included in the
computation of other categories of foreign personal holding company
income in accordance with its characterization under section 988 (a)(2)
or (d) (for example, foreign currency gain that is treated as interest
income under section 988(a)(2) will be included in the computation of
foreign personal holding company income under paragraph (b)(ii) of this
section).
(iii) Qualified business units using the dollar approximate
separate transactions method. This paragraph (g) does not apply to any
DASTM gain or loss computed under Sec. 1.985-3(d). Such gain or loss is
allocated under the rules of Sec. 1.985-3 (e)(2)(iv) or (e)(3).
However, the provisions of this paragraph (g) do apply to section 988
transactions denominated in a currency other than the United States
dollar or the currency that would be the qualified business unit's
functional currency were it not hyperinflationary.
(iv) Gain or loss allocated under Sec. 1.861-9. [Reserved]
(h) Income equivalent to interest--(1) In general--(i) Inclusion in
foreign personal holding company income. Except as provided in this
paragraph (h), foreign personal holding company income includes income
equivalent to
[[Page 46528]]
interest as defined in paragraph (h)(2) of this section.
(ii) Exceptions--(A) Liability hedging transactions. Income, gain,
deduction or loss that is allocated and apportioned in the same manner
as interest expense under the provisions of Sec. 1.861-9T is not income
equivalent to interest for purposes of this paragraph (h).
(B) Interest. Amounts treated as interest under section
954(c)(1)(A) and paragraph (b) of this section are not income
equivalent to interest for purposes of this paragraph (h).
(2) Definition of income equivalent to interest--(i) In general.
The term income equivalent to interest includes income that is derived
from--
(A) A transaction or series of related transactions in which the
payments, net payments, cash flows, or return predominantly reflect the
time value of money;
(B) Transactions in which the payments (or a predominant portion
thereof) are, in substance, for the use or forbearance of money;
(C) Notional principal contracts, to the extent provided in
paragraph (h)(3) of this section;
(D) Factoring, to the extent provided in paragraph (h)(4) of this
section;
(E) Conversion transactions, but only to the extent that gain
realized with respect to such a transaction is treated as ordinary
income under section 1258;
(F) The performance of services, to the extent provided in
paragraph (h)(5) of this section;
(G) The commitment by a lender to provide financing, whether or not
such financing actually is provided;
(H) Transfers of debt securities subject to section 1058; and
(I) Other transactions, as provided by the Commissioner in
published guidance. See Sec. 601.601(d)(2) of this chapter.
(ii) Income from the sale of property. Income from the sale of
property will not be treated as income equivalent to interest by reason
of paragraph (h)(2)(i) (A) or (B) of this section. Income derived by a
controlled foreign corporation will be treated as arising from the sale
of property only if the corporation in substance carries out sales
activities. Accordingly, an arrangement that is designed to lend the
form of a sales transaction to a transaction that in substance
constitutes an advance of funds will be disregarded. For example, if a
controlled foreign corporation acquires property on 30-day payment
terms from one person and sells that property to another person on 90-
day payment terms and at prearranged prices and terms such that the
foreign corporation bears no substantial economic risk with respect to
the purchase and sale other than the risk of non-payment, the foreign
corporation has not in substance derived income from the sale of
property.
(3) Notional principal contracts--(i) In general. Income equivalent
to interest includes income from notional principal contracts
denominated in the functional currency of the taxpayer (or a qualified
business unit of the taxpayer, as defined in section 989(a)), the value
of which is determined solely by reference to interest rates or
interest rate indices, to the extent that the income from such
transactions accrues on or after August 14, 1989.
(ii) Regular dealers. Income equivalent to interest does not
include income earned by a regular dealer (as defined in paragraph
(a)(4)(iv) of this section) from notional principal contracts that are
dealer property (as defined in paragraph (a)(4)(v) of this section).
(4) Income equivalent to interest from factoring--(i) General rule.
Income equivalent to interest includes factoring income. Except as
provided in paragraph (h)(4)(ii) of this section, the term factoring
income includes any income (including any discount income or service
fee, but excluding any stated interest) derived from the acquisition
and collection or disposition of a factored receivable. The amount of
income equivalent to interest realized with respect to a factored
receivable is the difference (if a positive number) between the amount
paid for the receivable by the foreign corporation and the amount that
it collects on the receivable (or realizes upon its sale of the
receivable). The rules of this paragraph (h)(4) apply only with respect
to the tax treatment of factoring income derived from the acquisition
and collection or disposition of a factored receivable and shall not
affect the characterization of an expense or loss of either the person
whose goods or services gave rise to a factored receivable or the
obligor under a receivable.
(ii) Exceptions. Factoring income shall not include--
(A) Income treated as interest under section 864(d) (1) or (6)
(relating to income derived from trade or service receivables of
related persons), even if such income is treated as not described in
section 864(d)(1) by reason of the same-country exception of section
864(d)(7);
(B) Income derived from a factored receivable if payment for the
acquisition of the receivable is made on or after the date on which
stated interest begins to accrue, but only if the rate of stated
interest equals or exceeds 120 percent of the Federal short-term rate
(as defined under section 1274) (or the analogous rate for a currency
other than the dollar) as of the date on which the receivable is
acquired by the foreign corporation; or
(C) Income derived from a factored receivable if payment for the
acquisition of the receivable by the foreign corporation is made only
on or after the anticipated date of payment of all principal by the
obligor (or the anticipated weighted average date of payment of a pool
of purchased receivables).
(iii) Factored receivable. For purposes of this paragraph (h)(4),
the term factored receivable includes any account receivable or other
evidence of indebtedness, whether or not issued at a discount and
whether or not bearing stated interest, arising out of the disposition
of property or the performance of services by any person, if such
account receivable or evidence of indebtedness is acquired by a person
other than the person who disposed of the property or provided the
services that gave rise to the account receivable or evidence of
indebtedness. For purposes of this paragraph (h)(4), it is immaterial
whether the person providing the property or services agrees to
transfer the receivable at the time of sale (as by accepting a third-
party charge or credit card) or at a later time.
(iv) Examples. The following examples illustrate the application of
this paragraph (h)(4).
Example 1. DP, a domestic corporation, owns all of the
outstanding stock of FS, a controlled foreign corporation. FS
acquires accounts receivable arising from the sale of property by
unrelated corporation X. The receivables have a face amount of $100,
and after 30 days bear stated interest equal to at least 120 percent
of the applicable Federal short-term rate (determined as of the date
the receivable is acquired by FS). FS purchases the receivables from
X for $95 on Day 1 and collects $100 plus stated interest from the
obligor under the receivable on Day 40. Income (other than stated
interest) derived by FS from the factored receivables is factoring
income within the meaning of paragraph (h)(4)(i) of this section
and, therefore, is income equivalent to interest.
Example 2. The facts are the same as in Example 1, except that,
rather than collecting $100 plus stated interest from the obligor
under the factored receivable on Day 40, FS sells the receivable to
controlled foreign corporation Y on Day 15 for $97. Both the income
derived by FS on the factored receivable and the income derived by Y
(other than stated interest) on the receivable are factoring income
within the meaning of paragraph (h)(4)(i) of this section, and
[[Page 46529]]
therefore, constitute income equivalent to interest.
Example 3. The facts are the same as in Example 1, except that
FS purchases the receivables from X for $98 on Day 30. Income
derived by FS from the factored receivables is excluded from
factoring income under paragraph (h)(4)(ii)(B) of this section and,
therefore, does not give rise to income equivalent to interest.
Example 4. The facts are the same as in Example 3, except that
it is anticipated that all principal will be paid by the obligor of
the receivables by Day 30. Income derived by FS from this maturity
factoring of the receivables is excluded from factoring income under
paragraph (h)(4)(ii)(C) of this section and, therefore, does not
give rise to income equivalent to interest.
Example 5. The facts are the same as in Example 4, except that
FS sells the factored receivable to Y for $99 on day 45, at which
time stated interest is accruing on the unpaid balance of $100.
Because interest was accruing at the time Y acquired the receivable
at a rate equal to at least 120 percent of the applicable Federal
short-term rate, income derived by Y from the factored receivable is
excluded from factoring income under paragraph (h)(4)(ii)(B) of this
section and, therefore, does not give rise to income equivalent to
interest.
Example 6. DP, a domestic corporation engaged in an integrated
credit card business, owns all of the outstanding stock of FS, a
controlled foreign corporation. On Day 1 individual A uses a credit
card issued by DP to purchase shoes priced at $100 from X, a foreign
corporation unrelated to DP, FS, or A. On Day 7, X transfers the
receivable (which does not bear stated interest) arising from A's
purchase to FS in exchange for $95. FS collects $100 from A on Day
45. Income derived by FS on the factored receivable is factoring
income within the meaning of paragraph (h)(4)(i) of this section
and, therefore, is income equivalent to interest.
(5) Receivables arising from performance of services. If payment
for services performed by a controlled foreign corporation is not made
until more than 120 days after the date on which such services are
performed, then the income derived by the controlled foreign
corporation constitutes income equivalent to interest to the extent
that interest income would be imputed under the principles of section
483 or the original issue discount provisions (sections 1271 through
1275), if--
(i) Such provisions applied to contracts for the performance of
services;
(ii) The time period referred to in sections 483(c)(1) and
1274(c)(1)(B) were 120 days rather than six months; and
(iii) The time period referred to in section 483(c)(1)(A) were 120
days rather than one year.
(6) Examples. The following examples illustrate the application of
this paragraph (h).
Example 1. CFC, a controlled foreign corporation, promises that
Corporation A may borrow up to $500 in principal for one year
beginning at any time during the next three months at an interest
rate of 10 percent. In exchange, Corporation A pays CFC a commitment
fee of $2. The entire $2 fee is included in the computation of CFC's
foreign personal holding company income under paragraph (h)(2)(i)(G)
of this section, regardless of whether Corporation A actually
borrows from CFC.
Example 2. (i) At the beginning of its current taxable year,
CFC, a controlled foreign corporation, purchases at face value a
one-year debt instrument issued by Corporation A having a $100
principal amount and bearing a floating rate of interest set at the
London Interbank Offered Rate (LIBOR) plus one percentage point.
Contemporaneously, CFC borrows $100 from Corporation B for one year
at a fixed interest rate of 10 percent, using the debt instrument as
security.
(ii) During its current taxable year, CFC accrues $11 of
interest from Corporation A on the bond. Because interest is
excluded from the definition of income equivalent to interest under
paragraph (h)(1)(ii)(B) of this section, the $11 is not income
equivalent to interest.
(iii) During its current taxable year, CFC incurs $10 of
interest expense with respect to the borrowing from Corporation B.
That expense is allocated and apportioned to, and reduces, subpart F
income to the extent provided in section 954(b)(5) and Secs. 1.861-
9T through 1.861-12T and 1.954-1(c).
Example 3. (i) On January 1, 1994, CFC, a controlled foreign
corporation with the United States dollar as its functional
currency, purchases at face value a 10-year debt instrument issued
by Corporation A having a $100 principal amount and bearing a
floating rate of interest set at the London Interbank Offered Rate
(LIBOR) plus one percentage point payable on December 31st of each
year. CFC subsequently determines that it would prefer receiving a
fixed rate of return. Accordingly, on January 1, 1995, CFC enters
into a 9-year interest rate swap agreement with Corporation B
whereby Corporation B promises to pay CFC on December 31st of each
year an amount equal to 10 percent on a notional principal amount of
$100. In exchange, CFC promises to pay Corporation B an amount equal
to LIBOR plus one percentage point on the notional principal amount.
(ii) On December 31, 1995, CFC receives $9 of interest income
from Corporation A with respect to the debt instrument. On the same
day, CFC receives a total of $10 from Corporation B and pays $9 to
Corporation B with respect to the interest rate swap.
(iii) The $9 of interest income is foreign personal holding
income under section 954(c)(1). Pursuant to Sec. 1.446-3(d), CFC
recognizes $1 of swap income for its 1995 taxable year that is also
foreign personal holding company income because it is income
equivalent to interest under paragraph (h)(2)(i)(C) of this section.
Example 4. (i) CFC, a controlled foreign corporation, purchases
commodity X on the spot market for $100 and, contemporaneously,
enters into a 3 month forward contract to sell commodity X for $104,
a price set by the forward market.
(ii) Assuming that substantially all of CFC's expected return is
attributable to the time value of the net investment, as described
in section 1258(c)(1), the transaction is a conversion transaction
under section 1258(c). Accordingly, any gain treated as ordinary
income under section 1258(a) will be foreign personal holding
company income because it is income equivalent to interest under
paragraph (h)(2)(i)(E) of this section.
Par. 4. Section 1.957-1 is amended by adding paragraphs (a), (c)
Examples 8 through 10, and (d) to read as follows:
Sec. 1.957-1 Definition of controlled foreign corporation.
(a) In general. The term controlled foreign corporation means any
foreign corporation of which more than 50 percent (or such lesser
amount as is provided in section 957(b) or section 953(c)) of either--
(1) The total combined voting power of all classes of stock of the
corporation entitled to vote; or
(2) The total value of the stock of the corporation, is owned
within the meaning of section 958(a), or (except for purposes of
section 953(c)) is considered as owned by applying the rules of section
958(b) and Sec. 1.958-2, by United States shareholders on any day
during the taxable year of such foreign corporation. For the definition
of the term United States shareholder, see sections 951(b) and
953(c)(1)(A). For the definition of the term foreign corporation, see
Sec. 301.7701-5 of this chapter (Procedure and Administration
Regulations). For the treatment of associations as corporations, see
section 7701(a)(3) and Secs. 301.7701-1 and 301.7701-2 of this chapter.
For the definition of the term stock, see sections 958(a)(3) and
7701(a)(7). For the classification of a member in an association, joint
stock company, or insurance company as a shareholder, see section
7701(a)(8).
* * * * *
(c) * * *
Example 8. For its prior taxable year, JV, a foreign
corporation, had outstanding 1000 shares of class A stock, which is
voting common, and 1000 shares of class B stock, which is nonvoting
preferred. DP, a domestic corporation, and FP, a foreign
corporation, each owned precisely 500 shares of both class A and
class B stock, and each elected 5 of the 10 members of JV's board of
directors. The other facts and circumstances were such that JV was
not a controlled foreign corporation on any day of the prior taxable
year. On the first day of the current taxable year, DP purchased one
share of class B stock from FP. JV was a controlled foreign
corporation on that day because over 50 percent of the total value
in the corporation
[[Page 46530]]
was held by a person that was a United States shareholder under section
951(b).
Example 9. The facts are the same as in Example 8 except that
the stock of FP was publicly traded, FP had one class of stock, and
on the first day of the current taxable year DP purchased one share
of FP stock on the foreign stock exchange instead of purchasing one
share of JV stock from FP. JV became a controlled foreign
corporation on that day because over 50 percent of the total value
in the corporation was held by a person that was a United States
shareholder under section 951(b).
Example 10. X, a foreign corporation, is incorporated under the
laws of country Y. Under the laws of country Y, X is considered a
mutual insurance company. X issues insurance policies that provide
the policyholder with the right to vote for directors of the
corporation, the right to a share of the assets upon liquidation in
proportion to premiums paid, and the right to receive policyholder
dividends in proportion to premiums paid. Only policyholders are
provided with the right to vote for directors, share in assets upon
liquidation, and receive distributions. United States policyholders
contribute 25 percent of the premiums and have 25 percent of the
outstanding rights to vote for the board of directors. Based on
these facts, the United States policyholders are United States
shareholders owning the requisite combined voting power and value.
Thus, X is a controlled foreign corporation for purposes of taking
into account related person insurance income under section 953(c).
(d) Effective date. Paragraphs (a) and (c) Examples 8 through 10 of
this section are effective for taxable years of a controlled foreign
corporation beginning after November 6, 1995.
Sec. 1.954A-1 and 1.954A-2 [Removed]
Par. 5. Sections 1.954A-1 and 1.954A-2 are removed.
Sec. 1.957-1T [Removed]
Par. 6. Section 1.957-1T is removed.
PART 4--[ADDED]
Par. 7. 26 CFR part 4 is added to read as follows:
PART 4--TEMPORARY INCOME TAX REGULATIONS UNDER SECTION 954 OF THE
INTERNAL REVENUE CODE
Sec.
4.954-0 Introduction.
4.954-1 Foreign base company income; taxable years beginning after
December 31, 1986.
4.954-2 Foreign personal holding company income; taxable years
beginning after December 31, 1986.
Authority: 26 U.S.C. 7805.
Sec.
4.954-0 also issued under 26 U.S.C. 954 (b) and (c).
4.954-1 also issued under 26 U.S.C. 954 (b) and (c).
4.954-2 also issued under 26 U.S.C. 954 (b) and (c).
Secs. 1.954-0T, 1.954-1T and 1.954-2T [Redesignated as Secs. 4.954-0,
4.954-1 and 4.954-2]
Par. 8. Sections 1.954-0T, 1.954-1T and 1.954-2T are redesignated
as Secs. 4.954-0, 4.954-1 and 4.954-2, respectively, and the language
``temporary'' is removed at the end of each section heading.
Par. 9. Newly designated Sec. 4.954-0 is amended by:
1. Removing the language ``Secs. 1.954-1T and 1.954-2T'' from the
first sentence of paragraph (a)(1) and adding ``Secs. 4.954-1 and
4.954-2'' in its place.
2. Adding a sentence at the end of paragraph (a)(1) to read as set
forth below.
3. In paragraph (b) by removing the entries numbered (I), (II), and
(III) and adding in their places entries for the headings of
Secs. 4.954-0 through 4.954-2 as follows:
Sec. 4.954-0 Introduction.
(a) * * * (1) * * * For further guidance, see Sec. 1.954-0(a) of
this chapter.
(b) * * *
Sec.
4.954-0 Introduction.
* * * * *
4.954-1 Foreign base company income.
* * * * *
4.954-2 Foreign personal holding company income.
* * * * *
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 10. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Par. 11. In Sec. 602.101, paragraph c is amended by:
1. Removing the following entries from the table:
Sec. 602.101 OMB Control numbers.
* * * * *
(c) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------
* * * * *
1.954-1T................................................... 1545-1068
1.954-2T................................................... 1545-1068
* * * * *
1.954A-2................................................... 1545-0755
------------------------------------------------------------------------
2. Adding entries in numerical order to the table to read as
follows:
Sec. 602.101 OMB Control numbers.
* * * * *
(c) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------
* * * * *
1.954-1.................................................... 1545-1068
1.954-2.................................................... 1545-1068
* * * * *
4.954-1.................................................... 1545-1068
4.954-2.................................................... 1545-1068
* * * * *
------------------------------------------------------------------------
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: August 22, 1995.
Cynthia Gibson Beerbower,
Deputy Assistant Secretary of the Treasury.
[FR Doc. 95-21838 Filed 9-6-95; 8:45 am]
BILLING CODE 4830-01-U
