Title 26 – Internal Revenue–Volume 12

(1) The term section 902 corporation means any foreign corporation with respect to which one or more domestic corporations meet the ownership requirements of section 902(a) or (b).

(2) The term section 902 shareholder means any domestic corporation that meets the ownership requirements of section 902(a) or (b) with respect to a section 902 corporation.

(3) The term payor means a person that pays or accrues a foreign income tax within the meaning of § 1.901-2(f), and also includes a person that takes foreign income taxes paid or accrued by a partnership, S corporation, estate or trust into account pursuant to section 702(a)(6), section 901(b)(5) or section 1373(a).

(4) The term covered person means, with respect to a payor –

(i) Any entity in which the payor holds, directly or indirectly, at least a 10 percent ownership interest (determined by vote or value);

(ii) Any person that holds, directly or indirectly, at least a 10 percent ownership interest (determined by vote or value) in the payor; or

(iii) Any person that bears a relationship that is described in section 267(b) or 707(b) to the payor.

(5) The term foreign income tax means any income, war profits, or excess profits tax paid or accrued to any foreign country or to any possession of the United States. A foreign income tax includes any tax paid or accrued in lieu of such a tax within the meaning of section 903.

(6) The term post-1986 foreign income taxes has the meaning provided in § 1.902-1(a)(8).

(7) The term post-1986 undistributed earnings has the meaning provided in § 1.902-1(a)(9).

(8) The term disregarded entity means an entity that is disregarded as an entity separate from its owner, as provided in § 301.7701-2(c)(2)(i) of this chapter.

(9) The term hybrid partnership means a partnership that is subject to income tax in a foreign country as a corporation (or otherwise at the entity level) on the basis of residence, place of incorporation, place of management or similar criteria.

(b) Taxes paid or accrued by a partnership, S corporation or trust. Under section 909(c)(1), section 909 applies at the partner level, and similar rules apply in the case of an S corporation or trust. Accordingly, in the case of foreign income taxes paid or accrued by a partnership, S corporation or trust, taxes allocated to one or more partners, shareholders or beneficiaries (as the case may be) will be treated as split taxes to the extent such taxes would be split taxes if the partner, shareholder or beneficiary had paid or accrued the taxes directly on the date such taxes are taken into account by the partner under sections 702 and 706(a), by the shareholder under section 1373(a), or by the beneficiary under section 901(b)(5). Any such split taxes will be suspended in the hands of the partner, shareholder or beneficiary.

(c) Related income of a partnership, S corporation or trust. For purposes of determining whether related income is taken into account by a covered person, related income of a partnership, S corporation or trust is considered to be taken into account by the partner, shareholder or beneficiary to whom the related income is allocated.

(d) Application of section 909 to pre-1987 accumulated profits and pre-1987 foreign income taxes. Section 909 and §§ 1.909-1 through 1.909-5 will apply to pre-1987 accumulated profits (as defined in § 1.902-1(a)(10)(i)) and pre-1987 foreign income taxes (as defined in § 1.902-1(a)(10)(iii)) of a section 902 corporation attributable to taxable years beginning on or after January 1, 2012.

(e) Effective/applicability date. This section applies to taxable years ending after February 9, 2015. See 26 CFR 1.909-1T (revised as of April 1, 2014) for rules applicable to taxable years beginning on or after January 1, 2011, and ending on or before February 9, 2015.

[T.D. 9710, 80 FR 7328, Feb. 10, 2015]

§ 1.909-2 Splitter arrangements.

(a) Foreign tax credit splitting event – (1) In general. There is a foreign tax credit splitting event with respect to foreign income taxes paid or accrued if and only if, in connection with an arrangement described in paragraph (b) of this section (a splitter arrangement) the related income was, is or will be taken into account for U.S. Federal income tax purposes by a person that is a covered person with respect to the payor of the tax. Foreign income taxes that are paid or accrued in connection with a splitter arrangement are split taxes to the extent provided in paragraph (b) of this section. Income (or, as appropriate, earnings and profits) that was, is or will be taken into account by a covered person in connection with a splitter arrangement is related income to the extent provided in paragraph (b) of this section.

(2) Split taxes not taken into account. Split taxes will not be taken into account for U.S. Federal income tax purposes before the taxable year in which the related income is taken into account by the payor or, in the case of split taxes paid or accrued by a section 902 corporation, by a section 902 shareholder of such section 902 corporation. Therefore, in the case of split taxes paid or accrued by a section 902 corporation, split taxes will not be taken into account for purposes of sections 902 or 960, or for purposes of determining earnings and profits under section 964(a), before the taxable year in which the related income is taken into account by the payor section 902 corporation, a section 902 shareholder of the section 902 corporation, or a member of the section 902 shareholder’s consolidated group. See § 1.909-3(a) for rules relating to when split taxes and related income are taken into account.

(b) Splitter arrangements. The arrangements set forth in this paragraph (b) are splitter arrangements.

(1) Reverse hybrid splitter arrangements – (i) In general. A reverse hybrid is a splitter arrangement when a payor pays or accrues foreign income taxes with respect to income of a reverse hybrid. A reverse hybrid splitter arrangement exists even if the reverse hybrid has a loss or a deficit in earnings and profits for a particular year for U.S. Federal income tax purposes (for example, due to a timing difference).

(ii) Split taxes from a reverse hybrid splitter arrangement. The foreign income taxes paid or accrued with respect to income of the reverse hybrid are split taxes.

(iii) Related income from a reverse hybrid splitter arrangement. The related income with respect to split taxes from a reverse hybrid splitter arrangement is the earnings and profits (computed for U.S. Federal income tax purposes) of the reverse hybrid attributable to the activities of the reverse hybrid that gave rise to income included in the payor’s foreign tax base with respect to which the split taxes were paid or accrued. Accordingly, related income of the reverse hybrid includes items of income or expense attributable to a disregarded entity owned by the reverse hybrid only to the extent that the income attributable to the activities of the disregarded entity is included in the payor’s foreign tax base.

(iv) Reverse hybrid. The term reverse hybrid means an entity that is a corporation for U.S. Federal income tax purposes but is a fiscally transparent entity (under the principles of § 1.894-1(d)(3)) or a branch under the laws of a foreign country imposing tax on the income of the entity.

(v) Examples. The following examples illustrate the rules of paragraph (b)(1) of this section.

Example 1.(i) Facts. USP, a domestic corporation, wholly owns DE, a disregarded entity for U.S. federal income tax purposes that is organized in country A and treated as a corporation for country A tax purposes. DE wholly owns RH, a corporation for U.S. Federal income tax purposes that is organized in country A and treated as a fiscally transparent entity for country A tax purposes. Country A imposes an income tax at the rate of 30% on DE with respect to the items of income earned by RH. Prior to year 1, RH had no income for country A purposes and had no post-1986 earnings and profits for U.S. Federal income tax purposes. In year 1, RH earns 200u of income on which DE pays 60u of country A tax. Pursuant to § 1.901-2(f)(4)(ii), USP is treated as legally liable for the 60u of country A taxes paid by DE. DE has no other income. In year 2, RH earns no income and incurs no losses or expenses. At the end of year 2, RH distributes 100u to DE.

(ii) Result. (A) Split taxes and related income. Pursuant to § 1.909-2(b)(1)(iv), RH is a reverse hybrid because it is a corporation for U.S. Federal income tax purposes and a fiscally transparent entity for country A purposes. Pursuant to § 1.909-2(b)(1), RH is a covered person with respect to USP because USP wholly owns RH for U.S. Federal income tax purposes. Pursuant to § 1.909-2(b)(1)(i), there is a splitter arrangement with respect to RH because USP paid country A tax with respect to the income of RH. All 60u of taxes paid by USP in year 1 with respect to the income of RH are split taxes pursuant to § 1.909-2(b)(1)(ii). The post-1986 earnings and profits of RH are 200u as of the end of year 1. Pursuant to § 1.909-2(b)(1)(iii), the related income in year 1 is the 200u of RH’s earnings and profits that are attributable to the activities that gave rise to the split taxes. No additional split taxes or related income arise in year 2.

(B) Distribution. Because DE is a disregarded entity, the 100u distribution by RH at the end of year 2 is treated as a dividend to USP. Pursuant to § 1.909-6(d)(7) and § 1.909-3(a), 100u of the 200u of related income of RH, or 50%, is taken into account by USP by reason of the 100u dividend. Accordingly, pursuant to § 1.909-6(e)(4) and § 1.909-3(a), a ratable portion of the split taxes, or 30u of taxes (50% of 60u), is no longer treated as split taxes and is taken into account by USP for U.S. Federal income tax purposes.

Example 2.(i) Facts. The facts are the same as in Example 1, except that in year 2, RH has a 100u loss for U.S. Federal income tax purposes as well as for country A tax purposes. For country A tax purposes, DE takes the 100u loss into account in year 2 and may not carry back the 100u loss to offset its country A taxable income for year 1. At the end of year 2, RH distributes 100u to DE.

(ii) Result. (A) Split taxes and related income. The split taxes and related income for year 1 are the same as in Example 1. Pursuant to § 1.909-2(b)(1)(iii), § 1.909-6(d)(1) and § 1.909-3(a), the total related income of RH is reduced to 100u (200u − 100u) in year 2 because RH incurred a 100u loss in year 2 attributable to the activities that are included in DE’s country A tax base.

(B) Distribution. Because DE is a disregarded entity, the 100u distribution by RH at the end of year 2 is treated as a dividend to USP. Pursuant to § 1.909-6(d)(7) and § 1.909-3(a), 100u of the 100u of related income of RH, or 100%, is taken into account by USP by reason of the 100u dividend. Accordingly, pursuant to § 1.909-6(e)(4) and § 1.909-3(a), a ratable portion of the split taxes, or 60u of taxes (100% of 60u), is no longer treated as split taxes and is taken into account by USP for U.S. Federal income tax purposes.

(2) Loss-sharing splitter arrangements – (i) In general. A foreign group relief or other loss-sharing regime is a loss-sharing splitter arrangement to the extent that a shared loss of a U.S. combined income group could have been used to offset income of that group in the current or in a prior foreign taxable year (usable shared loss) but is used instead to offset income of another U.S. combined income group.

(ii) U.S. combined income group. The term U.S. combined income group means an individual or a corporation and all entities (including entities that are fiscally transparent for U.S. Federal income tax purposes under the principles of § 1.894-1(d)(3)) that for U.S. Federal income tax purposes combine any of their respective items of income, deduction, gain or loss with the income, deduction, gain or loss of such individual or corporation. A U.S. combined income group can arise, for example, as a result of an entity being disregarded or, in the case of a partnership or hybrid partnership and a partner, as a result of the allocation of income or any other item of the partnership to the partner. For purposes of this paragraph (b)(2)(ii), a branch is treated as an entity, all members of a U.S. affiliated group of corporations (as defined in section 1504) that file a consolidated return are treated as a single corporation, and two or more individuals that file a joint return are treated as a single individual. A U.S. combined income group may consist of a single individual or corporation and no other entities, but cannot include more than one individual or corporation. In addition, an entity may belong to more than one U.S. combined income group. For example, a hybrid partnership with two corporate partners that do not combine any of their items of income, deduction, gain or loss for U.S. Federal income tax purposes is in a separate U.S. combined income group with each of its partners.

(iii) Income and shared loss of a U.S. combined income group – (A) Income. Except as otherwise provided in this paragraph (b)(2)(iii)(A), the income of a U.S. combined income group is the aggregate amount of taxable income recognized or taken into account for foreign tax purposes by those members that have positive taxable income for foreign tax purposes. In the case of an entity that is fiscally transparent (under the principles of § 1.894-1(d)(3)) for foreign tax purposes and that is a member of more than one U.S. combined income group, the foreign taxable income of the entity is allocated between or among the groups under foreign tax law. In the case of an entity that is not fiscally transparent for foreign tax purposes and that is a member of more than one U.S. combined income group, the foreign taxable income of the entity is allocated between or among those groups based on U.S. Federal income tax principles. For example, in the case of a hybrid partnership, the foreign taxable income of the partnership is allocated between or among the groups in the manner the partnership allocates the income under section 704(b). To the extent the foreign taxable income would be income under U.S. Federal income tax principles in another year, the income is allocated between or among the groups based on how the hybrid partnership would allocate the income if the income were recognized for U.S. Federal income tax purposes in the year in which the income is recognized for foreign tax purposes. To the extent the foreign taxable income would not constitute income under U.S. Federal income tax principles in any year, the income is allocated between or among the groups in the same manner as the partnership items attributable to the activity giving rise to the foreign taxable income.

(B) Shared loss. The term shared loss means a loss of one entity for foreign tax purposes that, in connection with a foreign group relief or other loss-sharing regime, is taken into account by one or more other entities. Except as otherwise provided in this paragraph (b)(2)(iii)(B), the amount of shared loss of a U.S. combined income group is the sum of the shared losses of all members of the U.S. combined income group. In the case of an entity that is fiscally transparent (under the principles of § 1.894-1(d)(3)) for foreign tax purposes and that is a member of more than one U.S. combined income group, the shared loss of the entity is allocated between or among the groups under foreign tax law. In the case of an entity that is not fiscally transparent for foreign tax purposes and that is a member of more than one U.S. combined income group, the shared loss of the entity will be allocated between or among those groups based on U.S. Federal income tax principles. For example, in the case of a hybrid partnership, the shared loss of the partnership will be allocated between or among the groups in the manner the partnership allocates the loss under section 704(b). To the extent the shared loss would be a loss under U.S. Federal income tax principles in another year, the loss is allocated between or among the groups based on how the partnership would allocate the loss if the loss were recognized for U.S. Federal income tax purposes in the year in which the loss is recognized for foreign tax purposes. To the extent the shared loss would not constitute a loss under U.S. Federal income tax principles in any year, the loss is allocated between or among the groups in the same manner as the partnership items attributable to the activity giving rise to the shared loss.

(iv) Split taxes from a loss-sharing splitter arrangement. Split taxes from a loss-sharing splitter arrangement are foreign income taxes paid or accrued by a member of the U.S. combined income group with respect to income from the current foreign taxable year, or, in the case of a foregone carryback loss, from the prior foreign taxable year, equal to the amount of the usable shared loss of that group that offsets income of another U.S. combined income group.

(v) Related income from a loss-sharing splitter arrangement. The related income with respect to split taxes from a loss-sharing splitter arrangement is an amount of income of the individual or corporate member of the U.S. combined income group equal to the amount of income under foreign tax law of that U.S. combined income group that is offset by the usable shared loss of another U.S. combined income group.

(vi) Foreign group relief or other loss-sharing regime. A foreign group relief or other loss-sharing regime exists when an entity may surrender its loss to offset the income of one or more other entities. A foreign group relief or other loss-sharing regime does not include an allocation of loss of an entity that is a partnership or other fiscally transparent entity (under the principles of § 1.894-1(d)(3)) for foreign tax purposes or regimes in which foreign tax is imposed on combined income (such as a foreign consolidated regime), as described in § 1.901-2(f)(3).

(vii) Examples. The following examples illustrate the rules of paragraph (b)(2) of this section.

Example 1.(i) Facts. USP, a domestic corporation, wholly owns CFC1, a corporation organized in country A. CFC1 wholly owns CFC2 and CFC3, both corporations organized in country A. CFC2 wholly owns DE, an entity organized in country A. DE is a corporation for country A tax purposes and a disregarded entity for U.S. Federal income tax purposes. Country A has a loss-sharing regime under which a loss of CFC1, CFC2, CFC3 or DE may be used to offset the income of one or more of the others. Country A imposes an income tax at the rate of 30% on the taxable income of corporations organized in country A. In year 1, before any loss sharing, CFC1 has no income, CFC2 has income of 50u, CFC3 has income of 200u, and DE has a loss of 100u. Under the provisions of country A’s loss-sharing regime, the group decides to use DE’s 100u loss to offset 100u of CFC3’s income. After the loss is shared, for country A’s tax purposes, CFC2 still has 50u of income on which it pays 15u of country A tax. CFC3 has income of 100u (200u less the 100u shared loss) on which it pays 30u of country A tax. For U.S. Federal income tax purposes, the loss sharing with CFC3 is not taken into account. Because DE is a disregarded entity, its 100u loss is taken into account by CFC2 and reduces its earnings and profits for U.S. Federal income tax purposes. Accordingly, before application of section 909, CFC2 has a loss for earnings and profits purposes of 65u (50u income less 15u taxes paid to country A less 100u loss of DE). CFC2 also has the U.S. dollar equivalent of 15u of foreign income taxes to add to its post-1986 foreign income taxes pool. CFC3 has earnings and profits of 170u (200u income less 30u of taxes) and the dollar equivalent of 30u of foreign income taxes to add to its post-1986 foreign income taxes pool.

(ii) Result. Pursuant to § 1.909-2(b)(2)(ii), CFC2 and DE constitute one U.S. combined income group, while CFC1 and CFC3 each constitute separate U.S. combined income groups. Pursuant to § 1.909-2(b)(2)(iii)(A), the income of the CFC2 U.S. combined income group is 50u (CFC2’s country A taxable income of 50u). The income of the CFC3 U.S. combined income group is 200u (CFC3’s country A taxable income of 200u). Pursuant to § 1.909-2(b)(2)(iii)(B), the shared loss of the CFC2 U.S. combined income group includes the 100u of shared loss incurred by DE. The usable shared loss of the CFC2 U.S. combined income group is 50u, the amount of the group’s shared loss that could have otherwise offset CFC2’s 50u of country A taxable income that is included in the income of the CFC2 U.S. combined income group. There is a splitter arrangement because the 50u usable shared loss of the CFC2 U.S. combined income group was used instead to offset income of CFC3, which is included in the CFC3 U.S. combined income group. Pursuant to § 1.909-2(b)(2)(iv), the split taxes are the 15u of country A income taxes paid by CFC2 on 50u of income, an amount of income of the CFC2 U.S. combined income group equal to the amount of usable shared loss of that group that was used to offset income of the CFC3 U.S. combined income group. Pursuant to § 1.909-2(b)(2)(v), the related income is the 50u of CFC3’s income that equals the amount of income of the CFC3 U.S. combined income group that was offset by the usable shared loss of the CFC2 U.S. combined income group.

Example 2.(i) Facts. USP, a domestic corporation, wholly owns CFC1, a corporation organized in country B. CFC1 wholly owns CFC2 and CFC3, both corporations organized in country B. CFC2 wholly owns DE, an entity organized in country B. DE is a corporation for country B tax purposes and a disregarded entity for U.S. Federal income tax purposes. CFC2 and CFC3 each own 50% of HP1, an entity organized in country B. HP1 is a corporation for country B tax purposes and a partnership for U.S. Federal income tax purposes. All items of income and loss of HP1 are allocated for U.S. Federal income tax purposes equally between CFC2 and CFC3, and all entities use the country B currency “u” as their functional currency. Country B has a loss-sharing regime under which a loss of any of CFC1, CFC2, CFC3, DE, and HP1 may be used to offset the income of one or more of the others. Country B imposes an income tax at the rate of 30% on the taxable income of corporations organized in country B. In year 1, before any loss sharing, CFC2 has income of 100u, CFC1 and CFC3 have no income, DE has a loss of 100u, and HP1 has income of 200u. Under the provisions of country B’s loss-sharing regime, the group decides to use DE’s 100u loss to offset 100u of HP1’s income. After the loss is shared, for country B tax purposes, CFC2 has 100u of income on which it pays 30u of country B income tax, and HP1 has 100u of income (200u less the 100u shared loss) on which it pays 30u of country B income tax. For U.S. Federal income tax purposes, the loss sharing with HP1 is not taken into account, and, because DE is a disregarded entity, its 100u loss is taken into account by CFC2 and reduces CFC2’s earnings and profits for U.S. Federal income tax purposes. The 200u income of HP1 is allocated 50/50 to CFC2 and CFC3, as is the 30u of country B income tax paid by HP1. Accordingly, before application of section 909, for U.S. Federal income tax purposes, CFC2 has earnings and profits of 55u (100u income plus 100u share of HP1’s income less 100u loss of DE less 30u country B income tax paid by CFC2 less 15u share of HP1’s country B income tax) and the dollar equivalent of 45u of country B income tax to add to its post-1986 foreign income taxes pool. CFC3 has earnings and profits of 85u (100u share of HP1’s income less 15u share of HP1’s country B income taxes) and the dollar equivalent of 15u of country B income tax to add to its post-1986 foreign income taxes pool.

(ii) U.S. combined income groups. Pursuant to § 1.909-2(b)(2)(ii), because the income and loss of HP1 are combined in part with the income and loss of both CFC2 and CFC3, it belongs to both of the separate CFC2 and CFC3 U.S. combined income groups. DE is a member of the CFC2 U.S. combined income group.

(iii) Income of the U.S. combined income groups. Pursuant to § 1.909-2(b)(2)(iii)(A), the income of the CFC2 U.S. combined income group is the 200u country B taxable income of the members of the group with positive taxable incomes (CFC2’s country B taxable income of 100u plus 50% of HP1’s country B taxable income of 200u, or 100u). Because DE does not have positive taxable income for country B tax purposes, its 100u loss is not included in the income of the CFC2 U.S. combined income group. The income of the CFC3 U.S. combined income group is 100u (50% of HP1’s country B taxable income of 200u, or 100u).

(iv) Shared loss of the U.S. combined income groups. Pursuant to § 1.909-2(b)(2)(iii)(B), the shared loss of the CFC2 U.S. combined income group is the 100u loss incurred by DE that is used to offset 100u of HP1’s income. The CFC3 U.S. combined income group has no shared loss. Pursuant to § 1.909-2(b)(2)(i), the usable shared loss of the CFC2 U.S. combined income group is 100u, the full amount of the group’s 100u shared loss that could have been used to offset income of the CFC2 U.S. combined income group had the loss been used to offset 100u of CFC2’s country B taxable income.

(v) Income offset by shared loss. The shared loss of the CFC2 combined income group is used to offset 100u country B taxable income of HP1. Because the taxable income of HP1 is allocated 50/50 between the CFC2 and CFC3 U.S. combined income groups, the shared loss is treated as offsetting 50u of the CFC2 U.S. combined income group’s income and 50u of the CFC3 U.S. combined income group’s income.

(vi) Splitter arrangement. There is a splitter arrangement because 50u of the 100u usable shared loss of the CFC2 U.S. combined income group was used to offset income of the CFC3 U.S. combined income group. Pursuant to § 1.909-2(b)(2)(iv), the split taxes are the 15u of country B income tax paid by CFC2 on 50u of its income, which is equal to the amount of the CFC2 U.S. combined income group’s usable shared loss that was used to offset income of another U.S. combined income group. Pursuant to § 1.909-2(b)(2)(v), the related income is the 50u of CFC3’s income that was offset by the usable shared loss of the CFC2 U.S. combined income group.

(3) Hybrid instrument splitter arrangements – (i) U.S. equity hybrid instrument splitter arrangement – (A) In general. A U.S. equity hybrid instrument is a splitter arrangement if:

(1) Under the laws of a foreign jurisdiction in which the instrument owner is subject to tax, the instrument gives rise to income includible in the instrument owner’s income and such inclusion results in foreign income taxes paid or accrued by the instrument owner;

(2) Under the laws of a foreign jurisdiction in which the issuer is subject to tax, the instrument gives rise to deductions that are incurred or otherwise taken into account by the issuer; and

(3) The events that give rise to income includible in the instrument owner’s income for foreign tax purposes as described in paragraph (b)(3)(i)(A)(1) of this section, and to deductions for the issuer for foreign tax purposes as described in paragraph (b)(3)(i)(A)(2) of this section, do not result in an inclusion of income for the instrument owner for U.S. federal income tax purposes.

(B) Split taxes from a U.S. equity hybrid instrument splitter arrangement. Split taxes from a U.S. equity hybrid instrument splitter arrangement equal the total amount of foreign income taxes paid or accrued by the owner of the hybrid instrument less the amount of foreign income taxes that would have been paid or accrued had the owner of the U.S. equity hybrid instrument not been subject to foreign tax on income from the instrument with respect to the events described in § 1.909-2(b)(3)(i)(A).

(C) Related income from a U.S. equity hybrid instrument splitter arrangement. The related income with respect to split taxes from a U.S. equity hybrid instrument splitter arrangement is income of the issuer of the U.S. equity hybrid instrument in an amount equal to the amounts giving rise to the split taxes that are deductible by the issuer for foreign tax purposes, determined without regard to the actual amount of the issuer’s income or earnings and profits for U.S. Federal income tax purposes.

(D) U.S. equity hybrid instrument. The term U.S. equity hybrid instrument means an instrument that is treated as equity for U.S. Federal income tax purposes but for foreign income tax purposes either is treated as indebtedness or otherwise entitles the issuer to a deduction with respect to such instrument.

(E) Example – (i) Facts. USP, a domestic corporation, wholly owns CFC1, which wholly owns CFC2. Both CFC1 and CFC2 are corporations organized in country A. CFC2 issues an instrument to CFC1 that is treated as indebtedness for country A tax purposes but equity for U.S. Federal income tax purposes. Under country A’s income tax laws, the instrument accrues interest at the end of each month, which results in a deduction for CFC2 and an income inclusion and tax liability for CFC1 in country A. The accrual of interest does not result in an inclusion of income for CFC1 for U.S. Federal income tax purposes. Pursuant to the terms of the instrument, CFC2 makes a distribution at the end of the year equal to the amounts of interest that have accrued during the year, and such payment is treated as a dividend that is included in the income of CFC1 for U.S. Federal income tax purposes.

(ii) Result. Pursuant to § 1.909-2(b)(3)(i)(D), because the instrument is treated as equity for U.S. Federal income tax purposes but is treated as indebtedness for country A tax purposes, it is a U.S. equity hybrid instrument. Pursuant to § 1.909-2(b)(3)(i)(A)(3), because the accrual of interest under foreign law does not result in an inclusion of income of CFC1 for U.S. Federal income tax purposes, there is a splitter arrangement. The fact that the payment of the accrued amount at the end of the year pursuant to the terms of the instrument gives rise to a dividend that is included in income of CFC1 for U.S. Federal income tax purposes does not change the result because it is the accrual of interest and not the payment that gives rise to income or deductions under foreign law. The payments will be treated as a distribution of related income to the extent provided by § 1.909-3 and § 1.909-6(d).

(ii) U.S. debt hybrid instrument splitter arrangement – (A) In general. A U.S. debt hybrid instrument is a splitter arrangement if foreign income taxes are paid or accrued by the issuer of a U.S. debt hybrid instrument with respect to income in an amount equal to the interest (including original issue discount) paid or accrued on the instrument that is deductible for U.S. Federal income tax purposes but that does not give rise to a deduction under the laws of a foreign jurisdiction in which the issuer is subject to tax.

(B) Split taxes from a U.S. debt hybrid instrument splitter arrangement. Split taxes from a U.S. debt hybrid instrument splitter arrangement are the foreign income taxes paid or accrued by the issuer on the income that would have been offset by the interest paid or accrued on the U.S. debt hybrid instrument had such interest been deductible for foreign tax purposes.

(C) Related income from a U.S. debt hybrid instrument splitter arrangement. The related income from a U.S. debt hybrid instrument splitter arrangement is the gross amount of the interest income recognized for U.S. Federal income tax purposes by the owner of the U.S. debt hybrid instrument, determined without regard to the actual amount of the owner’s income or earnings and profits for U.S. Federal income tax purposes.

(D) U.S. debt hybrid instrument. The term U.S. debt hybrid instrument means an instrument that is treated as equity for foreign tax purposes but as indebtedness for U.S. Federal income tax purposes.

(4) Partnership inter-branch payment splitter arrangements – (i) In general. An allocation of foreign income tax paid or accrued by a partnership with respect to an inter-branch payment as described in § 1.704-1(b)(4)(viii)(d)(3) (revised as of April 1, 2011) (the inter-branch payment tax) is a splitter arrangement to the extent the inter-branch payment tax is not allocated to the partners in the same proportion as the distributive shares of income in the CFTE category to which the inter-branch payment tax is or would be assigned under § 1.704-1(b)(4)(viii)(d) without regard to § 1.704-1(b)(4)(viii)(d)(3).

(ii) Split taxes from a partnership inter-branch payment splitter arrangement. The split taxes from a partnership inter-branch splitter arrangement equal the excess of the amount of the inter-branch payment tax allocated to a partner under the partnership agreement over the amount of the inter-branch payment tax that would have been allocated to the partner if the inter-branch payment tax had been allocated to the partners in the same proportion as the distributive shares of income in the CFTE category referred to in paragraph (b)(4)(i) of this section.

(iii) Related income from a partnership inter-branch payment splitter arrangement. The related income from a partnership inter-branch payment splitter arrangement equals the amount of income allocated to a partner that exceeds the amount of income that would have been allocated to the partner if income in the CFTE category referred to in paragraph (b)(4)(i) of this section in the amount of the inter-branch payment had been allocated to the partners in the same proportion as the inter-branch payment tax was allocated under the partnership agreement.

(c) Effective/applicability date. This section applies to foreign income taxes paid or accrued in taxable years ending after February 9, 2015. However, a taxpayer may choose to apply the provisions of § 1.909-2T (as contained in 26 CFR part 1, revised as of April 1, 2014) in lieu of this section to foreign income taxes paid or accrued in its first taxable year ending after February 9, 2015, and in taxable years of foreign corporations with respect to which the taxpayer is a domestic shareholder (as defined in § 1.902-1(a)) that end with or within that first taxable year. See 26 CFR 1.909-2T (revised as of April 1, 2014) for rules applicable to foreign income taxes paid or accrued in taxable years beginning on or after January 1, 2012, and ending on or before February 9, 2015.

[T.D. 9710, 80 FR 7328, Feb. 10, 2015]

§ 1.909-3 Rules regarding related income and split taxes.

(a) Interim rules for identifying related income and split taxes. The principles of paragraphs (d) through (f) of § 1.909-6 apply to related income and split taxes in taxable years beginning on or after January 1, 2011, except that the alternative method for identifying distributions of related income described in § 1.909-6(d)(4) applies only to identify the amount of pre-2011 split taxes of a section 902 corporation that are suspended as of the first day of the section 902 corporation’s first taxable year beginning on or after January 1, 2011.

(b) Split taxes on deductible disregarded payments. Split taxes include taxes paid or accrued in taxable years beginning on or after January 1, 2011, with respect to the amount of a disregarded payment that is deductible by the payor of the disregarded payment under the laws of a foreign jurisdiction in which the payor of the disregarded payment is subject to tax on related income from a splitter arrangement. The amount of the deductible disregarded payment to which this paragraph (b) applies is limited to the amount of related income from such splitter arrangement.

(c) Effective/applicability date. This section applies to taxable years ending after February 9, 2015. See 26 CFR 1.909-3T (revised as of April 1, 2014) for rules applicable to taxable years beginning on or after January 1, 2011, and ending on or before February 9, 2015.

[T.D. 9710, 80 FR 7332, Feb. 10, 2015]

§ 1.909-4 Coordination rules.

(a) Interim rules. The principles of paragraph (g) of § 1.909-6 apply to taxable years beginning on or after January 1, 2011.

(b) Effective/applicability date. This section applies to taxable years ending after February 9, 2015. See 26 CFR 1.909-4T (revised as of April 1, 2014) for rules applicable to taxable years beginning on or after January 1, 2011, and ending on or before February 9, 2015.

[T.D. 9710, 80 FR 7332, Feb. 10, 2015]

§ 1.909-5 2011 and 2012 splitter arrangements.

(a) Taxes paid or accrued in taxable years beginning in 2011. (1) Foreign income taxes paid or accrued by any person in a taxable year beginning on or after January 1, 2011, and before January 1, 2012, in connection with a pre-2011 splitter arrangement (as defined in § 1.909-6(b)), are split taxes to the same extent that such taxes would have been treated as pre-2011 split taxes if such taxes were paid or accrued by a section 902 corporation in a taxable year beginning on or before December 31, 2010. The related income with respect to split taxes from such an arrangement is the related income described in § 1.909-6(b), determined as if the payor were a section 902 corporation.

(2) Foreign income taxes paid or accrued by any person in a taxable year beginning on or after January 1, 2011, and before January 1, 2012, in connection with a partnership inter-branch payment splitter arrangement described in § 1.909-2(b)(4) are split taxes to the extent that such taxes are identified as split taxes in § 1.909-2(b)(4)(ii). The related income with respect to the split taxes is the related income described in § 1.909-2(b)(4)(iii).

(b) Taxes paid or accrued in certain taxable years beginning in 2012 with respect to a foreign consolidated group splitter arrangement. Foreign income taxes paid or accrued by any person in a taxable year beginning on or after January 1, 2012, and on or before February 14, 2012, in connection with a foreign consolidated group splitter arrangement described in § 1.909-6(b)(2) are split taxes to the same extent that such taxes would have been treated as pre-2011 split taxes if such taxes were paid or accrued by a section 902 corporation in a taxable year beginning on or before December 31, 2010. The related income with respect to split taxes from such an arrangement is the related income described in § 1.909-6(b)(2), determined as if the payor were a section 902 corporation.

(c) Effective/applicability date. The rules of this section apply to foreign income taxes paid or accrued in taxable years beginning on or after January 1, 2011, and on or before February 14, 2012.

[T.D. 9710, 80 FR 7332, Feb. 10, 2015]

§ 1.909-6 Pre-2011 foreign tax credit splitting events.

(a) Foreign tax credit splitting event – (1) In general. This section provides rules for determining whether foreign income taxes paid or accrued by a section 902 corporation (as defined in section 909(d)(5)) in taxable years beginning on or before December 31, 2010 (pre-2011 taxable years and pre-2011 taxes) are suspended under section 909 in taxable years beginning after December 31, 2010, (post-2010 taxable years) of a section 902 corporation. Paragraph (b) of this section identifies an exclusive list of arrangements that will be treated as giving rise to foreign tax credit splitting events in pre-2011 taxable years (pre- 2011 splitter arrangements). Paragraphs (c), (d), and (e) of this section provide rules for determining the related income and pre-2011 split taxes paid or accrued with respect to pre-2011 splitter arrangements. Paragraph (f) of this section provides rules concerning the application of section 909 to partnerships and trusts. Paragraph (g) of this section provides rules concerning the interaction between section 909 and other Internal Revenue Code (Code) provisions.

(2) Taxes not subject to suspension under section 909. Pre-2011 taxes that will not be suspended under section 909 or paragraph (a) of this section are:

(i) Any pre-2011 taxes that were not paid or accrued in connection with a pre-2011 splitter arrangement identified in paragraph (b) of this section;

(ii) Any pre-2011 taxes that were paid or accrued in connection with a pre-2011 splitter arrangement identified in paragraph (b) of this section (pre-2011 split taxes) but that were deemed paid under section 902(a) or 960 on or before the last day of the section 902 corporation’s last pre-2011 taxable year;

(iii) Any pre-2011 split taxes if either the payor section 902 corporation took the related income into account in a pre-2011 taxable year or a section 902 shareholder (as defined in § 1.909-1(a)(2)) of the relevant section 902 corporation took the related income into account on or before the last day of the section 902 corporation’s last pre-2011 taxable year; and

(iv) Any pre-2011 split taxes paid or accrued by a section 902 corporation in taxable years of such section 902 corporation beginning before January 1, 1997.

(3) Taxes subject to suspension under section 909. To the extent that the section 902 corporation paid or accrued pre-2011 split taxes that are not described in paragraph (a)(2) of this section, section 909 and the regulations under that section will apply to such pre-2011 split taxes for purposes of applying sections 902 and 960 in post-2010 taxable years of the section 902 corporation. Accordingly, these taxes will be removed from the section 902 corporation’s pools of post-1986 foreign income taxes and suspended under section 909 as of the first day of the section 902 corporation’s first post-2010 taxable year. There is no increase to a section 902 corporation’s earnings and profits for the amount of any pre-2011 taxes to which section 909 applies that were previously deducted in computing earnings and profits in a pre-2011 taxable year.

(b) Pre-2011 splitter arrangements. The arrangements set forth in this paragraph (b) are pre-2011 splitter arrangements.

(1) Reverse hybrid structure splitter arrangements. A reverse hybrid structure exists when a section 902 corporation owns an interest in a reverse hybrid. A reverse hybrid is an entity that is a corporation for U.S. Federal income tax purposes but is a pass-through entity or a branch under the laws of a foreign country imposing tax on the income of the entity. As a result, the owner of the reverse hybrid is subject to tax on the income of the entity under foreign law. A pre-2011 splitter arrangement involving a reverse hybrid structure exists when pre-2011 taxes are paid or accrued by a section 902 corporation with respect to income of a reverse hybrid that is a covered person with respect to the section 902 corporation. A pre-2011 splitter arrangement involving a reverse hybrid structure may exist even if the reverse hybrid has a deficit in earnings and profits for a particular year (for example, due to a timing difference). Such taxes paid or accrued by the section 902 corporation are pre-2011 split taxes. The related income is the earnings and profits (computed for U.S. Federal income tax purposes) of the reverse hybrid attributable to the activities of the reverse hybrid that gave rise to income included in the foreign tax base with respect to which the pre-2011 split taxes were paid or accrued. Accordingly, related income of the reverse hybrid would not include any item of income or expense attributable to a disregarded entity (as defined in § 301.7701-2(c)(2)(i) of this chapter) owned by the reverse hybrid if income attributable to the activities of the disregarded entity is not included in the foreign tax base.

(2) Foreign consolidated group splitter arrangements. A foreign consolidated group exists when a foreign country imposes tax on the combined income of two or more entities. Tax is considered imposed on the combined income of two or more entities even if the combined income is computed under foreign law by attributing to one such entity the income of one or more entities. A foreign consolidated group is a pre-2011 splitter arrangement to the extent that the taxpayer did not allocate the foreign consolidated tax liability among the members of the foreign consolidated group based on each member’s share of the consolidated taxable income included in the foreign tax base under the principles of § 1.901-2(f)(3) (revised as of April 1, 2011). A pre-2011 splitter arrangement involving a foreign consolidated group may exist even if one or more members has a deficit in earnings and profits for a particular year (for example, due to a timing difference). Pre-2011 taxes paid or accrued with respect to the income of a foreign consolidated group are pre-2011 split taxes to the extent that taxes paid or accrued by one member of the foreign consolidated group are imposed on a covered person’s share of the consolidated taxable income included in the foreign tax base. The related income is the earnings and profits (computed for U.S. Federal income tax purposes) of such other member attributable to the activities of that other member that gave rise to income included in the foreign tax base with respect to which the pre-2011 split taxes were paid or accrued. No inference should be drawn from the treatment of foreign consolidated groups under section 909 as to the determination of the person who paid the foreign income tax for U.S. Federal income tax purposes.

(3) Group relief or other loss-sharing regime splitter arrangements – (i) In general. A foreign group relief or other loss-sharing regime exists when one entity with a loss permits the loss to be used to offset the income of one or more entities (shared loss). A pre-2011 splitter arrangement involving a shared loss exists when the following three conditions are met:

(A) There is an instrument that is treated as indebtedness under the laws of the jurisdiction in which the issuer is subject to tax and that is disregarded for U.S. Federal income tax purposes (disregarded debt instrument). Examples of a disregarded debt instrument include a debt obligation between two disregarded entities that are owned by the same section 902 corporation, two disregarded entities that are owned by a partnership with one or more partners that are section 902 corporations, a section 902 corporation and a disregarded entity that is owned by that section 902 corporation, or a partnership in which the section 902 corporation is a partner and a disregarded entity that is owned by such partnership.

(B) The owner of the disregarded debt instrument pays a foreign income tax attributable to a payment or accrual on the instrument.

(C) The payment or accrual on the disregarded debt instrument gives rise to a deduction for foreign tax purposes and the issuer of the instrument incurs a shared loss that is taken into account under foreign law by one or more entities that are covered persons with respect to the owner of the instrument.

(ii) Split taxes and related income. In situations described in paragraph (b)(3)(i) of this section, pre-2011 taxes paid or accrued by the owner of the disregarded debt instrument with respect to amounts paid or accrued on the instrument (up to the amount of the shared loss) are pre-2011 split taxes. The related income of a covered person is an amount equal to the shared loss, determined without regard to the actual amount of the covered person’s earnings and profits.

(4) Hybrid instrument splitter arrangements – (i) In general. A hybrid instrument for purposes of this paragraph (b)(4) is an instrument that either is treated as equity for U.S. Federal income tax purposes but is treated as indebtedness for foreign tax purposes (U.S. equity hybrid instrument), or is treated as indebtedness for U.S. Federal income tax purposes but is treated as equity for foreign tax purposes (U.S. debt hybrid instrument).

(ii) U.S. equity hybrid instrument splitter arrangement. If the issuer of a U.S. equity hybrid instrument is a covered person with respect to a section 902 corporation that is the owner of the U.S. equity hybrid instrument, there is a pre-2011 splitter arrangement with respect to the portion of the pre-2011 taxes paid or accrued by the owner section 902 corporation with respect to the amounts on the instrument that are deductible by the issuer as interest under the laws of a foreign jurisdiction in which the issuer is subject to tax but that do not give rise to income for U.S. Federal income tax purposes. Pre-2011 split taxes paid or accrued by the section 902 corporation equal the total amount of pre-2011 taxes paid or accrued by the section 902 corporation less the amount of pre-2011 taxes that would have been paid or accrued had the section 902 corporation not been subject to tax on income from the U.S. equity hybrid instrument. The related income of the issuer of the U.S. equity hybrid instrument is an amount equal to the amounts that are deductible by the issuer for foreign tax purposes, determined without regard to the actual amount of the issuer’s earnings and profits.

(iii) U.S. debt hybrid instrument splitter arrangement. If the owner of a U.S. debt hybrid instrument is a covered person with respect to a section 902 corporation that is the issuer of the U.S. debt hybrid instrument, there is a pre-2011 splitter arrangement with respect to the portion of the pre-2011 taxes paid or accrued by the section 902 corporation on income in an amount equal to the interest (including original issue discount) paid or accrued on the instrument that is deductible for U.S. Federal income tax purposes but that does not give rise to a deduction under the laws of a foreign jurisdiction in which the issuer is subject to tax. Pre-2011 split taxes are the pre-2011 taxes paid or accrued by the section 902 corporation on the income that would have been offset by the interest paid or accrued on the U.S. debt hybrid instrument had such interest been deductible for foreign tax purposes. The related income with respect to a U.S. debt hybrid instrument is the gross amount of the interest income recognized for U.S. Federal income tax purposes by the owner of the U.S. debt hybrid instrument, determined without regard to the actual amount of the owner’s earnings and profits.

(c) General rules for applying section 909 to pre-2011 split taxes and related income – (1) Annual determination. The determination of related income, other income, pre-2011 split taxes, and other taxes, and the portion of these amounts that were distributed, deemed paid or otherwise transferred or eliminated must be made on an annual basis beginning with the first taxable year of the section 902 corporation beginning after December 31, 1996 (post-1996 taxable year) in which the section 902 corporation paid or accrued a pre-2011 tax with respect to a pre-2011 splitter arrangement and ending with the section 902 corporation’s last pre-2011 taxable year. Annual amounts of related income and pre-2011 split taxes are aggregated for each separate pre-2011 splitter arrangement.

(2) Separate categories. The determination of annual and aggregate amounts of related income and pre-2011 split taxes with respect to each pre-2011 splitter arrangement must be made for each separate category as defined in § 1.904-4(m) of the section 902 corporation, each covered person, and any other person that succeeds to the related income and pre-2011 split taxes. In the case of a pre-2011 splitter arrangement involving a shared loss (as described in paragraph (b)(3) of this section), the amount of the related income in each separate category of the covered person is equal to the amount of income in that separate category that was offset by the shared loss for foreign tax purposes. In the case of a pre-2011 splitter arrangement involving a U.S. equity hybrid instrument (as described in paragraph (b)(4)(ii) of this section), the related income is assigned to the issuer’s separate categories in the same proportions as the pre-2011 split taxes. Earnings and profits, including related income, are assigned to separate categories under the rules of §§ 1.904-4, 1.904-5, and 1.904-7. Foreign income taxes, including pre-2011 split taxes, are assigned to separate categories under the rules of § 1.904-6. A section 902 shareholder must consistently apply methodologies for determining pre-2011 split taxes and related income with respect to all pre-2011 splitter arrangements.

(d) Special rules regarding related income – (1) Annual adjustments. In the case of each pre-2011 splitter arrangement involving a reverse hybrid or a foreign consolidated group (as described in paragraphs (b)(1) and (2) of this section, respectively), a covered person’s aggregate amount of related income must be adjusted each year by the net amount of income and expense attributable to the activities of the covered person that give rise to income included in the foreign tax base, even if the net amount is negative and regardless of whether the section 902 corporation paid or accrued any pre-2011 split taxes in such year.

(2) Effect of separate limitation losses and deficits. Related income is determined without regard to the application of § 1.960-1(i)(4) (relating to the effect of separate limitation losses on earnings and profits in another separate category) or section 952(c)(1) (relating to certain earnings and profits deficits).

(3) Pro rata method for distributions out of earnings and profits that include both related income and other income. If the earnings and profits of a covered person include amounts attributable to both related income and other income, including earnings and profits attributable to taxable years beginning before January 1, 1997, then distributions, deemed distributions, and inclusions out of earnings and profits (for example, under sections 301, 304, 367(b), 951(a), 964(e), 1248, or 1293) of the covered person are considered made out of related income and other income on a pro rata basis. Any reduction of a covered person’s earnings and profits that results from a payment on stock that is not treated as a dividend for U.S. Federal income tax purposes (for example, pursuant to section 312(n)(7)) will also reduce related income and other income on a pro rata basis.

(4) Alternative method for distributions out of earnings and profits that include both related income and other income. Solely for purposes of identifying the amount of pre-2011 split taxes of a section 902 corporation that are suspended as of the first day of the section 902 corporation’s first post-2010 taxable year, in lieu of the rule set forth in paragraph (d)(3) of this section, a section 902 shareholder may choose to treat all distributions, deemed distributions, and inclusions out of earnings and profits of a covered person as attributable first to related income. A section 902 shareholder may choose to use this alternative method on a timely filed original income tax return for the first post-2010 taxable year in which the shareholder computes an amount of foreign income taxes deemed paid with respect to a section 902 corporation that paid or accrued pre-2011 split taxes. Such choice by a section 902 shareholder is evidenced by employing the method on its income tax return; the section 902 shareholder need not file a separate statement. A section 902 shareholder that chooses this alternative method must consistently apply it with respect to all pre-2011 splitter arrangements.

(5) Distributions, deemed distributions, and inclusions of related income. Distributions, deemed distributions, and inclusions of related income (including indirectly through a partnership) to persons other than the payor section 902 corporation retain their character as related income with respect to the associated pre-2011 split taxes.

(6) Carryover of related income. Related income carries over to other corporations in the same manner as earnings and profits carry over under section 381, § 1.367(b)-7, or similar rules, and retains its character as related income with respect to the associated pre-2011 split taxes.

(7) Related income taken into account by a section 902 shareholder. Related income will be considered taken into account by a section 902 shareholder to the extent that the related income is recognized as gross income by the section 902 shareholder, or by an affiliated corporation described in paragraph (d)(9) of this section, upon a distribution, deemed distribution, or inclusion (such as under section 951(a)) out of the earnings and profits of the covered person attributable to such related income.

(8) Related income taken into account by a payor section 902 corporation. Related income will be considered taken into account by a payor section 902 corporation to the extent that:

(i) The related income is reflected in the earnings and profits of such section 902 corporation for U.S. Federal income tax purposes by reason of a distribution, deemed distribution, or inclusion out of the earnings and profits of the covered person attributable to such related income; or

(ii) The related income is reflected as a positive adjustment to the earnings and profits of such section 902 corporation for U.S. Federal income tax purposes by reason of the section 902 corporation and the covered person combining in a transaction described in section 381(a)(1) or (a)(2).

(9) Related income taken into account by an affiliated group of corporations that includes a section 902 shareholder. A section 902 shareholder will be considered to have taken related income into account if one or more members of an affiliated group of corporations (as defined in section 1504) that files a consolidated Federal income tax return that includes the section 902 shareholder takes the related income into account.

(10) Distributions of previously-taxed earnings and profits. Distributions and deemed distributions described in paragraph (d) of this section (including in the case of a section 902 shareholder that has chosen the alternative method described in paragraph (d)(4) of this section) do not include distributions of amounts described in section 959(c)(1) or (c)(2), which are distributed before amounts described in section 959(c)(3).

(e) Special rules regarding pre-2011 split taxes – (1) Taxes deemed paid pro-rata out of pre-2011 split taxes and other taxes. If the pre-2011 taxes of a section 902 corporation include both pre-2011 split taxes and other taxes, then foreign income taxes deemed paid under section 902 or 960 or otherwise removed from post-1986 foreign income taxes in pre-2011 taxable years will be treated as attributable to pre-2011 split taxes and other taxes on a pro-rata basis.

(2) Pre-2011 split taxes deemed paid in pre-2011 taxable years. Pre-2011 split taxes deemed paid in pre-2011 taxable years in connection with a dividend paid to a shareholder described in section 902(b) retain their character as pre-2011 split taxes. The section 902(b) shareholder will be treated as the payor section 902 corporation with respect to those pre-2011 split taxes.

(3) Carryover of pre-2011 split taxes. Pre-2011 split taxes that carry over to another foreign corporation, including under section 381, § 1.367(b)-7 or similar rules, retain their character as pre-2011 split taxes. The transferee foreign corporation will be treated as the payor section 902 corporation with respect to those pre-2011 split taxes.

(4) Determining when pre-2011 split taxes are no longer treated as pre-2011 split taxes. For each pre-2011 splitter arrangement, as related income is taken into account by the payor section 902 corporation or a section 902 shareholder as provided in paragraph (d) of this section, a ratable portion of the associated pre-2011 split taxes will no longer be treated as pre-2011 split taxes. In the case of a pre-2011 splitter arrangement involving a reverse hybrid or a foreign consolidated group (as described in paragraphs (b)(1) and (2) of this section, respectively), if aggregate related income is reduced to zero (other than as a result of a distribution, deemed distribution, or inclusion described in paragraph (d) of this section) or less than zero, pre-2011 split taxes will retain their character as pre-2011 split taxes until the amount of aggregate related income is positive and the related income is taken into account by the payor section 902 corporation or a section 902 shareholder as provided in paragraph (d) of this section.

(f) Rules relating to partnerships and trusts – (1) Taxes paid or accrued by partnerships. In the case of foreign income taxes paid or accrued by a partnership, the taxes will be treated as pre-2011 split taxes to the extent such taxes are allocated to one or more section 902 corporations and would be pre-2011 split taxes if the partner section 902 corporation had paid or accrued the taxes directly on the date such taxes are included by the section 902 corporation under sections 702 and 706(a). Further, any foreign income taxes subject to section 909 will be suspended in the hands of the partner section 902 corporation.

(2) Section 704(b) allocations. Partnership allocations that satisfy the requirements of section 704(b) and the regulations thereunder will not constitute pre-2011 splitter arrangements except to the extent the arrangement is otherwise described in paragraph (b) of this section (for example, a payment or accrual on a disregarded debt instrument that gives rise to a shared loss).

(3) Trusts. Rules similar to the rules of paragraph (f)(1) of this section will apply in the case of any trust with one or more beneficiaries that is a section 902 corporation.

(g) Interaction between section 909 and other Code provisions – (1) Section 904(c). Section 909 does not apply to excess foreign income taxes that were paid or accrued in pre-2011 taxable years and carried forward and deemed paid or accrued under section 904(c) in a post-2010 taxable year.

(2) Section 905(a). For purposes of determining in post-2010 taxable years the allowable deduction for foreign income taxes paid or accrued under section 164(a), the carryover of excess foreign income taxes under section 904(c), and the extended period for claiming a credit or refund under section 6511(d)(3)(A), foreign income taxes to which section 909 applies are first taken into account and treated as paid or accrued in the year in which the related income is taken into account, and not in the earlier year to which the tax relates (determined without regard to section 909).

(3) Section 905(c). If a redetermination of foreign income taxes claimed as a direct credit under section 901 occurs in a post-2010 taxable year and the foreign tax redetermination relates to a pre-2011 taxable year, to the extent such foreign tax redetermination increased the amount of foreign income taxes paid or accrued with respect to the pre-2011 taxable year (for example, due to an additional assessment of foreign tax or a payment of a previously accrued tax not paid within two years), section 909 will not apply to such taxes. If a redetermination of foreign tax paid or accrued by a section 902 corporation occurs in a post-2010 taxable year and increases the amount of foreign income taxes paid or accrued by the section 902 corporation with respect to a pre-2011 taxable year (for example, due to an additional assessment of foreign tax or a payment of a previously accrued tax not paid within two years), such taxes will be treated as pre-2011 taxes. Section 909 will apply to such taxes if they are pre-2011 split taxes and the taxes will be suspended in the post-2010 taxable year in which they would otherwise be taken into account as a prospective adjustment to the section 902 corporation’s pools of post-1986 foreign income taxes.

(4) Other foreign tax credit provisions. Section 909 does not affect the applicability of other restrictions or limitations on the foreign tax credit under existing law, including, for example, the substantiation requirements of section 905(b).

(h) Effective/applicability date. This section applies to foreign income taxes paid or accrued by section 902 corporations in pre-2011 taxable years for purposes of computing foreign income taxes deemed paid with respect to distributions or inclusions out of earnings and profits of section 902 corporations in taxable years of the section 902 corporation ending after February 9, 2015. See 26 CFR 1.909-6T (revised as of April 1, 2014) for rules applicable to foreign income taxes paid or accrued by section 902 corporations in pre-2011 taxable years for purposes of computing foreign income taxes deemed paid with respect to distributions or inclusions out of earnings and profits of section 902 corporations in taxable years of the section 902 corporation beginning after December 31, 2010, and ending on or before February 9, 2015.

[T.D. 9710, 80 FR 7332, Feb. 10, 2015]

§ 1.910 [Reserved]

§ 1.911-1 Partial exclusion for earned income from sources within a foreign country and foreign housing costs.

(a) In general. Section 911 provides that a qualified individual may elect to exclude the individual’s foreign earned income and the housing cost amount from the individual’s gross income for the taxable year. Foreign earned income is excludable to the extent of the applicable limitation for the taxable year. The housing cost amount for the taxable year is excludable to the extent attributable to employer provided amounts. If a portion of the housing cost amount for the taxable year is attributable to non-employer provided amounts, such amount may be deductible by the qualified individual subject to a limitation. The amounts excluded under section 911(a) and the amount deducted under section 911(c)(3)(A) for the taxable year shall not exceed the individual’s foreign earned income for such taxable year. Foreign earned income must be earned during a period for which the individual qualifies to make an election under section 911(d)(1). A housing cost amount that would be deductible except for the application of this limitation may be carried over to the next taxable year and is deductible to the extent of the limitation for that year. Except as otherwise provided, §§ 1.911-1 through 1.911-7 apply to taxable years beginning after December 31, 1981. These sections do not apply to any item of income, expense, deduction, or credit arising before January 1, 1982, even if such item is attributable to services performed after December 31, 1981.

(b) Scope. Section 1.911-2 provides rules for determining whether an individual qualifies to make an election under section 911. Section 1.911-3 provides rules for determining the amount of foreign earned income that is excludable under section 911(a)(1). Section 1.911-4 provides rules for determining the housing cost amount and the portions excludable under section 911(a)(2) or deductible under section 911(c)(3). Section 1.911-5 provides special rules applicable to married couples. Section 1.911-6 provides for the disallowance of deductions, exclusions, and credits attributable to amounts excluded under section 911. Section 1.911-7 provides procedural rules for making or revoking an election under section 911. Section 1.911-8 provides a reference to rules applicable to taxable years beginning before January 1, 1982.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2964, Jan. 23, 1985]

§ 1.911-2 Qualified individuals.

(a) In general. An individual is a qualified individual if:

(1) The individual’s tax home is in a foreign country or countries throughout –

(i) The period of bona fide residence described in paragraph (a)(2)(i) of this section, or

(ii) The 330 full days of presence described in paragraph (a)(2)(ii) of this section, and

(2) The individual is either –

(i) A citizen of the United States who establishes to the satisfaction of the Commissioner or his delegate that the individual has been a bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year, or

(ii) A citizen or resident of the United States who has been physically present in a foreign country or countries for at least 330 full days during any period of twelve consecutive months.

(b) Tax home. For purposes of paragraph (a)(i) of this section, the term “tax home” has the same meaning which it has for purposes of section 162(a)(2) (relating to travel expenses away from home). Thus, under section 911, an individual’s tax home is considered to be located at his regular or principal (if more than one regular) place of business or, if the individual has no regular or principal place of business because of the nature of the business, then at his regular place of abode in a real and substantial sense. An individual shall not, however, be considered to have a tax home in a foreign country for any period for which the individual’s abode is in the United States. Temporary presence of the individual in the United States does not necessarily mean that the individual’s abode is in the United States during that time. Maintenance of a dwelling in the United States by an individual, whether or not that dwelling is used by the individual’s spouse and dependents, does not necessarily mean that the individual’s abode is in the United States.

(c) Determination of bona fide residence. For purposes of paragraph (a)(2)(i) of this section, whether an individual is a bona fide resident of a foreign country shall be determined by applying, to the extent practical, the principles of section 871 and the regulations thereunder, relating to the determination of the residence of aliens. Bona fide residence in a foreign country or countries for an uninterrupted period may be established, even if temporary visits are made during the period to the United States or elsewhere on vacation or business. An individual with earned income from sources within a foreign country is not a bona fide resident of that country if:

(1) The individual claims to be a nonresident of that foreign country in a statement submitted to the authorities of that country, and

(2) The earned income of the individual is not subject, by reason of nonresidency in the foreign country, to the income tax of that country.

If an individual has submitted a statement of nonresidence to the authorities of a foreign country the accuracy of which has not been resolved as of any date when a determination of the individual’s bona fide residence is being made, then the individual will not be considered a bona fide resident of the foreign country as of that date.

(d) Determination of physical presence. For purposes of paragraph (a)(2)(ii) of this section, the following rules apply.

(1) Twelve-month test. A period of twelve consecutive months may begin with any day but must end on the day before the corresponding day in the twelfth succeeding month. The twelve-month period may begin before or after arrival in a foreign country and may end before or after departure.

(2) 330-day test. The 330 full days need not be consecutive but may be interrupted by periods during which the individual is not present in a foreign country. In computing the minimum 330 full days of presence in a foreign country or countries, all separate periods of such presence during the period of twelve consecutive months are aggregated. A full day is a continuous period of twenty-four hours beginning with midnight and ending with the following midnight. An individual who has been present in a foreign country and then travels over areas not within any foreign country for less than twenty-four hours shall not be deemed outside a foreign country during the period of travel. If an individual who is in transit between two points outside the United States is physically present in the United States for less than twenty-four hours, such individual shall not be treated as present in the United States during such transit but shall be treated as travelling over areas not within any foreign country. For purposes of this paragraph (d)(2), the term “transit between two points outside the United States” has the same meaning that it has when used in section 7701(b)(6)(C).

(3) Illustrations of the physical presence requirement. The physical presence requirement of paragraph (a)(2)(ii) of this section is illustrated by the following examples:

Example 1.B, a U.S. citizen, arrives in Venezuela from New York at 12 noon on April 24, 1982. B remains in Venezuela until 2 p.m. on March 21, 1983, at which time B departs for the United States. Among other possible twelve month periods, B is present in a foreign country an aggregate of 330 full days during each of the following twelve month periods: March 21, 1982 through March 20, 1983; and April 25, 1982 through April 24, 1983.

Example 2.C, a U.S. citizen, travels extensively from the time C leaves the United States on March 5, 1982, until the time C departs the United Kingdom on January 1, 1984, to return to the United States permanently. The schedule of C’s travel and the number of full days at each location are listed below:

Country	Time and date of arrival	Time and date of departure	Full days in foreign country
United States		10 p.m. (by air) Mar. 5, 1982
United Kingdom	9 a.m. Mar. 6, 1982	10 p.m. (by ship) June 25, 1982	110
United States	11 a.m. June 30, 1982	1 p.m. (by ship) July 19, 1982	0
France	3 p.m. July 24, 1982	11 a.m. (by air) Aug. 22, 1983	393
United States	4 p.m. Aug. 22, 1983	9 a.m. (by air) Sept. 4, 1983	0
United Kingdom	9 a.m. Sept. 5, 1983	9 a.m. (by air) Jan. 1, 1984	117
United States	1 p.m. Jan. 1, 1984

Among other possible twelve-month periods, C is present in a foreign country or countries an aggregate of 330 full days during the following twelve-month periods: March 2, 1982 through March 1, 1983; and January 21, 1983 through January 20, 1984. The computation of days with respect to each twelve month period may be illustrated as follows:

First twelve-month period (March 2, 1982 through March 1, 1983):

	Full days in foreign country
Mar. 2, 1982 through Mar. 6, 1982	0
Mar. 7, 1982 through June 24, 1982	110
June 25, 1982 through July 24, 1982	0
July 25, 1982 through Mar. 1, 1983	220
Total full days	330

Second twelve-month period (January 21, 1983 through January 20, 1984):

	Full days in foreign country
Jan. 21, 1983 through Aug. 21, 1983	213
Aug. 22, 1983 through Sept. 5, 1983	0
Sept. 6, 1983 through Dec. 31, 1983	117
Jan. 1, 1984 through Jan. 20, 1984	0
Total full days	330

(e) Special rules. For purposes only of establishing that an individual is a qualified individual under paragraph (a) of this section, residence or presence in a foreign country while there employed by the U.S. government or any agency or instrumentality of the U.S. government counts towards satisfaction of the requirements of § 1.911-2(a). (But see section 911(b)(1)(B)(ii) and § 1.911-3(c)(3) for the rule excluding amounts paid by the U.S. government to an employee from the definition of foreign earned income.) Time spent in a foreign country prior to January 1, 1982, counts toward satisfaction of the bona fide residence and physical presence requirements, even though no exclusion or deduction may be allowed under section 911 for income attributable to services performed during that time. For purposes or paragraph (a)(2)(ii) of this section, the term “resident of the United States” includes an individual for whom a valid election is in effect under section 6013 (g) or (h) for the taxable year or years during which the physical presence requirement is satisfied.

(f) Waiver of period of stay in foreign country due to war or civil unrest. Notwithstanding the requirements of paragraph (a) of this section, an individual whose tax home is in, a foreign country, and who is a bona fide resident of, or present in a foreign country for any period, who leaves the foreign country after August 31, 1978, before meeting the requirements of paragraph (a) of this section, may as provided in this paragraph, qualify to make an election under section 911(a) and § 1.911-7(a). If the Secretary determines, after consultation with the Secretary of State or his delegate, that war, civil unrest, or similar adverse conditions existed in a foreign country, then the Secretary shall publish the name of the foreign country and the dates between which such conditions were deemed to exist. In order to qualify to make an election under this paragraph, the individual must establish to the satisfaction of the Secretary that the individual left a foreign country, the name of which has been published by the Secretary, during the period when adverse conditions existed and that the individual could reasonably have expected to meet the requirements of paragraph (a) of this section but for the adverse conditions. The individual shall attach to his return for the taxable year a statement that the individual expected to meet the requirements of paragraph (a) of this section but for the conditions in the foreign country which precluded the normal conduct of business by the individual. Such individual shall be treated as a qualified individual, but only for the actual period of residence or presence. Thus, in determining the number of the individual’s qualifying days, only days within the period of actual residence or presence shall be counted.

(g) United States. The term “United States” when used in a geographical sense includes any territory under the sovereignty of the United States. It includes the states, the District of Columbia, the possessions and territories of the United States, the territorial waters of the United States, the air space over the United States, and the seabed and subsoil of those submarine areas which are adjacent to the territorial waters of the United States and over which the United States has exclusive rights, in accordance with international law, with respect to the exploration and exploitation of natural resources.

(h) Foreign country. The term “foreign country” when used in a geographical sense includes any territory under the sovereignty of a government other than that of the United States. It includes the territorial waters of the foreign country (determined in accordance with the laws of the United States), the air space over the foreign country, and the seabed and subsoil of those submarine areas which are adjacent to the territorial waters of the foreign country and over which the foreign country has exclusive rights, in accordance with international law, with respect to the exploration and exploitation of natural resources.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2965, Jan. 23, 1985]

§ 1.911-3 Determination of amount of foreign earned income to be excluded.

(a) Definition of foreign earned income. For purposes of section 911 and the regulations thereunder, the term “foreign earned income” means earned income (as defined in paragraph (b) of this section) from sources within a foreign country (as defined in § 1.911-2(h)) that is earned during a period for which the individual qualifies under § 1.911-2(a) to make an election. Earned income is from sources within a foreign country if it is attributable to services performed by an individual in a foreign country or countries. The place of receipt of earned income is immaterial in determining whether earned income is attributable to services performed in a foreign country or countries.

(b) Definition of earned income – (1) In general. The term “earned income” means wages, salaries, professional fees, and other amounts received as compensation for personal services actually rendered including the fair market value of all remuneration paid in any medium other than cash. Earned income does not include any portion of an amount paid by a corporation which represents a distribution of earnings and profits rather than a reasonable allowance as compensation for personal services actually rendered to the corporation.

(2) Earned income from business in which capital is material. In the case of an individual engaged in a trade or business (other than in corporate form) in which both personal services and capital are material income producing factors, a reasonable allowance as compensation for the personal services actually rendered by the individual shall be considered earned income, but the total amount which shall be treated as the earned income of the individual from such trade or business shall in no case exceed thirty percent of the individual’s share of the net profits of such trade or business.

(3) Professional fees. Earned income includes all fees received by an individual engaged in a professional occupation (such as doctor or lawyer) in the performance of professional activities. Professional fees constitute earned income even though the individual employs assistants to perform part or all of the services, provided the patients or clients are those of the individual and look to the individual as the person responsible for the services rendered.

(1) Excluded from gross income under section 119;

(2) Received as a pension or annuity (including social security benefits);

(3) Paid to an employee by an employer which is the U.S. government or any U.S. government agency or instrumentality;

(4) Included in the individual’s gross income by reason of section 402(b) (relating to the taxability of a beneficiary of a nonexempt trust) or section 403(c) (relating to the taxability of a beneficiary under a nonqualified annuity or under annuities purchased by exempt organizations);

(5) Included in gross income by reason of § 1.911-6(b)(4)(ii); or

(6) Received after the close of the first taxable year following the taxable year in which the services giving rise to the amounts were performed. For treatment of amounts received after December 31, 1962, which are attributable to services performed on or before December 31, 1962, and with respect to which there existed on March 12, 1962, a right (whether forfeitable or nonforfeitable) to receive such amounts, see § 1.72-8.

(d) Determination of the amount of foreign earned income that may be excluded under section 911(a)(1) – (1) In general. Foreign earned income described in this section may be excluded under section 911(a)(1) and this paragraph only to the extent of the limitation specified in paragraph (d)(2) of this section. Income is considered to be earned in the taxable year in which the services giving rise to the income are performed. The determination of the amount of excluded earned income in this manner does not affect the time for reporting any amounts included in gross income.

(2) Limitation – (i) In general. The term “section 911(a)(1) limitation” means the amount of foreign earned income for a taxable year which may be excluded under section 911(a)(1). The section 911(a)(1) limitation shall be equal to the lesser of the qualified individual’s foreign earned income for the taxable year in excess of amounts that the individual elected to exclude from gross income under section 911(a)(2) or the product of the annual rate for the taxable year (as specified in paragraph (d)(2)(ii) of this section) multiplied by the following fraction:

(ii) Annual rate for the taxable year. The annual rate for the taxable year is the rate set forth in section 911(b)(2)(A).

(3) Number of qualifying days. For purposes of section 911 and the regulations thereunder, the number of qualifying days is the number of days in the taxable year within the period during which the individual met the tax home requirement and either the bona fide residence requirement or the physical presence requirement of § 1.911-2(a). Although the period of bona fide residence must include an entire taxable year, the entire uninterrupted period of residence may include fractional parts of a taxable year. For instance, if an individual who was a calendar year taxpayer established a tax home and a residence in a foreign country as of November 1, 1982, and maintained the tax home and the residence through March 31, 1984, then the uninterrupted period of bona fide residence includes fractional parts of the years 1982 and 1984, and all of 1983. The number of qualifying days in 1982 is sixty-one. The number of qualifying days in 1983 is 365. The number of qualifying days in 1984 is ninety-one. The period during which the physical presence requirement of § 1.911-2(a)(2)(ii) is met is any twelve consecutive month period during which the individual is physically present in one or more foreign countries for 330 days and the individual’s tax home is in a foreign country during each day of such physical presence. Such period may include days when the individual is not physically present in a foreign country, and days when the individual does not maintain a tax home in a foreign country. Such period may include fractional parts of a taxable year. Thus, if an individual’s period of physical, presence is the twelve-month period beginning June 1, 1982, and ending May 31, 1983, the number of qualifying days in 1982 is 214 and the number of qualifying days in 1983 is 151.

(e) Attribution rules – (1) In general. Foreign earned income is considered to be earned in the taxable year in which the individual performed the services giving rise to the income. If income is earned in one taxable year and received in another taxable year, then, for purposes of determining the amount of foreign earned income that the individual may exclude under section 911(a), the individual must attribute the income to the taxable year in which the services giving rise to the income were performed. Thus, any reimbursement would be attributable to the taxable year in which the services giving rise to the obligation to pay the reimbursement were performed, not the taxable year in which the reimbursement was received. For example, tax equalization payments are normally received in the year after the year in which the services giving rise to the obligation to pay the tax equalization payment were performed. Therefore, such payments will almost always have to be attributed to the prior year. Foreign earned income attributable to services performed in a preceding taxable year shall be excludable from gross income in the year of receipt only to the extent such amount could have been excluded under paragraph (d)(1) in the preceding taxable year, had such amount been received in the preceding taxable year. The taxable year to which income is attributable will be determined on the basis of all the facts and circumstances.

(2) Priority of use of the section 911(a)(1) limitation. Foreign earned income received in the year in which it is earned shall be applied to the section 911(a)(1) limitation for that year before applying income earned in that year that is received in any other year. Foreign earned income that is earned in one year and received in another year shall be applied to the section 911(a)(1) limitation for the year in which it was earned, on a year by year basis, in any order that the individual chooses. (But see section 911(b)(1)(B)(iv)). An individual may not amend his return to change the treatment of income with respect to the section 911(a)(1) exclusion after the period provided by section 6511(a). The special period of limitation provided by section 6511(d)(3) does not apply for this purpose. For example, C, a qualified individual, receives an advance bonus of $10,000 in 1982, salary of $70,000 in 1983, and a performance bonus of $10,000 in 1984, all of which are foreign earned income for 1983. C has a section 911(a)(1) limitation for 1983 of $80,000, and has no housing cost amount exclusion. On his income tax return for 1983, C elects to exclude foreign earned income of $70,000 received in 1983. C may also exclude his $10,000 advance bonus received in 1982 (by filing an amended return for 1982), or he may exclude the $10,000 performance bonus received in 1984 on his 1984 income tax return. However, C may not exclude part of the 1982 bonus and part of the 1984 bonus.

(3) Exception for year-end payroll period. Notwithstanding paragraph (e)(1) of this section, salary or wage payments of a cash basis taxpayer shall be attributed entirely to the year of receipt under the following circumstances:

(i) The period for which the payment is made is a normal payroll period of the employer which regularly applies to the employee;

(ii) The payroll period includes the last day of the employee’s taxable year;

(iii) The payroll period does not exceed 16 days; and

(iv) The payment is part of a normal payroll of the employer that is distributed at the same time, in relation to the payroll period, that such payroll would normally be distributed, and is distributed before the end of the next succeeding payroll period.

(4) Attribution of bonuses and substantially nonvested property to periods in which services were performed – (i) In general. Bonuses and substantially nonvested property are attributable to all of the services giving rise to the income on the basis of all the facts and circumstances. If an individual receives a bonus or substantially nonvested property (as defined in § 1.83-3(b)) and it is determined to be attributable to services performed in more than one taxable year, then, for purposes of determining the amount eligible for exclusion from gross income in the year the bonus is received or the property vests, a portion of such amount shall be treated as attributable to services performed in each taxable year (or portion thereof) during the period when services giving rise to the bonus or the substantially nonvested property were performed. Such portion shall be determined by dividing the amount of the bonus or the excess of the fair market value of the vested property over the amount paid, if any, for the vested property, by the number of months in the period when services giving rise to such amount were performed, and multiplying the quotient by the number of months in such period in the taxable year. For purposes of this section, the term “month” means a calendar month. A fraction of a calendar month shall be deemed a month if it includes fifteen or more days.

(ii) Examples. The following examples illustrate the application of this paragraph (e)(4).

Example 1.A, an employee of M Corporation during all of 1983 and 1984, worked in the United States from January 1 through April 30, 1983, and received $12,000 of salary for that period. A worked in country F from May 1, 1983 through the end of 1984, and is a qualified individual under § 1.911-2(a) for that period. For the period from May 1 through December 31, 1983, A received $32,000 of salary. M pays a bonus on December 20, 1983 to each of M’s employees in an amount equal to 10 percent of the employee’s regular wages or salary for the 1983 calendar year. The amount of A’s bonus is $4,400 for 1983. The portion of A’s bonus that is attributable to services performed in country F and is foreign earned income for 1983 is $3,200, or $32,000 × 10 percent. The remaining $1,200 of A’s bonus is attributable to services performed in the United States, and is not foreign earned income.

Example 2.The facts are the same as in example 1, except that M determines bonuses separately for each country based on the productivity of the employees in that country. M pays a bonus to employees in country F, in the amount of 15 percent of each employee’s wages or salary earned in country F. A’s country F bonus is $4,800 for 1983 ($32,000 × 15 percent), and is foreign earned income for 1983. If A also receives a bonus (or if A’s bonus is increased) for working in the United States during 1983, that amount is not foreign earned income.

Example 3.X corporation offers its employees a bonus of $40,000 if the employee accepts employment in a foreign country and remains in a foreign country for a period of at least four years. A, an employee of X, is a calendar year and cash basis taxpayer. A accepts employment with X in foreign country F. A begins work in F on July 1, 1983 and continues to work in F for X until June 30, 1987. In 1987 X pays A a $40,000 bonus. The bonus is attributable to services A performed from July 1, 1983 through June 30, 1987. The amount of the bonus attributable to 1987 is $5,000 (($40,000 ÷ 48) × 6). The amount of the bonus attributable to 1986 is $10,000 (($40,000 ÷ 48) × 12). A may exclude the $10,000 attributable to 1986 only to the extent that amount could have been excluded under section 911(a)(1) had A received it in 1986. The remaining $25,000 is attributable to services performed in taxable years before 1986. Such amounts may not be excluded under section 911 because they are received after the close of the taxable year following the taxable year in which the services giving rise to the income were performed.

(iii) Special rule for elections under section 83(b). If an individual receives substantially nonvested property and makes an election under section 83(b) and § 1.83-2(a) to include in his gross income the amount determined under section 83(b)(1)(A) and (B) and § 1.83-2(a) for the taxable year in which the property is transferred (as defined in § 1.83-3(a)), then, for the purpose of determining the amount eligible for exclusion in the year of receipt, the individual may elect either of the following options:

(A) Substantially nonvested property may be treated as attributable entirely to services performed in the taxable year in which an election to include it in income is made. If so treated, then the amount otherwise included in gross income as determined under § 1.83-2(a) will be excludable under section 911(a) for such year subject to the limitation provided in § 1.911-3(d)(2) for such year.

(B) A portion of the substantially nonvested property may be treated as attributable to services performed or to be performed in each taxable year during which the substantial risk of forfeiture (as defined in section 83(c) and § 1.83-3(c)) exists. The portion treated as attributable to services performed or to be performed in each taxable year is determined by dividing the amount of the substantially nonvested property included in gross income as determined under § 1.83-2(a) by the number of months during the period when a substantial risk of forfeiture exists. The quotient is multiplied by the total number of months in the taxable year during which a substantial risk of forfeiture exists. The amount determined to be attributable to services performed in the year the election is made shall be excluded from gross income for such year as provided in paragraph (d)(2) of this section. Amounts treated as attributable to services performed in subsequent taxable years shall be excludable in the year of receipt only to the extent such amounts could be excluded under paragraph (d)(2) of this section in such subsequent years. An individual may obtain such additional exclusion by filing an amended return for the taxable year in which the property was transferred. The individual may only amend his or her return within the period provided by section 6511(a) and the regulations thereunder.

(5) Moving expense reimbursements – (i) Source of reimbursements. For the purpose of determining whether a moving expense reimbursement is attributable to services performed within a foreign country or within the United States, in the absence of evidence to the contrary, the reimbursement shall be attributable to future services to be performed at the new principal place of work. Thus, a reimbursement received by an employee from his employer for the expenses of a move to a foreign country will generally be attributable to services performed in the foreign country. A reimbursement received by an employee from his employer for the expenses of a move from a foreign country to the United States will generally be attributable to services performed in the United States. For purposes of this paragraph (e)(5), evidence to the contrary includes, but is not limited to, an agreement, between the employer and the employee, or a statement of company policy, which is reduced to writing before the move to the foreign country and which is entered into or established to induce the employee or employees to move to a foreign country. The writing must state that the employer will reimburse the employee for moving expenses incurred in returning to the United States regardless of whether the employee continues to work for the employer after the employee returns to the United States. The writing may contain conditions upon which the right to reimbursement is determined as long as the conditions set forth standards that are definitely ascertainable and the conditions can only be fulfilled prior to, or through completion of the employee’s return move to the United States that is the subject of the writing. In no case will an oral agreement or statement of company policy concerning moving expenses be considered evidence to the contrary. For the purpose of determining whether a storage expense reimbursement is attributable to services performed within a foreign country, in the case of storage expenses incurred after December 31, 1983, the reimbursement shall be attributable to services performed during the period of time for which the storage expenses are incurred.

(ii) Attribution of foreign source reimbursements to taxable years in which services are performed – (A) In general. If a reimbursement for moving expenses is determined to be from foreign sources under paragraph (e)(5)(i) of this section, then for the purpose of determining the amount eligible for exclusion in accordance with paragraphs (d)(2) and (e)(2) of this section, the reimbursement shall be considered attributable to services performed in the year of the move as long as the individual is a qualified individual for a period that includes 120 days in the year of the move. The period that is used in determining the number of qualifying days for purposes of the individual’s section 911(a)(1) limitation (under paragraph (d)(2) of this section) must also be used in determining whether the individual is a qualified individual for a period that includes 120 days in the year of the move. If the individual is not a qualified individual for such period, then the individual shall treat a portion of the reimbursement as attributable to services performed in the year of the move, and a portion as attributable to services performed in the succeeding taxable year, if the move is from the United States to a foreign country, or to the prior taxable year, if the move is from a foreign country to the United States. The portion of the reimbursement treated as attributable to services performed in the year of the move shall be determined by multiplying the total reimbursement by the following fraction:

The remaining portion of the reimbursement shall be treated as attributable to services performed in the year succeeding or preceding the year of the move. Amounts treated as attributable to services performed in a year succeeding or preceding the year of the move shall be excludable in the year of receipt only to the extent such amounts could be excluded under paragraph (d)(2) of this section in such succeeding or preceding year.

(B) Moves beginning before January 1, 1984. Notwithstanding paragraph (e)(5)(ii)(A) of this section, this paragraph (e)(5)(ii)(B) shall apply for moves begun before January 1, 1984. If a reimbursement for moving expenses is determined to be from foreign sources under paragraph (e)(5)(i) of this section, then for the purpose of determining the amount eligible for exclusion in accordance with paragraphs (d)(2) and (e)(2) of this section, the reimbursement shall be considered attributable to services performed in the year of the move. However, if the individual does not qualify under section 911(d)(1) and § 1.911-2(a) for the entire taxable year of the move, then the individual shall treat a portion of the reimbursement as attributable to services performed in the succeeding taxable year, if the move is from the United States to a foreign country, or to the prior taxable year, if the move is from a foreign country to the United States. The portion of the reimbursement treated as attributable to services performed in the year succeeding or preceding the move shall be determined by multiplying the total reimbursement by the following fraction:

and subtracting the product from the total reimbursement. Amounts treated as attributable to services performed in a year succeeding or preceding the year of the move shall be excludable in the year of receipt only to the extent such amounts could be excluded under paragraph (d)(2) of this section in such succeeding or preceding year.

(f) Examples. The following examples illustrate the application of this section.

Example 1.A is a U.S. citizen and calendar year taxpayer. A’s tax home was in foreign country F and A was physically present in F for 330 days during the period from July 4, 1982 through July 3, 1983. The number of A’s qualifying days in 1982 as determined under paragraph (d)(2) of this section is 181. In 1982 A receives $40,000 attributable to services performed in foreign country F in 1982. Under paragraph (d)(2) of this section A’s section 911(a)(1) limitation is $37,192, that is the lesser of $40,000 (foreign earned income) or

Example 2.The facts are the same as in example 1 except that in 1982 A receives $30,000 attributable to services performed in foreign country F. A excludes this amount from gross income under paragraph (d) of this section. In addition, in 1983 A receives $10,000 attributable to services performed in F in 1982 and $35,000 attributable to services performed in F in 1983. On his return for 1983, A must report $45,000 of income. A’s section 911(a)(1) limitation for 1983 is the lesser of $35,000 (foreign earned income) or $49,329, the annual rate for the taxable year multiplied by a fraction the numerator of which is A’s qualifying days in the taxable year and the denominator of which is the number of days in the taxable year ($80,000 × 184/365). On his tax return for 1983 A may exclude $35,000 attributable to services performed in 1983. A may only exclude $7,192 of the $10,000 received in 1983 attributable to services performed in 1982 because such amount is only excludable in 1983 to the extent such amount could have been excluded in 1982 subject to the section 911(a)(1) limitation for 1982 which is $37,192 ($75,000 × 181/365). No portion of amounts attributable to services performed in 1982 may be used in calculating A’s section 911(a)(1) limitation for 1983. Thus, even though A could have excluded an additional $5,329 in 1983 if A had had more foreign earned income attributable to 1983, A may not exclude the $2,808 of remaining foreign earned income attributable to 1982.

Example 3.C is a U.S. citizen and calendar year taxpayer. C establishes a bona fide residence and a tax home in foreign country J on March 1, 1982, and maintains a tax home and a residence in J until December 31, 1986. In March of 1982 C’s employer, Y corporation, transfers stock in Y to C. The stock is subject to forfeiture if C returns to the U.S. before January 1, 1985. C elects under section 83(b) to include $15,000, the amount determined with respect to such stock under section 83(b)(1), in gross income in 1982. C’s other foreign earned income in 1982 is $58,000. C elects under paragraph (e)(4)(iii)(B) of this section to treat the stock as if earned over the period of the substantial risk of forfeiture. The number of months in the period of the substantial risk of forfeiture is thirty-four. The number of months in the taxable year 1982 within the period of foreign employment is ten. For purposes of determining C’s section 911(a)(1) limitation, $4,412 (($15,000/34) × 10) of the amount included in gross income under section 83(b) is treated as attributable to services performed in 1982, $5,294 is treated as attributable to services to be performed in 1983, and $5,294 is treated as attributable to services to be performed in 1984. In 1982, C excludes $62,412 under section 911(a)(1). That is the lesser of foreign earned income for 1982 ($58,000 + $4,412) or the annual rate for the taxable year multiplied by a fraction the numerator of which is C’s qualifying days in the taxable year and the denominator of which is the number of days in the taxable year ($75,000 × 306/365). C continues to perform services in foreign country J throughout 1983 and 1984. C would be able to exclude the remaining $5,294 attributable to services performed in 1983 and $5,294 attributable to services performed in 1984 if those amounts would be excludable if they had been received in 1983 or 1984 respectively. If C is entitled to exclude the additional amounts, C must claim the exclusion by filing an amended return for 1982.

Example 4.D is a U.S. citizen and a calendar year taxpayer. In September, 1984 D moves to a foreign country K. D is physically present in K, and D’s tax home is in K, from September 15, 1984 through December 31, 1985. D receives $6,000 in April, 1985 from his employer, as a reimbursement for expenses of moving to K, pursuant to a written agreement that such moving expenses would be reimbursed to D upon successful completion of 6 months employment in K. Under paragraph (e)(15)(i) of this section, the reimbursement is attributable to services performed in K. Under the physical presence test of § 1.911-2(a)(2)(ii), among other periods D is a qualified individual for the period of August 10, 1984 through August 9, 1985, which includes 144 days in 1984. Under paragraph (e)(5)(ii)(A) of this section, for the purpose of determining the amount eligible for exclusion, the reimbursement is considered attributable to services performed in 1984 (the year of the move) because D is a qualified individual under § 1.911-2(a) for a period that includes 120 days in 1984. The reimbursement may be excluded under paragraphs (d)(2) and (e)(2) of this section, to the extent that D’s foreign earned income for 1984 that was earned and received in 1984 was less than the annual rate for the taxable year multiplied by the number of D’s qualifying days in the taxable year over the number of days in D’s taxable year ($80,000 × 144/366), or $31,475.

Example 5.The facts are the same as in example 4 except that D is not a qualified individual under the physical presence test, but is a qualified individual under the bona fide residence test for the period of September 15, 1984 through December 31, 1985. Under paragraph (e)(5)(ii)(A) of this section, for the purpose of determining the amount eligible for exclusion, the reimbursement is considered attributable to services performed in 1984 and 1985 because D is not a qualified individual for a period that includes 120 days in 1984 (the year of the move). The portion of the reimbursement treated as attributable to services performed in 1984 is $6,000 × 108/366, or $1,770, and may be excluded, subject to D’s 1984 section 911(a)(1) limitation. The balance of the reimbursement, $4,230, is treated as attributable to services performed in 1985, and may be excluded to the extent provided in paragraphs (d)(2) and (e)(2) of this section.

Example 6.The facts are the same as in example 4, with the following additions. Before D moved to K, D and his employer signed a written agreement that D would perform services for the employer for at least one year, primarily in country K, and, if D did not voluntarily cease to work for the employer primarily in country K before one year had elapsed, the employer would reimburse D for one half of D’s expenses, up to a maximum of $4,000, of moving back to the United States. The agreement also stated that, if D did not voluntarily leave the employment in K before two years had elapsed, the employer would reimburse D for all of D’s reasonable expenses of moving back to the United States. The agreement further stated that D’s right to reimbursement would not be conditioned upon the performance of services after D ceased to work in K. D worked in country K for all of 1985. On January 1, 1986, D left K and moved to the United States. In February, 1986 the employer paid D $3,500 as reimbursement for one-half of D’s expenses of moving to the United States. Although D did not fulfill the condition in the agreement to receive full reimbursement, all of the conditions in the agreement set forth definitely ascertainable standards and no condition could be fulfilled after D moved back to the United States. The agreement fulfills the requirements of paragraph (e)(5)(i) of this section, and therefore is evidence that the reimbursement should not be attributable to future services to be performed at D’s new principal place of work. Under the facts and circumstances, the reimbursement is attributable to services performed in K. Under paragraph (e)(5)(ii)(A) of this section, the entire reimbursement is attributable to services performed in 1985. The amount attributable to 1985 may be excluded to the extent provided in paragraphs (d)(2) and (e)(2) of this section.
(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2966, Jan. 23, 1985]

§ 1.911-4 Determination of housing cost amount eligible for exclusion or deduction.

(a) Definition of housing cost amount. The term “housing cost amount” means an amount equal to the reasonable expenses paid or incurred (as defined in section 7701(a)(25)) during the taxable year by or on behalf of the individual attributable to housing in a foreign country for the individual and any spouse or dependents who reside with the individual (or live in a second foreign household described in paragraph (b)(5) of this section) less the base housing amount as defined in paragraph (c) of this section. The housing cost amount must be reduced by the amount of any military or section 912 allowance or similar allowance excludable from gross income that is intended to compensate the individual or the individual’s spouse in whole or in part for the expenses of housing during the same period for which the individual claims a housing cost amount exclusion or deduction.

(b) Housing expenses – (1) Included expenses. For purposes of paragraph (a) of this section, housing expenses include rent, the fair rental value of housing provided in kind by the employer, utilities (other than telephone charges), real and personal property insurance, occupancy taxes not described in paragraph (b)(2)(v) of this section, nonrefundable fees paid for securing a leasehold, rental of furniture and accessories, household repairs, and residential parking.

(2) Excluded expenses. Housing expenses do not include:

(i) The cost of house purchase, improvements, and other costs that are capital expenditures;

(ii) The cost of purchased furniture or accessories or domestic labor (maids, gardeners, etc.);

(iii) Amortized payments of principal with respect to an evidence of indebtedness secured by a mortgage on the taxpayer’s housing;

(iv) Depreciation of housing owned by the taxpayer, or amortization or depreciation of capital improvements made to housing leased by the taxpayer;

(v) Interest and taxes deductible under section 163 or 164 or other amounts deductible under section 216(a) (relating to deduction of interest and taxes by cooperative housing corporation tenant);

(vi) The expenses of more than one foreign household except as provided in paragraph (b)(5) of this section;

(vii) Expenses excluded from gross income under section 119;

(viii) Expenses claimed as deductible moving expenses under section 217; or

(ix) The cost of a pay television subscription.

(3) Limitation. Housing expenses are taken into account for purposes of this section only to the extent attributable to housing for portions of the taxable year within the period during which the individual satisfies the requirements of § 1.911-2(a). Housing expenses are not taken into account for the period during which the value of the individual’s housing is excluded from gross income under section 119, unless the individual maintains a second foreign household described in paragraph (b)(5) of this section. If an individual maintains two foreign households, only expenses incurred with respect to the abode which bears the closest relationship, not necessarily geographic, with respect to the individual’s tax home shall be taken into account, unless one of the households is a second foreign household.

(4) Reasonableness. An amount paid for housing shall not be treated as reasonable, for purposes of paragraph (a) of this section, to the extent that the expense is lavish or extravagant under the circumstances.

(5) Expenses of a second foreign household – (i) In general. The term “second foreign household” means a separate abode maintained by an individual outside of the U.S. for his or her spouse or dependents (who, if minors, are in the individual’s legal custody or the joint custody of the individual and the individual’s spouse) at a place other than the tax home of the individual because of adverse living conditions at the individual’s tax home. If an individual maintains a second foreign household the expenses of the second foreign household may be included in the individual’s housing expenses under paragraph (b)(1) of this section. Under no circumstances shall an individual be considered to maintain more than one second foreign household at the same time.

(ii) Adverse living conditions. Solely for purposes of paragraph (b)(5)(i) of this section, adverse living conditions are living conditions which are dangerous, unhealthful, or otherwise adverse. Adverse living conditions include a state of warfare or civil insurrection in the general area of the individual’s tax home. Adverse living conditions exist if the individual resides on the business premises of the employer for the convenience of the employer and, because of the nature of the business (for example, a construction site or drilling rig), it is not feasible for the employer to provide housing for the individual’s spouse or dependents. The criteria used by the Department of State in granting a separate maintenance allowance are relevant, but not determinative, for purposes of determining whether a separate household is provided because of adverse living conditions.

(c) Base housing amount – (1) In general. The base housing amount is equal to the product of 16 percent of the annual salary of an employee of the United States who is compensated at a rate equal to the annual salary rate paid for step 1 of grade GS-14, multiplied by the following fraction:

For purposes of the above fraction, the number of qualifying days is determined in accordance with § 1.911-3(d)(3).

(2) Annual salary of step 1 of grade GS-14. The annual salary rate for a step 1 of grade GS-14 is determined on January first of the calendar year in which the individual’s taxable year begins.

(d) Housing cost amount exclusion – (1) Limitation. A qualified individual who has elected to exclude his or her housing cost amount may only exclude the lesser of the full amount of either the individual’s housing cost amount attributable to employer provided amounts or the individual’s foreign earned income for the taxable year. A qualified individual who elects to exclude his or her housing cost amount may not claim less than the full amount of the housing cost exclusion determined under this paragraph.

(2) Employer provided amounts. For purposes of this section, the term “employer provided amounts” means any amounts paid or incurred on behalf of the individual by the individual’s employer which are foreign earned income included in the individual’s gross income for the taxable year (without regard to section 911). Employer provided amounts include, but are not limited to, the following amounts: Any salary paid by the employer to the employee; any reimbursement paid by the employer to the employee for housing expenses, educational expenses for the individual’s dependents, or as part of a tax equalization plan; the fair market value of compensation provided in kind (including lodging, unless excluded under section 119, relating to meals and lodging furnished for the convenience of the employer); and any amount paid by the employer to any third party on behalf of the employee. An individual will only have earnings that are not employer provided amounts if the individual has earnings from self-employment.

(3) Housing cost amount attributable to employer provided amounts. For the purpose of determining what portion of the housing cost amount is excludable and what portion is deductible the following rules apply. If the individual has no income from self-employment, then the entire housing cost amount is attributable to employer provided amounts and is, therefore, excludable to the extent of the limitation provided in paragraph (d)(1) of this section. If the individual only has income from self-employment, then the entire housing cost amount is attributable to non-employer provided amounts and is, therefore, deductible to the extent of the limitation provided in paragraph (e) of this section. In all other instances, the housing cost amount attributable to employer provided amounts shall be determined by multiplying the housing cost amount by the following fraction: Employer provided amounts over foreign earned income for the taxable year. The housing cost amount attributable to non-employer provided amounts shall be determined by subtracting the portion of the housing cost amount attributable to employer provided amounts from the total housing cost amount.

(e) Housing cost amount deduction – (1) In general. If a portion of the individual’s housing cost amount is determined under paragraph (d)(3) of this section to be attributable to non-employer provided amounts, the individual may deduct that amount from gross income for the taxable year but only to the extent of the individual’s foreign earned income (as defined in § 1.911-3) for the taxable year in excess of foreign earned income excluded and the housing cost amount excluded from gross income for the taxable year under § 1.911-3 and this section.

(2) Carryover. If any portion of the individual’s housing cost amount deduction is disallowed for the taxable year under paragraph (e)(1) of this section, such portion shall be carried over and treated as a deduction from gross income for the succeeding taxable year (but only for the succeeding taxable year) to the extent of the excess, if any, of:

(i) The amount of foreign earned income for the succeeding taxable year less the foreign earned income and the housing cost amount excluded from gross income under § 1.911-3 and this section for the succeeding taxable year over,

(ii) The portion, if any, of the housing cost amount that is deductible under paragraph (e)(1) of this section for the succeeding taxable year.

(f) Examples. The following examples illustrate the application of this section. In all examples the annual rate for a step 1 of GS-14 as of January first of the calendar year in which the individual’s taxable year begins is $39,689.

Example 1.B, a U.S. citizen is a calendar year taxpayer who was a bona fide resident of and whose tax home was located in foreign country G for the entire taxable year 1982. B receives an $80,000 salary from B’s employer for services performed in G. B incurs no business expenses. B receives housing provided by B’s employer with a fair rental value of $15,000. The value of the housing furnished by B’s employer is not excluded from gross income under section 119. B pays $10,000 for housing expenses. B’s gross income and foreign earned income for 1982 is $95,000. B elects the foreign earned income exclusion of section 911(a)(1) and the housing cost amount exclusion of section 911(a)(2). B must first compute his housing cost amount exclusion. B’s housing cost amount is $18,650 determined by reducing B’s housing expenses, $25,000 ($15,000 fair rental value of housing and $10,000 of other expenses), by the base housing amount of $6,350 (($39,689 × .16) × 365/365). Because B has no income from self-employment, the entire amount is attributable to employer provided amounts and therefore, is excludable. B’s section 911(a)(1) limitation is $75,000. That is the lesser of $75,000 × 365/365 or $95,000−18,650. B’s total exclusion for 1982 under section 911(a)(1) and (2) is $93,650.

Example 2.The facts are the same as in example 1 except that B’s salary for 1982 is $70,000. B’s foreign earned income for 1982 is $85,000. B’s housing cost amount is $18,650, all of which is attributable to employer provided amounts. B’s housing cost amount is excludable to the extent of the lesser of B’s housing cost amount attributable to employer provided amounts, $18,650, or the foreign earned income for the taxable year, $85,000. Thus, B excludes $18,650 under section 911(a)(2). B’s section 911(a)(1) limitation for 1982 is $66,350 (the lesser of $75,000 × 365/365 or $85,000−18,650). B’s total exclusion for 1982 under section 911(a)(1) and (2) is $85,000.

Example 3.The facts are the same as in example 2 except that in 1983, B receives $5,000 attributable to services performed in 1982. B may exclude the entire $5,000 in 1983 because such amount would have been excludable under § 1.911-3(d)(1) had it been received in 1982.

Example 4.C is a U.S. citizen self-employed and a calendar year and cash basis taxpayer. C arrived in foreign country H on October 3, 1982, and departed from H on March 8, 1984. C’s tax home was located in H throughout that period. C was physically present for 330 full days during the twelve consecutive month period August 30, 1982, through August 29, 1983. The number of C’s qualifying days in 1982 is 124. During 1982 C had $35,000 of foreign earned income, none of which was attributable to employer provided amounts and $8,000 of reasonable housing expenses. C’s housing cost amount is $5,843 ($8,000−((39,689 × .16) × 124/365)). C elects to exclude her foreign earned income under § 1.911-3(d)(1). C’s section 911(a)(1) limitation for 1982 is $25,479 (the lesser of C’s foreign earned income for the taxable year ($35,000) or the annual rate for the taxable year multiplied by the number of C’s qualifying days over the number of days in the taxable year ($75,000 × 124/365 = $25,479). C may not claim the housing cost amount exclusion under section 911(a)(2) because no portion of the housing cost amount is attributable to employer provided amounts. C may deduct the lesser of her housing cost amount ($5,843) or her foreign earned income in excess of amounts excluded under section 911(a) ($35,000−25,479 = $9,521). Thus, C’s housing cost amount deduction is $5,843.

Example 5.The facts are the same as in example 4 except that C had $30,000 of foreign earned income for 1982, none of which was attributable to employer provided amounts. C elects to exclude $25,479 under § 1.911-3(d)(1). C may only deduct $4,521 of her housing cost amount under paragraph (e)(1) of this section because her foreign earned income in excess of amounts excluded under section 911(a) is $4,521($30,000−25,479). The $1,322 of unused housing cost amount deduction may be carried over to the subsequent taxable year.

Example 6.The facts are the same as in example 4 except that C had $15,000 of foreign earned income of 1982, none of which was attributable to employer provided amounts. C elects to exclude the entire $15,000 under § 1.911-3(d)(1). C is not entitled to a housing cost amount deduction for 1982 since she has no foreign earned income in excess of amounts excluded under section 911(a). C may carry over her entire housing cost amount deduction to 1983.

Example 7.The facts are the same as in example 6. In addition, during taxable year 1983 C had $115,000 of foreign earned income, none of which was attributable to employer provided amounts, and $40,000 of reasonable housing expenses C elects to exclude her foreign earned income under § 1.911-3(d)(1). C’s section 911(a)(1) limitation is the lesser of $115,000 or $80,000 ($80,000 × 365/365). C’s housing cost amount for 1983 is $33,650 (40,000−(39,689 × .16) × 365/365). Since no portion of that amount is attributable to employer provided amounts, C may not claim a housing cost amount exclusion. C may deduct the lesser of her housing cost amount ($33,650) or her foreign earned income in excess of amounts excluded under section 911(a) ($115,000−80,000 = 35,000). Thus, C may deduct her $33,650 housing cost amount in 1983. In addition, C may deduct $1,350 of the housing cost amount deduction carried over from taxable year 1982.

(($115.000−80,000)−33,650 = $1,350). The remaining $4,493 ($5,843−1,350) of the housing cost amount deduction carried over from taxable year 1982 may not be deducted in 1983 or carried over to 1984.

Example 8.D is a U.S. citizen and a calendar year and cash basis taxpayer. D is a bona fide resident of and maintains his tax home in foreign country J for all of taxable year 1984. In 1984, D earns $80,000 of foreign earned income, $60,000 of which is an employer provided amount and $20,000 of which is a non-employer provided amount. D’s total housing cost amount for 1984 is $25,000. D elects to exclude, under section 911(a)(2), the portion of his housing cost amount that is attributable to employer provided amounts. D’s excludable housing cost amount is $18,750; that is the total housing cost amount ($25,000) multiplied by employer provided amounts for the taxable year ($60,000) over foreign earned income for the taxable year ($80,000). D also elects to exclude his foreign earned income under § 1.911-3(d)(1). D’s section 911(a)(1) limitation for 1984 is $61,250 (the lesser of $80,000−$18,750 or $80,000 × 366/366). D’s total exclusion for 1984 under section 911(a)(1) and (2) is $80,000. D cannot claim a housing cost amount deduction in 1984 because D has no foreign earned income in excess of his foreign earned income and housing cost amount excluded from gross income for the taxable year under § 1.911-3 and this section. D may carry over his housing cost amount deduction of $6,250, the total housing cost amount less the portion attributable to employer provided amounts ($25,000−18,750), to taxable year 1985.
(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2970, Jan. 23, 1985]

§ 1.911-5 Special rules for married couples.

(a) Married couples with two qualified individuals – (1) In general. In the case in which a husband and wife both are qualified individuals under § 1.911-2(a), each individual may make one or more elections under § 1.911-7 and exclude from gross income foreign earned income and exclude or deduct housing cost amounts subject to the rules of paragraphs (a)(2) and (3) of this section.

(2) Computation of excluded foreign earned income. The amount of excludable foreign earned income is determined separately for each spouse under the rule of § 1.911-3 on the basis of the income attributable to the services of that spouse. If the spouses file separate returns each may exclude the amount of his or her foreign earned income attributable to his or her services subject to the limitations of § 1.911-3(d)(2). If the spouses file a joint return, the sum of these foreign earned income amounts so determined for each spouse may be excluded. For example, H and W both qualify under § 1.911-2(a)(2)(i) for the entire 1983 taxable year. During 1983 W earns $100,000 of foreign earned income and H earns $45,000 of foreign earned income. H and W file a joint return for 1983. On their joint return H and W may exclude from gross income a total of $125,000. That amount is determined by adding W’s section 911(a)(1) limitation, $80,000 (the lesser of $80,000 × 365/365 or $100,000), and H’s section 911(a)(1) limitation, $45,000 (the lesser of $80,000 × 365/365 or $45,000).

(3) Computation of housing cost amount – (i) Spouses residing together. If the spouses reside together, and file a joint return, they may compute their housing cost amount either jointly or separately. If the spouses reside together and file separate returns, they must compute their housing cost amounts separately. If the spouses compute their housing cost amounts separately, they may allocate the housing expenses to either of them or between them for the purpose of calculating separate housing cost amounts, but each spouse claiming a housing cost amount exclusion or deduction must use his or her full base housing amount in such computation. If the spouses compute their housing cost amount jointly, then only one of the spouses may claim the housing cost amount exclusion or deduction.

Either spouse may claim the housing cost amount exclusion or deduction; however, if the spouses have different periods of residence or presence and the spouse with the shorter period of residence or presence claims the exclusion or deduction, then only the expenses incurred in that shorter period may be claimed as housing expenses. The spouse claiming the exclusion or deduction may aggregate the couple’s housing expenses, and subtract his or her base housing amount. For example, H and W reside together and file a joint return. H was a bona fide resident of and maintained his tax home in foreign country M from August 17, 1982, through December 31, 1983. W was a bona fide resident of and maintained her tax home in foreign country M from September 15, 1982, through December 31, 1983. During 1982, H and W earn and receive, respectively, $25,000 and $10,000 of foreign earned income. H paid $10,000 for qualified housing expenses in 1982, $7,500 of that was for qualified housing expenses incurred from September 15, 1982, through December 31, 1982. W paid $3,000 for qualified housing expenses in 1982 all of which were incurred during her period of residence. H and W may choose to compute their housing cost amount jointly. If they do so and H claims the housing cost amount exclusion his exclusion would be $10,617. H’s housing expenses would be $13,000 ($10,000 + $3,000) and his base housing amount would be $2,383 ((39,689 × .16) × 137/365 = $2,383). If instead W claims the housing cost amount exclusion her exclusion would be $8,621. W’s housing expenses would be $10,500 ($7,500 + 3,000) and her base housing amount would be $1,879 (($39,689 × .16) × 108/365 = $1,879). If H and W file jointly and both claim a housing cost amount exclusion, then H’s and W’s housing cost amounts would be, respectively, $7,617 ($10,000−2,383) and $1,121 ($3,000−1,879).

(ii) Spouses residing apart. If the spouses reside apart, both spouses may exclude or deduct their housing cost amount if the spouses have different tax homes that are not within reasonable commuting distance (as defined in § 1.119-1(d)(4)) of each other and neither spouse’s residence is within a reasonable commuting distance of the other spouse’s tax home. If the spouses’ tax homes, or one spouse’s residence and the other spouse’s tax home, are within a reasonable commuting distance of each other, only one spouse may exclude or deduct his or her housing cost amount. Regardless of whether the spouses file joint or separate returns, the amount of the housing cost amount exclusion or deduction must be determined separately for each spouse under the rules of § 1.911-4. If both spouses claim a housing cost amount exclusion or deduction directly as qualified individuals, neither may claim any such exclusion or deduction under section 911(c)(2)(B)(ii), relating to a second foreign household maintained for the other spouse. If one spouse fails to claim a housing cost amount exclusion or deduction which that spouse could claim directly, the other spouse may claim such exclusion or deduction under section 911(c)(2)(B)(ii), relating to a second foreign household maintained for the first spouse, provided that all the requirements of that section are met. Spouses may not claim more than one second foreign household and the expenses of such household may only be claimed by one spouse. For example, if both H and W are qualified individuals and H’s tax home is in London and W’s tax home is in Paris, then both H and W may exclude or deduct their housing cost amounts; however, H and W must compute these amounts separately regardless of whether they file joint or separate returns. If instead of living in Paris, W lives in an area where there are adverse living conditions and W maintains H’s home in London, then W may add those housing expenses to her housing expenses and compute one base housing amount. In that case H may not claim a housing cost amount exclusion or deduction.

(iii) Housing cost amount attributable to employer provided amounts. Each spouse claiming a housing cost amount exclusion or deduction shall compute the portion of the housing cost amount that is attributable to employer provided amounts separately, based on his or her separate foreign earned income, in accordance with § 1.911-4(d)(3).

(b) Married couples with community income. The amount of excludable foreign earned income of a husband and wife with community income is determined separately for each spouse in accordance with paragraph (a) of this section on the basis of income attributable to that spouse’s services without regard to community property laws. See sections 879 and 6013 (g) and (h) for special rules regarding treatment of community income of a nonresident alien individual married to a U.S. citizen or resident.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2972, Jan. 23, 1985]

§ 1.911-6 Disallowance of deductions, exclusions, and credits.

(a) In general. No deduction or exclusion from gross income under subtitle A of the Code or credit against the tax imposed by chapter 1 of the Code shall be allowed to the extent the deduction, exclusion, or credit is properly allocable to or chargeable against amounts excluded from gross income under section 911(a). For purposes of the preceding sentence, deductions, exclusions, and credits which are definitely related (as provided in § 1.861-8), in whole or in part, to earned income shall be allocated and apportioned to foreign earned income and U.S. source earned income in accordance with the rules contained in § 1.861-8. Deductions, exclusions, and credits which are definitely related to all gross income under § 1.861-8, including deductions for interest described in § 1.861-8(e)(2)(ii), are definitely related, in whole or in part, to earned income. In the case of interest expense allocable, in whole or in part, to foreign earned income under § 1.861-8(e)(2)(ii), the expense shall normally be apportioned under option one of the optional gross income methods of apportionment (§ 1.861-8(e)(2)(v)i(A)), but without regard to conditions (1) and (2) of subdivision (vi)(A) (the fifty percent conditions). Such interest expense shall not normally be apportioned under the asset method of § 1.861-8(e)(2)(v). This is because, where section 911 is the operative section, the expense normally relates more closely to gross income generated from activities than to the amount of capital utilized or invested in activities or property. Deductions that are allocated and apportioned to foreign earned income must then be allocated and apportioned to foreign earned income that is excluded under section 911(a). If an individual has foreign earned income from both self-employment and other employment, the amount excluded under section 911(a)(1) shall be deemed to include a pro rata amount of the self-employment income and the income from other employment; thus, a pro rata portion of deductible expenses attributable to self-employment income must be disallowed. For purposes of section 911 (d)(6) and this section only, deductions, exclusions, or credits which are not definitely related to any class of gross income shall not be allocable or chargeable to excluded amounts and are, therefore, deductible to the extent allowed by chapter 1 of the Code. Examples of deductions that are not definitely related to a class of gross income are personal and family medical expenses, qualified retirement contributions (but see section 219(b)(1)), real estate taxes and mortgage interest on a personal residence, charitable contributions, alimony payments, and deductions for personal exemptions. In addition, for purposes of this section, amounts excludable or deductible under section 911 or 119 shall not be allocable or chargeable to other amounts excluded under section 911(a). Thus, an individual’s housing cost amount which is excludable or deductible under § 1.911-4(d) for a taxable year is not apportioned in part to the individual’s foreign earned income which is excluded for such year under § 1.911-3(d). Therefore, the entire amount of such exclusion or deduction is allowed to the extent provided in § 1.911-4. This section does not affect the time for claiming any deduction, exclusion, or credit that is not allocated or apportioned to excluded amounts.

(b) Moving expenses – (1) In general. No deduction shall be allowed for moving expenses under section 217 to the extent the deduction is properly allocable to or chargeable against amounts of foreign earned income excluded from gross income under section 911(a). If an individual’s new principal place of work is in a foreign country, deductible moving expenses will be allocable to foreign earned income. If an individual treats a reimbursement from his employer for the expenses of a move from a foreign country to the United States as attributable to services performed in a foreign country under § 1.911-3(e)(5)(i), then deductible moving expenses attributable to that move will be allocable to foreign earned income. If the individual is a qualified individual who elects to exclude foreign earned income under section 911(a), then some or all of such moving expenses must be disallowed as a deduction.

(2) Attribution of moving expense deduction to taxable years in which services are performed. If a moving expense deduction is properly allocable to foreign earned income, the deduction shall be considered attributable to services performed in the year of the move as long as the individual is a qualified individual under § 1.911-2(a) for a period that includes 120 days in the year of the move. If the individual is not a qualified individual for such period, then the individual shall treat the deduction as attributable to services performed in both the year of the move and the succeeding taxable year, if the move is from the United States to the foreign country, or the prior taxable year, if the move is from a foreign country to the United States. Notwithstanding the preceding two sentences, storage expenses incurred after December 31, 1983 shall be treated as attributable to services performed in the year in which the expenses are incurred.

(3) Formula for disallowance of moving expense deduction. The portion of the moving expense deduction that is disallowed shall be determined by multiplying the moving expense deduction by a fraction the numerator of which is all amounts excluded under section 911(a) for the year or years to which the deduction is attributable (under paragraph (b)(2) of this section) and the denominator of which is foreign earned income (as defined in § 1.911-3(a)) for that year or years.

(4) Effect of disallowance based on attribution of deduction to subsequent year’s income. An individual may claim a moving expense deduction in the taxable year in which the amount of the expense is paid or incurred even if attributable, in part, to the succeeding year. However, at such time as the individual excludes income under section 911(a) for the year or years to which the deduction is attributable, the individual shall either –

(i) File an amended return for the year in which the deduction was claimed that does not claim the portion of the deduction that is disallowed because it is chargeable against excluded income, or

(ii) Include in income for the year following the year in which the deduction was claimed an amount equal to the amount of the deduction that is disallowed.

Any amount included in income under paragraph (b)(4)(ii) of this section is not foreign earned income.

(5) Moves beginning before January 1, 1984. Notwithstanding paragraphs (b)(1) through (3) of this section, the rules of this paragraph (b)(5) shall apply for moves beginning before January 1, 1984.

(i) Individual qualifies for the entire taxable year of the move. If the individual is a qualified individual for the entire taxable year of the move, then the amount of moving expense disallowed shall be determined by multiplying the moving expense deduction otherwise allowable by a fraction the numerator of which is the foreign earned income excluded under section 911(a) for the taxable year of the move and the denominator of which is the foreign earned income for the same taxable year.

(ii) Individual qualifies for less than the entire taxable year of the move. If the individual is a qualified individual for less than the entire taxable year of the move, then, for the purpose of determining the portion of the otherwise allowable moving expense deduction that is disallowed, the individual must attribute a portion of the otherwise allowable moving expense deduction either to the succeeding taxable year, if the move is from the United States to a foreign country, or to the prior taxable year, if the move is from a foreign country to the United States. The portion of the moving expense deduction treated as attributable to services performed in the year of the move shall be determined by multiplying the otherwise allowable moving expense deduction by the following fraction:

The portion of the moving expense deduction treated as attributable to the year succeeding or preceding the move shall be determined by subtracting the portion of the moving expense deduction that is attributable to the year of the move from the total moving expense deduction. The allocation of a portion of the moving expense deduction to a succeeding or preceding taxable year does not affect the time for claiming the allowable moving expense deduction. The portion of the moving expense deduction that is disallowed shall be determined by multiplying the moving expense deduction attributable to the year of the move or the succeeding or preceding year, as the case may be, by a fraction the numerator of which is amounts excluded under section 911(a) for that year and the denominator of which is foreign earned income for that year.

(c) Foreign taxes – (1) Amount disallowed. No deduction or credit is allowed for foreign income, war profits, or excess profits taxes paid or accrued with respect to amounts excluded from gross income under section 911. To determine the amount of disallowed foreign taxes, multiply the foreign tax imposed on foreign earned income (as defined in § 1.911-3(a)) received or accrued during the taxable year by a fraction, the numerator of which is amounts excluded under section 911(a) in such taxable year less deductible expenses properly allocated to such amounts (see paragraphs (a) and (b) of this section), and the denominator of which is foreign earned income (as defined in § 1.911-3(a)) received or accrued during the taxable year less deductible expenses properly allocated or apportioned thereto. For the purpose of determining the extent to which foreign taxes are disallowed, the housing cost amount deduction is treated as definitely related to foreign earned income that is not excluded. If the foreign tax is imposed on foreign earned income and some other income (for example earned income from sources within the United States or an amount not subject to tax in the United States), and the taxes on the other amount cannot be segregated, then the denominator equals the total of the amounts subject to tax less deductible expenses allocable to all such amounts.

(2) Definitions and special rules – (i) Taxable year. For purposes of paragraph (c)(1) of this section, the term “taxable year” means the individual’s taxable year for U.S. tax purposes. Such term includes the portion of any foreign taxable year within the individual’s U.S. taxable year and excludes the portion of any foreign taxable year not within the individual’s U.S. taxable year.

(ii) Apportionment of foreign taxes. For purposes of this paragraph (c), foreign taxes imposed on foreign earned income shall be deemed to accrue, on a pro rata basis, to income as the income is received or accrued. The taxes so accrued shall be apportioned to the taxable year during which the income is received or accrued. This rule applies for all individuals, regardless of their method of accounting.

(iii) Effect of disallowance. The disallowance of foreign taxes under this paragraph (c) shall not affect the time for claiming any deduction or credit for foreign taxes paid. Rather, the disallowance shall only affect the amount of taxes considered paid or accrued to any foreign country.

(iv) Interest on foreign taxes. Any interest expense incurred on a liability for foreign taxes is allocated and apportioned not under this paragraph (c) but under paragraph (a) of this section to foreign earned income and then to excluded foreign earned income and to that extent disallowed as a deduction under paragraph (a). In that regard, see also § 1.861-8(e)(2) for the specific rules for allocation and apportionment of interest expense.

(d) Examples. The following examples illustrate the application of this section.

Example 1.In 1982 A, an architect, operates his business as a sole proprietorship in which capital is not a material income producing factor. A receives $1,000,000 in gross receipts, all of which is foreign source earned income, and incurs $500,000 of otherwise deductible business expenses definitely related to the foreign earned income. A elects to exclude $75,000 under section 911(a)(1). The expenses must be apportioned to excluded earned income as follows: $500,000 × $75,000/1,000,000. Thus, $37,500 of the business expenses are not deductible.

Example 2.The facts are the same as in example 1, except that $100,000 of A’s gross receipts is U.S. source earned income and $68,000 of A’s business expenses are attributable to the U.S. source earned income. Thus, A has $900,000 of foreign earned income and $432,000 of deductions allocated to foreign earned income. The expenses apportioned to excluded earned income are $432,000 × $75,000/$900,000, or $36,000, which are not deductible.

Example 3.B is a U.S. citizen, calendar year and cash basis taxpayer. B moves to foreign country N and maintains a tax home and is physically present there from July 1, 1984 through May 26, 1985. Among other possible periods, B is a qualified individual for 219 days in the year of the move. B pays $6,000 of otherwise deductible moving expenses in 1984. For 1984, B’s foreign earned income is $60,000 and B excludes $47,869 ($80,000 × 219/366) under section 911(a). Under paragraph (b)(2) of this section, B’s moving expenses are attributable to services performed in 1984. Under paragraph (b)(3) of this section, $6,000 × $47,869/$60,000, or $4,789, of B’s moving expense deduction is disallowed. B may deduct $1,211 of moving expenses on his 1984 return.

Example 4.The facts are the same as in example 3 except that B maintains a tax home and is physically present in foreign country N from October 9, 1984 through September 3, 1985. Among other possible periods, B is a qualified individual for no more than 119 days in 1984 and 281 days in 1985. B’s foreign earned income for 1984 is $60,000. B’s foreign earned income for 1985 is $150,000. Because B is a qualified individual for less than 120 days in the year of the move, under paragraph (b)(2) of this section, B’s moving expenses are attributable to services performed in 1984 and 1985. At the close of 1984, B may either seek an extension of time to file under § 1.911-7(c) or may file an income tax return without claiming the exclusions or deduction under section 911. B does not seek an extension and files without excluding foreign earned income; thus B may deduct his moving expenses in full. B later amends his 1984 return and excludes foreign earned income for that year. B excludes foreign earned income for 1985. B must determine the portion of the moving expense deduction that is disallowed. The portion of the moving expense deduction that is disallowed is determined by multiplying the otherwise allowable moving expense deduction by a fraction. The numerator of the fraction is the sum of amounts excluded under section 911(a) for 1984 and 1985, that is $26,082 or $80,000 × 119/365, plus $61,589, or $80,000 × 281/365, which totals $87,671. The denominator of the fraction is the sum of foreign earned income for 1984 and 1985, that is $60,000 plus $150,000, or $210,000. B’s allowable moving expense deduction is $3,495, or $6,000−($6,000 × $87,671/$210,000). If B does not file an amended 1984 return (and does not exclude foreign earned income for 1984), but excludes foreign earned income under section 911(a) for 1985, a portion of his moving expense deduction is disallowed, based on the same formula. The amount disallowed is $6,000 × $61,589/$210,000, or $1,760. This amount may be recaptured either by filing an amended return for 1984 or by including it in income for 1985 (in which case it is not foreign earned income).

Example 5.C is a U.S. citizen, a self-employed individual, and a cash basis and calendar year taxpayer. For the entire 1982 taxable year C maintained his tax home and his bona fide residence in foreign country P. During 1982 C earned and received $120,000 of foreign earned income, none of which was attributable to employer provided amounts. C paid $40,000 of business expenses. C elected to exclude foreign earned income under section 911(a)(1) and claimed a housing cost amount deduction of $15,000. C received $10,000 of foreign source interest income which was included with C’s earned income in a single tax base and taxed at graduated rates. For 1982, C paid $30,000 in income tax to foreign country P. The amount of C’s business expenses that is properly apportioned to excluded amounts (and therefore, not deductible) equals $25,000, which is determined by multiplying the otherwise allowable deductions by C’s excluded amounts over C’s foreign earned income ($40,000 × 75,000/120,000). The amount of country P tax that is properly apportioned to excluded amounts (and therefore, not deductible or creditable) equals $20,000, which is determined by multiplying the tax of $30,000 by the following fraction:

Example 6.D is a U.S. citizen and an accrual basis and calendar year taxpayer for U.S. tax purposes. For the entire period from January 1, 1982 through December 31, 1983, D maintains his tax home and his bona fide residence in foreign country R. For purposes of R’s income tax, D is a cash basis taxpayer and uses a fiscal year that begins on April 1 and ends on the following March 31. During his entire period of residence in R, D receives foreign earned income of $10,000 each month, all of which is attributable to employer provided amounts. For his foreign taxable year ending March 31, 1982, D pays $10,000 of income tax to R. For his foreign taxable year ending March 31, 1983, D pays $54,000 of income tax to R. Under paragraph (c)(2)(ii) of this section, all of the $10,000 of tax paid for this foreign taxable year ending March 31, 1982 is imposed on foreign earned income received in 1982, as is $40,500, or
9/12 × $54,000, of tax paid for his foreign taxable year ending March 31, 1983. (D received $10,000 per month for the last 3 months of his foreign taxable year ending March 31, 1982, all of which are within his U.S. taxable year ending December 31, 1982 under paragraph (c)(2)(i) of this section, and $10,000 per month for each month of his foreign taxable year ending March 31, 1983, of which the first 9 months are within his U.S. taxable year ending December 31, 1982. Under paragraph (c)(2)(ii) of this section, foreign taxes are deemed to accrue on a pro rata basis to income as it is received or accrued. Thus, all of the $10,000 of foreign taxes imposed on the income received during D’s foreign taxable year ending March 31, 1982 accrue to D’s 1982 foreign earned income, as do
9/12 (or $90,000/120,000) of foreign taxes imposed on income received during D’s foreign taxable year ending March 31, 1983, for purposes of determining the amount of D’s foreign taxes that is disallowed.) For 1982, D has no deductible expenses, and elects to exclude his housing cost amount of $21,000 under section 911(a)(2) and foreign earned income of $75,000 under section 911(a)(1). The amount of D’s foreign taxes disallowed for deduction or credit purposes for 1982 is $8,000 (that is, $10,000 × $96,000/$120,000) of the taxes for his foreign taxable year ending March 31, 1982, plus $32,400 (that is, $40,500 × $96,000/$120,000) of the taxes for his foreign taxable year ending March 31, 1983, or $40,400. From 1982, D has $2,000 ($10,000−$8,000) of deductible or creditable taxes accrued on March 31, 1982, and $8,100 ($40,500-$32,400) of deductible or creditable taxes accrued on March 31, 1983, after the disallowance based on his 1982 excluded income.

Example 7.E is a United States citizen, calendar year and cash basis taxpayer. E is physically present in and establishes his tax home in foreign country S on May 1, 1981. For purposes of country S, E’s taxable year begins on April 1 and ends the following March 31. E receives foreign earned income of $15,000 each month beginning on May 1, 1981. At the end of his foreign taxable year ending on March 31, 1982, E pays $70,000 of income tax to S on $165,000 of foreign earned income. Under section 911, as in effect for taxable years beginning before January 1, 1982, E may not exclude any income that is earned or received during 1981. None of E’s taxes paid in 1982 that are attributable to income earned or received in 1981 are subject to disallowance because, under paragraph (c)(2)(ii) of this section, the only taxes disallowed are those deemed to accrue on income earned and received after December 31, 1981, and excluded from gross income. The amount of E’s taxes paid in 1982 that are attributable to 1981 is $50,909, or $70,000 × $120,000/$165,000. E elects to exclude foreign earned income for 1982. The amount of E’s taxes paid to S in 1982 that accrue to 1982 foreign earned income, and are therefore subject to disallowance based on excluded income, is $19,091, or $70,000 × $45,000/$165,000.
(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2973, Jan. 23, 1985]

§ 1.911-7 Procedural rules.

(a) Elections of a qualified individual – (1) In general. In order to receive either exclusion provided by section 911(a), a qualified individual must elect, separately with respect to each exclusion, to exclude foreign earned income under section 911(a)(1) and the housing cost amount under section 911(a)(2). Any such elections may be made on Form 2555 or on a comparable form. Each election must be filed either with the income tax return, or with an amended return, for the first taxable year of the individual for which the election is to be effective. An election once made remains in effect for that year and all subsequent years unless revoked under paragraph (b) of this section. Each election shall contain information sufficient to determine whether the individual is a qualified individual as provided in § 1.911-2. The statement shall include the following information:

(i) The individual’s name, address, and social security number;

(ii) The name of the individual’s employer;

(iii) Whether the individual claimed exclusions under section 911 for earlier years after 1981 and within the five preceding taxable years;

(iv) Whether the individual has revoked a previously made election and the taxable year for which such revocation was effective;

(v) The exclusion or exclusions the individual is electing;

(vi) The foreign country or countries in which the individual’s tax home is located and the date when such tax home was established;

(vii) The status (either bona fide residence or physical presence) under which the individual claims the exclusion;

(viii) The individual’s qualifying period of residence or presence;

(ix) The individual’s foreign earned income for the taxable year including the fair market value of all noncash remuneration; and,

(x) If the individual elects to exclude the housing cost amount, the individual’s housing expenses.

(2) Requirement of a return – (i) In general. In order to make a valid election under this paragraph (a), the election must be made:

(A) With an income tax return that is timely filed (including any extensions of time to file),

(B) With a later return filed within the period prescribed in section 6511(a) amending the foregoing timely filed income tax return,

(C) With an original income tax return that is filed within one year after the due date of the return (determined without regard to any extension of time to file); this one year period does not constitute an extension of time for any purpose – it is merely a period during which a valid election may be made on a late return, or

(D) With an income tax return filed after the period described in paragraphs (a)(2)(i)(A), (B), or (C) of this section provided –

(1) The taxpayer owes no federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached either before or after the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion; or

(2) The taxpayer owes federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached before the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.

(3) A taxpayer filing an income tax return pursuant to paragraph (a)(2)(i)(D)(1) or (2) of this section must type or legibly print the following statement at the top of the first page of the Form 1040: “Filed Pursuant to Section 1.911-7(a)(2)(i)(D).”

(ii) Election for 1982 and 1983 taxable years. Solely for purposes of paragraph (a)(2)(i)(A) of this section, an income tax return for any taxable year beginning before January 1, 1984, shall be considered timely filed if it is filed on or before July 23, 1985.

(3) Housing cost amount deduction. An individual does not have to make an election in order to claim the housing cost amount deduction. However, such individual must provide the Commissioner with information sufficient to determine the individual’s correct amount of tax. Such information shall include the following: The individual’s name, address, and social security number; the name of the individual’s employer; the foreign country in which the individual’s tax home was established; the status under which the individual claims the deduction; the individual’s qualifying period of residence or presence; the individual’s foreign earned income for the taxable year; and the individual’s housing expenses.

(4) Effect of immaterial error or omission. An inadvertent error or omission of information required to be provided to make an election under this paragraph (a) shall not render the election invalid if the error or omission is not material in determining whether the individual is a qualified individual or whether the individual intends to make the election.

(b) Revocation of election – (1) In general. An individual may revoke any election made under paragraph (a) of this section for any taxable year. A revocation must be made separately with respect to each election. The individual may revoke an election for any taxable year, including the first taxable year for which an election was effective, by filing a statement that the individual is revoking one or more of the previously made elections. The statement must be filed with the income tax return, or with an amended return, for the first taxable year of the individual for which the revocation is to be effective. A revocation once made is effective for that year and all subsequent years. If an election is revoked for any taxable year, including the first taxable year for which the election was effective, the individual may not, without the consent of the Commissioner, again make the same election until the sixth taxable year following the taxable year for which the revocation was first effective. For example, a qualified individual makes an election to exclude foreign earned income under section 911(a)(1) and files it with his 1982 income tax return. The individual files 1983 and 1984 income tax returns on which he excludes his foreign earned income. Then, within 3 years after filing his 1982 income tax return, the individual files an amended 1982 income tax return with a statement revoking his election to exclude foreign earned income under section 911(a)(1). The revocation of the election is effective for taxable years 1982, 1983, and 1984. The individual may not elect to exclude income under section 911(a)(1) for any taxable year before 1988, unless he obtains consent to reelect under paragraph (b)(2) of this section.

(2) Reelection before sixth taxable year after revocation. If an individual revoked an election under paragraph (b)(1) of this section and within five taxable years the individual wishes to reelect the same exclusion, then the individual may apply for consent to the reelection. The application for consent shall be made by requesting a ruling from the Associate Chief Counsel (Technical), National Office, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC 20224. In determining whether to consent to reelection the Associate Chief Counsel or his delegate shall consider any facts and circumstances that may be relevant to the determination. Relevant facts and circumstances may include the following: a period of United States residence, a move from one foreign country to another foreign country with differing tax rates, a substantial change in the tax laws of the foreign country of residence or physical presence, and a change of employer.

(c) Returns and extensions – (1) In general. Any return filed before completion of the period necessary to qualify an individual for any exclusion of deduction provided by section 911 shall be filed without regard to any exclusion or deduction provided by that section. A claim for a credit or refund of any overpayment of tax may be filed, however, if the taxpayer subsequently qualifies for any exclusion or deduction under section 911. See section 6012(c) and § 1.6012-1(a)(3), relating to returns to be filed and information to be furnished by individuals who qualify for any exclusion or deduction under section 911.

(d) Declaration of estimated tax. In estimating gross income for the purpose of determining whether a declaration of estimated tax must be made for any taxable year, an individual is not required to take into account income which the individual reasonably believes will be excluded from gross income under the provisions of section 911. In computing estimated tax, however, the individual must take into account, among other things, the denial of the foreign tax credit for foreign taxes allocable to the excluded income (see § 1.911-6(c)).

(e) Effective/applicability date. This section applies to applications for extension of time to file returns filed after July 1, 2008.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2976, Jan. 23, 1985, as amended by T.D. 8480, 58 FR 34885, June 30, 1993; 73 FR 37365, July 1, 2008]

§ 1.911-8 Former deduction for certain expenses of living abroad.

For rules relating to the deduction for certain expenses of living abroad applicable to taxable years beginning before January 1, 1982, see 26 CFR 1.913-1 through 1.913-13 as they appeared in the Code of Federal Regulations revised as of April 1, 1982.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2977, Jan. 23, 1985]

earned income of citizens of united states

§ 1.912-1 Exclusion of certain cost-of-living allowances.

(a) Amounts received by Government civilian personnel stationed outside the continental United States as cost-of-living allowances in accordance with regulations approved by the President are, by the provisions of section 912(1), excluded from gross income. Such allowances shall be considered as retaining their characteristics under section 912(1) notwithstanding any combination thereof with any other allowance. For example, the cost-of-living portion of a “living and quarters allowance” would be excluded from gross income whether or not any other portion of such allowance is excluded from gross income.

(b) For purposes of section 912(1), the term “continental United States” includes only the 48 States existing on February 25, 1944 (the date of the enactment of the Revenue Act of 1943 (58 Stat. 21)) and the District of Columbia.

§ 1.912-2 Exclusion of certain allowances of Foreign Service personnel.

Gross income does not include amounts received by personnel of the Foreign Service of the United States as allowances or otherwise under the provisions of chapter 9 of title I of the Foreign Service Act of 1980 or the provisions of section 28 of the State Department Basic Authorities Act (formerly section 914 of title IX of the Foreign Service Act of 1946).

[T.D. 8256, 54 FR 28620, July 6, 1989]

§ 1.921-1T Temporary regulations providing transition rules for DISCs and FSCs.

(a) Termination of a DISC – (1) At end of 1984.

Q-1: What is the effect of the termination on December 31, 1984, of a DISC’s taxable year?

A-1: Without regard to the annual accounting period of the DISC, the last taxable year of each DISC beginning during 1984 shall be deemed to close on December 31, 1984. The corporation’s DISC election also shall be deemed revoked at the close of business on December 31, 1984. (A DISC that does not elect to be an interest charge DISC as of January 1, 1985, in addition to a corporation described in section 992(a)(3), shall be referred to as a “former DISC”.) A corporation which wishes to be treated as a FSC, a small FSC, or an interest charge DISC must make an election as provided under paragraph (b) (Q & A #1) of this section.

(2) Deemed distributions for short taxable years.

Q-2: If the termination of the DISC’s taxable year on December 31, 1984, results in a short taxable year, how are the deemed distributions under section 995(b)(1)(E) determined?

A-2: The deemed distributions are determined on the basis of the DISC’s taxable income for its short taxable year ending on December 31, 1984. In computing the incremental distribution under section 995(b)(1)(E), the export gross receipts for the short taxable year must be annualized.

(3) Qualification as a DISC for 1984.

Q-3: Must the DISC satisfy all the tests set forth in section 992(a)(1) for the DISC’s taxable year ending December 31, 1984?

A-3: All of the tests under section 992(a)(1), except the qualified assets test under section 992(a)(1)(B), must be satisfied.

(4) Commissions for 1984.

Q-4: Must commissions be paid by a related supplier to a DISC with respect to the DISC’s taxable year ending December 31, 1984?

A-4: No.

Q-4A: Must commissions which were earned prior to January 1, 1985, be paid by a related supplier if the last date payment is required (as set forth in § 1.994-1(e)(3)) is after December 31, 1984?

A-4A: No.

(5) Producer’s loans of 1984.

Q-5: Must the producer’s loan rules under section 993(d) be satisfied with respect to the DISC’s taxable year ending December 31, 1984?

A-5: Yes.

(6) Accumulated DISC income.

Q-6. Under what circumstances is any remaining accumulated DISC income treated as previously taxed income (and not taxed)?

A-6. The accumulated DISC income of a DISC (but not a DISC described in section 992(a)(3)) as of December 31, 1984, is treated as previously taxed income when actually distributed after December 31, 1984. Any amounts distributed by the former DISC (including a DISC which has elected to be an interest charge DISC) after December 31, 1984, shall be treated as made first out of current earnings and profits and then out of previously taxed income to the extent thereof. For purposes of the preceding sentence, amounts distributed before July 1, 1985, shall be treated as made first out of previously taxed income to the extent thereof. If property other than money is distributed and if such property was a qualified export asset within the meaning of section 993(b) on December 31, 1984, then for purposes of section 311, no gain or loss will be recognized on the distribution and the distributee will have the same basis in the property as the distributor.

Q-7: May a DISC that was previously disqualified, but has requalified as of December 31, 1984, treat any accumulated DISC income as previously taxed income?

A-7: If a DISC was previously disqualified, but has requalified as of December 31, 1984, any accumulated DISC income previously required to be taken into income upon prior disqualification shall not be treated as previously taxed income. All accumulated DISC income derived since requalification, however, will be treated as previously taxed income.

(7) Distribution of previously taxed income.

Q-8: What effect will the distribution of previously taxed income have on the earnings and profits of corporate shareholders of the former DISC?

A-8: The earnings and profits of the corporate shareholders of the former DISC will be increased by the amount of money and the adjusted basis of any property which is distributed out of previously taxed income.

Q-9: Will the distribution of the former DISC’s accumulated DISC income as previously taxed income after December 31, 1984, result in a reduction in the shareholder’s basis of the stock of the former DISC and consequent taxation of the excess of the distribution over such basis as capital gain under section 996(d)?

A-9: No. This distribution will be treated both as amounts representing deemed distributions under section 995(b)(1) and as previously taxed income. Thus, no capital gain will arise.

(8) Qualifying distributions.

Q-10: How is a qualifying distribution to satisfy the qualified export receipts tests under section 992(c)(1)(A) which is made with respect to the DISC’s taxable year ending on December 31, 1984, treated?

A-10: The distribution will not be treated as previously taxed income but will be taxed to the shareholder of the former DISC, as provided under section 992(c) and 996(a)(2) and the regulations thereunder, in the shareholder’s taxable year in which the distribution is made.

(9) Deficiency distributions.

Q-11: With respect to an audit adjustment made after December 31, 1984, may a deficiency distribution be made, and if so, in what manner may it be made?

A-11: A deficiency distribution may be made notwithstanding the fact that after December 31, 1984, the former DISC is a taxable corporation under subchapter C, has elected to be treated as an interest charge DISC, or has been liquidated, reorganized or is otherwise no longer in existence. However, such deficiency distribution shall be treated as made out of accumulated DISC income which is not previously taxed income because it will be treated as distributed prior to December 31, 1984, to the DISC’s shareholders.

Q-11A: Must a former DISC remain in existence in order for a former DISC shareholder to take advantage of the spread provided in section 995(b)(2) with respect to DISC disqualification?

A-11A: No. With respect to distributions deemed to be received by a former DISC shareholder under section 995(b)(2) for taxable years beginning after December 31, 1984, if the former DISC shareholder elects, the rules of section 995(b)(2)(B) shall apply even though the former DISC does not continue in existence. If the former DISC is no longer in existence, the former DISC’s shareholders will be deemed to have received the distribution on the last day of their taxable years over the applicable period of time determined under section 995(b)(2) as if the former DISC had remained in existence.

(10) Deemed distribution for 1984.

Q-12: How is the deemed distribution to a shareholder for the DISC’s taxable year ending December 31, 1984, taken into account?

A-12 (i) If the taxable year of the DISC ending on December 31, 1984, (A) is the first taxable year of the DISC which begins in 1984, (B) begins after the date in 1984 on which the taxable year of the DISC’s shareholder begins, and (C) if the DISC’s shareholder makes an election under section 805(b)(3) of the Tax Reform Act of 1984, the deemed distribution under section 995(b) with respect to income derived by the DISC for such taxable year of the DISC shall be treated as received by the shareholder in 10 equal installments (unless the shareholder elects to be treated as receiving the deemed distribution in income over a smaller number of equal installments). The first installment shall be treated as received by the shareholder on the last day of the shareholder’s second taxable year beginning in 1984 (if any), or if the shareholder had only one taxable year which began in 1984, on the last day of the shareholder’s first taxable year beginning in 1985. One installment shall be treated as received by the shareholder on the last day of each succeeding taxable year of the shareholder until the entire amount of the DISC’s 1984 deemed distribution has been included in the shareholder’s taxable income. To make the election under section 805(b)(3) of the Tax Reform Act of 1984, the DISC shareholder must attach a statement to its timely filed tax return (including extensions) for its taxable year which includes December 31, 1984, indicating the total amount of the shareholder’s pro rata share of the DISC’s deemed distribution for 1984 (determined under section 995(b) of the Code without regard to the election under section 805(b)(3) of the Tax Reform Act of 1984), and the number of equal installments, if less than 10, over which the shareholder wishes to spread its pro rata share of the deemed distribution for 1984. If the election under section 805(b)(3) of the Tax Reform Act of 1984 is made, it may not be changed or revoked. In determining estimated tax payments, the portion of the deemed distribution includible in the shareholder’s taxable income for any taxable year under this subdivision (i) shall be treated as received by the shareholder on the last day of such taxable year.

(ii) Except as provided in subdivision (i), the deemed distribution under section 995(b) with respect to income derived by the DISC for its taxable year ending on December 31, 1984, shall be included in the shareholder’s taxable income for its taxable year which includes December 31, 1984. Thus, if the taxable year of the DISC and the DISC’s shareholder both begin on January 1, 1984, and end on December 31, 1984 (or, if the taxable year of the DISC beginning in 1984 begins before the taxable year of the DISC’s shareholder), the deemed distribution with respect to the DISC’s taxable year ending on December 31, 1984, will be included in the DISC shareholder’s taxable year ending on (or including) December 31, 1984, and the election described in subdivision (i) may not be made.

(iii) The provisions of this Question and Answer-12 apply without regard to any existence of the DISC after December 31, 1984, as an interest charge DISC.

Q-12A: If under section 805(b)(3) of the Tax Reform Act of 1984 the shareholders of the DISC are permitted to make an election to treat the DISC’s 1984 deemed distribution as received over a 10-year period, must the DISC distribute that amount to its shareholders ratably over the 10-year period?

A-12A: No. Under section 805(b)(3) of the Tax Reform Act of 1984, if the DISC’s deemed distribution for its taxable year which ended on December 31, 1984, is a qualified distribution, the shareholders of the DISC are permitted to make an election to treat the distribution as received over a 10-year period. The 10-year treatment applies even though the amount of the deemed distribution is distributed to the DISC’s shareholders prior to the period in which the distribution is taken into income by the shareholders. In addition, under section 996(e) of the Code, the shareholder’s basis in the stock of the DISC will be considered as increased, as of the date of liquidation, by the shareholder’s pro rata share of the amount of the undistributed qualified distribution even though that amount is treated as received by the shareholder in later years. Further, the actual distribution in liquidation of the former DISC after 1984 will increase the earnings and profits of a corporate distributee, and the amount actually distributed shall be treated under the rules of section 996.

(11) Conformity of accounting period.

Q-13: May a DISC be established or change its annual accounting period for taxable years beginning after March 21, 1984, and before January 1, 1985?

A-13: A DISC that is established or that changes its annual accounting period after March 21, 1984, must conform its annual accounting period to that of its principal shareholder (the shareholder with the highest percentage of voting power as defined in section 441(h)).

(12) DISC gains and distributions from U.S. sources.

Q-14: What is the effective date of the amendment to section 996(g), made by section 801(d)(10) of the Tax Reform Act of 1984, which treats certain DISC gains and distributions as derived from sources within the United States?

A-14: Under section 805(a)(3) of the Act, the amendment to section 996(g) shall apply to all gains referred to in section 995(c) and all distributions out of accumulated DISC income including deemed distributions made on or after June 22, 1984.

(b) Establishing and electing status as a FSC, small FSC or interest charge DISC – (1) Ninety-day period.

Q-1: How does a corporation elect to be treated as a FSC, a small FSC, or an interest charge DISC?

A-1: A corporation electing FSC or small FSC status must file Form 8279. A corporation electing interest charge DISC status must file Form 4876A. A corporation electing to be treated as a FSC, small FSC, or interest charge DISC for its first taxable year shall make its election within 90 days after the beginning of that year. A corporation electing to be treated as a FSC, small FSC, or interest charge DISC for any taxable year other than its first taxable year shall make its election during the 90-day period immediately preceding the first day of that taxable year. The election to be a FSC, small FSC, or interest charge DISC may be made by the corporation, however, during the first 90 days of a taxable year, even if that taxable year is not the corporation’s first taxable year, if that taxable year begins before July 1, 1985. Likewise, the election to be a FSC (or a small FSC) may be made during the first 90 days of any taxable year of a corporation if the corporation had in a prior taxable year elected small FSC (or FSC) status and the corporation revokes the small FSC (or FSC) election within the 90 day period. A corporation which was a DISC for its taxable year ending December 31, 1984, which wishes to be treated as an interest charge DISC beginning with its first taxable year beginning after December 31, 1984, may make the election to be treated as an interest charge DISC by filing Form 4876A on or before July 1, 1987. Also, if a corporation which has elected FSC, small FSC or interest charge DISC status, or a shareholder of that corporation, is acquired in a qualified stock purchase under section 338(d)(3), and if an election under section 338(a) is effective with regard to that corporation, the corporation may re-elect FSC, small FSC or interest charge DISC status, (whichever is applicable) not later than the date of the election under section 338(a), see section 338(g)(i) and § 1.338-2(d). This re-election is necessary because the original elections are deemed terminated if an election is made under section 338(a). The rules contained in § 1.992-2 (a)(1), (b)(1) and (b)(3) shall apply to the manner of making the election and the manner and form of shareholder consent.

(2) FSC incorporated in a possession.

Q-2: Where does a FSC which is incorporated in a U.S. possession file its election?

A-2: The election is filed with the Internal Revenue Service Center, Philadelphia, Pennsylvania 19255.

(3) Information returns.

Q-3: Must Form 5471 be filed with respect to the organization of a FSC pursuant to section 6046 or to provide information with respect to a FSC pursuant to section 6038?

A-3: A Form 5471 required under section 6046 need not be filed with respect to the organization of a FSC. The requirements of section 6046 shall be satisfied by the filing of a Form 8279 dealing with the election to be treated as a FSC or small FSC. However, a Form 5471 will be required with respect to a reorganization of a FSC (or small FSC) or an acquisition of stock of a FSC (or small FSC), as required under section 6046 and the regulations thereunder. Provided that a Form 1120 FSC is filed, a Form 5471 need not be filed to satisfy the requirements of section 6038.

(4) Conformity of accounting period.

Q-4: Since a FSC, small FSC, and interest charge DISC must use the same annual accounting period as the principal shareholder, must such corporation delay the beginning of its first taxable year beyond January 1, 1985 if the principal shareholder (the shareholder with the highest percentage of voting power as defined in section 441(h)) is not a calendar year taxpayer?

A-4: No. Where the principal shareholder is not a calendar year taxpayer, a corporation may elect to be treated as a FFSC, small FSC, or interest charge DISC for a taxable year beginning January 1, 1985. However, such corporation must close its first taxable year and adopt the annual accounting period of its principal shareholder as of the first day of the principal shareholder’s first taxable year beginning in 1985. A FSC, small FSC, or interest charge DISC need not obtain the consent of the Commissioner under section 442 to conform its annual accounting period to the annual accounting period of its principal shareholder.

(5) Dollar limitations for short taxable years.

Q-5: If a small FSC or an interest charge DISC has a short taxable year, how are the dollar limitations on foreign trading export gross receipts and qualified export gross receipts, respectively, determined for small FSCs and interest charge DISCs?

A-5: The dollar limitations are to be prorated on a daily basis. Thus, for example, if for its 1985 taxable year a small FSC has a short taxable year of 73 days, then in determining exempt foreign trade income, any foreign trading gross receipts that exceed $1 million (73/365 × $5 million) will not be taken into account.

(6) Change of accounting period.

Q-6: If the principal shareholder of a FSC, a small FSC, or an interest charge DISC (hereinafter referred to as a “FSC”) changes its annual accounting period or is replaced by a new principal shareholder during a taxable year, is it necessary for the FSC to change its annual accounting period?

A-6: If the principal shareholder changes its annual accounting period, the FSC must also change its annual accounting period to conform to that of its principal shareholder. If the voting power of the principal shareholder is reduced by an amount equal to at least 10 percent of the total shares entitled to vote and such shareholder is no longer the principal shareholder, the FSC must conform its accounting period to that of its new principal shareholder. However, in determining whether a shareholder is a principal shareholder, the voting power of the shareholders is determined as of the beginning of the FSC’s taxable year. Thus, for example, assume that for 1985 a FSC adopts a calendar year period as its annual accounting period to conform to that of its principal shareholder. Assume further than in March 1985 there is a 10 percent change in voting power and a different shareholder whose annual accounting period begins on July 1 becomes the new principal shareholder. The FSC will not be required to adopt the annual accounting period of its new principal shareholder until July 1, 1986. The FSC will have a short taxable year for the period January 1 to June 30, 1986.

(7) Transition transfers.

Q-7. Under what circumstances may a DISC or former DISC transfer its assets to a FSC or small FSC without incurring any tax liability on the transfer?

A-7. A DISC or former DISC will recognize no income, gain, or loss on a transfer of its qualified assets (as defined in section 993(b)) to a FSC or small FSC if all of the following conditions are met:

(i) The assets transferred were held by the DISC on August 4, 1983, and were transferred by the DISC or former DISC to the FSC or small FSC in a transfer completed before January 1, 1986; and

(ii) The assets are transferred in a transaction which would qualify for nonrecognition under subchapter C of chapter 1 of the Code, or would so qualify but for section 367 of the Code.

In such case, section 367 shall not apply to the transfer.

In addition, other provisions of subchapter C will apply to the transfer, such as section 358 (basis to shareholders), section 362 (basis to corporations), and section 381 (carryovers in corporate acquisitions). In determining whether a transfer by a DISC to a FSC or small FSC qualifies for nonrecognition under subchapter C, a liquidation of the assets of the DISC into a parent corporation followed by a transfer by the parent of those assets to the FSC or small FSC will be treated as a transaction described in section 368(a)(1)(D).

Notwithstanding the foregoing answer, a taxpayer which transfers a right to use its corporate name to a FSC in a transaction described in sections 332, 351, 354, 356 and 361 shall not be treated as having sold that right under section 367(d) or as having transferred that right to an entity that is not a corporation under section 367(a) provided that the corporate name is used only by the FSC and is not licensed or otherwise made available to others by the FSC.

(8) Completed contract method.

Q-8: Under what conditions is a taxpayer using the completed contract method of accounting as defined in § 1.451-3(d) exempted from satisfying the foreign management and foreign economic process requirements of subsections (c) and (d) of section 924?

A-8: If the taxpayer has entered into a binding contract before March 16, 1984, or has on March 15, 1984, and at all times thereafter a firm plan, evidenced in writing, to enter the contract and enters into a binding contract by December 31, 1984, then the taxpayer will be treated as having satisfied the foreign management tests of section 924(c) for periods before December 31, 1984, and the foreign economic process tests of section 924(d) with respect to costs incurred before December 31, 1984, with respect to the transaction. The FSC rules will apply to the income from the long-term contract if an election is made and the general FSC requirements under section 922 are satisfied. However, such taxpayer need not satisfy the activities test under section 925(c) for activities which occur before January 1, 1985 in order to use the transfer pricing rules under section 925.

(9) Long-term contract – before March 15, 1984.

Q-9: Under what conditions is a taxpayer who enters into a binding long-term contract (i.e., a contract which is not completed in the taxable year in which it is entered into) before March 15, 1984, but does not use the completed contract method of accounting exempted from satisfying the foreign management and economic process requirements of subsections (c) and (d) of section 924?

A-9: If a taxpayer enters into a binding contract before March 15, 1984, the taxpayer will be treated as having satisfied the foreign management tests of section 924(c) for periods before December 31, 1984, and the foreign economic process tests of section 924(d) with respect to costs incurred before December 31, 1984, but only with respect to income attributable to such contracts that is recognized before December 31, 1986. The FSC rules will apply to the income from the long-term contract if an election is made and the general FSC requirements under section 922 are satisfied. However, such taxpayer need not satisfy the activities test under section 925(c) for activities which occur before January 1, 1985, in order to use the transfer pricing rules under section 925.

(10) Long-term contract – after March 15, 1984.

Q-10: Under what conditions is a taxpayer who has a long-term contract (i.e., a contract which is not completed in the taxable year in which it is entered into) but does not use the completed contract method of accounting exempted from satisfying the foreign management and economic process requirements of subsections (c) and (d) of section 924 if such taxpayer enters into a binding contract after March 15, 1984 and before January 1, 1985?

A-10: If a taxpayer enters into a contract after March 15, 1984, and before January 1, 1985, the taxpayer will be treated as having satisfied the foreign management tests of section 924(c) for periods before December 31, 1984, and the foreign economic process tests of section 924(d) with respect to costs incurred before December 31, 1984, but only with respect to income attributable to such contract that is recognized before December 31, 1985.

The FSC rules will apply to the income from the long-term contract if an election is made and the general requirements under section 922 are satisfied. However, such taxpayer need not satisfy the activities test under section 925(c) for activities which occur before January 1, 1985 in order to use the transfer pricing rules under section 925.

(11) Incomplete transactions.

Q-11: In computing its foreign trade income, how should a FSC treat transfers of export property from a related supplier to a DISC which is subsequently resold by a FSC after the DISC’s termination?

A-11: In applying the gross receipts and combined taxable income methods under section 925 (a)(1) and (a)(2), the transaction is treated as if the transfer of export property were made by the related supplier to the FSC except that the foreign management and economic processes tests under section 924 and the activities test under section 925(c) shall be deemed to be satisfied for purposes of the transaction.

(12) Pre-effective date costs and activities.

Q-12: Are costs incurred and activities performed prior to January 1, 1985 taken into account for purposes of satisfying the foreign management and foreign economic processes requirements of subsections (c) and (d) of section 924 and the activities test under section 925(c)?

A-12: For purposes of determining the costs incurred and the activities performed to be taken into account with respect to contracts entered into after December 31, 1984, only those costs incurred and activities performed after December 31, 1984, are taken into consideration. Costs incurred and activities performed by a related supplier prior to January 1, 1985 (or prior to the effective date of a corporation’s election to be treated as a FSC if other than January 1, 1985) with respect to transactions occurring after January 1, 1985 (or after the effective date of a corporation’s election to be treated as a FSC) need not be taken into account for purposes of computing the FSC’s profit under section 925 but are treated for section 925(c) purposes as if they were performed on behalf of the FSC.

(13) FSC and interest charge DISC.

Q-13: Can a FSC and an interest charge DISC be members of the same controlled group?

A-13: A FSC and an interest charge DISC cannot be members of the same controlled group. If any controlled group of corporations of which an interest charge DISC is a member establishes a FSC, then any interest charge DISC which is a member of such group shall be treated as having terminated its status as an interest charge DISC.

Q-1: Under what circumstances are earnings of an export trade corporation that have not been included in income under section 951 treated as previously taxed income previously included in the income of a U.S. shareholder for purposes of section 959 (and not taxed)?

A-1: A corporation which qualifies as an export trade corporation (ETC) with respect to its last taxable year beginning before January 1, 1985, and elects to discontinue operations as an ETC for all taxable years beginning after December 31, 1984, shall not be required to take into income earnings attributable to previously excluded export trade income, as defined in § 1.970-1(b), derived with respect to taxable years beginning before January 1, 1985. However, any amounts distributed by the former ETC (i.e. a corporation which was an ETC for its last taxable year beginning before January 1, 1985) shall be treated as being made out of current earnings and profits and then out of previously taxed income. For purposes of determining the shareholder’s basis in the ETC stock, distributions of previously excluded export trade income shall be treated as if made out of previously taxed income which has already been included in gross income under section 951(a)(1)(B). Thus, no basis adjustment under section 961 is necessary. In addition, upon the sale or exchange of the stock of such corporation in a transaction described in section 1248(a), the earnings and profits of the corporation attributable to such previously untaxed income shall not be subject to section 1248(a).

(2) Qualification as an ETC for last year.

Q-2: Must an ETC satisfy all of the tests set forth in section 971(a)(1) for the ETC’s last taxable year beginning before January 1, 1985?

A-2: All of the tests in section 971(a)(1) must be satisfied, except that for purposes of the working capital requirements set forth in section 971(c)(1), the working capital of the ETC at the close of its last taxable year beginning before January 1, 1985 shall be deemed reasonable.

(3) Continuation of ETC status.

Q-3: May a corporation which chooses to remain an ETC after December 31, 1984, continue to do so?

A-3: Yes. However, previously untaxed income of such ETC shall not be treated as previously taxed income in accordance with Q&A #1 of this section.

(4) Discontinuation of ETC status.

Q-4: How does an ETC make an election to discontinue its operation as an ETC?

A-4: The United States shareholders (as defined in section 951(b)) must file a statement of election on behalf of the ETC indicating the intent of the ETC to discontinue operations as an ETC for taxable years beginning after December 31, 1984. In addition, the statement of election must include the name, address, taxpayer identification number and stock interest of each United States shareholder. The statement must also indicate that the corporation on behalf of which the shareholders are making the election qualified as an ETC for its last taxable year beginning before January 1, 1985, and also the amount of earnings attributable to previously excluded export trade income. The statement must be jointly signed by each United States shareholder with each shareholder stating under penalties of perjury that he or she holds the stock interest specified for such shareholder in the statement of election. A copy of the statement of election must be attached to Form 5471 (information return with respect to a foreign corporation) filed with respect to the ETC’s last taxable year beginning before January 1, 1985.

(5) Transition transfers.

Q-5: Under what circumstances may an electing ETC transfer its assets to a FSC without incurring any tax liability on the transfer?

A-5: An electing ETC will recognize no income, gain, or loss on a transfer of its assets to a FSC but only if all of the following conditions are met:

(i) The assets transferred were held by the ETC on August 4, 1983, and were transferred by the ETC to the FSC in a transfer completed before January 1, 1986; and

(ii) The assets are transferred in a transaction which would qualify for nonrecognition under subchapter C of chapter 1 of the Code, or would so qualify but for section 367 of the Code.

In such case, section 367 shall not apply to the transfer. In addition, other provisions of subchapter C will apply to the transfer such as section 358 (basis to shareholders), section 362 (basis to corporation) and section 381 (carryovers in corporate acquisitions). In determining whether a transfer by an ETC to a FSC qualifies for nonrecognition under subchapter C, a liquidation of the assets of the ETC into a parent corporation followed by a transfer by the parent of those assets to the FSC will be treated as a transaction described in section 368(a)(1)(D).

(Secs. 803 and 805 of the Tax Reform Act of 1984 (98 Stat. 1001) and sec. 7805 of the Internal Revenue Code of 1954 (68A Stat. 917; 26 U.S.C. 7805); sec. 805 (b)(3)(C) and (D) of the Tax Reform Act of 1984 (98 Stat. 1002), and sec. 7805 of the Code (68A Stat. 917; 26 U.S.C. 7805); secs. 367, 927, and 7805 of the Internal Revenue Code of 1954 (98 Stat. 662, 26 U.S.C. 367; 98 Stat. 663, 26 U.S.C. 367; 98 Stat. 993, 26 U.S.C. 927; 98 Stat. 994, 26 U.S.C. 927; and 68A Stat. 917, 26 U.S.C. 7805); sec. 805 of the Tax Reform Act of 1984 (Pub. L. 98-69, 98 Stat. 1000))

[T.D. 7983, 49 FR 40013, Oct. 12, 1984, as amended by T.D. 7992, 49 FR 48283, Dec. 12, 1984; T.D. 7993, 49 FR 48291, Dec. 12, 1984; T.D. 7992, 49 FR 49450, Dec. 20, 1984; T.D. 8126, 52 FR 6434, 6435, Mar. 3, 1987; T.D. 8515, 59 FR 2984, Jan. 20, 1994; T.D. 8858, 65 FR 1237, Jan. 7, 2000; T.D. 8940, 66 FR 9929, Feb. 13, 2001]

§ 1.921-2 Foreign Sales Corporation – general rules.

(a) Definition of a FSC and the Effect of a FSC Election.

Q-1. What is the definition of a Foreign Sales Corporation (hereinafter referred to as a “FSC” (All references to FSCs include small FSCs unless indicated otherwise))?

A-1. As defined in section 922(a), an FSC must satisfy the following eight requirements.

(i) The FSC must be a corporation organized or created under the laws of a foreign country that meets the requirements of section 927(e)(3) (a “qualifying foreign country”) or a U.S. possession other than Puerto Rico (an “eligible possession”). See Q&As 3, 4, and 5 of § 1.922-1.

(ii) A FSC may not have more than 25 shareholders at any time during the taxable year. See Q&A 6 of § 1.922-1.

(iii) A FSC may not have any preferred stock outstanding during the taxable year. See Q&As 7 and 8 of § 1.922-1.

(iv) A FSC must maintain an office outside of the United States in a qualifying foreign country or an eligible possession and maintain a set of permanent books of account (including invoices or summaries of invoices) at such office. See Q&As 9, 10, 11, 12, 13, 14, and 15 of § 1.922-1.

(v) A FSC must maintain within the United States the records required under section 6001. See Q&A 16 of § 1.922-1.

(vi) The FSC must have a board of directors which includes at least one individual who is not a resident of the United States at all times during the taxable year. See Q&As 17, 18, 19, 20, and 21 of § 1.922-1.

(vii) A FSC may not be a member, at any time during the taxable year, of any controlled group of corporations of which an interest charge DISC is a member. See Q&A 2 of this section and Q&A 13, of § 1.921-1T(b)(13).

(viii) A FSC must have made an election under section 927(f)(1) which is in effect for the taxable year. See Q&A 1 of § 1.921-1T(b)(1) and § 1.927(f)-1.

In addition, under section 441(h), the taxable year of a FSC must conform to the taxable year of its principal shareholder. See Q&A 4 of § 1.921-1T(b)(4).

Q-2. Does the reference to a DISC under section 922(a)(1)(F) which provides that a FSC cannot be a member, at any time during the taxable year, of any controlled group of corporations of which a DISC is a member refer solely to an interest charge DISC?

A-2. Yes.

(b) Small FSC.

Q-3. What is a small FSC?

A-3. A small FSC is a Foreign Sales Corporation which meets the requirements of section 922(a)(1) enumerated in Q&A 1 of this section as well as the requirements of section 922(b). Section 922(b) requires that a small FSC make a separate election to be treated as a small FSC. See Q&A 1 of § 1.921-1T(b) and § 1.927(f)-1. In addition, section 922(b) requires that the small FSC not be a member, at any time during the taxable year, of a controlled group of corporations which includes a FSC unless such FSC is a small FSC.

Q-4. What is the effect of an election as a small FSC?

A-4. Under section 924(b)(2), a small FSC need not meet the foreign management and economic processes tests of section 924(b)(1) in order to have foreign trading gross receipts. However, in determining the exempt foreign trade income of a small FSC, any foreign trading gross receipts for the taxable year in excess of $5 million are not taken into account. If the foreign trading gross receipts of a small FSC for the taxable year exceed the $5 million limitation, the FSC may select the gross receipts to which the limitation is allocated. In order to use the administrative pricing rules under section 925(a), a small FSC must satisfy the activities test under section 925(c). In addition, under section 441(h), the taxable year of a small FSC must conform to the taxable year of its principal shareholder (defined in Q&A 4 of § 1.921-1T(b)(4) as the shareholder with the highest percentage of its voting power).

Q-5. What is the effect on a small FSC (or FSC) (“target”) if it is acquired, directly or indirectly, by a corporation if that acquiring corporation (“acquiring”), or a member of the acquiring corporation’s controlled group, is a FSC (or small FSC)?

A-5. Unless the corporations in the controlled group elect to terminate the FSC (or small (FSC) election of the acquiring corporation, the target’s small FSC’s (or FSC’s) taxable year and election will terminate as of the day preceding the date the target small FSC and acquiring FSC became members of the same controlled group. The target small FSC will receive FSC benefits for the period prior to termination, but the $5 million small FSC limitation will be reduced to the amount which bears the same ratio to the $5 million as the number of days in the short year created by the termination bears to 365. The due date of the income tax return for the short taxable year created by this provision will be the date prescribed by section 6072(b), including extensions, starting with the last day of the short taxable year. If the short taxable year created by this provision ends prior to March 3, 1987, the filing date of the tax return for the short taxable year will be automatically extended until the earlier of May 18, 1987 or the date under section 6072 (b) assuming a short taxable year had not been created by these regulations.

Q-6. How does a FSC differ from a DISC?

A-6. A DISC is a domestic corporation which is not itself taxable while a FSC must be created or organized under the laws of a jurisdiction which is outside of the United States (including certain U.S. possessions) and may be taxable on its income except for its exempt foreign trade income. The DISC provisions enable a shareholder to obtain a partial deferral of tax on income from export sales and certain services, if 95 percent of its receipts and assets are export related. The FSC provisions contain no assets test, but a portion of income for export sales and certain services is exempt from U.S. taxes if the FSC satisfies certain foreign presence, foreign management, and foreign economic processes tests.

(d) Organization of a FSC.

Q-7. Under the laws of what countries may a FSC be organized?

A-7. A FSC may not be created or organized under the laws of the United States, a state, or other political subdivision. However, a FSC may be created or organized under the laws of a possession of the United States, including Guam. American Samoa, the Commonwealth of the Northern Mariana Islands and the Virgin Islands of the United States, but not Puerto Rico. These eligible possessions are located outside the U.S. customs territory. In addition, a FSC may incorporate under the laws of a foreign country that is a party to –

(i) An exchange of information agreement that meets the standards of the Caribbean Basin Economic Recovery Act of 1983 (Code section 274(h)(6)(C)), or

(ii) A bilateral income tax treaty with the United States if the Secretary certifies that the exchange of information program under the treaty carries out the purpose of the exchange of information requirements of the FSC legislation as set forth in section 927(e)(3), if the company is covered under the exchange of information program under subdivision (i) or (ii). The Secretary may terminate the certification. Any termination by the Secretary will be effective six months after the date of the publication of the notice of such termination in the Federal Register.

(e) Foreign Trade Income.

Q-8. How is foreign trade income defined?

A-8. Foreign trade income, defined in section 923(b), is gross income of an FSC attributable to foreign trading gross receipts. It includes both the profits earned by the FSC itself from exports and commissions earned by the FSC from products and services exported by others.

(f) Investment Income and Carrying Charges.

Q-9. What do the terms “investment income” and “carrying charges” mean?

A-9.

(i) Investment income means:

(A) Dividends,

(B) Interest,

(D) Annuities,

(E) Rents (other than rents from the lease or rental of export property for use by the lessee outside of the United States);

(F) Gains from the sale of stock or securities,

(G) Gains from future transactions in any commodity on, or subject to the rules of, a board of trade or commodity exchange (other than gains which arise out of a bona fide hedging transaction reasonably necessary to conduct the business of the FSC in the manner in which such business is customarily conducted by others),

(H) Amounts includable in computing the taxable income of the corporation under part I of subchapter J, and

(I) Gains from the sale or other disposition of any interest in an estate or trust.

(ii) Carrying charges means:

(A) Charges that are imposed by a FSC or a related supplier and that are identified as carrying charges, (“stated carrying charges”) and

(B)(1) Charges that are considered to be included in the price of the property or services sold by an FSC or a related supplier, as provided under Q&As 1 and 2 of § 1.927(d)-1, and

(2) Any other unstated interest.

Q-10. How are investment income and carrying charges treated?

A-10. Investment income and carrying charges are not foreign trading gross receipts. Investment income and carrying charges are includable in the taxable income of an FSC, except in the case of a commission FSC where carrying charges are treated as income of the related supplier, and are treated as income effectively connected with a trade or business conducted through a permanent establishment within the United States. The source of investment income and carrying charges is determined under sections 861, 862, and 863 of the Code.

(g) Small Businesses.

Q-11. What options are available to small businesses engaged in exporting?

A-11. A small business may elect to be treated as either a small FSC or an interest charge DISC. See Q&As 3 & 4 of § 1.921-2 relating to a small FSC. Rules with respect to interest charge DISCs are the subject of another regulations project.

[T.D. 8127, 52 FR 6469, Mar. 3, 1987]

§ 1.927(a)-1T Temporary regulations; definition of export property.

(a) General rule. Under section 927(a), except as otherwise provided with respect to excluded property in paragraphs (f), (g) and (h) of this section and with respect to certain short supply property in paragraph (i) of this section, export property is property in the hands of any person (whether or not a FSC) (any further reference to a FSC in this section shall include a small FSC unless indicated otherwise) –

(1) U.S. manufactured, produced, grown or extracted. Manufactured, produced, grown, or extracted in the United States by any person or persons other than a FSC (see paragraph (c) of this section),

(2) Foreign use, consumption or disposition. Held primarily for sale, lease or rental in the ordinary course of a trade or business by a FSC to a FSC or to any other person for direct use, consumption, or disposition outside the United States (see paragraph (d) of this section),

(3) Foreign content. Not more than 50 percent of the fair market value of which is attributable to articles imported into the United States (see paragraph (e) of this section), and

(4) Non-related FSC purchaser or user. Which is not sold, leased or rented by a FSC, or with a FSC as commission agent, to another FSC which is a member of the same controlled group (as defined in section 927(d)(4) and § 1.924(a)-1T(h)) as the FSC.

(b) Services. For purposes of this section, services (including the written communication of services in any form) are not export property. Whether an item is property or services shall be determined on the basis of the facts and circumstances attending the development and disposition of the item. Thus, for example, the preparation of a map of a particular construction site would constitute services and not export property, but standard maps prepared for sale to customers generally would not constitute services and would be export property if the requirements of this section were otherwise met.

(c) Manufacture, production, growth, or extraction of property – (1) By a person other than a FSC. Export property may be manufactured, produced, grown, or extracted in the United States by any person, provided that that person does not qualify as a FSC. Property held by a FSC which was manufactured, produced, grown or extracted by it at a time when it did not qualify as a FSC is not export property of the FSC. Property which sustains further manufacture, production or processing outside the United States prior to sale or lease by a person but after manufacture, production, processing or extraction in the United States will be considered as manufactured, produced, grown or extracted in the United States by that person only if the property is reimported into the United States for further manufacturing, production or processing prior to final export sale. In order to be considered export property, the property manufactured, produced, grown or extracted in the United States must satisfy all of the provisions of section 927(a) and this section.

(2) Manufactured, produced or processed. For purposes of this section, property which is sold or leased by a person is considered to be manufactured, produced or processed by that person or by another person pursuant to a contract with that person if the property is manufactured or produced, as defined in § 1.954-3(a)(4). For purposes of this section, however, in determining if the 20% conversion test of § 1.954-3(a)(4)(iii) has been met, conversion costs include assembly and packaging costs but do not include the value of parts provided pursuant to a services contract as described in § 1.924(a)-1T(d)(3). In addition, for purposes of this section, the 20% conversion test is extended and applied to the export property’s adjusted basis rather than to its cost of goods sold if it is leased or held for lease.

(d) Foreign use, consumption or disposition – (1) In general. (i) Under paragraph (a)(2) of this section, export property must be held primarily for the purpose of sale, lease or rental in the ordinary course of a trade or business, by a FSC to a FSC or to any other person, and the sale or lease must be for direct use, consumption, or disposition outside the United States. Thus, property cannot qualify as export property unless it is sold or leased for direct use, consumption, or disposition outside the United States. Property is sold or leased for direct use, consumption, or disposition outside the United States if the sale or lease satisfies the destination test described in subdivision (2) of this paragraph, the proof of compliance requirements described in subdivision (3) of this paragraph, and the use outside the United States test described in subdivision (4) of this paragraph.

(ii) Factors not taken into account. In determining whether property which is sold or leased to a FSC is sold or leased for direct use, consumption, or disposition outside the United States, the fact that the acquiring FSC holds the property in inventory or for lease prior to the time it sells or leases it for direct use, consumption, or disposition outside the United States will not affect the characterization of the property as export property. Fungible export property must be physically segregated from non-export property at all times after purchase by or rental by a FSC or after the start of the commission relationship between the FSC and related supplier with regard to the export property. Non-fungible export property need not be physically segregated from non-export property.

(2) Destination test. (i) For purposes of paragraph (d)(1) of this section, the destination test of this paragraph is satisfied with respect to property sold or leased by a seller or lessor only if it is delivered by the seller or lessor (or an agent of the seller or lessor) regardless of the F.O.B. point or the place at which title passes or risk of loss shifts from the seller or lessor –

(A) Within the United States to a carrier or freight forwarder for ultimate delivery outside the United States to a purchaser or lessee (or to a subsequent purchaser or sublessee),

(B) Within the United States to a purchaser or lessee, if the property is ultimately delivered outside the United States (including delivery to a carrier or freight forwarder for delivery outside the United States) by the purchaser or lessee (or a subsequent purchaser or sublessee) within 1 year after the sale or lease,

(C) Within or outside the United States to a purchaser or lessee which, at the time of the sale or lease, is a FSC or an interest charge DISC and is not a member of the same controlled group as the seller or lessor,

(D) From the United States to the purchaser or lessee (or a subsequent purchaser or sublessee) at a point outside the United States by means of the seller’s or lessor’s own ship, aircraft, or other delivery vehicle, owned, leased, or chartered by the seller or lessor,

(E) Outside the United States to a purchaser or lessee from a warehouse, storage facility, or assembly site located outside the United States, if the property was previously shipped by the seller or lessor from the United States, or

(F) Outside the United States to a purchaser or lessee if the property was previously shipped by the seller or lessor from the United States and if the property is located outside the United States pursuant to a prior lease by the seller or lessor, and either (1) the prior lease terminated at the expiration of its term (or by the action of the prior lessee acting alone), (2) the sale occurred or the term of the subsequent lease began after the time at which the term of the prior lease would have expired, or (3) the lessee under the subsequent lease is not a related person with respect to the lessor and the prior lease was terminated by the action of the lessor (acting alone or together with the lessee).

(ii) For purposes of this paragraph (d)(2) (other than paragraphs (d)(2)(i)(C) and (F)(3)), any relationship between the seller or lessor and any purchaser, subsequent purchaser, lessee, or sublessee is immaterial.

(iii) In no event is the destination test of this paragraph (d)(2) satisfied with respect to property which is subject to any use (other than a resale or sublease), manufacture, assembly, or other processing (other than packaging) by any person between the time of the sale or lease by such seller or lessor and the delivery or ultimate delivery outside the United States described in this paragraph (d)(2).

(iv) If property is located outside the United States at the time it is purchased by a person or leased by a person as lessee, such property may be export property in the hands of such purchaser or lessee only if it is imported into the United States prior to its further sale or lease (including a sublease) outside the United States. Paragraphs (a)(3) and (e) of this section (relating to the 50 percent foreign content test) are applicable in determining whether such property is export property. Thus, for example, if such property is not subjected to manufacturing or production (as defined in paragraph (c) of this section) within the United States after such importation, it does not qualify as export property.

(3) Proof of compliance with destination test – (i) Delivery outside the United States. For purposes of paragraph (d)(2) of this section (other than subdivision (i)(C) thereof), a seller or lessor shall establish ultimate delivery, use, or consumption of property outside the United States by providing –

(A) A facsimile or carbon copy of the export bill of lading issued by the carrier who delivers the property,

(B) A certificate of an agent or representative of the carrier disclosing delivery of the property outside the United States,

(C) A facsimile or carbon copy of the certificate of lading for the property executed by a customs officer of the country to which the property is delivered,

(D) If that country has no customs administration, a written statement by the person to whom delivery outside the United States was made,

(E) A facsimile or carbon copy of the Shipper’s Export Declaration, a monthly shipper’s summary declaration filed with the Bureau of Customs, or a magnetic tape filed in lieu of the Shipper’s Export Declaration, covering the property, or

(F) Any other proof (including evidence as to the nature of the property or the nature of the property or the nature of the transaction) which establishes to the satisfaction of the Commissioner that the property was ultimately delivered, or directly sold, or directly consumed outside the United States within 1 year after the sale or lease.

(ii) The requirements of subdivision (i)(A), (B), (C), or (E) of this paragraph will be considered satisfied even though the name of the ultimate consignee and the price paid for the goods is marked out provided that, in the case of a Shipper’s Export Declaration or other document listed in subdivision (i)(E) of this paragraph or a document such as an export bill of lading, such document still indicates the country in which delivery to the ultimate consignee is to be made and, in the case of a certificate of an agent or representative of the carrier, that the document indicates that the property was delivered outside the United States.

(iii) A seller or lessor shall also establish the meeting of the requirement of paragraph (d)(2)(i) of this section (other than subdivision (i)(C) thereof), that the property was delivered outside the United States without further use, manufacture, assembly, or other processing within the United States.

(iv) For purposes of paragraph (d)(2)(i)(C) of this section, a purchaser or lessee of property is deemed to qualify as a FSC or an interest charge DISC for its taxable year if the seller or lessor obtains from the purchaser or lessee a copy of the purchaser’s or lessee’s election to be treated as a FSC or interest charge DISC together with the purchaser’s or lessee’s sworn statement that the election has been timely filed with the Internal Revenue Service Center. The copy of the election and the sworn statement of the purchaser or lessee must be received by the seller or lessor within 6 months after the sale or lease. A purchaser or lessee is not treated as a FSC or interest charge DISC with respect to a sale or lease during a taxable year for which the purchaser or lessee does not qualify as a FSC or interest charge DISC if the seller or lessor does not believe or if a reasonable person would not believe at the time the sale or lease is made that the purchaser or lessee will qualify as a FSC or interest charge DISC for the taxable year.

(v) If a seller or lessor fails to provide proof of compliance with the destination test as required by this paragraph (d)(3), the property sold or leased is not export property.

(4) Sales and leases of property for ultimate use in the United States – (i) In general. For purposes of paragraph (d)(1) of this section, the use test in this paragraph (d)(4) is satisfied with respect to property which –

(A) Under subdivision (4)(ii) through (iv) of this paragraph is not sold for ultimate use in the United States, or

(B) Under subdivision (4)(v) of this paragraph is leased for ultimate use outside the United States.

(ii) Sales of property for ultimate use in the United States. For purposes of subdivision (4)(i) of this paragraph, a purchaser of property (including components, as defined in subdivision (4)(vii) of this paragraph) is deemed to use the property ultimately in the United States if any of the following conditions exist:

(A) The purchaser is a related party with respect to the seller and the purchaser ultimately uses the property, or a second product into which the property is incorporated as a component, in the United States.

(B) At the time of the sale, there is an agreement or understanding that the property, or a second product into which the property is incorporated as a component, will be ultimately used by the purchaser in the United States.

(C) At the time of the sale, a reasonable person would have believed that the property or the second product would be ultimately used by the purchaser in the United States unless, in the case of a sale of components, the fair market value of the components at the time of delivery to the purchaser constitutes less than 20 percent of the fair market value of the second product into which the components are incorporated (determined at the time of completion of the production, manufacture, or assembly of the second product).

For purposes of subdivision (4)(ii)(B) of this paragraph, there is an agreement or understanding that property will ultimately be used in the United States if, for example, a component is sold abroad under an express agreement with the foreign purchaser that the component is to be incorporated into a product to be sold back to the United States. As a further example, there would also be such an agreement or understanding if the foreign purchaser indicated at the time of the sale or previously that the component is to be incorporated into a product which is designed principally for the United States market. However, such an agreement or understanding does not result from the mere fact that a second product, into which components exported from the United States have been incorporated and which is sold on the world market, is sold in substantial quantities in the United States.

(iii) Use in the United States. For purposes of subdivision (4)(ii) of this paragraph, property (including components incorporated into a second product) is or would be ultimately used in the United States by the purchaser if, at any time within 3 years after the purchase of such property or components, either the property is or the components (or the second product into which the components are incorporated) are resold by the purchaser for use by a subsequent purchaser within the United States or the purchaser or subsequent purchaser fails, for any period of 365 consecutive days, to use the property or second product predominantly outside the United States (as defined in subdivision (4)(vi) of this paragraph).

(iv) Sales to retailers. For purposes of subdivision (4)(ii)(C) of this paragraph, property sold to any person whose principal business consists of selling from inventory to retail customers at retail outlets outside the United States will be considered to be used predominantly outside the United States.

(v) Leases of property for ultimate use outside the United States. For purposes of subdivision (4)(i) of this paragraph, a lessee of property is deemed to use property ultimately outside the United States during a taxable year of the lessor if the property is used predominantly outside the United States (as defined in subdivision (4)(vi) of this paragraph) by the lessee during the portion of the lessor’s taxable year which is included within the term of the lease. A determination as to whether the ultimate use of leased property satisfies the requirements of this subdivision is made for each taxable year of the lessor. Thus, leased property may be used predominantly outside the United States for a taxable year of the lessor (and thus, constitute export property if the remaining requirements of this section are met) even if the property is not used predominantly outside the United States in earlier taxable years or later taxable years of the lessor.

(vi) Predominant use outside the United States. For purposes of this paragraph (d)(4), property is used predominantly outside the United States for any period if, during that period, the property is located outside the United States more than 50 percent of the time. An aircraft, railroad rolling stock, vessel, motor vehicle, container, or other property used for transportation purposes is deemed to be used predominantly outside the United States for any period if, during that period, either the property is located outside the United States more than 50 percent of the time or more than 50 percent of the miles traversed in the use of the property are traversed outside the United States. However, property is deemed to be within the United States at all times during which it is engaged in transport between any two points within the United States, except where the transport constitutes uninterrupted international air transportation within the meaning of section 4262(c)(3) and the regulations under that section (relating to tax on air transportation of persons). An orbiting satellite is deemed to be located outside the United States. For purposes of applying section 4262(c)(3) to this subdivision, the term “United States” includes the Commonwealth of Puerto Rico.

(vii) Component. For purposes of this paragraph (d)(4), a component is property which is (or is reasonably expected to be) incorporated into a second product by the purchaser of such component by means of production, manufacture, or assembly.

(e) Foreign content of property – (1) The 50 percent test. Under paragraph (a)(3) of this section, no more than 50 percent of the fair market value of export property may be attributable to the fair market value of articles which were imported into the United States. For purposes of this paragraph (e), articles imported into the United States are referred to as “foreign content.” The fair market value of the foreign content of export property is computed in accordance with paragraph (e)(4) of this section. The fair market value of export property which is sold to a person who is not a related person with respect to the seller is the sale price for such property (not including interest, finance or carrying charges, or similar charges.)

(2) Application of 50 percent test. The 50 percent test is applied on an item-by-item basis. If, however, a person sells or leases a large volume of substantially identical export property in a taxable year and if all of that property contains substantially identical foreign content in substantially the same proportion, the person may determine the portion of foreign content contained in that property on an aggregate basis.

(3) Parts and services. If, at the time property is sold or leased the seller or lessor agrees to furnish parts pursuant to a services contract (as provided in § 1.924(a)-1T(d)(3)) and the price for the parts is not separately stated, the 50 percent test is applied on an aggregate basis to the property and parts. If the price for the parts is separately stated, the 50 percent test is applied separately to the property and to the parts.

(4) Computation of foreign content – (i) Valuation. For purposes of applying the 50 percent test, it is necessary to determine the fair market value of all articles which constitutes foreign content of the property being tested to determine if it is export property. The fair market value of the imported articles is determined as of the time the articles are imported into the United States.

(A) General rule. Except as provided in paragraph (e)(4)(i)(B), the fair market value of the imported articles which constitutes foreign content is their appraised value, as determined under section 403 of the Tariff Act of 1930 (19 U.S.C. 1401a) in connection with their importation. The appraised value of the articles is the full dutiable value of the articles, determined, however, without regard to any special provision in the United States tariff laws which would result in a lower dutiable value.

(B) Special election. If all or a portion of the imported article was originally manufactured, produced, grown, or extracted in the United States, the taxpayer may elect to determine the fair market value of the imported articles which constitutes foreign content under the provisions of this paragraph (e)(4)(i)(B) if the property is subjected to manufacturing or production (as defined in paragraph (c) of this section) within the United States after importation. A taxpayer making the election under this paragraph may determine the fair market value of the imported articles which constitutes foreign content to be the fair market value of the imported articles reduced by the fair market value at the time of the initial export of the portion of the property that was manufactured, produced, grown, or extracted in the United States. The taxpayer must establish the fair market value of the imported articles and of the portion of the property manufactured, produced, grown, or extracted in the United States at the time of the initial export in accordance with subdivision (4)(ii)(B) of this paragraph.

(ii) Evidence of fair market value – (A) General rule. For purposes of subdivision (4)(i)(A) of this paragraph, the fair market value of the imported articles is their appraised value, which may be evidenced by the customs invoice issued on the importation of such articles into the United States. If the holder of the articles is not the importer (or a related person with respect to the importer), the appraised value of the articles may be evidenced by a certificate based upon information contained in the customs invoice and furnished to the holder by the person from whom the articles (or property incorporating the articles) were purchased. If a customs invoice or certificate described in the preceding sentences is not available to a person purchasing property, the person shall establish that no more than 50 percent of the fair market value of such property is attributable to the fair market value of articles which were imported into the United States.

(B) Special election. For purposes of the special election set forth in subdivision (4)(i)(B) of this paragraph, if the initial export is made to a controlled person within the meaning of section 482, the fair market value of the imported articles and of the portion of the articles that are manufactured, produced, grown, or extracted within the United States shall be established by the taxpayer in accordance with the rules under section 482 and the regulations under that section. If the initial export is not made to a controlled person, the fair market value must be established by the taxpayer under the facts and circumstances.

(iii) Interchangeable component articles. (A) If identical or similar component articles can be incorporated interchangeably into property and a person acquires component articles that are imported into the United States and other component articles that are not imported into the United States, the determination whether imported component articles were incorporated in the property that is exported from the United States shall be made on a substitution basis as in the case of the rules relating to drawback accounts under the customs laws. See section 313(b) of the Tariff Act of 1930, as amended (19 U.S.C. 1313(b)).

(B) The provisions of subdivision (4)(iii)(A) of this paragraph may be illustrated by the following example:

Example.Assume that a manufacturer produces a total of 20,000 electronic devices. The manufacturer exports 5,000 of the devices and subsequently sells 11,000 of the devices to a FSC which exports the 11,000 devices. The major single component article in each device is a tube which represents 60 percent of the fair market value of the device at the time the device is sold by the manufacturer. The manufacturer imports 8,000 of the tubes and produces the remaining 12,000 tubes. For purposes of this subdivision, in accordance with the substitution principle used in the customs drawback laws, the 5,000 devices exported by the manufacturer are each treated as containing an imported tube because the devices were exported prior to the sale to the FSC. The remaining 3,000 imported tubes are treated as being contained in the first 3,000 devices purchased and exported by the FSC. Thus, since the 50 percent test is not met with respect to the first 3,000 devices purchased and exported by the FSC, those devices are not export property. The remaining 8,000 devices purchased and exported by the FSC are treated as containing tubes produced in the United States, and those devices are export property (if they otherwise meet the requirements of this section).

(f) Excluded property – (1) In general. Notwithstanding any other provision of this section, the following property is not export property –

(i) Property described in subdivision (2) of this paragraph (relating to property leased to a member of controlled group),

(ii) Property described in subdivision (3) of this paragraph (relating to certain types of intangible property),

(iii) Products described in paragraph (g) of this section (relating to oil and gas products), and

(iv) Products described in paragraph (h) of this section (relating to certain export controlled products).

(2) Property leased to member of controlled group – (i) In general. Property leased to a person (whether or not a FSC) which is a member of the same controlled group as the lessor constitutes export property for any period of time only if during the period –

(A) The property is held for sublease, or is subleased, by the person to a third person for the ultimate use of the third person;

(B) The third person is not a member of the same controlled group; and

(ii) Predominant use. The provisions of paragraph (d)(4)(vi) of this section apply in determining under subdivision (2)(i)(C) of this paragraph whether the property is used predominantly outside the United States by the third person.

(iii) Leasing rule. For purposes of this paragraph (f)(2), leased property is deemed to be ultimately used by a member of the same controlled group as the lessor if such property is leased to a person which is not a member of the controlled group but which subleases the property to a person which is a member of the controlled group. Thus, for example, if X, a FSC for the taxable year, leases a movie film to Y, a foreign corporation which is not a member of the same controlled group as X, and Y then subleases the film to persons which are members of the controlled group for showing to the general public, the film is not export property. On the other hand, if X, a FSC for the taxable year, leases a movie film to Z, a foreign corporation which is a member of the same controlled group as X, and Z then subleases the film to Y, another foreign corporation, which is not a member of the same controlled group for showing to the general public, the film is not disqualified from being export property.

(iv) Certain copyrights. With respect to a copyright which is not excluded by subdivision (3) of this paragraph from being export property, the ultimate use of the property is the sale or exhibition of the property to the general public. Thus, if A, a FSC for the taxable year, leases recording tapes to B, a foreign corporation which is a member of the same controlled group as A, and if B makes records from the recording tape and sells the records to C, another foreign corporation, which is not a member of the same controlled group, for sale by C to the general public, the recording tape is not disqualified under this paragraph from being export property, notwithstanding the leasing of the recording tape by A to a member of the same controlled group, since the ultimate use of the tape is the sale of the records (i.e., property produced from the recording tape).

(3) Intangible property. Export property does not include any patent, invention, model, design, formula, or process, whether or not patented, or any copyright (other than films, tapes, records, or similar reproductions, for commercial or home use), goodwill, trademark, tradebrand, franchise, or other like property. Although a copyright such as a copyright on a book or computer software does not constitute export property, a copyrighted article (such as a book or standardized, mass marketed computer software) if not accompanied by a right to reproduce for external use is export property if the requirements of this section are otherwise satisfied. Computer software referred to in the preceding sentence may be on any medium, including, but not limited to, magnetic tape, punched cards, disks, semi-conductor chips and circuit boards. A license of a master recording tape for reproduction outside the United States is not disqualified under this paragraph from being export property.

(g) Oil and gas – (1) In general. Under section 927(a)(2)(C), export property does not include oil or gas (or any primary product thereof).

(2) Primary product from oil or gas. A primary product from oil or gas is not export property. For purposes of this paragraph –

(i) Primary product from oil. The term “primary product from oil” means crude oil and all products derived from the destructive distillation of crude oil, including –

(A) Volatile products,

(B) Light oils such as motor fuel and kerosene,

(D) Lubricating oils,

(E) Greases and waxes, and

(F) Residues such as fuel oil.

For purposes of this paragraph, a product or commodity derived from shale oil which would be a primary product from oil if derived from crude oil is considered a primary product from oil.

(ii) Primary product from gas. The term “primary product from gas” means all gas and associated hydrocarbon components from gas wells or oil wells, whether recovered at the lease or upon further processing, including –

(A) Natural gas,

(B) Condensates,

(D) Liquid products such as natural gasoline.

(iii) Primary products and changing technology. The primary products from oil or gas described in subdivisions (2)(i) and (ii) of this paragraph and the processes described in those subdivisions are not intended to represent either the only primary products from oil or gas, or the only processes from which primary products may be derived under existing and future technologies. For example, petroleum coke, although not derived from the destructive distillation of crude oil, is a primary product from oil derived from an existing technology.

(iv) Non-primary products. For purposes of this paragraph, petrochemicals, medicinal products, insecticides and alcohols are not considered primary products from oil or gas.

(h) Export controlled products – (1) In general. Section 927(a)(2)(D) provides that an export controlled product is not export property. A product or commodity may be an export controlled product at one time but not an export controlled product at another time. For purposes of this paragraph, a product or commodity is an “export controlled product” at a particular time if at that time the export of such product or commodity is prohibited or curtailed under section 7(a) of the Export Administration Act of 1979, to effectuate the policy relating to the protection of the domestic economy set forth in paragraph (2)(C) of section 3 of the Export Administration Act of 1979. That policy is to use export controls to the extent necessary to protect the domestic economy from the excessive drain of scarce materials and to reduce the serious inflationary impact of foreign demand.

(2) Products considered export controlled products – (i) In general. For purposes of this paragraph, an export controlled product is a product or commodity, which is subject to short supply export controls under 15 CFR part 377. A product or commodity is considered an export controlled product for the duration of each control period which applies to such product or commodity. A control period of a product or commodity begins on and includes the initial control date (as defined in subdivision (2)(ii) of this paragraph) and ends on and includes the final control date (as defined in subdivision (2)(iii) of this paragraph).

(ii) Initial control date. The initial control date of a product or commodity which is subject to short supply export controls is the effective date stated in the regulations to 15 CFR part 377 which subjects the product or commodity to short supply export controls. If there is no effective date stated in these regulations, the initial control date of the product or commodity will be thirty days after the effective date of the regulations which subject the product or commodity to short supply export controls.

(iii) Final control date. The final control date of a product or commodity is the effective date stated in the regulations to 15 CFR part 377 which removes the product or commodity from short supply export controls. If there is no effective date stated in those regulations, the final control date of the product or commodity is the date which is thirty days after the effective date of the regulations which remove the product or commodity from short supply export control.

(iv) Expiration of Export Administration Act. An initial control date and final control date cannot occur after the expiration date of the Export Administration Act under the authority of which the short supply export controls were issued.

(3) Effective dates – (i) Products controlled on January 1, 1985. If a product or commodity was subject to short supply export controls on January 1, 1985, this paragraph shall apply to all sales, exchanges, other dispositions, or leases of the product or commodity made after January 1, 1985, by the FSC or by the FSC’s related supplier if the FSC is the commission agent on the transaction.

(ii) Products first controlled after January 1, 1985. If a product or commodity becomes subject to short supply export controls after January 1, 1985, this paragraph applies to sales, exchanges, other dispositions, or leases of such product or commodity made on or after the initial control date of such product or commodity, and to owning such product or commodity on or after such date.

(iii) Date of sales, exchange, lease, or other disposition. For purposes of this paragraph (h)(3), the date of sale, exchange, or other disposition of a product or commodity is the date as of which title to such product or commodity passes. The date of a lease is the date as of which the lessee takes possession of a product or commodity. The accounting method of a person is not determinative of the date of sale, exchange, other disposition, or lease.

(i) Property in short supply. If the President determines that the supply of any property which is otherwise export property as defined in this section is insufficient to meet the requirements of the domestic economy, he may by Executive Order designate such property as in short supply. Any property so designated will be treated under section 927(a)(3) as property which is not export property during the period beginning with the date specified in such Executive Order and ending with the date specified in an Executive Order setting forth the President’s determination that such property is no longer in short supply.

[T.D. 8126, 52 FR 6459, Mar. 3, 1987]

§ 1.927(b)-1T [Reserved]

§ 1.927(d)-1 [Reserved]

§ 1.927(d)-2T Temporary regulations; definitions and special rules relating to Foreign Sales Corporation.

(a) Definition of related supplier. For purposes of sections 921 through 927 and the regulations under those sections, the term “related supplier” means a related party which directly supplies to a FSC any property or services which the FSC disposes of in a transaction producing foreign trading gross receipts, or a related party which uses the FSC as a commission agent in the disposition of any property or services producing foreign trading gross receipts. A FSC may have different related suppliers with respect to different transactions. If, for example, X owns all the stock of Y, a corporation, and of F, a FSC, and X sells a product to Y which is resold to F, only Y is the related supplier of F. If, however, X sells directly to F and Y also sells directly to F, then, as to the transactions involving direct sales to F, each of X and Y is a related supplier of F.

(b) Definition of related party. The term “related party” means a person which is owned or controlled directly or indirectly by the same interests as the FSC within the meaning of section 482 and § 1.482-1(a).

[T.D. 8126, 52 FR 6465, Mar. 3, 1987]

possessions of the united states

§ 1.931-1 Exclusion of certain income from sources within Guam, American Samoa, or the Northern Mariana Islands.

(a) General rule. (1) An individual (whether a United States citizen or an alien), who is a bona fide resident of a section 931 possession during the entire taxable year, will exclude from gross income the income derived from sources within any section 931 possession and the income effectively connected with the conduct of a trade or business by such individual within any section 931 possession, except amounts received for services performed as an employee of the United States or any agency thereof. For purposes of section 931(d) and this section, an employee of the government of a section 931 possession will not be considered an employee of the United States or of an agency of the United States.

(2) The following example illustrates the application of the general rule in paragraph (a)(1) of this section:

Example.D, a United States citizen, files returns on a calendar year basis. In April 2008, D moves to American Samoa, where he purchases a house and accepts a permanent position with a local employer. For the remainder of the year and for the following three taxable years, D continues to live and work in American Samoa and has a closer connection to American Samoa than to the United States or any foreign country. Assuming that D otherwise meets the requirements under section 937(a) and § 1.937-1(b) and (f)(1) (year-of-move exception), D is considered a bona fide resident of American Samoa for 2008. Accordingly, under section 931 and paragraph (a)(1) of this section, D should exclude from his 2008 Federal gross income any income from sources within American Samoa and any income that is effectively connected with the conduct of a trade or business within American Samoa, as determined under section 937(b) and §§ 1.937-2 and 1.937-3, as applicable.

(b) Deductions and credits. In any case in which any amount otherwise constituting gross income is excluded from gross income under the provisions of section 931, there will not be allowed as a deduction from gross income any items of expenses or losses or other deductions (except the deduction under section 151, relating to personal exemptions), or any credit, properly allocable to, or chargeable against, the amounts so excluded from gross income. For purposes of the preceding sentence, the rules of § 1.861-8 will apply (with creditable expenditures treated in the same manner as deductible expenditures).

(1) The term section 931 possession means a possession that is a specified possession and that has entered into an implementing agreement, as described in section 1271(b) of the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085), with the United States that is in effect for the entire taxable year;

(2) The term specified possession means Guam, American Samoa, or the Northern Mariana Islands;

(3) The rules of § 1.937-1 will apply for determining whether an individual is a bona fide resident of a section 931 possession;

(4) The rules of § 1.937-2 will apply for determining whether income is from sources within a section 931 possession; and

(5) The rules of § 1.937-3 will apply for determining whether income is effectively connected with the conduct of a trade or business within a section 931 possession.

(d) Effective/applicability date. This section applies to taxable years ending after April 9, 2008.

[T.D. 9391, 73 FR 19360, Apr. 9, 2008]

§ 1.932-1 Coordination of United States and Virgin Islands income taxes.

(a) Scope – (1) In general. Section 932 and this section set forth the special rules relating to the filing of income tax returns and income tax liabilities of individuals described in paragraph (a)(2) of this section. Paragraph (h) of this section also provides special rules requiring consistent treatment of business entities in the United States and in the United States Virgin Islands (Virgin Islands).

(2) Individuals covered. This section will apply to any individual who –

(i) Is a bona fide resident of the Virgin Islands during the entire taxable year;

(ii)(A) Is a citizen or resident of the United States (other than a bona fide resident of the Virgin Islands) during the entire taxable year; and

(B) Has income derived from sources within the Virgin Islands, or effectively connected with the conduct of a trade or business within the Virgin Islands, for the taxable year; or

(iii) Files a joint return for the taxable year with any individual described in paragraph (a)(2)(i) or (ii) of this section.

(3) Definitions. For purposes of this section –

(i) The rules of § 1.937-1 will apply for determining whether an individual is a bona fide resident of the Virgin Islands;

(ii) The rules of § 1.937-2 will apply for determining whether income is from sources within the Virgin Islands; and

(iii) The rules of § 1.937-3 will apply for determining whether income is effectively connected with the conduct of a trade or business within the Virgin Islands.

(b) U.S. individuals with Virgin Islands income – (1) Dual filing requirement. Subject to paragraph (d) of this section, an individual described in paragraph (a)(2)(ii) of this section must make an income tax return for the taxable year to the United States and file a copy of such return with the Virgin Islands. Such individuals must also attach Form 8689, “Allocation of Individual Income Tax to the U.S. Virgin Islands,” to the U.S. income tax return and to the income tax return filed with the Virgin Islands.

(2) Tax payments. (i) Each individual to whom this paragraph (b) applies for the taxable year must pay the applicable percentage of the taxes imposed by this chapter for such taxable year (determined without regard to paragraph (b)(2)(ii) of this section) to the Virgin Islands.

(ii) A credit against the tax imposed by this chapter for the taxable year will be allowed in an amount equal to the taxes that are required to be paid to the Virgin Islands under paragraph (b)(2)(i) of this section and are so paid. Such taxes will be considered creditable in the same manner as taxes paid to the United States (for example, under section 31) and not as taxes paid to a foreign government (for example, under sections 27 and 901).

(iii) For purposes of this paragraph (b)(2) –

(A) The term applicable percentage means the percentage that Virgin Islands adjusted gross income bears to adjusted gross income;

(B) The term Virgin Islands adjusted gross income means adjusted gross income determined by taking into account only income derived from sources within the Virgin Islands and deductions properly apportioned or allocable to such income. For purposes of the preceding sentence, the rules of § 1.861-8 will apply; and

(c) Bona fide residents of the Virgin Islands. Subject to paragraph (d) of this section, an individual described in paragraph (a)(2)(i) of this section will be subject to the following income tax return filing requirements:

(1) Virgin Islands filing requirements. An individual to whom this paragraph (c) applies must file an income tax return for the taxable year with the Virgin Islands. On this return, the individual must report income from all sources and identify the source of each item of income shown on the return.

(2) U.S. filing requirements. (i) For purposes of calculating the income tax liability to the United States of an individual to whom this paragraph (c) applies, gross income will not include any amount included in gross income on the return filed with the Virgin Islands pursuant to paragraph (c)(1) of this section, and deductions and credits allocable to such income will not be taken into account, provided that –

(A) The individual fully satisfied the reporting requirements of paragraph (c)(1) of this section; and

(B) The individual fully paid the tax liability referred to in section 934(a) to the Virgin Islands with respect to such income.

(ii) For purposes of the U.S. statute of limitations under section 6501(a), an income tax return filed with the Virgin Islands by an individual who takes the position that he or she is a bona fide resident of the Virgin Islands described in paragraph (a)(2)(i) of this section (or an individual who files a joint return with such an individual under paragraph (d) of this section) will be deemed to be a U.S. income tax return, provided that the United States and the Virgin Islands have entered into an agreement for the routine exchange of income tax information satisfying the requirements of the Commissioner. The working arrangement announced in Notice 2007-31 satisfies the condition of the preceding sentence. See Notice 2007-31 (2007-16 IRB 971) (applicable to taxable years ending on or after December 31, 2006, unless and until arrangement terminates). In the absence of such an agreement, individuals to whom this paragraph (c) applies generally must file an income tax return for the taxable year with the United States to begin the period of limitations for Federal income tax purposes as provided in section 6501(a), and in such circumstances the Commissioner may by revenue procedure, notice, or other administrative pronouncement specify U.S. filing and other information reporting requirements for such individuals. For taxable years ending before December 31, 2006, the rules provided in section 3 of Notice 2007-19 (2007-11 IRB 689) will apply. See § 601.601(d)(2)(ii)(b).

(3) U.S. tax payments. In the case of an individual who is required to file an income tax return with the United States as a consequence of failing to satisfy the requirements of paragraphs (c)(2)(i)(A) or (B) of this section, there will be allowed as a credit against the tax imposed by this chapter for the taxable year an amount equal to the amount of the tax liability referred to in section 934(a) to the extent paid to the Virgin Islands. Such taxes shall be considered creditable in the same manner as taxes paid to the United States (for example, under section 31) and not as taxes paid to a foreign government (for example, under sections 27 and 901).

(d) Joint returns. In the case of married persons, if one or both spouses is an individual described in paragraph (a)(2) of this section and they file a joint return of income tax, the spouses must file their joint return with, and pay the tax due on such return to, the jurisdiction (or jurisdictions) where the spouse who has the greater adjusted gross income for the taxable year would be required under paragraph (b) or (c) of this section to file a return if separate returns were filed and all of their income were the income of such spouse. For this purpose, adjusted gross income of each spouse is determined under section 62 and the regulations under that section but without regard to community property laws; and, if one of the spouses dies, the taxable year of the surviving spouse will be treated as ending on the date of such death.

(e) Place for filing returns – (1) U.S. returns. Except as otherwise provided for returns filed under paragraph (c)(2)(ii) of this section, a return required under the rules of paragraphs (b) and (c) of this section to be filed with the United States must be filed as directed in the applicable forms and instructions.

(2) Virgin Islands returns. A return required under the rules of paragraphs (b) and (c) of this section to be filed with the Virgin Islands must be filed as directed in the applicable forms and instructions.

(f) Tax accounting standards – (1) In general. A dual filing taxpayer must use the same tax accounting standards on the returns filed with the United States and the Virgin Islands. A taxpayer who has filed a return only with the United States or only with the Virgin Islands as a single filing taxpayer for a prior taxable year and is required to file a return only with the other jurisdiction as a single filing taxpayer for a later taxable year may not, for such later taxable year, use different tax accounting standards unless the second jurisdiction consents to such change. However, such change will not be effective for returns filed thereafter with the first jurisdiction unless before such later date of filing the taxpayer also obtains the consent of the first jurisdiction to make such change. Any request for consent to make a change pursuant to this paragraph (f) must be made to the office where the return is required to be filed under paragraph (e) of this section and in sufficient time to permit a copy of the consent to be attached to the return for the taxable year.

(2) Definitions. For purposes of this paragraph (f), the terms –

(i) Dual filing taxpayer means a taxpayer who is required to file returns with the United States and the Virgin Islands for the same taxable year under the rules of paragraph (b) or (c) of this section;

(ii) Single filing taxpayer means a taxpayer who is required to file a return only with the United States (because the individual is not described in paragraph (a)(2) of this section) or only with the Virgin Islands (because the individual is described in paragraph (a)(2)(i) of this section and satisfies the conditions of paragraphs (c)(2)(i) and (ii) of this section) for the taxable year; and

(iii) Tax accounting standards includes the taxpayer’s accounting period, methods of accounting, and any election to which the taxpayer is bound with respect to the reporting of taxable income.

(g) Extension of territory – (1) Section 932(a) taxpayers – (i) General rule. With respect to an individual to whom section 932(a) applies for a taxable year, for purposes of taxes imposed by Chapter 1 of the Internal Revenue Code (Code), the United States generally will be treated, in a geographical and governmental sense, as including the Virgin Islands. The purpose of this rule is to facilitate the coordination of the tax systems of the United States and the Virgin Islands. Accordingly, the rule will have no effect where it is manifestly inapplicable or its application would be incompatible with the intent of any provision of the Code.

(ii) Application of general rule. Contexts in which the general rule of paragraph (g)(1)(i) of this section apply include –

(A) The characterization of taxes paid to the Virgin Islands. An individual to whom section 932(a) applies may take income tax required to be paid to the Virgin Islands under section 932(b) into account under sections 31, 6315, and 6402(b) as payments to the United States. Taxes paid to the Virgin Islands and otherwise satisfying the requirements of section 164(a) will be allowed as a deduction under that section, but income taxes required to be paid to the Virgin Islands under section 932(b) will be disallowed as a deduction under section 275(a);

(B) The determination of the source of income for purposes of the foreign tax credit (for example, sections 901 through 904). Thus, for example, after an individual to whom section 932(a) applies determines which items of income constitute income from sources within the Virgin Islands under the rules of section 937(b), such income will be treated as income from sources within the United States for purposes of section 904;

(C) The eligibility of a corporation to make a subchapter S election (sections 1361 through 1379). Thus, for example, for purposes of determining whether a corporation created or organized in the Virgin Islands may make an election under section 1362(a) to be a subchapter S corporation, it will be treated as a domestic corporation and a shareholder to whom section 932(a) applies will not be treated as a nonresident alien individual with respect to such corporation. While such an election is in effect, the corporation will be treated as a domestic corporation for all purposes of the Internal Revenue Code. For the consistency requirement with respect to entity status elections, see paragraph (h) of this section;

(D) The treatment of items carried over from other taxable years. Thus, for example, if an individual to whom section 932(a) applies has for a taxable year a net operating loss carryback or carryover under section 172, a foreign tax credit carryback or carryover under section 904, a business credit carryback or carryover under section 39, a capital loss carryover under section 1212, or a charitable contributions carryover under section 170, the carryback or carryover will be reported on the return filed in accordance with paragraph (b)(1) of this section, even though the return of the taxpayer for the taxable year giving rise to the carryback or carryover was required to be filed with the Virgin Islands under section 932(c); and

(E) The treatment of property exchanged for property of a like kind (section 1031). Thus, for example, if an individual to whom section 932(a) applies exchanges real property located in the United States for real property located in the Virgin Islands, notwithstanding the provisions of section 1031(h), such exchange may qualify as a like-kind exchange under section 1031 (provided that all the other requirements of section 1031 are satisfied).

(iii) Nonapplication of the general rule. Contexts in which the general rule of paragraph (g)(1)(i) of this section does not apply include –

(A) The application of any rules or regulations that explicitly treat the United States and any (or all) of its possessions as separate jurisdictions (for example, sections 931 through 937, 7651, and 7654).

(B) The determination of any aspect of an individual’s residency (for example, sections 937(a) and 7701(b)). Thus, for example, an individual whose principal place of abode is in the Virgin Islands is not considered to have a principal place of abode in the United States for purposes of section 32(c);

(C) The characterization of a corporation for purposes other than subchapter S (for example, sections 367, 951 through 964, 1291 through 1298, 6038, and 6038B). Thus, for example, if an individual to whom section 932(a) applies transfers appreciated tangible property to a corporation created or organized in the Virgin Islands in a transaction described in section 351, he or she must recognize gain unless an exception under section 367(a) applies. Also, if a corporation created or organized in the Virgin Islands qualifies as a passive foreign investment company under sections 1297 and 1298 with respect to an individual to whom section 932(a) applies, a dividend paid to such shareholder does not constitute qualified dividend income under section 1(h)(11)(B).

(2) Section 932(c) taxpayers – (i) General rule. With respect to an individual to whom section 932(c) applies for a taxable year, for purposes of the territorial income tax of the Virgin Islands (that is, mirrored sections of the Code), the Virgin Islands generally will be treated, in a geographical and governmental sense, as including the United States. The purpose of this rule is to facilitate the coordination of the tax systems of the United States and the Virgin Islands. Accordingly, the rule will have no effect where it is manifestly inapplicable or its application would be incompatible with the intent of any provision of the Code.

(ii) Application of general rule. Contexts in which the general rule of paragraph (g)(2)(i) of this section apply include –

(A) The characterization of taxes paid to the United States. A taxpayer described in section 932(c)(1) may take income tax paid to the United States into account under mirrored sections 31, 6315, and 6402(b) as payments to the Virgin Islands;

(B) The determination of the source of income for purposes of the foreign tax credit (for example, mirrored sections 901 through 904). Thus, for example, any item of income that constitutes income from sources within the United States under the rules of sections 861 through 865 will be treated as income from sources within the Virgin Islands for purposes of mirrored section 904;

(C) The eligibility of a corporation to make a subchapter S election (mirrored sections 1361 through 1379). Thus, for example, for purposes of determining whether a corporation created or organized in the United States may make an election under mirrored section 1362(a) to be a subchapter S corporation, it will be treated as a domestic corporation and a shareholder to whom section 932(c) applies will not be treated as a nonresident alien individual with respect to such corporation. While such an election is in effect, the corporation will be treated as a domestic corporation for all purposes of the territorial income tax. For the consistency requirement with respect to entity status elections, see paragraph (h) of this section;

(D) The treatment of items carried over from other taxable years. Thus, for example, if an individual to whom section 932(c) applies has for a taxable year a net operating loss carryback or carryover under mirrored section 172, a foreign tax credit carryback or carryover under mirrored section 904, a business credit carryback or carryover under mirrored section 39, a capital loss carryover under mirrored section 1212, or a charitable contributions carryover under mirrored section 170, the carryback or carryover will be reported on the return filed in accordance with paragraph (c)(1) of this section, even though the return of the taxpayer for the taxable year giving rise to the carryback or carryover was required to be filed with the United States; and

(E) The treatment of property exchanged for property of a like kind (mirrored section 1031). Thus, for example, if an individual to whom section 932(c) applies exchanges real property located in the United States for real property located in the Virgin Islands, notwithstanding the provisions of mirrored section 1031(h), such exchange may qualify as a like-kind exchange under mirrored section 1031 (provided that all the other requirements of mirrored section 1031 are satisfied).

(iii) Nonapplication of general rule. Contexts in which the general rule of paragraph (g)(2)(i) of this section does not apply include –

(A) The determination of any aspect of an individual’s residency (for example, mirrored section 7701(b)). Thus, for example, an individual whose principal place of abode is in the United States is not considered to have a principal place of abode in the Virgin Islands for purposes of mirrored section 32(c).

(B) The determination of the source of income for purposes other than the foreign tax credit (for example, sections 932(a) and (b), 934(b), and 937). Thus, for example, compensation for services performed in the United States and rentals or royalties from property located in the United States do not constitute income from sources within the Virgin Islands for purposes of section 934(b); and

(C) The definition of wages (mirrored section 3401). Thus, for example, services performed by an employee for an employer in the United States do not constitute services performed in the Virgin Islands under mirrored section 3401(a)(8).

(h) Entity status consistency requirement – (1) In general. Taxpayers should make consistent entity status elections (as defined in paragraph (h)(3) of this section), where applicable, in both the United States and the Virgin Islands. In the case of a business entity to which this paragraph (h) applies –

(i) If an entity status election is filed with the Internal Revenue Service (IRS) but not with the Virgin Islands Bureau of Internal Revenue (BIR), the Director of the BIR or his delegate, at his discretion, may deem the election also to have been made for Virgin Islands tax purposes;

(ii) If an entity status election is filed with the BIR but not with the IRS, the Commissioner, at his discretion, may deem the election also to have been made for Federal tax purposes; and

(iii) If inconsistent entity status elections are filed with the BIR and the IRS, both the Commissioner and the Director of the BIR or his delegate may, at their individual discretion, treat the elections they each received as invalid and may deem the election filed in the other jurisdiction to have been made also for tax purposes in their own jurisdiction. See Rev. Proc. 2006-23 (2006-1 CB 900) (see § 601.601(d)(2)(ii)(b) of this chapter) for procedures for requesting the assistance of the IRS when a taxpayer is or may be subject to inconsistent tax treatment by the IRS and a U.S. possession tax agency.

(2) Scope. This paragraph (h) applies to the following business entities:

(i) A business entity (as defined in § 301.7701-2(a) of this chapter) that is domestic (as defined in § 301.7701-5 of this chapter), or otherwise treated as domestic for purposes of the Code, and that is owned in whole or in part by any person who is either a bona fide resident of the Virgin Islands or a business entity created or organized in the Virgin Islands.

(ii) A business entity that is created or organized in the Virgin Islands and that is owned in whole or in part by any U.S. person (other than a bona fide resident of the Virgin Islands).

(3) Definition. For purposes of this section, the term entity status election includes an election under § 301.7701-3(c) of this chapter, an election under section 1362(a), and any other similar elections.

(4) Default status. Solely for the purpose of determining classification of an eligible entity under § 301.7701-3(b) of this chapter and under that section as mirrored in the Virgin Islands, an eligible entity subject to this paragraph (h) will be classified for both Federal and Virgin Islands tax purposes using the rule that applies to domestic eligible entities.

(5) Transition rules. (i) In the case of an election filed prior to April 11, 2005, except as provided in paragraph (h)(5)(ii) of this section, the rules of paragraph (h)(1) of this section will apply as of the first day of the first taxable year of the entity beginning after April 11, 2005.

(ii) In the unlikely circumstance that inconsistent elections described in paragraph (h)(1)(iii) of this section are filed prior to April 11, 2005, and the entity cannot change its classification to achieve consistency because of the sixty-month limitation described in § 301.7701-3(c)(1)(iv) of this chapter, then the entity may nevertheless request permission from the Commissioner or the Director of the BIR or his delegate to change such election to avoid inconsistent treatment by the Commissioner and the Director of the BIR or his delegate.

(iii) Except as provided in paragraphs (h)(5)(i) and (h)(5)(ii) of this section, in the case of an election filed with respect to an entity before it became an entity described in paragraph (h)(2) of this section, the rules of paragraph (h)(1) of this section will apply as of the first day that such entity is described in paragraph (h)(2) of this section.

(iv) In the case of an entity created or organized prior to April 11, 2005, paragraph (h)(4) of this section will take effect for Federal income tax purposes (or Virgin Islands income tax purposes, as the case may be) as of the first day of the first taxable year of the entity beginning after April 11, 2005.

(i) Examples. The rules of this section are illustrated by the following examples:

Example 1.(i) A is a U.S. citizen who resides in State R. For 2008, A files with the IRS a Form 1040, “U.S. Individual Income Tax Return,” reporting adjusted gross income of $90x, which includes $30x from sources in the Virgin Islands. The income tax liability reported on A’s Form 1040 is $18x. A files a copy of his Form 1040 with the Virgin Islands as required by section 932(a)(2) and paragraph (b)(1) of this section. A pays to the Virgin Islands the applicable percentage of his Federal income tax liability as required by section 932(b) and paragraph (b)(2) of this section, computed as follows: $30x/$90x × $18x = $6x income tax liability to the Virgin Islands.

(ii) A claims a credit in the amount of $6x against his Federal income tax liability reported on his Form 1040. A attaches a Form 8689, “Allocation of Individual Income Tax to the U.S. Virgin Islands,” to the Form 1040 filed with the IRS and to the copy filed with the Virgin Islands.

Example 2.(i) B, a U.S. citizen, files returns on a calendar year basis. In November 2008, B moves to the Virgin Islands, purchases a house, and accepts a permanent position with a local employer. For the remainder of the year and throughout 2009, B continues to live and work in the Virgin Islands and has a closer connection to the Virgin Islands than to the United States or any foreign country. As a consequence of his employment in the Virgin Islands, B earns income from the performance of services in the Virgin Islands during 2008 and 2009.

(ii) For 2008, B does not qualify as a bona fide resident under section 937(a) and § 1.937-1(b) and (f)(1). Therefore, B is subject to the rules of sections 932(a) and (b) and paragraph (b) of this section for 2008 because he has income derived from sources within the Virgin Islands as determined under the rules of section 937(b) and § 1.937-2.

(iii) For 2009, assuming that B otherwise satisfies the requirements of section 937(a) and § 1.937-1(b), B qualifies as a bona fide resident of the Virgin Islands. Therefore, section 932(c) and paragraph (c) of this section apply to B for 2009, and he must file his income tax return with the Virgin Islands under paragraph (c)(1) of this section. Provided that B fully satisfies the reporting requirements of paragraph (c)(1) of this section and fully pays the tax liability referred to in section 934(a), B will have no Federal income tax filing requirement or liability under paragraphs (c)(2) and (3) of this section.

Example 3.H and W are U.S. citizens. H resides in State T and W is a bona fide resident of the Virgin Islands. For 2008, H and W prepare a joint Form 1040, “U.S. Individual Income Tax Return,” reporting total adjusted gross income of $75x, of which $40x is attributable to compensation that W received for services performed in the Virgin Islands and $35x to compensation that H received for services performed in State T. Pursuant to section 932(d) and paragraph (d) of this section, because W would have the greater adjusted gross income if computed separately, H and W must file their joint Form 1040 with the Virgin Islands as required by section 932(c) and paragraph (c)(1) of this section. H and W may claim a tax credit on such return for income tax withheld during 2008 and paid to the IRS.

Example 4.(i) The facts are the same as in Example 3, except that H also earns $25x for services performed in the Virgin Islands, so that H and W’s total adjusted gross income is $100x, and their total income tax liability is $20x.

(ii) Pursuant to section 932(d) and paragraph (d) of this section, because H would have the greater adjusted gross income if computed separately, H and W must file their joint Form 1040 with the IRS and must file a copy of that joint Form 1040 with the Virgin Islands as required by section 932(a)(2) and paragraph (b)(1) of this section. H and W must pay the applicable percentage of their Federal income tax liability to the Virgin Islands as required by section 932(b) and paragraph (b)(2) of this section, computed as follows: $65x /$100x × $20x = $13x income tax liability to the Virgin Islands.

(iii) H and W claim a credit against their Federal income tax liability reported on their joint Form 1040 in the amount of $13x, the portion of their Federal income tax liability required to be paid to the Virgin Islands. H and W attach a Form 8689, “Allocation of Individual Income Tax to the U.S. Virgin Islands,” to their joint Form 1040 filed with the IRS and to the copy filed with the Virgin Islands.

Example 5.N, a U.S. citizen and calendar year taxpayer, takes the position that he is a bona fide resident of the Virgin Islands for the 2007 taxable year. On April 15, 2008, N files a Form 1040, “U.S. Individual Income Tax Return,” with the Virgin Islands for his 2007 taxable year. N does not file a Form 1040 with the IRS. Because there is an agreement in force between the United States and the Virgin Islands for the routine exchange of income tax information, under paragraph (c)(2)(ii) of this section, the Federal 3-year period of limitations under section 6501(a) will expire on April 15, 2011, and the IRS will make no further assessment of income tax after that date for N’s 2007 taxable year except as otherwise authorized by section 6501.

Example 6.(i) J is a U.S. citizen and a bona fide resident of the Virgin Islands. In 2008, J receives compensation for services performed as an employee in the Virgin Islands in the amount of $40x. J files with the Virgin Islands a Form 1040, “U.S. Individual Income Tax Return,” reporting gross income of only $30x. Based on these facts, J has not satisfied the conditions of section 932(c)(4) and paragraph (c) of this section for an exclusion from gross income for Federal income tax purposes.

(ii) The facts are the same as in paragraph (i) of this Example 6 except that on or before the last day prescribed for filing an income tax return for J’s 2008 taxable year, J files with the Virgin Islands an amended Form 1040 for 2008, correctly reporting the full $40x of compensation. Provided that J otherwise fully satisfies the reporting requirements of paragraph (c)(1) of this section and fully pays the tax liability referred to in section 934(a), J will have no Federal income tax filing requirement or liability under paragraphs (c)(2) and (3) of this section.

Example 7.(i) N is a U.S. citizen and a bona fide resident of the Virgin Islands. In 2008, N receives compensation for services performed in Country M. N files with the Virgin Islands a Form 1040, “U.S. Individual Income Tax Return,” reporting the compensation as income effectively connected with the conduct of a trade or business in the Virgin Islands. N claims a special credit against the tax on this compensation pursuant to a Virgin Islands law enacted within the limits of its authority under section 934.

(ii) Under the principles of section 864(c)(4) as applied pursuant to section 937(b)(1) and § 1.937-3(b), compensation for services performed outside the Virgin Islands may not be treated as income effectively connected with the conduct of a trade or business in the Virgin Islands for purposes of section 934(b). Consequently, N is not entitled to claim the special credit under Virgin Islands law with respect to N’s income from services performed in Country M. Because N has not fully paid his tax liability referred to in section 934(a), he has not satisfied the conditions of section 932(c)(4) and paragraph (c) of this section for an exclusion from gross income for Federal income tax purposes. Therefore, income reported on the Form 1040 as filed with the Virgin Islands must be included in N’s Federal gross income. Under paragraph (c)(3) of this section, the amount of tax paid to the Virgin Islands on such income will be allowed as a credit against N’s Federal income tax liability.

(j) Effective/applicability date. Except as otherwise provided in this paragraph (j), this section applies to taxable years ending after April 9, 2008. Taxpayers may choose to apply paragraph (c)(2)(ii) of this section to open taxable years ending on or after December 31, 2006.

[T.D. 9391, 73 FR 19361, Apr. 9, 2008, as amended at T.D. 9391, 73 FR 27728, May 14, 2007; T.D. 9391, 76 FR 4244, Jan. 25, 2011]

§ 1.933-1 Exclusion of certain income from sources within Puerto Rico.

(a) General rule. (1) An individual (whether a United States citizen or an alien), who is a bona fide resident of Puerto Rico during the entire taxable year, will exclude from gross income the income derived from sources within Puerto Rico, except amounts received for services performed as an employee of the United States or any agency thereof. For purposes of section 933 and this section, an employee of the government of Puerto Rico will not be considered an employee of the United States or of an agency of the United States.

(2) The following example illustrates the application of the general rule in paragraph (a)(1) of this section:

Example.E, a United States citizen, files returns on a calendar year basis. In April 2008, E moves to Puerto Rico, where he purchases a house and accepts a permanent position with a local employer. For the remainder of the year and for the following three taxable years, E continues to live and work in Puerto Rico and has a closer connection to Puerto Rico than to the United States or any foreign country. Assuming that E otherwise meets the requirements under section 937(a) and § 1.937-1(b) and (f)(1) (year-of-move exception), E is considered a bona fide resident of Puerto Rico for 2008. Accordingly, under section 933(1) and paragraph (a)(1) of this section, E should exclude from his 2008 Federal gross income any income from sources within Puerto Rico, as determined under section 937(b) and § 1.937-2.

(b) Taxable year of change of residence from Puerto Rico. A citizen of the United States who changes his residence from Puerto Rico after having been a bona fide resident thereof for a period of at least two years immediately preceding the date of such change in residence shall exclude from his gross income the income derived from sources within Puerto Rico which is attributable to that part of such period of Puerto Rican residence which preceded the date of such change in residence, except amounts received for services performed as an employee of the United States or any agency thereof.

(c) Deductions and credits. In any case in which any amount otherwise constituting gross income is excluded from gross income under the provisions of section 933, there will not be allowed as a deduction from gross income any items of expenses or losses or other deductions (except the deduction under section 151, relating to personal exemptions), or any credit, properly allocable to, or chargeable against, the amounts so excluded from gross income. For purposes of the preceding sentence, the rules of § 1.861-8 will apply (with creditable expenditures treated in the same manner as deductible expenditures).

(d) Definitions. For purposes of this section –

(1) The rules of § 1.937-1 will apply for determining whether an individual is a bona fide resident of Puerto Rico; and

(2) The rules of § 1.937-2 will apply for determining whether income is from sources within Puerto Rico.

(e) Effective/applicability date. Paragraphs (a), (c), (d), and (e) of this section apply to taxable years ending after April 9, 2008.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as amended by T.D. 9194, 70 FR 18934, Apr. 11, 2005; T.D. 9391, 73 FR 19365, Apr. 9, 2008]

§ 1.934-1 Limitation on reduction in income tax liability incurred to the Virgin Islands.

(a) General rule. Section 934(a) provides that tax liability incurred to the United States Virgin Islands (Virgin Islands) must not be reduced or remitted in any way, directly or indirectly, whether by grant, subsidy, or other similar payment, by any law enacted in the Virgin Islands, except to the extent provided in section 934(b). For purposes of the preceding sentence, the term “tax liability” means the liability incurred to the Virgin Islands pursuant to subtitle A of the Internal Revenue Code (Code), as made applicable in the Virgin Islands by the Act of July 12, 1921 (48 U.S.C. 1397), or pursuant to section 28(a) of the Revised Organic Act of the Virgin Islands (48 U.S.C. 1642), as modified by section 7651(5)(B).

(b) Exception for Virgin Islands income – (1) In general. Section 934(b)(1) provides an exception to the application of section 934(a). Under this exception, section 934(a) does not apply with respect to tax liability incurred to the Virgin Islands to the extent that such tax liability is attributable to income derived from sources within the Virgin Islands or income effectively connected with the conduct of a trade or business within the Virgin Islands.

(2) Limitation. Section 934(b)(2) limits the scope of the exception provided by section 934(b)(1). Pursuant to this limitation, the exception does not apply with respect to an individual who is a citizen or resident of the United States (other than a bona fide resident of the Virgin Islands). For the rules for determining tax liability incurred to the Virgin Islands by such an individual, see section 932(a) and the regulations under that section.

(3) Computation rule – (i) Operative rule. For purposes of section 934(b)(1) and this paragraph (b), tax liability incurred to the Virgin Islands for the taxable year attributable to income derived from sources within the Virgin Islands or income effectively connected with the conduct of a trade or business within the Virgin Islands will be computed as follows:

(A) Add to the income tax liability incurred to the Virgin Islands any credit against the tax allowed under mirrored section 901(a).

(B) Multiply by taxable income from sources within the Virgin Islands and income effectively connected with the conduct of a trade or business within the Virgin Islands (applying the rules of § 1.861-8 to determine deductions allocable to such income).

(D) Subtract the portion of any credit allowed under mirrored section 901 (other than credits for taxes paid to the United States) determined by multiplying the amount of taxable income from sources outside the Virgin Islands or the United States that is effectively connected to the conduct of a trade or business in the Virgin Islands divided by the total amount of taxable income from such sources.

(ii) Limitation. Tax liability incurred to the Virgin Islands attributable to income derived from sources within the Virgin Islands or income effectively connected with the conduct of a trade or business within the Virgin Islands, as computed in this paragraph (b)(3), however, will not exceed the total amount of income tax liability actually incurred.

(4) Definitions. For purposes of this section –

(i) Bona fide resident. The rules of § 1.937-1 will apply for determining whether an individual is a bona fide resident of the Virgin Islands;

(ii) Source. The rules of § 1.937-2 will apply for determining whether income is from sources within the Virgin Islands; and

(iii) Effectively connected income. The rules of § 1.937-3 will apply for determining whether income is effectively connected with the conduct of a trade or business in the Virgin Islands.

(c) Exception for qualified foreign corporations – (1) In general. Section 934(b)(3) provides an exception to the application of section 934(a). Under this exception, section 934(a) does not apply with respect to tax liability incurred to the Virgin Islands by a qualified foreign corporation to the extent that such tax liability is attributable to income that is derived from sources outside the United States and that is not effectively connected with the conduct of a trade or business within the United States.

(2) Qualified foreign corporation. For purposes of paragraph (c)(1) of this section, the term qualified foreign corporation means any foreign corporation if 1 or more United States persons own or are treated as owning (within the meaning of section 958) less than 10 percent of –

(i) The total voting power of the stock of such corporation; and

(ii) The total value of the stock of such corporation.

(3) Computation rule – (i) Operative rule. For purposes of section 934(b)(3) and this paragraph (c), tax liability incurred to the Virgin Islands for the taxable year attributable to income that is derived from sources outside the United States and that is not effectively connected with the conduct of a trade or business within the United States will be computed as follows:

(A) Add to the income tax liability incurred to the Virgin Islands any credit against the tax allowed under mirrored section 901(a).

(B) Multiply by taxable income that is derived from sources outside the United States and that is not effectively connected with the conduct of a trade or business within the United States (applying the rules of § 1.861-8 to determine deductions allocable to such income).

(D) Subtract any credit allowed under mirrored section 901 (other than credits for taxes paid to the United States or taxes for which a credit is allowable for Federal income tax purposes under section 906 of the Code).

(ii) Limitation. Tax liability incurred to the Virgin Islands attributable to income that is derived from sources outside the United States and that is not effectively connected with the conduct of a trade or business within the United States, as computed in this paragraph (c)(3), however, will not exceed the total amount of income tax liability actually incurred.

(4) U.S. income – (i) In general. For purposes of this section, except as provided in paragraph (c)(4)(ii) of this section, the rules of sections 861 through 865 and the regulations under those provisions will apply for determining whether income is from sources outside the United States or effectively connected with the conduct of a trade or business within the United States.

(ii) Conduit arrangements. Income will be considered to be from sources within the United States for purposes of paragraph (c)(1) of this section if, pursuant to a plan or arrangement –

(A) The income is received in exchange for consideration provided to another person; and

(B) Such person (or another person) provides the same consideration (or consideration of a like kind) to a third person in exchange for one or more payments constituting income from sources within the United States.

(d) Examples. The rules of this section are illustrated by the following examples:

Example 1.(i) S is a U.S. citizen and a bona fide resident of the Virgin Islands. For 2008, S files a Form 1040INFO, “Non-Virgin Islands Source Income of Virgin Islands Residents,” with the Virgin Islands on which S reports total gross income as follows:

Compensation for services performed in the Virgin Islands – $50,000

Compensation for services performed in the United States – $40,000

Compensation for services performed in Mexico – $30,000

Income from inventory sales in Latin America attributable to Virgin Islands office – $20,000

Interest on a U.S. bank account – $6,000

Interest on a V.I. bank account – $5,000

Dividends from a U.S. corporation – $4,000

(ii) Accordingly, S has total gross income of $155,000, comprising income from sources within the Virgin Islands or effectively connected to the conduct of a trade or business in the Virgin Islands (Virgin Islands ECI) of $75,000, income from sources within the United States of $50,000, and income from other sources (not Virgin Islands ECI) of $30,000. After taking into account allowable deductions, S’s total taxable income is $120,000, of which $45,000 is taxable income from sources within the Virgin Islands, $15,000 is taxable income from other sources that is Virgin Islands ECI under the rules of section 937(b) and §§ 1.937-2 and 1.937-3, and $22,500 is taxable income from sources outside the Virgin Islands (and outside the United States) that is not Virgin Islands ECI. S’s tax liability incurred to the Virgin Islands pursuant to the Internal Revenue Code as applicable in the Virgin Islands (mirror code) is $30,000. S is entitled to claim a credit under section 901 of the mirror code in the amount of $10,000 for income tax paid to Mexico and other Latin American countries, for a net income tax liability of $20,000.

(iii) Pursuant to a Virgin Islands law that was duly enacted within the limits of its authority under section 934, S may claim a special deduction relating to his business activities in the Virgin Islands. However, under section 934(b), S’s ability to claim this special deduction is limited. Specifically, the maximum amount of the reduction in S’s mirror code tax liability that may result from claiming this deduction, computed in accordance with paragraph (b)(3) of this section, is as follows: [($20,000 + $10,000) × (($45,000 + $15,000) / $120,000)] − [$10,000 × ($15,000 / ($15,000 + $22,500))] = [$30,000 × ($60,000 / $120,000)] − [$10,000 × ($15,000 / $37,500)] = ($30,000 × 0.5) − ($10,000 × 0.4) = $15,000 − $4,000 = $11,000

(iv) Accordingly, S’s net tax liability incurred to the Virgin Islands must be at least $19,000 ($30,000 − $11,000), prior to taking into account any foreign tax credit.

Example 2.The facts are the same as Example 1, except that S is a U.S. citizen who resides in the United States. As required by section 932(a) and (b), S files with the Virgin Islands a copy of his Federal income tax return and pays to the Virgin Islands the portion of his Federal income tax liability that his Virgin Islands adjusted gross income bears to his adjusted gross income. Under section 934(b)(2), S may not claim the special deduction offered under Virgin Islands law relating to business activities like his in the Virgin Islands to reduce any of his tax liability payable to the Virgin Islands under section 932(b).

Example 3.(i) Z is a nonresident alien who resides in Country FC. In 2008, Z receives dividends from a corporation organized under the law of the Virgin Islands in the amount of $90x. Z’s tax liability incurred to the Virgin Islands pursuant to section 871(a) of the Code as applicable in the Virgin Islands (mirror code) is $27x.

(ii) Pursuant to a Virgin Islands law that was duly enacted within the limits of its authority under section 934, Z may claim a special exemption for income relating to his investment in the Virgin Islands. The maximum amount of the reduction in Z’s mirror code tax liability that may result from claiming this exemption, computed in accordance with paragraph (b)(3) of this section, is as follows: $27x × ($90x/$90x) = $27x.

(iii) Accordingly, depending on the terms of the exemption as provided under Virgin Islands law, Z’s net tax liability incurred to the Virgin Islands may be reduced or eliminated entirely.

Example 4.(i) A Corp is organized under the laws of the Virgin Islands and is engaged in a trade or business in the United States through an office in State N. All of A Corp’s outstanding stock is owned by U.S. citizens who are bona fide residents of the Virgin Islands. During 2008, A Corp had $50x in gross income from sources within the Virgin Islands (as determined under section 937(b) and § 1.937-2) that is not effectively connected with the conduct of a trade or business in the United States; $20x in gross income from sources in Country H that is effectively connected with the conduct of A Corp’s trade or business in the United States; and $10x in gross income from sources in Country R that is not effectively connected with the conduct of A Corp’s trade or business in the United States.

(ii) Section 934(b)(3) permits the Virgin Islands to reduce or remit the income tax liability of a qualified foreign corporation arising under the Code as applicable in the Virgin Islands (mirror code) with respect to income that is derived from sources outside the United States and that is not effectively connected with the conduct of a trade or business in the United States. A foreign corporation constitutes a “qualified foreign corporation” under section 934(b)(3)(B) if less than 10 percent of the total voting power and value of the stock of the corporation is owned or treated as owned (within the meaning of section 958) by one or more United States persons. A U.S. citizen is a “United States person” as defined in section 7701(a)(30)(A). Given that 10 percent or more of the voting power and value of its stock is owned by U.S. citizens, A Corp does not constitute a “qualified foreign corporation” under section 934(b)(3)(B). Accordingly, the Virgin Islands may only reduce or remit A Corp’s mirror code income tax liability with respect to its $50x in gross income from sources within the Virgin Islands.

Example 5.(i) The facts are the same as in Example 4, except that the outstanding stock of A Corp is owned by the following individuals:

U.S. citizens who are bona fide residents of the Virgin Islands – 5%

U.S. citizens who are not bona fide residents of the Virgin Islands – 3%

Nonresident aliens who are bona fide residents of the Virgin Islands – 42%

Nonresident aliens who are not bona fide residents of the Virgin Islands – 50%

(ii) Given that less than 10 percent of the voting power and value of its stock is owned by United States persons, A Corp constitutes a qualified foreign corporation under section 934(b)(3)(B). Accordingly, the Virgin Islands may reduce or remit A Corp’s mirror code income tax liability with respect to its $50x in gross income from sources within the Virgin Islands and its $10x in gross income from sources in Country R that is not effectively connected with the conduct of A Corp’s trade or business in the United States. In no event, however, may the Virgin Islands reduce or remit A Corp’s mirror code income tax liability with respect to its $20x in gross income from sources in Country H that is effectively connected with the conduct of A Corp’s trade or business in the United States.

(e) Effective/applicability date. This section applies for taxable years ending after April 9, 2008.

[T.D. 9391, 73 FR 19365, Apr. 9, 2008]

§ 1.935-1 Coordination of individual income taxes with Guam and the Northern Mariana Islands.

(a) Application of section – (1) Scope. Section 935 and this section set forth the special rules relating to the filing of income tax returns, income tax liabilities, and estimated income tax of individuals described in paragraph (a)(2) of this section. Paragraph (e) of this section also provides special rules requiring consistent treatment of business entities in the United States and in section 935 possessions.

(2) Individuals covered. This section applies to any individual who –

(i) Is a bona fide resident of a section 935 possession during the entire taxable year, whether or not such individual is a citizen of the United States or a resident alien (as defined in section 7701(b)(1)(A));

(ii) Is a citizen of a section 935 possession but not otherwise a citizen of the United States;

(iii) Has income from sources within a section 935 possession for the taxable year, is a citizen of the United States or a resident alien (as defined in section 7701(b)(1)(A)) and is not a bona fide resident of a section 935 possession during the entire taxable year; or

(iv) Files a joint return for the taxable year with any individual described in paragraph (a)(2)(i), (ii), or (iii) of this section.

(3) Definitions. For purposes of this section, the following definitions apply:

(i) The term section 935 possession means Guam or the Northern Mariana Islands, unless such possession has entered into an implementing agreement, as described in section 1271(b) of the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085), with the United States that is in effect for the entire taxable year.

(ii) The term relevant possession means –

(A) With respect to an individual described in paragraph (a)(2)(i) of this section, the section 935 possession of which such individual is a bona fide resident;

(B) With respect to an individual described in paragraph (a)(2)(ii) of this section, the section 935 possession of which such individual is a citizen; and

(C) With respect to an individual described in paragraph (a)(2)(iii) of this section, the section 935 possession from which such individual derives income.

(iii) The rules of § 1.937-1 will apply for determining whether an individual is a bona fide resident of a section 935 possession.

(iv) The rules of § 1.937-2 generally will apply for determining whether income is from sources within a section 935 possession. Pursuant to § 1.937-2(a), however, the rules of § 1.937-2(c)(1)(ii) and (c)(2) do not apply for purposes of section 935(a)(3) (as in effect before the effective date of its repeal) and paragraph (a)(2)(iii) of this section.

(v) The term citizen of the United States means any individual who is a citizen within the meaning of § 1.1-1(c), except that the term does not include an individual who is a citizen of a section 935 possession but not otherwise a citizen of the United States. The term citizen of a section 935 possession but not otherwise a citizen of the United States means any individual who has become a citizen of the United States by birth or naturalization in the section 935 possession.

(vi) With respect to the United States, the term resident means an individual who is a citizen (as defined in § 1.1-1(c)) or resident alien (as defined in section 7701(b)) and who does not have a tax home (as defined in section 911(d)(3)) in a foreign country during the entire taxable year. The term does not include an individual who is a bona fide resident of a section 935 possession.

(vii) The term U.S. taxpayer means an individual described in paragraph (b)(1)(i) or (iii)(B) of this section.

(b) Filing requirement – (1) Tax jurisdiction. An individual described in paragraph (a)(2) of this section must file an income tax return for the taxable year –

(i) With the United States if such individual is a resident of the United States;

(ii) With the relevant possession if such individual is described in paragraph (a)(2)(i) of this section; or

(iii) If neither paragraph (b)(1)(i) nor paragraph (b)(1)(ii) of this section applies –

(A) With the relevant possession if such individual is described in paragraph (a)(2)(ii) of this section; or

(B) With the United States if such individual is a citizen of the United States, as defined in paragraph (a)(3) of this section.

(2) Joint returns. In the case of married persons, if one or both spouses is an individual described in paragraph (a)(2) of this section and they file a joint return of income tax, the spouses shall file their joint return with, and pay the tax due on such return to, the jurisdiction where the spouse who has the greater adjusted gross income for the taxable year would be required under subparagraph (1) of this paragraph to file his return if separate returns were filed. For this purpose, adjusted gross income of each spouse is determined under section 62 and the regulations thereunder but without regard to community property laws; and, if one of the spouses dies, the taxable year of the surviving spouse shall be treated as ending on the date of such death.

(3) Place for filing returns – (i) U.S. returns. A return required under this paragraph (b) to be filed with the United States must be filed as directed in the applicable forms and instructions.

(ii) Guam returns. A return required under this paragraph (b) to be filed with Guam must be filed as directed in the applicable forms and instructions.

(iii) NMI returns. A return required under this paragraph (b) to be filed with the Northern Mariana Islands must be filed as directed in the applicable forms and instructions.

(4) Tax accounting standards. A taxpayer who has filed his return with one of the jurisdictions named in subparagraph (1) of this paragraph for a prior taxable year and is required to file his return for a later taxable year with the other such jurisdiction may not, for such later taxable year, change his accounting period, method of accounting, or any election to which he is bound with respect to his reporting of taxable income to the first jurisdiction unless he obtains the consent of the second jurisdiction to make such change. However, such change will not be effective for returns filed thereafter with the first jurisdiction unless before such later date of filing he also obtains the consent of the first jurisdiction to make such change. Any request for consent to make a change pursuant to this subparagraph must be made to the office where the return is required to be filed under subparagraph (3) of this paragraph and in sufficient time to permit a copy of the consent to be attached to the return for the taxable year.

(5) Tax payments. The tax shown on the return must be paid to the jurisdiction with which such return is required to be filed and must be determined by taking into account any credit under section 31 for tax withheld by the relevant possession or the United States on wages, any credit under section 6402(b) for an overpayment of income tax to the relevant possession or the United States, and any payments under section 6315 of estimated income tax paid to the relevant possession or the United States.

(6) Liability to other jurisdiction – (i) Filing with the relevant possession. In the case of an individual who is required under paragraph (b)(1) of this section to file a return with the relevant possession for a taxable year, if such individual properly files such return and fully pays his or her income tax liability to the relevant possession, such individual is relieved of liability to file an income tax return with, and to pay an income tax to, the United States for the taxable year.

(ii) Filing with the United States. In the case of an individual who is required under paragraph (b)(1) of this section to file a return with the United States for a taxable year, such individual is relieved of liability to file an income tax return with, and to pay an income tax to, the relevant possession for the taxable year.

(7) [Reserved]

(c) Extension of territory – (1) U.S. taxpayers – (i) General rule. With respect to a U.S. taxpayer, for purposes of taxes imposed by Chapter 1 of the Internal Revenue Code (Code), the United States generally will be treated, in a geographical and governmental sense, as including the relevant possession. The purpose of this rule is to facilitate the coordination of the tax systems of the United States and the relevant possession. Accordingly, the rule will have no effect where it is manifestly inapplicable or its application would be incompatible with the intent of any provision of the Code.

(ii) Application of general rule. Contexts in which the general rule of paragraph (c)(1)(i) of this section apply include –

(A) The characterization of taxes paid to the relevant possession. Income tax paid to the relevant possession may be taken into account under sections 31, 6315, and 6402(b) as payments to the United States. Taxes paid to the relevant possession and otherwise satisfying the requirements of section 164(a) will be allowed as a deduction under that section, but income taxes paid to the relevant possession will be disallowed as a deduction under section 275(a);

(B) The determination of the source of income for purposes of the foreign tax credit (for example, sections 901 through 904). Thus, for example, after a U.S. taxpayer determines which items of income constitute income from sources within the relevant possession under the rules of section 937(b), such income will be treated as income from sources within the United States for purposes of section 904;

(C) The eligibility of a corporation to make a subchapter S election (sections 1361 through 1379). Thus, for example, for purposes of determining whether a corporation created or organized in the relevant possession may make an election under section 1362(a) to be a subchapter S corporation, it will be treated as a domestic corporation and a U.S. taxpayer shareholder will not be treated as a nonresident alien individual with respect to such corporation. While such an election is in effect, the corporation will be treated as a domestic corporation for all purposes of the Code. For the consistency requirement with respect to entity status elections, see paragraph (e) of this section;

(D) The treatment of items carried over from other taxable years. Thus, for example, if a U.S. taxpayer has for a taxable year a net operating loss carryback or carryover under section 172, a foreign tax credit carryback or carryover under section 904, a business credit carryback or carryover under section 39, a capital loss carryover under section 1212, or a charitable contributions carryover under section 170, the carryback or carryover will be reported on the return filed with the United States in accordance with paragraph (b)(1)(i) or (b)(1)(iii)(B) of this section, even though the return of the taxpayer for the taxable year giving rise to the carryback or carryover was required to be filed with a section 935 possession; and

(E) The treatment of property exchanged for property of a like kind (section 1031). Thus for example, if a U.S. taxpayer exchanges real property located in the United States for real property located in the relevant possession, notwithstanding the provisions of section 1031(h), such exchange may qualify as a like-kind exchange under section 1031 (provided that all the other requirements of section 1031 are satisfied).

(iii) Nonapplication of general rule. Contexts in which the general rule of paragraph (c)(1)(i) of this section does not apply include –

(B) The determination of any aspect of an individual’s residency (for example, sections 937(a) and 7701(b)). Thus, for example, an individual whose principal place of abode is in the relevant possession is not considered to have a principal place of abode in the United States for purposes of section 32(c);

(C) The determination of the source of income for purposes other than the foreign tax credit (for example, sections 935, 937, and 7654). Thus, for example, income determined to be derived from sources within the relevant possession under section 937(b) will not be considered income from sources within the United States for purposes of Form 5074, “Allocation of Individual Income Tax to Guam or the Commonwealth of the Northern Mariana Islands (CNMI)”;

(D) The definition of wages (section 3401). Thus, for example, services performed by an employee for an employer in the relevant possession do not constitute services performed in the United States under section 3401(a)(8); and

(E) The characterization of a corporation for purposes other than subchapter S (for example, sections 367, 951 through 964, 1291 through 1298, 6038, and 6038B). Thus, for example, if a U.S. taxpayer transfers appreciated tangible property to a corporation created or organized in the relevant possession in a transaction described in section 351, he or she must recognize gain unless an exception under section 367(a) applies. Also, if a corporation created or organized in the relevant possession qualifies as a passive foreign investment company under sections 1297 and 1298 with respect to a U.S. taxpayer, a dividend paid to such shareholder does not constitute qualified dividend income under section 1(h)(11)(B).

(2) Application in relevant possession. In applying the territorial income tax of the relevant possession, such possession generally will be treated, in a geographical and governmental sense, as including the United States. Thus, for example, income tax paid to the United States may be taken into account under sections 31, 6315, and 6402(b) as payments to the relevant possession. Moreover, a citizen of the United States (as defined in paragraph (a)(3) of this section) not a resident of the relevant possession will not be treated as a nonresident alien individual for purposes of the territorial income tax of the relevant possession. Thus, for example, a citizen of the United States (as so defined), or a resident of the United States, will not be treated as a nonresident alien individual for purposes of section 1361(b)(1)(C) of the Guam territorial income tax.

(d) Special rules for estimated income tax – (1) In general. An individual must make each payment of estimated income tax (and any amendment to the estimated tax payment) to the jurisdiction with which the individual reasonably believes, as of the date of that payment (or amendment), that he or she will be required to file a return for the taxable year under paragraph (b)(1) of this section. In determining the amount of such estimated income tax, income tax paid to the relevant possession may be taken into account under sections 31 and 6402(b) as payments to the United States, and vice versa. For other rules relating to estimated income tax, see section 6654.

(2) Joint estimated income tax. In the case of married persons making a joint payment of estimated income tax, the taxpayers must make each payment of estimated income tax (and any amendment to the estimated tax payment) to the jurisdiction where the spouse who has the greater estimated adjusted gross income for the taxable year would be required under paragraph (d)(1) of this section to pay estimated income tax if separate payments were made. For this purpose, estimated adjusted gross income of each spouse for the taxable year is determined without regard to community property laws.

(3) Erroneous payment. If the individual or spouses erroneously pay estimated income tax to the United States instead of the relevant possession or vice versa, only subsequent payments or amendments of the payments are required to be made pursuant to paragraph (d)(1) or (d)(2) of this section with the other jurisdiction.

(4) Place for payment. Estimated income tax required under this paragraph (d) to be paid to Guam or the Northern Mariana Islands must be paid as directed in the applicable forms and instructions issued by the relevant possession. Estimated income tax required under paragraph (d)(1) of this section to be paid to the United States must be paid as directed in the applicable forms and instructions.

(5) Liability to other jurisdiction – (i) Filing with Guam or the Northern Mariana Islands. Subject to paragraph (d)(6) of this section, an individual required under this paragraph (d) to pay estimated income tax (and amendments thereof) to Guam or the Northern Mariana Islands is relieved of liability to pay estimated income tax (and amendments thereof) to the United States.

(ii) Filing with the United States. Subject to paragraph (d)(6) of this section, an individual required under this paragraph (d) to pay estimated income tax (and amendments thereof) to the United States is relieved of liability to pay estimated income tax (and amendments thereof) to the relevant possession.

(6) Underpayments. The liability of an individual described in paragraph (a)(2) of this section for underpayments of estimated income tax for a taxable year, as determined under section 6654, will be to the jurisdiction with which the individual is required under paragraph (b) of this section to file his or her return for the taxable year.

(e) Entity status consistency requirement – (1) In general. Taxpayers should make consistent entity status elections (as defined in paragraph (e)(3)(ii) of this section), when applicable, in both the United States and section 935 possessions. In the case of a business entity to which this paragraph (e) applies –

(i) If an entity status election is filed with the Internal Revenue Service (IRS) but not with the relevant possession, the appropriate tax authority of the relevant possession, at his discretion, may deem the election also to have been made for the relevant possession tax purposes;

(ii) If an entity status election filed with the relevant possession but not with the IRS, the Commissioner, at his discretion, may deem the election also to have been made for Federal tax purposes; and

(iii) If inconsistent entity status elections are filed with the relevant possession and the IRS, both the Commissioner and the appropriate tax authority of the relevant possession may, at their individual discretion, treat the elections they each received as invalid and may deem the election filed in the other jurisdiction to have been made also for tax purposes in their own jurisdiction. See Rev. Proc. 2006-23 (2006-1 C.B. 900) (see § 601.601(d)(2)(ii)(b) of this chapter) for procedures for requesting the assistance of the IRS when a taxpayer is or may be subject to inconsistent tax treatment by the IRS and a U.S. possession tax agency.)

(2) Scope. This paragraph (e) applies to the following business entities:

(i) A business entity (as defined in § 301.7701-2(a) of this chapter) that is domestic (as defined in § 301.7701-5 of this chapter), or otherwise treated as domestic for purposes of the Code, and that is owned in whole or in part by any person who is either a bona fide resident of a section 935 possession or a business entity created or organized in a section 935 possession.

(ii) A business entity that is created or organized in a section 935 possession and that is owned in whole or in part by any U.S. person (other than a bona fide resident of such possession).

(3) Definitions. For purposes of this section –

(i) The term appropriate tax authority of the relevant possession means the individual responsible for tax administration in such possession or his delegate; and

(ii) The term entity status election includes an election under § 301.7701-3(c) of this chapter, an election under section 1362(a), and any other similar elections.

(4) Default status. Solely for the purpose of determining classification of an eligible entity under § 301.7701-3(b) of this chapter and under that section as mirrored in the relevant possession, an eligible entity subject to this paragraph (e) will be classified for both Federal and the relevant possession tax purposes using the rule that applies to domestic eligible entities.

(5) Transition rules – (i) In the case of an election filed prior to April 11, 2005, except as provided in paragraph (e)(5)(ii) of this section, the rules of paragraph (e)(1) of this section will apply as of the first day of the first taxable year of the entity beginning after April 11, 2005.

(ii) In the unlikely circumstance that inconsistent elections described in paragraph (e)(1)(iii) of this section are filed prior to April 11, 2005, and the entity cannot change its classification to achieve consistency because of the sixty-month limitation described in § 301.7701-3(c)(1)(iv) of this chapter, then the entity may nevertheless request permission from the Commissioner or appropriate tax authority of the relevant possession to change such election to avoid inconsistent treatment by the Commissioner and the appropriate tax authority of the relevant possession.

(iii) Except as provided in paragraphs (e)(5)(i) and (e)(5)(ii) of this section, in the case of an election filed with respect to an entity before it became an entity described in paragraph (e)(2) of this section, the rules of paragraph (e)(1) of this section will apply as of the first day that such entity is described in paragraph (e)(2) of this section.

(iv) In the case of an entity created or organized prior to April 11, 2005, paragraph (e)(4) of this section will take effect for Federal income tax purposes (or the relevant possession income tax purposes, as the case may be) as of the first day of the first taxable year of the entity beginning after April 11, 2005.

(f) Examples. The application of this section is illustrated by the following examples:

Example 1.(i) B, a United States citizen, files returns on a calendar year basis. In November 2008, B moves to Possession G, a section 935 possession; purchases a house; and accepts a permanent position with a local employer. For the remainder of the year and throughout 2009, B continues to live and work in Possession G and has a closer connection to Possession G than to the United States or any foreign country. As a consequence of his employment in Possession G, B earns income from the performance of services in Possession G during 2008 and 2009.

(ii) For 2008, B does not qualify as a bona fide resident of Possession G under section 937(a) and § 1.937-1(b) and (f)(1). Therefore, B is subject to the rules applicable to individuals described in paragraph (a)(2)(iii) of this section for 2008 because he has income derived from sources within Possession G as determined under the rules of section 937(b) and § 1.937-2.

(iii) For 2009, assuming that B otherwise satisfies the requirements of section 937(a) and § 1.937-1(b), B qualifies as a bona fide resident of Possession G. Therefore, section 935(b)(1)(B) and paragraph (b)(1)(ii) of this section apply to B for 2009, and he must file his income tax return with Possession G under paragraph (b)(1) of this section. Provided that B properly files such return and pays his income tax liability to Possession G, B is relieved of liability to file an income tax return with, and to pay an income tax to, the United States for 2009 under paragraph (b)(6) of this section.

Example 2.(i) The facts are the same as in Example 1 except that B’s employment terminates in June 2011. B properly pays his April 2008 estimated tax to the United States, continues to pay estimated tax for the 2008 taxable year to the United States under paragraph (d) of this section, and properly files his 2008 return with the United States.

(ii)(A) On the date of each payment of estimated tax in 2009, B reasonably believes that he would be required to file his return for 2009 with Possession G under paragraph (b)(1) of this section.

(B) In August 2009, B determines that he has overpaid tax for the previous year in the amount of $1000. B properly pays all estimated taxes to Possession G for 2009, subtracting the $1000 overpayment from his estimated tax payments pursuant to section 6402(b), and properly files his tax return with Possession G.

(iii) In April 2010, B reasonably believes that he would be returning to the United States in the Fall of 2010, and properly pays estimated tax to the United States. By June 2010, B reasonably believes that he would not be moving from Possession G and would be a bona fide resident of Possession G for the entire taxable year. B makes his remaining estimated tax payments to Possession G. On his 2010 tax return filed with Possession G, pursuant to section 6315, B properly takes into account payments made to both the United States and Possession G as estimated taxes.

(iv) In April 2011, B reasonably believes that he would be a bona fide resident of Possession G for the entire taxable year 2011 and properly pays estimated taxes to Possession G. By the time B pays his estimated taxes for June 2011, B’s employment terminates and he moves to State H. B properly makes his remaining estimated tax payments to the United States. On his return for 2011, properly filed with the United States, B determines that he has underpaid estimated taxes throughout 2011 in an amount subject to penalty under section 6654. B owes the United States an estimated tax penalty under section 6654.

(g) Effective/applicability date. Paragraphs (a), (b)(1), (b)(3), (b)(5) through (b)(7), and (c) through (f) of this section apply to taxable years ending after April 9, 2008.

(Secs. 7805 (68A Stat. 917; 26 U.S.C. 7805) and 7654(e) (86 Stat. 1496; 26 U.S.C. 7654 (e)) of the Internal Revenue Code of 1954)

[T.D. 7385, 40 FR 50261, Oct. 29, 1975, as amended by T.D. 9194, 70 FR 18937, Apr. 11, 2005; T.D. 9391, 73 FR 19367, Apr. 9, 2008]

§ 1.936-1 Elections.

(a) Making an election. A domestic corporation shall make an election under section 936(e), for any taxable year beginning after December 31, 1975, by filing Form 5712 on or before the later of –

(1) The date on which such corporation is required, pursuant to sections 6072(b) and 6081, to file its Federal income tax return for the first taxable year for which the election is made; or

(2) April 8, 1980.

Form 5712 shall be filed with the Internal Revenue Service Center, 11601 Roosevelt Boulevard, Philadelphia, Pennsylvania 19155 (Philadelphia Center).

(b) Revoking an election. Any corporation to which an election under section 936 (e) applies on February 8, 1980 is hereby granted the consent of the Secretary to revoke that election for the first taxable year to which the election applied. (The corporation may make a new election under § 1.936-1 (a) for any subsequent taxable year.) The corporation shall make this revocation by sending to the Philadelphia Center a written statement of revocation on or before April 8, 1980.

(Secs. 7805 and 936(e) of the Internal Revenue Code of 1954 (68A Stat. 917 and 90 Stat. 1644; 26 U.S.C. 7805 and 936(e)))

[T.D. 7673, 45 FR 8588, Feb. 8, 1980; T.D. 7673, 45 FR 16174, Mar. 13, 1980]

§ 1.936-4 Intangible property income in the absence of an election out.

The rules in this section apply for purposes of section 936(h) and also for purposes of section 934(e), where applicable.

Q. 1: If a possessions corporation and its affiliates do not make an election under either the cost sharing or 50/50 profit split option, what rules will govern the treatment of income attributable to intangible property owned or leased by the possessions corporation?

A. 1: Intangible property income will be allocated to the possessions corporation’s U.S. shareholders with the proration of income based on shareholdings. If a shareholder of the possessions corporation is a foreign person or a tax-exempt person, the possessions corporation will be taxable on that shareholder’s pro rata amount of the intangible property income. If any class of the stock of a possessions corporation is regularly traded on an established securities market, then the intangible property income will be taxable to the possessions corporation rather than the corporation’s U.S. shareholders. For these purposes, a United States shareholder includes any shareholder who is a United States person as described under section 7701(a)(30). The term “intangible property income” means the gross income of a possessions corporation attributable to any intangible property other than intangible property which has been licensed to such corporation since prior to 1948 and which was in use by such corporation on September 3, 1982.

Q. 2: What is the source of the intangible property income described in question 1?

A. 2: The intangible property income is U.S. source, whether taxed to U.S. shareholders or taxed to the possessions corporation. Such intangible property income, if treated as income of the possessions corporation, does not enter into the calculation of the 80-percent possessions source test or the 65-percent active trade or business test of section 936(a)(2)(A) and (B).

Q. 3: How will the amount of income attributable to intangible property be measured?

A. 3: Income attributable to intangible property includes the amount received by a possessions corporation from the sale, exchange, or other disposition of any product or from the rendering of a service which is in excess of the reasonable costs it incurs in manufacturing the product or rendering the service (other than costs incurred in connection with intangibles) plus a reasonable profit margin. A reasonable profit margin shall be computed with respect to direct and indirect costs other than (i) costs incurred in connection with intangibles, (ii) interest expense, and (iii) the cost of materials which are subject to processing or which are components in a product manufactured by the possessions corporation. Notwithstanding the above, certain taxpayers who have been permitted by the Internal Revenue Service in taxable years beginning before January 1, 1983, to use the cost-plus method of pricing without reflecting a return from intangibles, but including the cost of materials in the cost base, will not be precluded from doing so. (Sec. 3.02(3), Rev. Proc. 63-10, 1963-1 C.B. 490.) Thus, the Internal Revenue Service may continue in appropriate cases to permit such taxpayers to continue to report their income as they have been under existing procedures described in the previous sentence if it is appropriate under all the facts and circumstances and does not distort the income of the taxpayer.

Q. 4: If there is no intangible property related to a product produced in whole or in part by a possessions corporation, what method may the possessions corporation use to compute its income?

A. 4: The taxpayer may compute its income using the appropriate method as provided under section 482 and the regulations thereunder. The taxpayer may also elect the cost sharing or profit split method.

[T.D. 8090, 51 FR 21524, June 13, 1986]

§ 1.936-5 Intangible property income when an election out is made: Product, business presence, and contract manufacturing.

The rules in this section apply for purposes of section 936(h) and also for purposes of section 934(e), where applicable.

(a) Definition of product.

Q. 1: What does the term “product” mean?

A. 1: The term “product” means an item of property which is the result of a production process. The term “product” includes component products, integrated products, and end-product forms. A component product is a product which is subject to further processing before sale to an unrelated party. A component product may be produced from other items of property, and if it is so produced, may be treated as including or not including (at the choice of the possessions corporation) one or more of such other items of property for all purposes of section 936(h)(5). An integrated product is a product which is not subject to any further processing before sale to an unrelated party and which includes all component products from which it is produced. An end-product form is a product which –

(1) Is not subject to any further processing before sale to an unrelated party;

(2) Is produced from a component product or products; and

(3) Is treated as not including certain component products for all purposes of section 936(h)(5).

A possessions corporation may treat a component product, integrated product, or end-product form as its possession product even though the final stage or stages of production occur outside the possession. Further processing includes transformation, incorporation, assembly, or packaging.

Q. 2: If a possessions corporation produces both a component product and an integrated product (which by definition includes the end-product form), may the possessions corporation use the options under section 936(h)(5) to compute its income with respect to either the component product, the integrated product or the end-product form?

A. 2: Yes. The possessions corporation may choose to treat the component product, the integrated product, or the end-product form as the product for purposes of determining whether the possessions corporation satisfies the significant business presence test. The possessions corporation must treat the same item of property as its product (the possession product) for all purposes of section 936(h)(5) for that taxable year, including the significant business presence test under section 936(h)(5)(B)(ii), the possessions sales calculation under section 936(h)(5)(C)(i)(I), the determination of income under section 936(h)(5)(C)(i)(II), and the combined taxable income computations under section 936(h)(5)(C)(ii). Although the possessions corporation must treat the same item of property as its product for all purposes of section 936(h)(5) in a particular taxable year, its choice of the component product, integrated product or end-product form may be different from year to year. The possessions corporation must specify the possession product on a statement attached to its return (Schedule P of Form 5735). The possessions corporation may specify its choice by either listing the components that are included in the possession product or the components that are excluded from the possession product. The possessions corporation must file a separate Schedule P with respect to each possession product. The possessions corporation must attach to each Schedule P detailed computations indicating how the significant business presence test is satisfied with respect to the possession product identified in that Schedule P.

Q. 3: A possessions corporation produces a product that is sometimes sold to unrelated parties without further processing and is sometimes sold to unrelated parties after further processing. May the possessions corporation choose to treat the same item of property as the possession product even though in some cases it is an integrated product and in some cases it is a component product?

A. 3: Yes. Except as provided in questions and answers 4 and 5, the possessions corporation must designate a single possession product even though it is sometimes a component product and sometimes an integrated product.

Q. 4: A possessions corporation produces a product that is sometimes sold without further processing by any member of the affiliated group to unrelated parties or to related parties for their own consumption and is sometimes sold after further processing by any member of the affiliated group to unrelated parties or to related parties for their own consumption. May the possessions corporation designate two products as possession products?

A. 4: The possessions corporation may designate two or more possession products. The possessions corporation must use a consistent definition of the possession product for all items of property that are sold to unrelated parties or consumed by related parties at the same stage in the production process. The significant business presence test shall apply separately to each product designated by the possessions corporation. The possessions corporation shall compute its income separately with respect to each product.

Q. 5: A possessions corporation produces a product in one taxable year and does not sell all of the units that it produced. In the next taxable year the possessions corporation produces a product which includes the product produced in the prior year. The possessions corporation could not have satisfied the significant business presence test with respect to the units produced the first taxable year if the larger possession product had been designated. May the possessions corporation designate two possession products in the second year?

A. 5: Yes. The possessions corporation may designate two possession products. However, once a product has been designated for a particular year all sales of units produced in that year must be defined in the same manner. In addition, the taxpayer must maintain a significant business presence in a possession with respect to that product. Sales shall be deemed made first out of the current year’s production. If all of the current year’s production is sold and some inventory is liquidated, then the taxpayer’s method of inventory accounting shall be applied to determine what year’s layer of inventory is liquidated.

Example 1.A possessions corporation S, manufactures a bulk pharmaceutical in a possession. S transfers the bulk pharmaceutical to its U.S. parent, P, for encapsulation and sale by P to customers. S satisifes the significant business presence test with respect to the bulk pharmaceutical (the component product) and the combination of the bulk pharmaceutical and the capsule (the integrated product). S may use the cost sharing or profit split method to compute its income with respect to either the component product or the integrated product.

Example 2.The facts are the same as in example 1 except that S does not satisfy the significant business presence test with respect to the integrated product. S may use the cost sharing or profit split method to compute its income only with respect to the component product. However, if in a later taxable year S satisfies the significant business presence test with respect to the integrated product, then S may use the cost sharing or profit split method to compute its income with respect to that integrated product for that later taxable year.

Example 3.P, a domestic corporation, produces in bulk form in the United States the active ingredient for a pharmaceutical product, P transfers the bulk form to S, a wholly owned possessions corporation. S uses the bulk form to produce in Puerto Rico the finished dosage form drug. S transfers the drug in finished dosage form to P, which sells the drug to unrelated customers in the U.S. The direct labor costs incurred in Puerto Rico by S during its taxable year in formulating, filling and finishing the dosage form are at least 65 percent of the total direct labor costs incurred by the affiliated group in producing the bulk and finished forms during that period. S manufactures (within the meaning of section 954(d)(1)(A)) the finished dosage form. S has elected out under section 936(h)(5) under the profit split option for the drug product area (SIC 283). P and S may treat the bulk and finished dosage forms as parts of an integrated product. Since S satisfies the significant business presence requirement with respect to the integrated product, it is entitled to 50 percent of the combined taxable income on the integrated product.

Example 4.A possessions corporation, S. produces the keyboard of an electric typewriter and incorporates the keyboard with components acquired from a related corporation into finished typewriters. S does not satisfy the significant business presence test with respect to the typewriters (the integrated product). Therefore, S may use the cost sharing or profit split method to compute its income only with respect to a component product or end-product form. For taxable year 1983, S specifies on a statement attached to its return (Schedule P of Form 5735) that the possession product is the end-product form. The statement indentifies the components – for example, the keyboard structure and frame – which are included in the possession product. S’s definition of the possession product will apply to all units of the electric typewriters which S produces in whole or in part in the possession and which are sold in 1983. Thus, all units of a given component incorporated into such typewriters will be treated in the same way. For example, all keyboards and all frames will be included in the possession product, and all electric drive mechanisms and rollers will be excluded from the possession product.

Example 5.Possessions corporation A produces printed circuit boards in a possession. The printed circuit boards are sold to unrelated parties. A also uses the boards to produce personal computers in the possession. A may designate two possession products: printed circuit boards and personal computers. The significant business presence test applies separately with respect to each of these products. Thus, for those printed circuit boards that are sold to unrelated parties, only the costs of the possessions corporation and the other members of the affiliated group that are incurred with respect to units of the printed circuit boards which are produced in whole or in part in the possessions and sold to third parties shall be taken into account. Conversely, with respect to personal computers, only the costs incurred with respect to the personal computers shall be taken into account. This would include the costs with respect to printed circuit boards that are incorporated into personal computers but not the costs incurred with respect to printed circuit boards that are sold without further processing to unrelated parties.

Example 6.Possessions corporation S produces integrated circuits in a possession. P, an affilate of S, produces circuit boards in the United States. P transfers the circuit boards to S. S assembles the integrated circuits and the circuit boards. S sells some of the loaded circuit boards to third parties. S retains some of the loaded circuit boards and incorporates them into central processing units. The central processing units are then sold to third parties. S may designate two possession products. S must use a consistent definition of the possession product for all units that are sold at the same stage in the production process. Thus, with respect to those units sold after assembly of the integrated circuits and the printed circuits boards, if S cannot satisfy the significant business presence test with respect to all the loaded circuit boards (the integrated product), then S must designate a lesser product, either the integrated circuit (the component product) or the loaded circuit board less the printed circuit board (the end-product form) as its possession product. With respect to the central processing units sold the same rule would apply. Thus, if S cannot satisfy the significant business presence test with respect to the entire central processing unit for all of the central processing units sold, S must designate some lesser product as its possession product.

Example 7.S is a possession corporation. In 1985, S produced 100 units of product X. Those units were finished into product Y in 1985 by affiliates of S. Product X is a component of product Y. In 1985, S satisfies the direct labor test with respect to product X but not with respect to product Y. S designates the component product X as its possession product. In 1986 S produces 100 units of product X and finishes those units into product Y. S would have satisfied the significant business presence test with respect to product X if S had designated product X as its possession product in 1986. In addition, in 1986 S satisfies the significant business presence test with respect to the integrated product Y. In 1986, S sells 150 units of Y. One hundred of those units would be deemed to be produced in 1986. With respect to those units S may designate the integrated product Y as its possession product. Under S’s method of inventory accounting the remaining 50 units were determined to have been produced in 1985. With respect to those units S must define its possession product as it did for the taxable year in which those units were produced. Thus, S’s possession product would be the component product X.

Q. 6: May an affiliated group establish groupings of possession products and treat the groupings as single products?

A. 6: An affiliated group may establish reasonable groupings of possession products based on similarities in the production processes of the possession products. Possession products that are grouped shall be treated as a single product. The determination of whether the production processes involved in producing the products that are to be grouped are similar is based on the production processes of the components that are included in the possession product. The affiliated group may establish new groupings each year. Any grouping which materially distorts a taxpayer’s income or the application of the significant business presence test may be disallowed by the Commissioner. The mere fact that a grouping results in an increased allocation of income to the possessions corporation does not, of itself, create a material distortion of income. If the Commissioner determines that the taxpayer’s grouping is improper with respect to one or more products in a group, then those products shall be excluded from the group. The effect of excluding a product or products from the group is that the taxpayer must demonstrate that the group without the excluded products (and each excluded product itself) satisfies the significant business presence test. If the group without the excluded products, or any of the excluded products themselves, fails to satisfy the significant business presence test, then the possessions corporation’s income from those products shall be determined under section 936(h)(1) through (4) and the regulations thereunder.

Example 1.The following are examples of possession products the processes of production of which are sufficiently similar that they may be grouped and treated as a single product:

(A) Beverage bases or concentrates for different soft drinks or soft drink syrups, regardless of whether some include sweeteners and some do not:

(B) Different styles of clothing;

(D) Equipment which relies on gravity to deliver solutions to patients intravenously;

(E) Equipment which relies on machines to deliver solutions to patients intravenously;

(F) Video game cartridges, even though the concept and design of each game title is, in part, protected against infringement by separate copyrights;

(G) All integrated circuits;

(H) All printed circuit boards; and

(I) Hardware and software if the software is one of several alternative types of software offered by the manufacturer and sold only with the hardware, and a purchaser of the hardware would ordinarily purchase one or more of the manufacturer-provided alternative types of software. In all other cases, hardware and software may not be grouped and treated as a single product.

Groupings (D) and (E) do not include any solutions which are delivered through the equipment described therein.

Example 2.A possessions corporation produces in Puerto Rico non-programmable, interactive cathode ray tube computer terminals that vary in price. These terminals all interact with a computer or controller to perform their functions of data entry, graphics word processing, and program development. The terminals can be purchased with options that include a built-in printer, different language keyboards, specialized cathode ray tubes, and different power supply features. All terminals are produced in one integrated process requiring the same skills and operations. The differences in the production of the terminals include differences in the number of printed circuit boards incorporated in each terminal, the use of unique keyboards, and the installation and testing of the built-in printer. Some difference in direct labor time to manufacture the terminals occurs, primarily due to the differing number and complexity of printed circuit boards incorporated into each terminal. Different model numbers are assigned to various computer terminals. A grouping by the taxpayer of all of the terminals as one product will be respected by the Service, unless the Service establishes that substantial distortion results. This grouping is proper because the processes of producing each of the terminals are similar.

Example 3.A possessions corporation, S produces several models of serial matrix impact printers and teleprinters. These products have differing performance standards based on such factors as speed (in characters per second), numbers of columns, and cost. The production process for all types of printers involves production of three basic elements: electronic circuitry, the printing head, and the mechanical parts. The process of producing all the printers is similar. Thus, all printers could be grouped and treated as a single product. S purchases electronic circuitry and mechanical parts from a U.S. affiliate. S performs manufacturing functions relative to the printing head and assembles and tests the finished printers. S does not satisfy the significant business presence test with respect to the integrated products. S therefore specifies on a statement attached to its return (Schedule P of Form 5735) that the possession product for both the serial matrix printers and the teleprinters is the end-product form. The statement identifies the components which are included in each possession product. S may group and treat as a single product the serial matrix printers and the teleprinters if both end-product forms include and exclude similar components. Thus, if the end-product form for both the serial matrix printers and the teleprinters includes the mechanical parts and excludes the electronic circuitry, then S may group and treat as a single product the two end-product forms. If, however, the end-product forms for the two items of property contain components that are not similar and as a result of this definition of the end-product forms the production processes involved in producing the two end-product forms are not similar, then S may not group the end-product forms.

Q. 7: Is the affiliated group permitted to include in a group an item of property that is not produced in whole or in part in a possession?

A. 7: No.

Example 1.Possessions corporation S produces 70 units of product A in a possession. P, an affiliate of S, produces 30 units of product A entirely in the United States. All of the units are sold to unrelated parties. The affiliated group is not permitted to group the 30 units of product A produced in the United States with the 70 units produced in the possession because those units are not produced in whole or in part in a possession.

Example 2.The facts are the same as in example 1 except that the 30 units of product A are transferred to possessions corporation S. S incorporates the 100 units of product A into product B. This incorporation takes place in the possession. S may group and treat as a single product all of the units of product B even though some of those units contain units of product A that were produced in the possession and some that were produced in the United States.

Q. 8: What factors should be disregarded in determining whether a particular grouping of similar items of property is reasonable?

A. 8: In general, differences in the following factors will be disregarded in determining whether a particular grouping of items of property is reasonable:

(1) Differences in testing requirements (e.g., some products sold for military use may require more extensive or different testing than products sold for commercial use);

(2) Differences in the product specifications that are designed to accommodate the product to its area of use or for conditions under which used (e.g., electrical products designed for ultimate use in the United States differ from electrical products designed for ultimate use in Europe);

(3) Differences in packaging or labeling (e.g., differences in the number of units of the items shipped in one package); and

(4) Minor differences in the operations of the items of property.

Q. 9: What rules apply for purposes of determining whether pharmaceutical products are properly grouped and treated as a single product?

A. 9: The rules contained in questions and answers 6 through 8 of this section shall apply. Thus, an affiliated group may establish reasonable groupings based on similarities in the production processes of two or more possession products. In establishing a group the affiliated group may only compare the production processes involved in producing the possession products. The fact that two pharmaceutical products contain different active or inert ingredients is not relevant to the determination of whether the pharmaceutical products may be grouped. For example, if the possession products are bulk chemicals and the production processes involved in producing the bulk chemicals are similar, those bulk chemicals may be grouped and treated as a single product even though they contain different active or inert ingredients. The affiliated group may also group and treat as a single product the finished dosage form drug as long as the production processes involved in producing the finished dosage forms are similar. For these purposes, the production processes involved in producing the following classes of items shall be considered to be sufficiently similar that possession products delivered in a form described in one of the categories may be grouped with other possession products delivered in a form described in the same category.

The categories are:

(1) Capsules, tablets, and pills;

(2) Liquids, ointments, and creams; or

(3) Injectable and intravenous preparations.

No distinctions should be based on packaging, list numbers, or size of dosage. The affiliated group may group and treat as a single product the integrated product (combination of the bulk and the delivery form) only if all the production processes involved in producing the integrated products are similar. The rules of this question and answer are illustrated by the following examples.

Example 1.Possessions corporation S produces two chemical active ingredients X and Y. Both chemical ingredients are produced through the process of fermentation. The affiliated group is permitted to group and treat as a single product the two chemical ingredients.

Example 2.The facts are the same as in example 1 and possessions corporation S finishes chemical ingredient X into tablets and chemical ingredient Y into capsules. The affiliated group is permitted to group and treat as a single product the combination of the bulk pharmaceutical and the finishing because the production processes involved in producing the integrated products are similar.

Example 3.Possessions corporation S produces in a possession a bulk chemical X by fermentation. A United States affiliate, P, produces in the United States a bulk chemical, Y, by fermentation. Both bulk chemicals are finished by S in the possession. The finished dosage form of X is in pill form. The finished dosage form of Y is in injectable form. If S’s possession product is the integrated product or the end-product form then S may not group X and Y because the production processes involved in producing the finished dosage form of X and Y are not similar. If S’s possession product is the component then S may not group X and Y because the bulk chemical Y is not produced in whole or in part in a possession.

Q. 10: Will the fact that a manufacturer of a drug must submit a New Drug Application (“NDA”) or a supplemental NDA to the Food and Drug Administration have any effect on the definition or grouping of a product?

A. 10: No.

Q. 11: A possessions corporation which produced a product or rendered a type of service in a possession on or before September 3, 1982, is not required to meet the significant business presence test in a possession with respect to such product or type of service for its taxable years beginning before January 1, 1986 (the interim period). During such interim period, how will the term “product” be defined for purposes of allocating income under the cost sharing or profit split methods?

A. 11: During the interim period the product will be determined based on the activities performed by the possessions corporation within a possession on September 3, 1982. During the interim period the possessions corporation may compute its income under the cost sharing or profit split method only with respect to the product that is produced or manufactured within the meaning of section 954(d)(1)(A) within the possession. If the product is manufactured from a component or components produced by an affiliated corporation or a contract manufacturer, then the product will not be treated as including such component or components for purposes of the computation of income under the cost sharing or profit split methods. Thus, the possessions corporation is not entitled to any return on the intangibles associated with the component or components. Notwithstanding the preceding sentences, for taxable years beginning before January 1, 1986, a possessions corporation may compute its income under the cost sharing or profit split method with respect to a product which includes a component or components produced by an affiliated corporation or contract manufacturer if the possessions corporation satisfies with respect to such product the significant business presence test described in section 936(h)(5)(B)(ii) and the regulations thereunder.

Example 1.A possessions corporation, S, was manufacturing (within the meaning of section 954(d)(1)(A)) integrated circuits in a possession on September 3, 1982. S transferred those integrated circuits to related corporation P. P incorporated the integrated circuits into central processing units (CPUs in the United States) and sold the CPUs to unrelated parties. S continued to manufacture integrated circuits in the possession through Juanuary 1, 1986. For taxable years beginning before January 1, 1986, S may compute its income under the cost sharing or profit split method with respect to the integrated circuits regardless of whether S satisfies the significant business presence test. However, unless S satisfies the significant business presence test with respect to the central processing units, S may not compute its income under the cost sharing or profit split methods with respect to the CPUs, and thus, S is not entitled to any return on manufacturing intangibles associated with CPUs to the extent that they are not related to the integrated circuits produced by S, nor (except as provided in the profit split methods) to any return on marketing intangibles.

Example 2.A possessions corporation, S, was engaged on September 3, 1982, in the manufacture (within the meaning of section 954(d)(1)(A)) of a bulk pharmaceutical in Puerto Rico from raw materials. S sold the bulk pharmaceutical to its U.S. parent, P, for encapsulation and sale by P to customers as the product X. Because S was not engaged in the encapsulation of X, S is not considered to have manufactured the integrated product, X, in Puerto Rico. During the interim period, S may compute its income under the cost sharing or profit split methods with respect to the integrated product, X, only if S satisfies the significant business presence test with respect to X. S may compute its income under the cost sharing or profit split methods with respect to the component product (the bulk pharmaceutical).

Example 3.P is a domestic corporation that is not a possessions corporation. P manufactures a bulk pharmaceutical in the United States. P transfers the bulk pharmaceutical to its wholly owned subsidiary, S, a possessions corporation. On September 3, 1982, S was engaged in the encapsulation of the bulk pharmaceutical in Puerto Rico in a manner which satisfies the test of section 954(d)(1)(A). For taxable years beginning before January 1, 1986, S may compute its income under the cost sharing or profit split methods with respect to the end-product form the (the encapsulated drug) regardless of whether S meets the significant business presence test. However, unless S satisfies the significant business presence test with respect to the integrated product, S may not compute its income under the cost sharing or profit split methods with respect to the integrated product, and thus, S is not entitled to any return on the intangibles associated with the bulk pharmaceutical.

Q. 12: On September 3, 1982, a possessions corporation, S was engaged in the manufacture (within the meaning of section 954(d)(1)(A)) of X in a possession. During the interim period, after September 3, 1982, but before January 1, 1986, S produced Y, which differs from X in terms of minor design features. S did not produce Y in a possession on September 3, 1982. Will S be considered to have commenced production of a new product after September 3, 1982, for purposes of the application of the significant business presence test for the interim period?

A. 12: No. X and Y will be considered to be a single product, and therefore S will not be required to satisfy the business presence test separately with respect to Y during the interim period. In all cases in which the items of property produced on or before September 3, 1982 and the items of property produced after that date could have been grouped together under the guidelines provided in § 1.936-5(a) questions and answers 6 through 10, the possessions corporation will not be considered to manufacture a new product after September 3, 1982.

Q. 13: May the term “product” be defined differently for export sales than for domestic sales?

A. 13: Yes. For rules concerning the application of the separate election for export sales see § 1.936-7(b).

(b) Requirement of significant business presence – (1) General rules.

Q. 1: In general, a possessions corporation may compute its income under the cost sharing or profit split methods with respect to a product only if the possessions corporation has a significant business presence in a possession with respect to that product. When will a possession corporation be considered to have a significant business presence in a possession?

A. 1: For purposes of the cost sharing method, the significant business presence test is met if the possessions corporation satisfies either a value added test or a direct labor test. For purposes of the profit split method, the significant business presence test is met if the possessions corporation satisfies either a value added test or a direct labor test and also manufactures the product in the possession within the meaning of section 954(d)(1)(A).

Q. 2: How may a possessions corporation satisfy the direct labor test with respect to a product?

A. 2: The possessions corporation will satisfy the direct labor test with respect to a product if the direct labor costs incurred by the possessions corporation as compensation for services performed in a possession are greater than or equal to 65 percent of the direct labor costs of the affiliated group for units of the possession product produced during the taxable year in whole or in part by the possessions corporation.

Q. 3: How may a possessions corporation satisfy the value added test?

A. 3: In order to satisfy the value added test, the production costs of the possessions corporation incurred in the possession with respect to units of the possession product produced in whole or in part by the possessions corporation in the possession and sold or otherwise disposed of during the taxable year by the affiliated group to unrelated parties must be greater than or equal to twenty-five percent of the difference between gross receipts from such sales or other dispositions and the direct material costs of the affilated group for materials purchased for such units from unrelated parties.

Q. 4: Must the significant business presence test be met with respect to all units of the product produced during the taxable year by the affiliated group?

A. 4: No. The significant business presence test must be met with respect to only those units of the product produced during the taxable year in whole or in part by the possessions corporation in a possession.

Q. 5: For purposes of determining whether a possessions corporation satisfies the significant business presence test, how shall the possessions corporation treat the cost of components transferred to the possessions corporation by a member of the affiliated group?

A. 5: The treatment of the cost of components transferred from an affiliate depends on whether the possession product is treated as including the components for purposes of section 936(h). If it is, then for purposes of the value added test, the production costs associated with the component shall be treated as production costs of the affiliated group that are not incurred by the possessions corporation. Those production costs, other than the cost of materials, shall not be treated as a cost of materials. For purposes of the direct labor test and the alternative significant business presence test, the direct labor costs associated with such components shall be treated as direct labor costs of the affiliated group that are not incurred by the possessions corporation. If the possession product is treated as not including such component for purposes of section 936(h), then, solely for purposes of determining whether the possessions corporation satisfies the value added test, the cost of the component shall not be treated as either a cost of materials or as a production cost. For purposes of the direct labor test and the alternative significant business presence test, the direct labor costs associated with such component shall not be treated as direct labor costs of the affiliated group. If the possession product is treated as not including such component, then the possessions corporation shall not be entitled to any return on the intangibles associated with the manufacturing or marketing of the component.

Q. 6: May two or more related possessions corporations aggregate their production or direct labor costs for purposes of determining whether they satisfy the significant business presence test with respect to a single product?

A. 6: No.

Q. 7: A possessions corporation, S, purchases raw materials and components from an unrelated corporation which conducts business outside of a possession. The unrelated corporation is not a contract manufacturer. What is the treatment of such raw materials and components for purposes of the significant business presence test?

A. 7: Where Company S purchases raw materials or components from an unrelated corporation which is not a contract manufacturer, the raw materials and components are treated as materials, and the costs related thereto are treated as a cost of materials.

(2) Direct labor costs.

Q. 1: How is the term “direct labor costs” to be defined?

A. 1: The term “direct labor costs” has the same meaning which it has for purposes of § 1.471-11(b)(2)(i). Thus, direct labor costs include the cost of labor which can be identified or associated with particular units or groups of units of a specific product. The elements of direct labor include such items as basic compensation, overtime pay, vacation and holiday pay, sick leave pay (other than payments pursuant to a wage continuation plan under section 105(d)), shift differential, payroll taxes, and payments to a supplemental unemployment benefit plan paid or incurred on behalf of employees engaged in direct labor.

Q. 2: May a taxpayer treat a cost as a direct labor cost if it is not included in inventoriable costs under section 471 and the regulations thereunder?

A. 2: No. A cost may be treated as a direct labor cost only if it is included in inventoriable costs. However, a cost may be considered a direct labor cost even though the activity to which it relates would not constitute manufacturing under section 954(d)(1)(A) as long as the cost is included in inventoriable costs.

Q. 3: May the members of the affiliated group include as direct labor costs the labor element in indirect production costs?

A. 3: No. The labor element of indirect production costs may not be considered as part of direct labor costs.

Q. 4: Do direct labor costs include the costs which can be identified or associated with particular units or groups of units of a specific product if those costs could also be described as quality control and inspection?

A. 4: Yes. Direct labor costs include costs which can be identified or associated with particular units or groups of units of a specific product. Thus, if quality control and inspection is an integral part of the production process, then the labor associated with that quality control and inspection shall be considered direct labor. For example, integrated circuits are soldered to printed circuit boards by passing the boards over liquid solder. Employees inspect each of the boards and repair any imperfectly soldered joints discovered on that inspection. The labor associated with this process is direct labor. However, if a person performs random inspections on limited numbers of products, then that labor associated with those inspections shall be considered quality control and therefore indirect labor.

Q. 5: Do direct labor costs of the possessions corporation include only the costs which were actually incurred or do they take into account, in addition, any labor savings which result because the activities were performed in a possession rather than in the United States?

A. 5: Direct labor costs include only the costs which were actually incurred.

Q. 6: For purposes of determining whether a possessions corporation satisfies the significant business presence test for a taxable year with respect to a product, how shall the possessions corporation compute its direct labor costs of units of the product?

A. 6: The direct labor test shall be applied separately to products produced in whole or in part by the possessions corporation in the possession during each taxable year. Sales shall be deemed to be made first out of the current year’s production. If sales are made only out of the current year’s production, then the direct labor costs of producing those units that are sold shall be the pro rata portion of the total direct labor costs of producing all the units that are produced in whole or in part in the possession by the possessions corporation during the current year. If all of the current year’s production is sold and some inventory is liquidated, then the direct labor test shall be applied separately to the current year’s production and the liquidated inventory. The direct labor costs of producing the liquidated inventory shall be the pro rata portion of the total direct labor costs that were incurred in producing all the units that were produced in whole or in part by the possessions corporation in the possessions in the layer of liquidated inventory determined under the member’s method of inventory accounting.

Example.S is a cash basis calendar year taxpayer that has made an election under section 936(a). In 1985 S produced 100 units of product X. Fifty percent of the direct labor costs of the affiliated group were incurred by S and were compensation for services performed in the possession. Thus, S did not satisfy the significant business presence test with respect to product X in taxable year 1985. During 1986 S produced 100 units of product X. One hundred percent of the direct labor costs of the affiliated group were incurred by S and were compensation for services performed in the possession. In 1986 S sells 150 units of product X. One hundred of those units are deemed to be from the units produced in 1986. With respect to those units S satisfies the significant business presence test. Under S’s method of inventory accounting the remaining 50 units were determined to be produced in 1985. With respect to those units S does not satisfy the significant business presence test because only 50% of the direct labor costs incurred in producing those units were incurred by S and were compensation for services performed in the possession.

Q. 7: What is the result if in a particular taxable year the possessions corporation satisfies the significant business presence test with respect to units of the product produced in one year and fails the significant business with respect to units produced in another year?

A. 7: For those units of the product with respect to which the possession corporation satisfies the significant business presence test, the possessions corporation may compute its income under the provisions of section 936(h)(5). For those units of the product with respect to which the possessions corporations fails the significant business presence test, the possessions corporation must compute its income under section 936(h)(1) through (4).

Q. 8: Do direct labor costs include costs incurred in a prior taxable year with respect to units of the possession product that are finished in a later taxable year?

A. 8: Yes.

(3) Direct material costs.

Q. 1: How is the term “direct material costs” to be defined?

A. 1: Direct material costs include the cost of those materials which become an integral part of the specific product and those materials which are consumed in the ordinary course of manufacturing and can be identified or associated with particular units or groups of units of that product. See § 1.471-3 for the elements of direct material costs.

Q. 2: May a taxpayer treat a cost as a direct material cost if it is not included in inventoriable costs under section 471 and the regulations thereunder?

A. 2: A taxpayer may not treat such costs as direct material costs.

(4) Production costs.

Q. 1: How is the term “production costs” defined?

A. 1: The term “production costs” has the same meaning which it has for purposes of § 1.471-11(b) except that the term does not include direct material costs and interest. Thus, production costs include direct labor costs and fixed and variable indirect production costs (other than interest).

Q. 2: With respect to indirect production costs described in § 1.471-11(c)(2) (ii) and (iii), may a possessions corporation include these costs in production costs for purposes of section 936, if they are not included in inventoriable costs under section 471 and the regulations thereunder?

A. 2: No. A possessions corporation may include these costs only if they are included for purposes of section 471 and the regulations thereunder. If a possessions corporation and the other members of the affiliated group include and exclude different indirect production costs in their inventoriable costs, then, for purposes of the significant business presence test, the possessions corporation shall compute its production costs and the production costs of the other members of the affiliated group by subtracting from the production costs of each member all indirect costs included by that member that are not included in production costs by all other members of the affiliated group.

Q. 3: Does a change in a taxpayer’s method of accounting for purposes of section 471 affect the taxpayer’s computation of production costs for purposes of section 936?

A. 3: Yes. If a taxpayer changes its method of accounting for purposes of section 471, then the same change shall apply for purposes of section 936.

Q. 4: For purposes of determining whether a possessions corporation satisfies the significant business presence test for a taxable year with respect to a product, how shall the possessions corporation compute its costs of producing units of the product sold or otherwise disposed to unrelated parties during the taxable year?

A. 4: All members of the affiliated group may elect to use their current year production costs regardless of whether the members use the FIFO or LIFO method of inventory accounting. If some or all of the current year’s production of a product is sold, then the production costs of producing those units sold shall be the pro rata portion of the total production costs of producing all the units produced in the current year. If all of the current year’s production of a product is sold and some inventory is liquidated, then the production costs of producing the liquidated inventory shall be the pro rata portion of the production costs incurred in producing the layer of liquidated inventory as determined under the member’s method of inventory accounting.

Q. 5: How should the members of the affiliated group determine the portion of their production costs that is allocable to units of the product sold or otherwise disposed of during the taxable year?

A. 5: The members of the affiliated group may use either standard production costs (so long as variances are not material), average production costs, or FIFO production costs to determine the production costs that will be considered to be attributable to units of the product sold or otherwise disposed of during the taxable year. However, all members of the affiliated group must use the same method.

Q. 6: When is the quality control and inspection of a product considered to be part of the production activity for that product?

A. 6: Quality control and inspection of a manufactured product before its sale or other disposition by the manufacturer, or before its incorporation into other products, is considered to be part of the indirect production activity for that initial product. Subsequent testing of a product to ensure that the product is compatible with other products is not a part of the production activity for the initial product.

When a component is incorporated into an end-product form and the end-product form is then tested, the latter testing will be considered to be a part of the indirect production activity for the end-product form and will not be considered to be a part of the production activity for the component.

Q. 7: For purposes of the significant business presence test and the allocation of income to a possessions corporation, what is the treatment of the cost of installation of a product?

A. 7: For purposes of the significant business presence test and the allocation of income to a possessions corporation, product installation costs need not be taken into account as costs incurred in the manufacture of that product, if the taxpayer keeps such permanent books of account or records as are sufficient to establish the fair market price of the uninstalled product. In such a case, the cost of installation materials, the cost of the labor for installation, and a reasonable profit for installation will not be included in the costs and income associated with the possession product. If the taxpayer does not keep such permanent books of account or records, then the cost of installation materials and the cost of labor for installation shall be treated as costs associated with the possession product and income will be allocated to the possessions corporation and its affiliates under the rules provided in these regulations.

Q. 8: For purposes of the significant business presence test and the allocation of income to a product or service, what is the treatment of the cost of servicing and maintaining a possession product that is sold to an unrelated party?

A. 8: The cost of servicing and maintaining a possession product after it is sold is not associated with the production of that product.

Q. 9: For purposes of the significant business presence test and the allocation of income to a possessions corporation, what is the treatment of the cost of samples?

A. 9: The cost of producing samples will be treated as a marketing expense and not as inventoriable costs for these purposes. However, for taxable years beginning prior to January 1, 1986, the cost of producing samples may be treated as either a marketing expense or as inventoriable costs.

(5) Gross receipts.

Q. 1: How shall the affiliated group determine gross receipts from sales or other dispositions by the affiliated group to unrelated parties of the possession product?

A. 1: Gross receipts shall be determined in the same manner as possession sales under the rules contained in § 1.936-6(a)(2).

(6) Manufacturing within the meaning of section 954(d)(1)(A).

Q. 1: What is the test for determining, within the meaning of section 954(d)(1)(A), whether a product is manufactured or produced by a possessions corporation in a possession?

A. 1: A product is considered to have been manufactured or produced by a possessions corporation in a possession within the meaning of section 954(d)(1)(A) and § 1.954-3(a)(4) if –

(i) The property has been substantially transformed by the possessions corporation in the possession;

(ii) The operations conducted by the possessions corporation in the possession in connection with the property are substantial in nature and are generally considered to constitute the manufacture or production of property; or

(iii) The conversion costs sustained by the possessions corporation in the possession, including direct labor, factory burden, testing of components before incorporation into an end product and testing of the manufactured product before sales account for 20 percent or more of the total cost of goods sold of the possessions corporation.

In no event, however, will packaging, repackaging, labeling, or minor assembly operations constitute manufacture or production of property. See particularly examples 2 and 3 of § 1.954-3(a)(4)(iii).

Q. 2: Does the requirement that a possession product be produced or manufactured in a possession within the meaning of section 954(d)(1)(A) apply to taxable years beginning before January 1, 1986?

A. 2: A possessions corporation must satisfy this requirement for taxable years beginning before January 1, 1986, in the following cases:

(i) If the possessions corporation makes a separate election under section 936(h)(5)(F)(iv)(II) with respect to export sales;

(ii) If the possessions corporation is electing as its possession product a product that is subject to the interim period rules of § 1.936-5(a) question and answer (10); or

(iii) If the possessions corporation is electing as its possession product a product that is not subject to the interim period rules of § 1.936-5 (a) question and answer (10) and the possessions corporation computes its income under the profit split method with respect to that product.

For rules concerning products first produced in a possession after September 3, 1982, see § 1.936-5(b)(7) question and answer (2).

(7) Start-up operations.

Q. 1: With respect to products not produced (and types of services not rendered) in the possession on or before September 3, 1982, when must a possessions corporation first satisfy the 25 percent value added test or the 65 percent direct labor test?

A. 1: A transitional period is established such that a possessions corporation engaged in start-up operations with respect to a product or service need not satisfy the 25 percent value added test or the 65 percent labor test until the third taxable year following the taxable year in which such product is first sold by the possessions corporation or such service is first rendered by the possessions corporation. During the transitional period, the applicable percentages for these tests will be as follows:

	Any year after 1982
	1	2	3
Value added test	10	15	20
Labor test	35	45	55

Q. 2: Does the requirement that a possession product be produced or manufactured in a possessions within the meaning of section 954(d)(1)(A) apply to a product if the possessions corporation is engaged in start-up operations with respect to that product?

A. 2: The possessions corporation must produce or manufacture the possessions product within the meaning of section 954(d)(1)(A) if the possessions corporation computes its income with respect to that product under the profit split method.

Q. 3: When will a possessions corporation be considered to be engaged in start-up operations?

A. 3: A possessions corporation is engaged in start-up operations if it begins operations in a possession with respect to a product or type of service after September 3, 1982. Subject to the further provisions of this answer, a possessions corporation will be considered to begin operations with respect to a product if, under the rules of § 1.936-5(a) questions and answers (6) through (10), such product could not be grouped with any other item of property manufactured in whole or in part in the possessions by any member of the affiliated group in any preceding taxable year. Any improvement or other change in a possession product which does not substantially change the production process would not be deemed to create a new product. A change in the division of manufacturing activity between the possessions corporation and its affiliates with respect to an item of property will not give rise to a new product. If a possessions corporation was producing a possession product that was either a component product or an end-product form and the possessions corporation expands its operations in the same possession so that it is now producing a product that includes the earlier possession product, the possessions corporation will not be entitled to use the start-up significant business presence test unless the production costs incurred by the possessions corporation in the possession in producing a unit of its new possession product are at least double the production costs incurred by the possessions corporation in the possession in producing a unit of the earlier possession product. If any member of an affiliated group actually groups two or more items of property then, solely for the purposes of determining whether any item of property in that group is a new product, that grouping shall be respected. However, the fact that an affiliated group does not actually group two or more items of property shall be disregarded in determining whether any item of property is a new product. Notwithstanding the above, if a possessions corporation is producing a possession product in one possession and such corporation or a member of its affiliated group begins operations in a different possession, regardless of whether the items of property could be grouped, the affiliated group may treat the units of the item of property produced at the new site of operations in the different possession as a new product.

(8) Alternative significant business presence test.

Q. 1: Will the Secretary adopt a significant business presence test other than those set forth in section 936(h)(5)(B)(ii)?

A. 1: Yes. The following significant business presence test is adopted both for the transitional period and thereafter. A possessions corporation will have a significant business presence in a possession for a taxable year with respect to a product or type of service if –

(i) No less than 50 percent of the direct labor costs of the affiliated group for units of the product produced, in whole or in part, during the taxable year by the possessions corporation or for the type of service rendered by the possessions corporation during the taxable year are incurred by the possessions corporation as compensation for services performed in the possession; and

(ii) The direct labor costs of the possessions corporation for units of the product produced or the type of service rendered plus the base period construction costs are no less than 70 percent of the sum of such base period construction costs and the direct labor costs of the affiliated group for such units of the product produced or the type of service rendered.

Notwithstanding satisfaction of the above test, for purposes of determining whether a possessions corporation may compute its income under the profit split method, a possessions corporation will not be treated as having a significant business presence in a possession with respect to a product unless the possessions corporation manufactures the product in the possession within the meaning of section 954(d)(1)(A).

Q. 2: How is the term “base period construction costs” defined?

A. 2: The term “base period construction costs” means the average construction costs incurred by or on behalf of the possessions corporation for services in the possession during the taxable year and the preceding four taxable years for section 1250 property (as defined in section 1250(c) and the regulations thereunder) that is used for the production of the product or the rendering of the service in the possession, and which represents the original use of the section 1250 property. For purposes of the preceding sentence, if the possessions corporation was not in existence during one or more of the four preceding taxable years, its construction costs for that year or years shall be deemed to be zero. Construction costs include architects’ and engineers’ fees, labor costs, and overhead and profit (if the construction is performed by a person that is not a member of the affiliated group).

Q. 1: For purposes of determining whether a possessions corporation satisfies the significant business presence test with respect to a product, the costs incurred by the possessions corporation or by any of its affiliates in connection with contract manufacturing which is related to that product and is performed outside the possession shall be treated as direct labor costs of the affiliated group and shall not be treated as production costs of the possessions corporation or as material costs. How is the term “contract manufacturing” to be defined?

A. 1: The term “contract manufacturing” includes any arrangement between a possessions corporation (or another member of the affiliated group) and an unrelated person if the unrelated person:

(1) Performs work on inventory owned by a member of the affiliated group for a fee without the passage of title;

(2) Performs production activities (including manufacturing, assembling, finishing, or packaging) under the direct supervision and control of a member of the affiliated group; or

(3) Does not undertake any significant risk in manufacturing its product (e.g., it is paid by the hour).

Q. 2: Does an arrangement between a member of the affiliated group and an unrelated party constitute contract manufacturing if the unrelated party uses an intangible owned or licensed by a member of the affiliated group?

A. 2: Such an arrangement will be treated as contract manufacturing if the unrelated party makes use of a patent owned or licensed by a member of the affiliated group in producing the product which becomes part of the possession product of the possessions corporation. In addition, such use of manufacturing intangibles other than patents may be treated as contract manufacturing if it is established that the arrangement has the effect of materially distorting the application of the significant business presence test. However, the preceding sentence shall not apply if the possessions corporation establishes that the arrangement was entered into for a substantial business purpose (e.g., to obtain the benefit of special expertise of the manufacturer or economies of scale). These rules shall not apply to such contract manufacturing performed in taxable years beginning before January 1, 1986, nor shall the rules apply to binding contracts for the performance of such contract manufacturing entered into before June 13, 1986.

Q. 3: For purposes of the significant business presence test, how shall a possessions corporation treat the cost of contract manufacturing performed within a possession?

A. 3: If the possessions corporation uses the value added test, it will be permitted to treat the cost of the contract manufacturing performed in a possession, not including material costs, as a production cost of the possessions corporation. If it uses the direct labor test or the alternative significant business presence test set forth in § 1.936-5(b)(8), it is permitted to treat the direct labor costs of the contract manufacturer associated with such contract manufacturing as a cost of direct labor of the possessions corporation. The allowable amount of the direct labor cost shall be determined in accordance with question and answer 4 below.

Q. 4: How are the amounts paid by a possessions corporation to a contract manufacturer for services rendered in a possession to be treated by the possessions corporation in computing the direct labor cost of the product to which such contract manufacturing relates?

A. 4: If the possessions corporation can establish the contract manufacturer’s direct labor cost which was incurred in the possession, such cost will be treated as incurred by the possessions corporation as compensation for services performed in the possession. If the possessions corporation cannot establish such cost, then 50 percent of the amount paid to such contract manufacturer may be treated as incurred by the possessions corporation as compensation for services performed in the possession: provided, that not more than 50 percent of the fair market value of the product manufactured by the contract manufacturer is attributable to articles shipped into the possession, and the possessions corporation receives a statement from the contract manufacturer that this test has been satisfied. If this fair market value test is not satisfied, then the cost of contract manufacturing performed within a possession shall not be treated as a production cost or a direct labor cost of either the possessions corporation or the affiliated group.

Q. 5: For purposes of the significant business presence test, what is the treatment of costs which are incurred by a member of the affiliated group (including the possessions corporation) for contract manufacturing performed outside of the possession with respect to an item of property which is a component of the possession product?

A. 5: If the possession product is treated as including such component, the cost of the contract manufacturing shall be treated as a direct labor cost of members of the affiliated group other than the possessions corporation for purposes of the direct labor test and the alternative significant business presence test, and shall not be treated as a production cost of the possessions corporation or as a cost of materials for purposes of the value added test. If the possession product is treated as not including such component, the cost of the contract manufacturing shall not be treated as a direct labor cost of any member of the affiliated group for purposes of the direct labor test and the alternative significant business presence test, and shall not be treated as a production cost of the possessions corporation or as a cost of materials for purposes of the value added test.

[T.D. 8090, 51 FR 21524, June 13, 1986; 51 FR 27174, July 30, 1986]

§ 1.936-6 Intangible property income when an election out is made: Cost sharing and profit split options; covered intangibles.

The rules in this section apply for purposes of section 936(h) and also for purposes of section 934(e) where applicable.

(a) Cost sharing option – (1) Product area research.

Q. 1: Cost sharing payments are based on research undertaken by the affiliated group in the “product area” which includes the possession product. The term “product area” is defined by reference to the three-digit classification under the Standard Industrial Classification (SIC) code. Which governmental agency has jurisdiction to decide the proper SIC category for any specfic product?

A. 1: Solely for the purpose of determining the tax consequences of operating in a possession, the Secretary or his delegate has exclusive jurisdiction to decide the proper SIC category under which a product is classified. For this purpose, the product area under which a product is classified will be determined according to the 1972 edition of the SIC code. From time to time and in appropriate cases, the Secretary may prescribe regulations or issue rulings determining the proper SIC category under which a particular product is to be classified, and may prescribe regulations for aggregating two or more three-digit classifications of the SIC code and for classifying product areas according to a system other than under the SIC code.

Q. 2: How is the term “affiliated group” defined for purposes of the cost sharing option?

A. 2: For purposes of the cost sharing option, the term “affiliated group” means the possessions corporation and all other organizations, trades or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, within the meaning of section 482.

Q. 3: Are research and development expenditures that are included in product area research limited to research and development expenditures that are deductible under section 174 or that are incurred by U.S. affiliates?

A. 3: No, product area research is not limited to product area research expenditures deductible under section 174 or to expenses incurred by U.S. affiliates. Product area research also includes deductions permitted under section 168 with respect to research property which are not deductible under section 174; qualified research expenses within the meaning of section 30(b); payments (such as royalities) for the use of, or right to use, a patent, invention, formula, process, design, pattern or know-how; and a proper allowance for amounts incurred in the acquisition of manufacturing intangible property. In the case of an acquisition of depreciable or amortizable manufacturing intangible property, the annual amount of product area research shall be be equal to the allowable depreciation or amortization on the intangible property for the taxable year. In the case of an acquisition of nondepreciable or nonamortizable manufacturing intangible property, the amount expended for the acquisition shall be deemed to be amortized over a five year period and included in product area research in the year of the deemed amortization. Any contingent payment made with respect to the acquisition of nonamortizable manufacturing intangible property shall be treated as amounts incurred in the acquisition of nonamortizable manufacturing intangible property when paid or accrued.

Q. 4: Does royalty income from a person outside the affiliated group with respect to the manufacturing intangibles within a product area reduce the product area research pool within the same product area?

A. 4: Yes.

Q. 5: Does income received from a person outside the affiliated group from the sale of a manufacturing intangible reduce the product area research pool within the same product area?

A. 5: In determining product area research, the income from the sale attributable to noncontingent payments will reduce product area research ratably over the remaining useful life of the property in the case of an amortizable intangible and ratably over a 5-year period in the case of a nonamortizable intangible. Any income attributable to contingent amounts received with respect to the sale of manufacturing intangible property shall be treated as amounts received from the sale of the manufacturing intangible property in the year in which such contingent amounts are received or accrued.

Q. 6: If a member of an affiliated group incurs research and development expenses pursuant to a contract with an unrelated person who is entitled to exclusive ownership of all the technology resulting from the expenditures, is the amount of product area research reduced by the amount of such expenditures?

A. 6: To the extent that the product area research expenditures can be allocated solely to the technology produced for the unrelated person, such expenditures will not be included in product area research expenditures provided, however, that the unrelated person has exclusive ownership of all the technology resulting from these expenditures, and further that no member of the affiliated group has a right to use any of the technology.

Q. 7: What is the treatment of product area research expenditures attributable to a component where the component and the integrated product fall within different product areas?

A. 7: For purposes of the computation of product area research expenditures in the product area by the affiliated group, the product area in which the component falls is aggregated with the product area in which the integrated product falls. However, if the component product and integrated product are in separate SIC codes and if the component product is not included in the definition of the possession product, then the product area research expenditures are not aggregated. The same rule applies where the taxpayer elects a component product which encompasses another component product and the two component products fall into separate SIC codes. In such case, the product area in which the first component falls is aggregated with the product area in which the second component falls.

(2) Possession sales and total sales.

Q. 1: The cost sharing payment is the same proportion of the total cost of product area research which the amount of “possession sales” of the affiliated group bears to the “total sales” of the affiliated group within the product area. How are “possession sales” defined for purposes of the cost sharing fraction?

A. 1: The term “possession sales” means the aggregate sales or other dispositions of the possession product, to persons who are not members of the affiliated group, less returns and allowances and less indirect taxes imposed on the production of the product, for the taxable year. Except as otherwise indicated in § 1.936-6(a)(2), the sales price to be used is the sales price received by the affiliated group from persons who are not members of the affiliated group.

Q. 2: For purposes of the numerator of the cost sharing fraction, how are possession sales computed where the possession product is a component product or an end-product form?

A. 2: (i) The sales price of the component product or end-product form is determined as follows. With respect to a component product, an independent sales price from comparable uncontrolled transactions must be used if such price can be determined in accordance with § 1.482-2(e)(2). If an independent sales price of the component product from comparable uncontrolled transactions cannot be determined, then the sales price of the component product shall be deemed to be equal to the transfer price, determined under the appropriate section 482 method, which the possessions corporation uses under the cost sharing method in computing the income it derives from the active conduct of a trade or business in the possession with respect to the component product. The possessions corporation in lieu of using the transfer price determined under the preceding sentence may treat the sales price for the component product as equal to the same proportion of the third party sales price of the integrated product which the production costs attributable to the component product bear to the total production cost for the integrated product. Production cost will be the sum of direct and indirect production costs as defined in § 1.936-5(b)(4). If the possessions corporation determines the sales price of the component product using the production cost ratio, the transfer price used by the possessions corporation in computing its income from the component product under the cost sharing method may not be greater than such sales price.

(ii) With respect to an end-product form, the sales price of the end-product form is equal to the difference between the third party sales price of the integrated product and the independent sales price of the excluded component(s) from comparable uncontrolled transactions, if such price can be determined under § 1.482-2(e)(2). If an independent sales price of the excluded component(s) from uncontrolled transactions cannot be determined, then the sales price of the end-product form shall be deemed to be equal to the transfer price, determined under the appropriate section 482 method, which the possessions corporation uses under the cost sharing method in computing the income it derives from the active conduct of a trade or business in the possession with respect to such end-product form. The possessions corporation in lieu of using the transfer price determined under the preceding sentence may use the production cost ratio method described above to determine the sales price of the end-product form (i.e., the same proportion of the third party sales price of the integrated product which the production costs attributable to the end-product form bear to the total production costs for the integrated product). If the possessions corporation determines the sales price of the end-product form using the production cost ratio, the transfer price used by the possessions corporation in computing its income from the end-product form under the cost sharing method may not be greater than such sales price. For similar rules applicable to the profit split option see § 1.936-6(b)(1), question and answer 12.

Q. 3: For purposes of determining possessions sales in the numerator of the cost sharing fraction, will the replacement part price of the product be treated as a price from comparable uncontrolled transactions?

A. 3: Prices for replacement parts are generally higher than prices for equipment sold as part of an original system. Thus, prices for replacement parts cannot generally be used directly as prices for comparable uncontrolled transactions. However, replacement part prices may be used for estimating comparable uncontrolled prices where the price differential can be reasonably determined and taken into account under § 1.482-2(e)(2).

Q. 4: For purposes of determining possession sales in the cost sharing fraction, what is the treatment of components that are purchased by one possessions corporation from an affiliated possessions corporation and which are incorporated into a possession product where the transferor possessions corporation treats the transferred component as a possession product?

A. 4: When one possessions corporation purchases components from a second possessions corporation which is an affiliated corporation, the purchase price of the components paid to the second possessions corporation shall be subtracted from the sales proceeds of the product produced in the possession by the first possessions corporation, and only the remainder is included in the numerator of the cost sharing formula for the first corporation. For example, assume that N corporation manufactures a component for sale to O corporation for $100 (a price which reflects prices in comparable uncontrolled transactions). Both N and O are affiliated possessions corporations. N has designated that component product as its possession product. O then incorporates that product into a second product which is sold to customers for $300 N and O must make separate cost sharing payments. The cost sharing payment of N corporation is determined by including $100 as possession sales, and the payment of O is determined by subtracting that $100 purchase price from the $300 received from customers. Thus, the possessions sales amount of O is $200. This rule is intended to prevent the double counting of the sales of a component produced by one possessions corporation and incorporated into another product by an affiliated possessions corporation.

Q. 5: Are pre-TEFRA sales included in the cost sharing fraction?

A. 5: No. Pre-TEFRA sales are sales of products produced by the possessions corporation and transferred to an affiliate prior to a possessions corporation’s first taxable year beginning after December 31, 1982. Pre-TEFRA sales are not included in either the numerator or denominator of the cost sharing fraction. If the U.S. affiliate uses the FIFO method of costing inventory, the pre-TEFRA inventory will be treated as the first inventory sold by the U.S. affiliate during the first year in which section 936(h) applies. If the U.S. affiliate uses the LIFO method of costing inventory (either dollar-value or specific goods LIFO), pre-TEFRA inventor will be treated as inventory sold by the U.S. affiliate in the year in which the U.S. afiliate’s LIFO layer containing pre-TEFRA LIFO inventory is liquidated.

Q. 6: How are “possession sales” determined under the cost sharing formula if members of the affiliated group (other than the possessions corporation) include purchases of the possession product, X, in a dollar-value LIFO inventory pool (as provided under § 1.472-8)?

A. 6: Possession sales may be determined by applying the revenue identification method provided under paragraph (b)(1) Question and Answer 18 of this section.

Q. 7: Do possession sales include excise taxes paid by the possessions corporation when the product is sold for ultimate use or consumption in the possession?

A. 7: No. The amount of excise taxes is excluded from both the numerator and denominator of the cost sharing fraction.

Q. 8: How are “total sales” defined for purposes of the cost sharing fraction?

A. 8: The term “total sales” means aggregate sales or other dispositions of products in the same product area as the possession product, less returns and allowances and less indirect taxes imposed on the production of the product, for the taxable year to persons who are not members of the affiliated group. The sales price to be used is the sales price received by the affiliated group from persons who are not members of the affiliated group.

Q. 9: In computing that cost sharing payment, how are “total sales” computed if the dollar-value LIFO inventory pool includes some products which are not included in the product area (determined under the 3-digit SIC code) on which the denominator of the cost sharing fraction is based?

A. 9: In such case, the amount of the total sales within the product area to persons who are not members of the affiliated group by persons who are members of the affiliated group is determined by multiplying the total sales of the products within the dollar-value LIFO inventory pool by a fraction. The numerator of the fraction includes the dollar-value of purchases by members of the affiliated group (including the possessions corporation) of products within the product area made during the year, plus any added production costs (as defined in § 1.471-11(b), (c), and (d) but not including the costs of materials) incurred by the affiliates during the same period. The denominator of the fraction includes the dollar-value of purchases by members of the affiliated group (including the possessions corporation) of products within the dollar-value LIFO inventory pool made during the same period (including any production costs, as described above, incurred by the affiliate during the same period). For these purposes, purchases of a possession product are determined on the basis of the possessions corporation’s cost for its inventory purposes.

Q. 10: May a possessions corporation compute its income under the cost sharing method with respect to a possession product which the possessions corporation sells to a member of its affiliated group and which that member then leases to an unrelated person or uses in its own trade or business?

A. 10: Yes, provided that an independent sales price for the possession product from comparable uncontrolled transactions can be determined in accordance with § 1.482-2(e)(2), and, provided further, that such member complies with the requirements of § 1.936-6(a)(2), question and answer 14. If, however, there is a comparable uncontrolled price for an integrated product and the possession product is a component product or end-product form thereof, the possessions corporation may, if such member complies with the requirements of § 1.936-6(a)(2), question and answer 14, compute its income under the cost sharing method with respect to such possession product. In that case, the cost sharing payment shall be computed under the following question and answer.

Q. 11: How are possession sales and total sales to be determined for purposes of computing the cost sharing payment with respect to a possession product which the possessions corporation sells to a member of its affiliated group where that member then leases the possession product to unrelated persons or uses it in its own trade or business?

A. 11: If the possessions corporation is entitled to compute its income from such sales of the possession product under the cost sharing method, both possession sales and total sales shall be determined as if the possession product had been sold by the affiliate to an unrelated person at the time the possession product was first leased or otherwise placed in service by the affiliate. The sales price on such deemed sale shall be equal to the independent sales price from comparable uncontrolled transactions determined in accordance with § 1.482-2(e)(2), if any. If the possession product is a component product or an end-product form for which there is no such independent sales price but there is a comparable uncontrolled price for the integrated product which includes the possession product, the deemed sales price of the possession product shall be computed under the rules of § 1.936-6(a)(2) question and answer 2. The full amount of income received under the lease shall be treated as income of (and taxed to) the affiliate and not the possessions corporation.

Q. 12: When may a possessions corporation take into account in computing total sales under the cost sharing method products in the same product area as the possession product (other than the possession product itself) where such products are leased by members of the affiliated group to unrelated persons or used by any such member in its own trade or business?

A. 12: For purposes of computing total sales under the cost sharing method, the possessions corporation may take into account products in the same product area as the possession product itself where such products are leased by members of the affiliated group to unrelated persons or used in the trade or business of any such member, but only if an independent sales price of such products from comparable uncontrolled transactions may be determined under § 1.482-2(e)(2). In such cases, the units of such products which are leased or otherwise used internally by members of the affiliated group may be treated as sold to unrelated persons for such independent sales price for purposes of computing total sales.

Q. 13: Assuming that a possessions corporation is entitled to compute its income under the cost sharing method with respect to sales of a possession product to affiliates in cases where those affiliates lease units of the possession product to unrelated persons or use them internally, is the possessions corporation’s income from the possession product any different than if the affiliates had sold the product to unrelated parties?

A. 13: No.

Q. 14: If a possessions corporation sells units of a possession product to a member of its affiliated group and that affiliate then leases those units to an unrelated person or uses the units in its own trade or business, what requirements must the affilate meet in order for the possessions corporation to be entitled to the benefits of the cost sharing method with respect to such units?

A. 14: (i) For taxable years of the possessions corporation beginning on or before June 13, 1986, the affiliate need not meet any special requirements in order for the possessions corporation to be entitled to the beneifts of the cost sharing method with respect to such units. Thus, the affiliate’s basis in such units shall be equal to the transfer price used for computing the possessions corporation’s gross income with respect to such units under section 936(h)(5)(C)(i)(II), and the income derived by the affiliate from such lease or internal use shall be reported by the affiliate when and to the extent actually derived. The affiliate shall not be deemed to have sold such units to an unrelated party at the time they were first leased or otherwise placed in service for any purpose other than the computation of possession sales and total sales. A similar rule applies to other products in the same product area as the possession product which are sold by any member in its own trade or business and which the possessions corporation takes into account in computing total sales under the cost sharing method.

(ii) For taxable years of the possessions corporations beginning after June 13, 1986, a possessions corporations will not be entitled to the benefits of the cost sharing method with respect to units of the possession product which the possessions corporation sells to an affiliate where the affiliate then leases such units to an unrelated person or uses them in its own trade or business, unless the affiliate agrees to be treated for all tax purposes as having sold such units to an unrelated party at the time they were first leased or otherwise placed in service by such affiliate. The affiliate must demonstrate such agreement by reporting its income from such units as if:

(A) It had sold such units to an unrelated person at such time at a price equal to the price used to compute possessions sales under § 1.936-6(a)(2), question and answer 11;

(B) It had immediately repurchased such units for the same price; and

For treatment of other products in the same product area as the possession product see § 1.936-6(a)(2), question and answer 12.

(iii) The principles contained in questions and answers 11, 12, 13, and 14 are illustrated by the following example:

Example.Possessions corporation S and its affiliate A are calendar year taxpayers. In 1985, S manufactures 100 units of possession product X. S sells 50 units of X to unrelated persons in arm’s length transactions for $10 per unit. In applying the cost sharing method to determine the portion of its gross income from such sales which qualifies for the possessions tax credit, S determines that $8 of the $10 sales price may be taken into account. S sells the remaining 50 units of X to A, and A then leases such units to unrelated persons. In 1985, A also manufacturers 100 units of product Y, the only other product in the same product area as X manufactured or sold by any member of the affiliated group. A manufactured the 100 units of Y at a cost of $15 per unit, sold 50 units of Y to unrelated persons in arm’s length transactions for $20 per unit, and leased the remaining 50 units of Y to unrelated persons.

S may compute its income under the cost sharing method with respect to the 50 units of X it sold to A because S can determine an independent sales price of X from comparable uncontrolled transactions under § 1.482-2(e)(2). For purposes of computing both possessions sales and total sales, the 50 units of X sold to A will be deemed to have been sold by A to an unrelated person for $10 per unit. The income of S qualifying for the possessions tax credit from the sale of those 50 units of X to A, and A’s basis in those units, will both be determined using the $8 transfer price determined under section 936 (h)(5)(C)(i)(II). For purposes of computing total sales in the denominator of the cost sharing fraction, S may also take into account the 50 units of Y leased by A to unrelated persons, as if A had sold those units for $20 per unit. A’s basis in those units of Y will continue to be its actual cost basis of $15 per unit.

If all of the above transactions had occurred in 1987, S would be entitled to compute its income under the cost sharing method with respect to the 50 units of X it sold to A only if A agreed to be treated for all tax purposes as if it had sold such units for $10 per unit, realized income on such deemed sale of $2 per unit, repurchased such units immediately for $10 per unit, and then leased such units, which would then have a $10 per unit basis in A’s hands. For purposes of computing total sales, S would be entitled to take into account the 50 units of X leased by A to unrelated persons as if A had sold such units for $20 per unit.

(3) Credits against cost sharing payments.

Q. 1: Is the cost of product area research paid or accrued by the possessions corporation in a taxable year creditable against the cost sharing payment?

A. 1: Yes, if the cost of the product area research is paid or accrued solely by the possessions corporation. Thus, payments by the possessions corporation under cost sharing arrangements with, or royalties paid to, unrelated persons are so creditable. Amounts (such as royalties) paid directly or indirectly to, or on behalf of, related persons and amounts paid under any cost sharing agreements with related persons are not creditable against the cost sharing payment.

Q. 2: Do royalties or other payments made by an affiliate of the possessions corporation to another member of the affiliated group reduce the cost sharing payment if such royalties or other payments are based, in part, on activity of the possessions corporation?

A. 2: No. Payments made between affiliated corporations do not reduce the cost sharing payment. Thus, for example, if a possessions corporation sells a component to a foreign affiliate for incorporation by the foreign affiliate into an integrated product sold to unrelated persons, and the foreign affiliate pays a royalty to the U.S. parent of the possessions corporation based on the total value of the integrated product, the cost sharing payment of the possessions corporation is not reduced.

(4) Computation of cost sharing payment.

Q. 1: S is a possessions corporation engaged in the manufacture and sale of four products (A, B, C, and D) all of which are classified under the same three-digit SIC code. S sells its production to a U.S. affiliate, P, which resells it to unrelated parties in the United States. P’s third party sales of each of these products produced in whole or in part by S (computed as provided under paragraph (a)(2) of § 1.936-6) are $1 million or a total of $4 million for A, B, C, and D. P’s other sales of products in the same SIC code are $3,000,000; and the defined worldwide product area research of the affiliated group is $350,000. How should S compute the cost sharing amount for products A, B, C, and D?

A. 1: The cost sharing amount is computed separately for each product on Schedule P of Form 5735. S should use the following formula for each of the products A, B, C, and D:

Q. 2: The facts are the same as in question 1 except that S manufactures product D under a license from an unrelated person. S pays the unrelated party an annual license fee of $20,000. Thus, the worldwide product area research expense of the affiliated group is $370,000. How should the cost sharing payment be adjusted?

A. 2: The cost sharing fee should be reduced by the $20,000 license fee made as a direct annual payment to a third party on account of product D. The cost sharing payment with respect to product D in this example will be adjusted as follows:

Q. 3: The facts are the same as in question 1 except that S also manufactures and exports product E to a foreign affiliate, which resells it to unrelated persons for $1 million. S makes a separate election for its export sales. How should S compute the cost sharing amount for product E?

A. 3: The numerator of the cost sharing fraction is the aggregate sales or other dispositions by members of the affiliated group of the units of product E produced in whole or in part in the possession to persons who are not members of the affiliated group. The cost sharing amount for product E would be computed as follows:

Q. 4: The facts are the same as in question 1, except that S also receives $10,000 in royalty income from unrelated persons for the licensing of certain manufacturing intangible property rights. What is the amount of the product area research that must be allocated in determining the cost sharing amount?

A. 4: If the affiliated group receives royalty income from unrelated persons with respect to manufacturing intangibles in the same product area, then the product area research to be considered shall be first reduced by such royalty income. In this case, the amount of product area research to be used in determining S’s cost sharing payment should be reduced by the $10,000 royalty payment received to $340,000.

Q. 5: May a possessions corporation redetermine the amount of its required cost sharing payment after filing its tax return?

A. 5: If after filing its tax return, a possessions corporation files an amended return, or if an adjustment is made on audit, either of which affects the amount of the cost sharing payment required, then a redetermination of the cost sharing payment must be made. See, however, section 936(h)(5)(C)(i)(III)(a) with respect to the increase in the cost sharing payment due to interest imposed under section 6601(a).

(5) Effect of election under the cost sharing method.

Q. 1: What is the effect of the cost sharing method?

A. 1: The cost sharing payment reduces the amount of deductions (and the amount of reductions in earnings and profits) otherwise allowable to the U.S. affiliates (other than tax-exempt affiliates) within the affiliated group as determined under section 936(h)(5)(C)(i)(I)(b) which have incurred research expenditures (as defined in § 1.936-6(a)(1), question and answer (3) in the same product area for which the cost sharing option is elected, during the taxable year in which the cost sharing payment accrues. If there are no such U.S. affiliates, the reductions with respect to deductions and earnings and profits, as the case may be, are made with respect to foreign affiliates within the same affiliated group which have incurred product area research expenditures in such product area attributable to a U.S. trade or business. If there are no affiliates which have incurred research expenditures in such product area, the reductions are then made with respect to any other U.S. affiliate and, if there is no such U.S. affiliate, then to any other foreign affiliate. The allocations of these reductions in each case shall be made in proportion to the gross income of the affiliates. In the case of foreign affiliates, the allocation shall be made in proportion to gross income attributable to the U.S. trade or business or worldwide gross income, as the case may be. With respect to each group above, the reduction of deductions shall be applied first to deductions under section 174, then to deductions under section 162, and finally to any other deductions on a pro rata basis.

Q. 2: For purposes of estimated tax payments, when is the cost sharing amount deemed to accrue?

A. 2: The cost sharing amount is deemed to accrue to the appropriate affiliate on the last day of the taxable year of each such affiliate in which or with which the taxable year of the possessions corporation ends.

Q. 3: If the cost sharing method is elected and the year of accrual of the cost sharing payment to the appropriate affiliate (described in question and answer 1 of this paragraph (a)(5)) differs from the year of actual payment by the possessions corporation, in what year are the deductions of the recipients reduced?

A. 3: In the year the cost sharing payment has accrued.

Q. 4: What is the treatment of income from intangibles under the cost sharing method?

A. 4: Under the cost sharing method, a possessions corporation is treated as the owner, for purposes of obtaining a return thereon, of manufacturing intangibles related to a possession product. The term “manufacturing intangible” means any patent, invention, formula, process, design, pattern, or know-how. The possessions corporation will not be treated as the owner, for purposes of obtaining a return thereon, of any manufacturing intangibles related to a component product produced by an affiliated corporation and transferred to the possessions corporation for incorporation into the possession product, except in the case that the possession product is treated as including such component product for all purposes of section 936(h)(5). Further, the possessions corporation will not be treated as the owner, for purposes of obtaining a return thereon, of any marketing intangibles except “covered intangibles.” (See § 1.936-6(c).)

Q. 5: If the cost sharing option is elected, is it necessary for the possessions corporation to be the legal owner of the manufacturing intangibles related to the possession product in order for the possessions corporation to receive a full return with respect to such intangibles?

A. 5: No. There is no requirement that manufacturing intangibles be owned by the possessions corporation.

Q. 6: How is income attributable to marketing intangibles treated under the cost sharing method?

A. 6: Except in the case of “covered intangibles” (see § 1.936-6(c)), the possessions corporation is not treated as the owner of any marketing intangibles, and income attributable to marketing intangible of the possessions corporation will be allocated to the possessions corporation’s U.S. shareholders with the proration of income based on shareholdings. If a shareholder of the possessions corporation is a foreign, person or is otherwise tax exempt, the possessions corporation is taxable on that shareholder’s pro rata amount of the intangible property income. If the possessions corporation is a corporation any class of the stock of which is regularly traded on an established securities market, then the income attributable to marketing intangibles will be taxable to the possessions corporation rather than the corporation’s U.S. shareholders.

Q. 7: What is the source of the intangible property income described in question and answer 6?

A. 7: The intangible property income is U.S. source whether taxed to the U.S. shareholder or taxed to the possessions corporation and section 863 (b) does not apply for this purpose. However, such intangible property income, if treated as income of the possessions corporation, does not enter into the calculation of the 80-percent possession source test or the 65-percent active trade or business test.

Q.7a: What is the source of the taxpayer’s gross income derived from a sale in the United States of a possession product purchased by the taxpayer (or an affiliate) from a corporation that has an election in effect under section 936, if the income from such sale is taken into account to determine benefits under cost sharing for the section 936 corporation? Is the result different if the taxpayer (or an affiliate) derives gross income from a sale in the United States of an integrated product incorporating a possession product purchased by the taxpayer (or an affiliate) from the section 936 corporation, if the taxpayer (or an affiliate) processes the possession product or an excluded component in the United States?

A.7a: Under either scenario, the income is U.S. source, without regard to whether the possession product is a component, end-product, or integrated product. Section 863 does not apply in determining the source of the taxpayer’s income. This Q&A 7a is applicable for taxable years beginning on or after November 13, 1998.

Q. 8: May marketing intangible income, if any, be allocated to the possessions corporation with respect to custom-made products?

A. 8: No. If the cost sharing option is elected, then income attributable to marketing intangibles (other than “covered intangibles” described in § 1.936-6(c)) will be taxed as discussed in questions and answers 6 and 7 of paragraph (a)(5) of this section. It is immaterial whether the product is custom-made.

Q. 9: In order to sell a pharmaceutical product in the United States, a New Drug Application (“NDA”) for the product must be approved by the U.S. Food and Drug Administration. Is an NDA considered a manufacturing or marketing intangible for purposes of the allocation of income under the cost sharing method?

A. 9: A manufacturing intangible.

Q. 10: Can a copyright be, in whole or in part, a manufacturing intangible for purposes of the allocation of income under the cost sharing method?

A. 10: In general, a copyright is a marketing intangible. See section 936(h)(3)(B)(ii). However, copyrights may be treated either as manufacturing intangibles or nonmanufacturing intangibles (or as partly each) depending upon the function or the use of the copyright. If the copyright is used in manufacturing, it will be treated as a manufacturing intangible; but if it is used in marketing, even if it is also classified as know-how, it will be treated as a marketing intangible.

Q. 11: If the cost sharing option is elected and a patent is related to the product produced by the possessions corporation, does the return to the possessions corporation with respect to the manufacturing intangible include the make, use, and sell elements of the patent?

A. 11: Yes. A patent confers an exclusive right for 17 years to sell a product covered by the patent. During this period, the return to the possessions corporation includes the make, use and sell elements of the patent.

Q. 12: For purposes of the cost sharing option, may a safe haven rule be applied to determine the amount of marketing intangible income?

A. 12: No. The amount of marketing intangible income is determined on the basis of all relevant facts and circumstances. The section 482 regulations will continue to apply except to the extent modified by the election. Rev. Proc. 63-10 and Rev. Proc. 68-22 do not apply for this purpose.

Q. 13: If a product covered by the cost sharing election is sold by a possessions corporation to an affiliated corporation for resale to an unrelated party, may the resale price method under section 482 be used to determine the intercompany price of the possessions corporation?

A. 13: In general, the resale price method may be used if (a) no comparable uncontrolled price for the product exists, and (b) the affiliated corporation does not add a substantial amount of value to the product by manufacturing or by the provision of services which are reflected in the sales price of the product to the customer. The possessions corporation will not be denied use of the resale price method for purposes of such inter-company pricing merely because the reseller adds more than an insubstantial amount to the value of the product by the use of intangible property.

Q. 14: If a possessions corporation makes the cost sharing election and uses the cost-plus method under section 482 to determine the arm’s-length price of a possession product, will the cost base include the cost of materials which are subject to processing or which are components in the possession product?

A. 14: A taxpayer may include the cost of materials in the cost base if it is appropriate under the regulations under § 1.482-2(e)(4).

Q. 15: If the possessions corporation computes its income with respect to a product under the cost sharing method, and the price of the product is determined under the cost-plus method under section 482, does the cost base used in computing cost-plus under section 482 include the amount of the cost sharing payment?

A. 15: The amount of the cost sharing payment is included in the cost base. However, no profit with respect to the cost sharing payment will be allowed.

Q. 16: If a member of the affiliated group transfers to a possessions corporation a component which is incorporated into a possession product, how will the transfer price for the component be determined?

A. 16: The transfer price for the component will be determined under section 482, and as follows. If the possession product is treated as not including such component for purposes of section 936(h)(5), the transfer price paid for the component will include a return on all intangibles related to the component product. If the possession product is treated as including such component for purposes of section 936(h)(5), then the transfer price paid for the component by the possessions corporation will not include a return on any manufacturing intangible related to the component product, and the possessions corporation will obtain the return on the manufacturing intangibles associated with the component.

Q. 17: If the possessions corporation computes its income with respect to a product under the cost sharing method, with respect to which units of the product shall the possessions corporation be treated as owning intangible property as a result of having made the cost sharing election?

A. 17: The possessions corporation shall not be treated as owning intangible property, as a result of having made the cost sharing election, with respect to any units of a possession product which were not taken into account by the possessions corporation in applying the significant business presence test for the current taxable year or for any prior taxable year in which the possessions corporation also had a significant business presence in the possession with respect to such product.

(b) Profit split option – (1) Computation of combined taxable income.

Q. 1: In determining combined taxable income from sales of a possession product, how are the allocations and apportionments of expenses, losses, and other deductions to be determined?

A. 1: (i) Expenses, losses, and other deductions are to be allocated and apportioned on a “fully-loaded” basis under § 1.861-8 to the combined gross income of the possessions corporation and other members of the affiliated group (other than foreign affiliates). For purposes of the profit split option, the term “affiliated group” is defined the same as under § 1.936-6 (a)(1) question and answer 2. The amount of research, development, and experimental expenses allocated and apportioned to combined gross income is to be determined under § 1.861-8(e)(3). The amount of research, development and experimental expenses and related deductions (such as royalties paid or accrued with respect to manufacturing intangibles by the possessions corporation or other domestic members of the affiliated group to unrelated persons or to foreign affiliates) allocated and apportioned to combined gross income shall in no event be less than the amount of the cost sharing payment that would have been required under the rules set forth in section 936(h)(5)(C)(i)(II) and paragraph (a) of this section if the cost sharing option had been elected. Other expenses which are subject to § 1.861-8(e) are to be allocated and apportioned in accordance with that section. For example, interest expense (including payments made with respect to bonds issued by the Puerto Rican Industrial, Medical and Environmental Control Facilities Authority (AFICA)) is to be allocated and apportioned under § 1.861-8(e)(2). With the exception of marketing and distribution expenses discussed below, the other remaining expenses which are definitely related to a class of gross income shall be allocated to that class of gross income and shall be apportioned on the basis of any reasonable method, as described in § 1.861-8 (b)(3) and (c)(1). Examples of such methods may include, but are not limited to, those specified in § 1.861-8(c)(1)(i) through (vi).

(ii) The class of gross income to which marketing and distribution expenses relate and shall be allocated is generally to be defined by the same “product area” as is determined for the relevant research, development, and experimental expenses (i.e., the appropriate 3-digit SIC code), but shall include only gross income generated or reasonably expected to be generated from the geographic area or areas to which the expenses relate. It shall be presumed that marketing and distribution expenses relate to all product sales within the same product area. If, however, it can be established that any of these expenses are separately identifiable expenses, such as advertising, and relate, directly or indirectly, solely to a specific product or a specific group of products, such expenses shall be allocated to the class of gross income defined by the specific product or group of products. Thus, advertising and other separately identifiable marketing expenses which relate specifically and exclusively to a particular product must be allocated entirely to the gross income from that product, even though the taxpayer or other members of an affiliated group which includes the taxpayer produce and market other products in the same 3-digit SIC code classification. The mere display of a company logo or mention of a company name solely in the context of identifying the manufacturer shall not prevent an advertisement from relating specifically and exclusively to a particular product or group of products.

(iii) If marketing and distribution expenses are allocated to a class of gross income which consists both of income from sales of possession products (the statutory grouping) and other income such as from sale by U.S. affiliates of products not produced in the possession (the residual grouping), then these marketing and distribution expenses shall be apportioned on a “fully loaded” basis which reflects, to a reasonably close extent, the factual relationship between these deductions and the statutory and residual groupings of gross income. Apportionment methods based upon comparisons of amounts incurred before ultimate sale of a product (including apportionment on a comparison of costs of goods sold, other expenses incurred, or other comparisons set forth in § 1.861-8 (c)(1)(v), such as time spent) are not on a “fully-loaded” basis and do not reflect this required factual relationship. These deductions shall be apportioned on a basis of comparison of the amount of gross sales or receipts or another method if it is established that such method similarly reflects the required factual relationship. Thus, for example, a comparison of units sold may be used only where the units are of the same or similar value and are, thus, in fact comparable.

(iv) The rules for allocation and apportionment of marketing and distribution expenses may be illustrated by the following examples:

Example 1.Assume that possessions corporation A manufacturers prescription pharmaceutical product #1 for resale by P, its U.S. parent corporation, in the United States. Additionally, assume that P manufactures prescription pharmaceutical products #2 and #3 in the United States for sale there. Further, assume that all three products are within the same product area, and that marketing and distribution expenses are internally divided by P among the three products on the basis of time spent by sales persons of P on marketing of the three products, as follows:

Product #1	50X
Product #2	80X
Product #3	110X
Total	240X

These expenses of 240X are allocated to gross income generated by all three products and shall be apportioned on the basis of gross sales or receipts of product #1 as compared to products #2 and #3 or another method which similarly reflects the factual relationship between these expenses and gross income derived from product #1 and products #2 and #3. Thus, if a sales method were used and sales of product #1 accounted for one-third of sales receipts from the three products, 80X (240 ÷ 3) of marketing and distribution expenses would be apportioned to the combined gross income from product #1.

Example 2.Corporation B produces and sells Brand W whiskey, in the United States. B’s subsidiary, S, which is a possessions corporation, produces soft drink extract in Puerto Rico which it sells to independent bottlers to produce Brand S soft drinks for sale in the United States. Corporation B’s advertisements and other promotional materials for Brand W whiskey make no reference to Brand S soft drinks (or any other Corporation B products), and Brand S soft drink advertisements and other promotional materials make no reference to Brand W whiskey (or any other corporation B products). For purposes of section 936(h), the advertising and other promotional expenses for Brand W whiskey must be allocated entirely to the gross income from sales of Brand W whiskey and the advertising and other promotional expenses for Brand S soft drink must be allocated entirely to the gross income from the sales of soft drink extract, notwithstanding the fact that whiskey and soft drink extract are both included in SIC code 208. A similar result would apply, for example, to separately identifiable advertising and other marketing expenses which relate specifically and exclusively to one or the other of the following pairs of products: chewing gum and granulated sugar (SIC code 206); canned tuna fish and freeze-dried coffee (SIC code 209); children’s underwear and ladies’ brassieres (SIC code 234); aspirin tablets and prescription antibiotic tablets (SIC code 283); floor wax and perfume (SIC code 284); adhesives and inks (SIC code 289); semi-conductors and cathode-ray tubes (SIC code 367); batteries and extension cords (SIC code 369); bandages and dental supplies (SIC code 384); stainless steel flatware and jewelry parts (SIC code 391); children’s toys and sporting goods (SIC code 394); hair curlers and zippers (SIC code 396); and paint brushes and linoleum tiles (SIC code 399).

Example 3.Assume the same facts as in Example 1 and that possessions corporation A also manufactures aspirin, a non-prescription product, for resale by its U.S. parent corporation, P. Further, assume that the advertising and separately identifiable marketing expenses which relate specifically and exclusively to aspirin sales total $100 and that these expenses are allocable solely to gross income derived from aspirin sales. The sales method continues to be used to apportion the marketing and distribution expenses related, directly or indirectly, to products #1, #2, and #3, and the apportionment of such expenses to product #1 for purposes of determining combined taxable income from product #1 will remain as stated in Example 1. None of the advertising and other separately identifiable marketing expenses which relate specifically and exclusively to aspirin will be taken into account in allocating and apportioning the marketing and distribution expenses relating to the gross income attributable to products #1, #2, and #3. Gross income attributable to aspirin will be considered as a separate class of gross income, and all the advertising and separately identifiable marketing expenses which relate specifically and exclusively to aspirin sales of $100 will be allocated to the class of gross income derived from aspirin sales. Similarly, none of the marketing and distribution expenses, directly or indirectly, related solely to the group of products #1, #2, and #3 will be taken into account in determining the combined taxable income from aspirin sales. the remaining marketing and distribution expenses which do not, directly or indirectly, relate solely to any specific product or group of products (e.g., the salaries of a Vice-President of Marketing who has responsibility for marketing all products and his staff) shall be allocated and apportioned on the basis of the gross receipts from the sales of all of the products (or a similar method) in determining combined taxable income of any product.

Q. 2: How may the allocation and apportionment of expenses to combined gross income be verified?

A. 2: Substantiation of the allocation and apportionment of expenses will be required upon audit of the possessions corporation and affiliates. Detailed substantiation may be necessary, particularly where the entities are engaged in multiple lines of business involving distinct product areas. Sources of substantiation may include certified financial reports. Form 10-K’s, annual reports, internal production reports, product line assembly work papers, and other relevant materials. In this regard, see § 1.861-8(f)(5).

Q. 3: Does section 936(h) override the moratorium provided by section 223 of the Economic Recovery Tax Act of 1981 and any subsequent similar moratorium?

A. 3: Yes. Thus, the allocation and apportionment of product area research described in question and answer 1 must be made without regard to the moratorium.

Q. 4: Is the cost of samples treated as a marketing expense?

A. 4: Yes. The cost of producing samples will be treated as a marketing expense and not as inventoriable costs for purposes of determining combined taxable income (and compliance with the significant business presence test). However, for taxable years beginning prior to January 1, 1986, the cost of producing samples may be treated as either a marketing expense or as inventoriable costs.

Q. 5: If a possessions corporation uses the profit split method to determine its taxable income from sales of a product, how does it determine its gross income for purposes of the 80-percent possession source test and the 65-percent active trade or business test of section 936(a)(2)?

A. 5: One-half of the deductions of the affiliated group (other than foreign affiliates) which are used in determining the combined taxable income from sales of the product are added to the portion of the combined taxable income allocated to the possessions corporation in order to determine the possessions corporation’s gross income from sales of such product.

Q. 6: How will income from intangibles related to a possession product be treated under the profit split method?

A. 6: Combined taxable income of the possessions corporation and affiliates from the sale of the possession product will include income attributable to all intangibles, including both manufacturing and marketing intangibles, associated with the product.

Q. 7: Can a possessions corporation apply the profit split option to a possession product if no U.S. affiliates derive income from the sale of the possession product?

A. 7: Yes.

Q. 8: With respect to the factual situation discussed in question and answer 7 how is combined taxable income computed?

A. 8: The profit split option is applied to the taxable income of the possessions corporation from sales of the possession product to foreign affiliates and unrelated persons. Fifty percent of that income is allocated to the possessions corporation, and the remainder is allocated to the appropriate affiliates as described in question and answer 13 of this paragraph (b)(1).

Q. 9: May a possessions corporation compute its income under the profit split method with respect to units of a possession product which it sells to a U.S. affiliate if the U.S. affiliate leases such units to unrelated persons or to foreign affiliates or uses such units in its own trade or business?

A. 9: Yes, provided that an independent sales price for the possession product from comparable uncontrolled transactions can be determined in accordance with § 1.482-2 (e)(2). If, however, there is a comparable uncontrolled price for an integrated product and the possession product is a component product or end-product form thereof, the possessions corporation may compute its income under the profit split method with respect to such units. In either case, the possessions corporation shall compute combined taxable income with respect to such units under the following question and answer.

Q. 10: If the possessions corporation is entitled to use the profit split method in the situation described in Q. 9 (leasing units of the possession product or use of such units in the taxpayer’s own trade or business), how should it compute combined taxable income with respect to such units?

A. 10: (i) Combined taxable income shall be computed as if the U.S. affiliate had sold the units to an unrelated person (or to a foreign affiliate) at the time the units were first leased or otherwise placed in service by the U.S. affiliate. The sales price on such deemed sale shall be equal to the independent sales price from comparable uncontrolled transactions determined in accordance with § 1.482-2(e)(2), if any.

(ii) If the possession product is a component product or an end-product form, the combined taxable income with respect to the possession product shall be determined under Q&A. 12 of this paragraph (b)(1).

(iii) For purposes of determining the basis of a component product or an end-product form, the deemed sales price of such product must be determined. The deemed sales price of the component product shall be determined by multiplying the deemed sales price of the integrated product that includes the component product by a ratio, the numerator of which is the production costs of the component product and the denominator of which is the production costs of the integrated product that includes the component product. The deemed sales price of an end-product form shall be determined by multiplying the deemed sales price of the integrated product that includes the end-product form by a ratio, the numerator of which is the production costs of the end-product form and the denominator of which is the production costs of the integrated product that includes the end-product form. For the definition of production costs, see Q&A. 12 of this paragraph (b)(1).

(iv)(A) If combined taxable income is determined under paragraph (v) of A. 12 of this paragraph (b)(1), in the case of a component product, the deemed sales price shall be determined by using the actual sales price of that product when sold as an integrated product (as adjusted under the rules of the fourth sentence of § 1.482-3(b)(2)(ii)(A)).

(B) If combined taxable income is determined under paragraph (v) of A. 12 of this paragraph (b)(1), in the case of an end-product form, the deemed sales price shall be determined by subtracting from the deemed sales price of the integrated product that includes the end-product form (e.g., the leased property) the actual sales price of the excluded component when sold as an integrated product to an unrelated person (as adjusted under the rules of the fourth sentence of § 1.482-3(b)(2)(ii)(A)).

(v) The full amount of income received under the lease shall be treated as income of (and be taxed to) the U.S. affiliate and not the possessions corporation.

Q. 11: In the situation described in question 9, how does the U.S. affiliate determine its basis in such units for purposes of computing depreciation and similar items?

A. 11: The U.S. affiliate shall be treated, for purposes of computing its basis in such units, as if it had repurchased such units immediately following the deemed sale and at the deemed sales price as provided in Q&A. 10 of this paragraph (b)(1).

The principles of questions and answers 10 and 11 are illustrated by the following example:

Example:Possessions corporation S manufactures 100 units of possession product X. S sells 50 units of X to an unrelated person in an arm’s length transaction for $10 per unit. S sells the remaining 50 units to its U.S. affiliate, A, which leases such units to unrelated persons. The combined taxable income for the 100 units of X is computed below on the basis of the given production, sales, and cost data:

Sales:
1. Total sales by S to unrelated persons (50 × $10)	$500
2. Total deemed sales by A to unrelated persons (50 × $10)	500
3. Total gross receipts (line 1 plus line 2)	1,000
Total costs:
4. Material costs	200
5. Production costs	300
6. Research expenses	0
7. Other expenses	100
8. Total (add lines 4 through 7)	600
Combined taxable income attributable to the 100 units of X:
9. Combined taxable income (line 3 minus line 8)	400
10. Share of combined taxable income apportioned to S (50% of line 9)	200
11. Share of combined taxable income apportioned to A (line 9 minus line 10)	200
A’s basis in 50 units of X leased by it to unrelated persons:
12. 50 units times $10 deemed repurchase price	500

Subsequent leasing income is entirely taxed to A.

Q. 12: If the possession product is a component product or an end-product form, how is the combined taxable income for such product to be determined?

A. 12: (i) Except as provided in paragraph (v) of this A. 12, combined taxable income for a component product or an end-product form is computed under the production cost ratio (PCR) method.

(ii) Under the PCR method, the combined taxable income for a component product will be the same proportion of the combined taxable income for the integrated product that includes the component product that the production costs attributable to the component product bear to the total production costs (including costs incurred by the U.S. affiliates) for the integrated product that includes the component product. Production costs will be the sum of the direct and indirect production costs as defined under § 1.936-5(b)(4) except that the costs will not include any costs of materials. If the possession product is a component product that is transformed into an integrated product in whole or in part by a contract manufacturer outside of the possession, within the meaning of § 1.936-5(c), the denominator of the PCR shall be computed by including the same amount paid to the contract manufacturer, less the costs of materials of the contract manufacturer, as is taken into account for purposes of the significant business presence test under § 1.936-5(c) Q&A. 5.

(iii) Under the PCR method the combined taxable income for an end-product form will be the same proportion of the combined taxable income for the integrated product that includes the end-product form that the production costs attributable to the end-product form bear to the total production costs (including costs incurred by the U.S. affiliates) for the integrated product that includes the end-product form. Production costs will be the sum of the direct and indirect production costs as defined under § 1.936-5(b)(4) except that the costs will not include any costs of materials. If the possession product is an end-product form and an excluded component is contract manufactured outside of the possession, within the meaning of § 1.936-5(c), the denominator shall be computed by including the same amount paid to the contract manufacturer, less cost of materials of the contract manufacturer, as is also taken into account for purposes of the significant business presence test under § 1.936-5(c) Q&A. 5.

(iv) This paragraph (iv) of A. 12 illustrates the computation of combined taxable income for a component product or end-product form under the PCR method. S, a possessions corporation, is engaged in the manufacture of microprocessors. S obtains a component from a U.S. affiliate, O. S sells its production to another U.S. affiliate, P, which incorporates the microprocessors into central processing units (CPUs). P transfers the CPUs to a U.S. affiliate, Q, which incorporates the CPUs into computers for sale to unrelated persons. S chooses to define the possession product as the CPUs. The combined taxable income for the sale of the possession product on the basis of the given production, sales, and cost data is computed as follows:

Production costs (excluding costs of materials):
1. O’s costs for the component	100
2. S’s costs for the microprocessors	500
3. P’s costs for the CPUs (the possession product)	200
4. Q’s costs for the computers	400
5. Total production costs for the computer (Add lines 1 through 4)	1,200
6. Combined production costs for the CPU (the possession product) (Add lines 1 through 3)	800
7. Ratio of production costs for the CPUs (the possession product) to the production costs for the computer	0.667
Determination of combined taxable income for computers:
Sales:
8. Total possession sales of computers to unrelated customers and foreign affiliates	7,500
Total costs of O, S, P, and Q incurred in production of a computer:
9. Production costs (enter from line 5)	1,200
10. Material costs	100
11. Total costs (line 9 plus line 10)	1,300
12. Combined gross income from sale of computers (line 8 minus line 11)	6,200
Expenses of the affiliated group (other than foreign affiliates) allocable and apportionable to the computers or any component thereof under the rules of §§ 1.861-8 through 1.861-14T and 1.936-6 (b)(1), Q&A. 1:
13. Expenses (other than research expenses)	980
Research expenses of the affiliated group allocable and apportionable to the computers:
14. Total sales in the 3-digit SIC Code	12,500
15. Possession sales of the computers (enter from line 8)	7,500
16. Cost sharing fraction (divide line 15 by line 14)	0.6
17. Research expenses incurred by the affiliated group in 3-digit SIC Code multiplied by 120 percent	700
18. Cost sharing amount (multiply line 16 by line 17)	420
19. Research of the affiliated group (other than foreign affiliates) allocable and apportionable under §§ 1.861-17 and 1.861-14T(e)(2) to the computers	300
20. Enter the greater of line 18 or line 19	420
Computation of combined taxable income of the computer and the CPU:
21. Combined taxable income attributable to the computer (line 12 minus line 13 and line 20)	4,800
22. Combined taxable income attributable to CPUs (multiply line 21 by line 7) (production cost ratio)	3,200
23. Share of combined taxable income apportioned to S (50 percent of line 22)	1,600
Share of combined taxable income apportioned to U.S. affiliate(s) of S:
24. Adjustments for research expenses (line 18 minus line 19 multiplied by line 7)	80
25. Adjusted combined taxable income (line 22 plus line 24)	3,280
26. Share of combined taxable income apportioned to affiliates of S (line 25 minus line 23)	1,680

(v)(A) If a possession product is sold by a taxpayer or its affiliate to unrelated persons in covered sales both as an integrated product and as a component product and the conditions of paragraph (v)(C) of this A. 12 are satisfied, the taxpayer may elect to determine the combined taxable income derived from covered sales of the component product under this paragraph (v). In that case, the combined taxable income derived from covered sales of the component product shall be determined by using the same per unit combined taxable income as is derived from covered sales of the product as an integrated product, but subject to the limitation of paragraph (v)(D) of this A. 12.

(B) In the case of a possession product that is an end-product form, if all of the excluded components are also separately sold by the taxpayer or its affiliate to unrelated persons in uncontrolled transactions and the conditions of paragraph (v)(C) of this A. 12 are satisfied, the taxpayer may elect to determine the combined taxable income of such end-product form under this paragraph (v). In that case, the combined taxable income derived from covered sales of the end-product form shall be determined by reducing the per unit combined taxable income from the integrated product that includes the end-product form by the per unit combined taxable income for excluded components determined under the rules of this paragraph (v), but subject to the limitation of paragraph (v)(D) of this A. 12. For this purpose, combined taxable income of the excluded components must be determined under section 936 as if the excluded components were possession products.

(C) In the case of component products, this paragraph (v) applies only if the sales price of the possession product sold in covered sales as an integrated product (i.e., in uncontrolled transactions) would be the most direct and reliable measure of an arm’s length price within the meaning of the fourth sentence of § 1.482-3(b)(2)(ii)(A) for the component product. For purposes of applying the fourth sentence of § 1.482-3(b)(2)(ii)(A), the sale of the integrated product that includes the component product is treated as being immediately preceded by a sale of the component (i.e. without further processing) in a controlled transaction. In the case of end-product forms, this paragraph (v) applies only if the sales price of excluded components separately sold in uncontrolled transactions would be the most direct and reliable measure of an arm’s length price within the meaning of the fourth sentence of § 1.482-3(b)(2)(ii)(A) for all excluded components of an integrated product that includes an end-product form. For purposes of applying the fourth sentence of § 1.482-3(b)(2)(ii)(A), the sale of the integrated product that includes excluded components is treated as being immediately preceded by a sale of the excluded components (i.e. without further processing) in a controlled transaction. Under the fourth sentence of § 1.482-3(b)(2)(ii)(A), the uncontrolled transactions referred to in this paragraph (v)(C) must have no differences with the controlled transactions that would affect price, or have only minor differences that have a definite and reasonably ascertainable effect on price and for which appropriate adjustments are made (resulting in appropriate adjustments to the computation of combined taxable income). If such adjustments cannot be made, or if there are more than minor differences between the controlled and uncontrolled transactions, the method provided by this paragraph (v)(C) cannot be used. Thus, for example, these uncontrolled transactions must involve substantially identical property in the same or a substantially identical geographic market, and must be substantially identical to the controlled transaction in terms of their volumes, contractual terms, and market level. See § 1.482-3(b)(2)(ii)(B).

(D) In no case can the per unit combined taxable income as determined under paragraph (v)(A) or (B) of this A. 12 be greater than the per unit combined taxable income of the integrated product that includes the component product or end-product form.

(E) The provisions of this paragraph (v) are illustrated by the following example. Taxpayer manufactures product A in a U.S. possession. Some portion of product A is sold to unrelated persons as an integrated product and the remainder is sold to related persons for transformation into product AB. The combined taxable income of integrated product A is $400 per unit and the combined taxable income of product AB is $300 per unit. The production cost ratio with respect to product A when sold as a component of product AB, is 2/3. Unless the taxpayer elects and satisfies the conditions of this paragraph (v), the combined taxable income with respect to A will be $200 per unit (combined taxable income for AB of $300 × the production cost ratio of 2/3). If, however, the comparability standards of paragraph (v)(C) of this A. 12 are met, the taxpayer may elect to determine combined taxable income of product A when sold as a component of product AB using the same per unit combined taxable income as product A when sold as an integrated product. However, the per unit combined taxable income from sales of product A as a component product may not exceed the per unit combined taxable income on the sale of product AB. Therefore, the combined taxable income of component product A may not exceed $300 per unit.

(vi) Taxpayers that have not elected the percentage limitation under section 936(a)(1) for the first taxable year beginning after December 31, 1993, may do so if the taxpayer has elected the profit split method and computation of combined taxable income is affected by Q&A.12 of this paragraph (b)(1).

(vii) The rules of Q&A. 12 of this paragraph (b)(1) apply for taxable years ending after June 9, 1996. If, however, the election under paragraph (v) of A. 12 of § 1.936-6(b)(1) is made, this election must be made for the taxpayer’s first taxable year beginning after December 31, 1993, and if not made effective for that year, the election cannot be made for any later taxable year. A successor corporation that makes the same or substantially similar products as its predecessor corporation cannot make an election under paragraph (v) of A.12 of § 1.936-6(b)(1) unless the election was made by its predecessor corporation for its first taxable year beginning after December 31, 1993.

Q. 13: If the profit split option is elected, how is the portion of combined taxable income not allocated to the possessions corporation to be treated?

A. 13: (i) The income shall be allocated to affiliates in the following order, but no allocations will be made to affiliates described in a later category if there are any affiliates in a prior category –

(A) First, to U.S. affiliates (other than tax exempt affiliates) within the group (as determined under section 482) that derive income with respect to the product produced in whole or in part in the possession;

(B) Second, to U.S. affiliates (other than tax exempt affiliates) that derive income from the active conduct of a trade or business in the same product area as the possession product;

(D) Fourth, to foreign affiliates that derive income from the active conduct of a U.S. trade or business in the same product area as the possession product (or, if the foreign members are resident in a country with which the U.S. has an income tax convention, then to those foreign members that have a permanent establishment in the United States that derives income in the same product area as the possession product); and

(E) Fifth, to all other affiliates.

(ii) The allocations made under paragraph (i)(A) of this A. 13 shall be made on the basis of the relative gross income derived by each such affiliate with respect to the product produced in whole or in part in the possession. For this purpose, gross income must be determined consistently for each affiliate and consistently from year to year.

(iii) The allocations made under paragraphs (i)(B) and (i)(D) of this A. 13 shall be made on the basis of the relative gross income derived by each such affiliate from the active conduct of the trade or business in the same product area.

(iv) The allocations made under paragraphs (i)(C) and (i)(E) of this A. 13 shall be made on the basis of the relative total gross income of each such affiliate before allocating income under this section.

(v) Income allocated to affiliates shall be treated as U.S. source and section 863(b) does not apply for this purpose.

(vi) For purposes of determining an affiliate’s estimated tax liability for income thus allocated for taxable years beginning prior to January 1, 1995, the income shall be deemed to be received on the last day of the taxable year of each such affiliate in which or with which the taxable year of the possessions corporation ends. For taxable years beginning after December 31, 1994, quarterly estimated tax payments will be required as provided under section 711 of the Uruguay Round Agreements, Public Law 103-465 (1994), page 230, and any administrative guidance issued by the Internal Revenue Service thereunder.

Q. 14: What is the source of the portion of combined taxable income allocated to the possessions corporation?

A. 14: Income allocated to the possessions corporation shall be treated as possession source income and as derived from the active conduct of a trade or business within the possession.

Q. 15: How is the profit split option to be applied to properly account for costs incurred in a year with respect to products which are sold by the possessions corporation to a U.S. affiliate during such year, but are not resold by the U.S. affiliate to persons who are not members of the affiliated group or to foreign affiliates until a later year?

A. 15: The rules under § 1.994-1(c)(5) are to be applied. Incomplete transactions will not be taken into consideration in computing combined taxable income. Thus, for example, if in 1983, A, a possessions corporation, sells units of a product with a cost to A of $5000 to B corporation, its U.S. affiliate, which use the dollar-value LIFO method of costing inventory, and B sells units with a cost of $4000 (representing A’s cost) to C corporation, a foreign affiliate, only $4000 of such costs shall be taken into consideration in computing the combined taxable income of the possessions corporation and U.S. affiliates for 1983. If a specific goods LIFO inventory method is used by B, the determination of whether A’s goods remain in B’s inventory shall be based on whether B’s specific goods LIFO grouping has experienced an increment or decrement for the year on the specific LIFO cost of such units, rather than on an average unit cost of such units. If the FIFO method of costing inventory is used by B, transfers may be based on the cost of the specific units transferred or on the average unit production cost of the units transferred, but in each case a FIFO flow assumption shall be used to identify the units transferred. For a determination of which goods are sold by taxpayers using the LIFO method, see question and answer 19.

Q. 16: If a possessions corporation purchases materials from an affiliate and computes combined taxable income for a possession product which includes such materials, how are those materials to be treated in the possessions corporation’s inventory?

A. 16: The cost of those materials is considered to be equal to the affiliate’s cost using the affiliate’s method of costing inventory.

Q. 17: If the possessions corporation uses the FIFO method of costing inventory and the U.S. affiliate uses the LIFO method of costing inventory, or vice versa, what method of costing inventory should be used in computing combined taxable income?

A. 17: The transferor corporation’s method of costing inventory determines the cost of inventory for purposes of combined taxable income while the transferee corporation’s method of costing inventory determines the flow. Assume, for example, that X corporation, a possessions corporation, using the FIFO method of costing inventory purchases materials from Y corporation, U.S. affiliate, also using the FIFO method. X corporation produces a product which it transfers to Z corporation, another U.S. affiliate using the LIFO method. Assume also that the final product satisfies the significant business presence test. Under the facts, the cost of the materials purchased by X from Y is Y’s FIFO cost. The costs of the inventory transferred by X to Z are determined under X’s FIFO method of accounting as is the flow of the inventory from X to Z. The costs added by Z are determined under Z’s LIFO method of inventory, as is the flow of the inventory from Z to unrelated persons or foreign affiliates.

Q. 18: How are the costs of a possession product and the revenues derived from the sale of a possession product determined if the U.S. affiliate includes purchases of the possessions product in a dollar-value LIFO inventory pool (as provided under § 1.472-8)?

A. 18: The following method will be accepted in determining the revenues derived from the sale of a possession product and the costs of a possession product if the U.S. affiliate includes purchases of the possession product in a dollar-value LIFO inventory pool. The rules apply solely for the cost sharing and profit split options under section 936(h).

(i) Revenue identification. The identification of revenues derived from sales of a possession product must generally be made on a specific identification basis. The particular method employed by a taxpayer for valuing its inventory will have no impact on the determination of what units are sold or how much revenue is derived from such sales. Thus, if a U.S. affiliate sells both item A (a possession product) and item B (a non-possession product), the actual sales revenues received by the U.S. affiliate from item A sales would constitute possession product revenue for purposes of the profit split option and possession sales for purposes of the cost sharing option regardless of whether the U.S. affiliate values its inventories on the FIFO or the LIFO method. In instances where sales of item A (i.e., the possession product) cannot be determined by use of specific identification (for example, in cases where items A and B are identical except that one is produced in the possession (item A) and the other (item B) is produced outside of the possession and it is not possible to segregate these items in the hands of the U.S. affiliate), it will be necessary to identify the portion of the combined sales of items A and B (which together can be identified on a specific identification basis) which is attributed to item A sales and the portion which is attributed to item B sales. The determination of the portion of aggregated sales attributable to item A and item B is independent of the LIFO method used to determine the cost of such sales and may be made under the following approach. A taxpayer may, for purposes of this section of the regulations, use the relative purchases (in units) of items A and B by the U.S. affiliate during the taxable year (or other appropriate measuring period such as the period during the taxable year used to determine current-year costs, i.e., earliest acquisitions period, latest acquisitions period, etc.) in determining the ratio to apply against the combined items A and B sales revenue. If the sales exceed current purchases, the taxpayer can use a FIFO unit approach which identifies actual unit sales on a first-in, first-out basis. Revenue determination where specific identification is not possible is illustrated by the following example:

Example.At the end of year 1, there are 600 units of combined items A and B which are to be allocated between A and B on the basis of annual purchases of A and B units during year 1. During year 1, 1,000 units of item A, a possession product, and 2,000 units of item B, a non-possession product, were purchased. Thus, the 600 units in year 1 ending inventory are allocated 200 (i.e.
1/3) to item A units and 400 (i.e.
2/3) to item B units based on the relative purchases of A (1,000) and B (2,000) in year 1. These units appear as beginning inventory in year 2.

In year 2, 1,500 units of item A are purchased and 1,500 units of item B are purchased. However, 3,300 units of items A and B in the aggregate are sold for $600,000. The relative proportion of the $600,000 attributable to item A and to item B sales would be determined as follows:

Year 2 sales	Item A	Item B
Unit sales from opening inventory	200	400
Unit sale from current-year purchases	1,350	1,350
Total unit sales (3,300)	1,550	1,750
Percentage	47	53

Year 2 Closing Inventory	Units
Item A	150
Item B	150

Thus, revenues from Item A sales for purposes of computing possession sales for the cost sharing option and revenues for the profit split option are $281,818.

(ii) Cost identification. The determination of the cost of possession product sales by the U.S. affiliate must be based on the LIFO inventory method of the U.S. affiliate. The LIFO cost of possession product sales will, for purposes of this section of the regulations, be determined by maintaining a separate LIFO cost for possession products in a taxpayer’s opening and closing LIFO inventory and using this cost to calculate an independent cost of possession product sales. This separate LIFO cost for possession products in the LIFO pool of a taxpayer is to be determined as follows:

(A) Determine the base-year cost of possession products in ending inventory in a LIFO pool.

(B) Determine the percentage of the base-year cost of possession products in the pool as compared to the total base-year cost of all items in the pool.

(C) Multiply the percentage determined in step (B) of this subdivision (ii) by the ending LIFO inventory value of the pool to determine the deemed LIFO cost attributable to possession products in the pool.

(D) Subtract the LIFO cost of possession products in ending inventory in the pool (as calculated in step (C) of this subdivision (ii)) from the sum of:

(1) Possession product purchases for the year, plus

(2) The portion of the opening LIFO inventory value of the pool attributed to possession products (i.e., the result obtained in step (C) of this subdivision (ii) for the prior year).

The number determined by this calculation is the LIFO cost of possession product sales from the taxpayer’s LIFO pool.

Example:Assume that item A is a possession product and item B is a non-possession product and also assume the inventory and purchases with respect to the LIFO pool as provided below:

Year 1 – Ending Inventory

	No. of units	Base-year cost/unit	Base-year cost	Percent
Item A	100	$2.00	$200	20
Item B	200	4.00	800	80

Year 1 – LIFO Value

	Base-year cost	Index	LIFO cost
Increment layer 2	$300	3.0	$900
Increment layer 1	400	2.0	800
Base layer	300	1.0	300
Pool total	$1,000		$2,000

Year 1 – LIFO Value Per Item

	Base-year cost	LIFO value
Total pool	$1,000	$2,000
Item A	200	400
Item B	800	1,600

Year 2 – Purchases

	Total purchases
Item A	$6,000
Item B	4,000

Year 2 – Ending Inventory

	No. of units	Base-year cost/unit	Base-year cost	Percent
Item A	200	$2.00	$400	50
Item B	100	4.00	400	50

Year 2 – LIFO Value

	Base-year cost	Index	LIFO cost
Increment layer 2	$100	3.0	$300
Increment layer 1	400	2.0	800
Base layer	$300	1.0	300
Pool total	800		1,400

The year 2 LIFO cost of possession product A sales will be calculated as follows:

(1) Base-year cost of item in year 2 ending inventory = $400

(2) Percentage of item A base-year cost to total base-year cost ($400 ÷ $800) = 50%

(3) LIFO value of item A ($1,400 × 50%) = $700

(4) LIFO cost of item A sales is determined by adding to the beginning inventory in year 2 the purchases of item A in year 2 and subtracting from this amount the ending inventory in year 2 ($400 + $6000 − $700 = $5700). The beginning inventory in year 2 is determined by multiplying the LIFO cost of the year 1 ending inventory by a percentage of item A base year cost to the total base-year cost in year 1. The ending inventory in year 2 is determined under (3) above.

Q. 19: If a possession product is purchased from a possessions corporation by a U.S. affiliate using the dollar-value LIFO method of costing its inventory and is included in a LIFO pool of the U.S. affiliate which includes products purchased from the possessions corporation in pre-TEFRA years, how should the LIFO index computation of the U.S. affiliate be made in the first year in which section 936(h) applies and in subsequent taxable years?

A. 19: The U.S. affiliate should treat the first taxable year for which section 936(h) applies as a new base year in accordance with procedures provided by regulations under section 472. Thus, the opening inventory for the first year for which section 936(h) applies (valuing possession products purchased from the possessions corporation on the basis of the cost of such possession products), would equal the new base year cost of the inventory of such pool of the U.S. affiliate. Increments and decrements at new base year cost would be valued for LIFO purposes pursuant to the procedures provided by regulations under section 472.

Q. 20: If the possessions corporation computes its income with respect to a product under the profit split method, with respect to which units of the product shall the profit split method apply?

A. 20: The profit split method shall apply to units of the possession product produced in whole or in part by the possessions corporation in the possession and sold during the taxable year by members of the affiliated group (other than foreign affiliates) to unrelated parties or to foreign affiliates. In no event shall the profit split method apply to units of the product which were not taken into account by the possessions corporation in applying the significant business presence test for the current taxable year or for any prior taxable year in which the possessions corporation also had a significant business presence in the possession with respect to such product.

(2) Pre-TEFRA inventory.

Q. 1: How is pre-TEFRA inventory to be determined if the profit split option is elected and the FIFO method of costing inventory is used by the U.S. affiliate?

A. 1: Pre-TEFRA inventory is inventory which was produced by the possessions corporation and transferred to a U.S. affiliate prior to the possessions corporation’s first taxable year beginning after December 31, 1982. Pre-TEFRA inventory will not be included for purposes of the profit split option. If the U.S. affiliate uses the FIFO method of costing inventory, the pre-TEFRA inventory will be treated as the first inventory sold by the U.S. affiliate during the first year in which section 936(h) applies and will not be included in the computation of combined taxable income for purposes of the profit split option. The treatment of pre-TEFRA inventory when FIFO costing is used by both the U.S. affiliate and the possessions corporation is illustrated by the following example in which FIFO unit costing is used:

Example.Assume the following:

	X		Y
	Possessions corporation		U.S. affiliate
	Number of units	Cost per unit	Number of units	Cost per unit
Beginning inventory	500	$150	200	$225
Units produced during 1983	1,000	200
Ending inventory	400	200	300

In 1983, the beginning inventory of X, a possessions corporation, is 500 units with a unit cost of $150 and the beginning inventory of Y, the U.S. affiliate, is 200 units with a unit cost of $225, which represents the section 482 price paid by Y. Y’s beginning inventory in 1983 represents purchases made in 1982 of products produced by X in that year. Y sells all the units it purchases from X to Z, a foreign affiliate. In 1983, X produces 1000 units at a unit cost of $200 and sells 1100 units to Y (the difference between 1500 units, representing X’s 1983 beginning inventory (500) and the units produced by X in 1983 (1000), and X’s ending inventory of 400 units). Of the 1100 units sold by X to Y in 1983 only 800 units (and not 1000 units) which were sold by Y to Z are taken into consideration in computing combined taxable income for 1983. Since FIFO costing by the possessions corporation is used, the cost is $150 per unit for the first 500 units and $200 per unit for the remaining 300 units. The 200 units sold by X to Y in 1982 are pre-TEFRA inventory and are not included in the computation of combined taxable income for 1983. They are also treated as the first units sold by Y to Z in 1983. This inventory has a unit cost of $225, which reflects the section 482 transfer price from X to Y in 1982. Y’s 1983 ending inventory of 300 units will not be taken into consideration in computing the combined taxable income of X and Y for 1983 because the units have not been sold to a foreign affiliate or to persons who are not members of the affiliated group. In a subsequent year when the units are sold to Z, the cost to X and selling price to Z of these units will enter into the computation of combined taxable income for that year.

Q. 1: What are “covered intangibles” under section 936(h)(5)(C)(i)(II)?

A. 1: The term “covered intangibles” means (1) intangible property developed in a possession solely by the possessions corporation and owned by it, (2) manufacturing intangible property (described in section 936(h)(3)(B)(i)) which is acquired by the possessions corporation from unrelated persons, and (3) any other intangible property (described in section 936(h)(3)(B) (ii) through (v), to the extent not described in section 936(h)(3)(B)(i)) which relates to sales of products or services to unrelated persons for ultimate consumption or use in the possession in which the possessions corporation conducts its business. The possessions corporation is treated as the owner of covered intangibles for purposes of obtaining a return thereon.

Q. 2: Do covered intangibles include manufacturing intangible property which is acquired by an affiliate and subsequently transferred to the possessions corporation?

A. 2: No. In order for a manufacturing intangible to be treated as a covered intangible, the intangible property must be acquired directly by the possessions corporation from an unrelated person unless the manufacturing intangible was acquired by an affiliate from an unrelated person and was transferred to the possessions corporation by the affiliate prior to September 3, 1982.

Q. 3: If a possessions corporation licenses a manufacturing intangible from an unrelated party, will the licensed intangible be treated as a covered intangible?

A. 3: No.

Q. 4: How is ultimate consumption or use determined for purposes of the definition of covered intangibles?

A. 4: A product will be treated as having its ultimate use or consumption in a possession if it is sold by the possessions corporation to a related or unrelated person in a possession and is not resold or used or consumed outside of the possession within one year after the date of the sale.

Q. 5: Are sales of products that relate to covered intangibles excluded from the cost sharing fraction?

A. 5: If no manufacturing intangibles other than covered intangibles are associated with the possession product, then sales of such product will be excluded from the cost sharing fraction. If both covered and non-covered manufacturing intangibles are associated with the possession product, then sales of such product will be included in the cost sharing fraction.

Q. 6: If the cost sharing option is elected, is it necessary for the possessions corporation to be the legal owner of covered intangibles described in section 936(h)(5)(C)(i)(II)(c) related to the product in order for the possessions corporation to receive a full return with respect to such intangibles?

A. 6: No. For purposes of section 936(h), it is immaterial whether such covered intangibles are owned by the possessions corporation or by another member of the affiliated group. Moreover, if the legal owner of such covered intangibles which are subject to section 936(h)(5) is an affiliate of the possessions corporation, such person will not be required to charge an arm’s-length royalty under section 482 to the possessions corporation.

[T.D. 8090, 51 FR 21532, June 13, 1986; 51 FR 27174, July 30, 1986, as amended by T.D. 8669, 61 FR 21367, May 10, 1996; 61 FR 39072, July 26, 1996; T.D. 8786, 63 FR 55025, Oct. 14, 1998]

§ 1.936-7 Manner of making election under section 936 (h)(5); special election for export sales; revocation of election under section 936(a).

(a) The rules in this section apply for purposes of section 936(h) and also for purposes of section 934(e), where applicable.

(b) Manner of making election.

Q. 1: How does a possessions corporation make an election to use the cost sharing method or profit split method?

A. 1: A possessions corporation makes an election to use the cost sharing or profit split method by filing Form 5712-A (“Election and Verification of the Cost Sharing or Profit Split Method Under Section 936(h)(5)”) and attaching it to its tax return. Form 5712-A must be filed on or before the due date (including extensions) of the tax return of the possessions corporation for its first taxable year beginning after December 31, 1982. The electing corporation must set forth on the form the name and the taxpayer identification number or address of all members of the affiliated group (including foreign affiliates not required to file a U.S. tax return). All members of the affiliated group must consent to the election. For elections filed with respect to taxable years beginning before January 1, 2003, an authorized officer of the electing corporation must sign the statement of election and must declare that he has received a signed statement of consent from an authorized officer, director, or other appropriate official of each member of the affiliated group. Elections filed for taxable years beginning after December 31, 2002, must incorporate a declaration by the electing corporation that it has received a signed consent from an authorized officer, director, or other appropriate official of each member of the affiliated group and will be verified by signing the return. The election is not valid for a taxable year unless all affiliates consent. A failure to obtain an affiliate’s written consent will not invalidate the election out if the possessions corporation made a good faith effort to obtain all the necessary consents or the failure to obtain the missing consent was inadvertent. Subsequently created or acquired affiliates are bound by the election. If an election out is revoked under section 936(h)(5)(F)(iii), a new election out with respect to that product area cannot be made without the consent of the Commissioner. The possessions corporation shall file an amended Form 5712-A with its timely filed (including extensions) income tax return to reflect any changes in the names or number of the members of the affiliated group for any taxable year after the first taxable year to which the election out applies. By consenting to the election out, all affiliates agree to provide information necessary to compute the cost sharing payment under the cost sharing method or combined taxable income under the profit split method, and failure to provide such information shall be treated as a request to revoke the election out under section 936(h)(5)(F)(iii).

Q. 2: May the “election out” under section 936(h)(5) be made on a product-by-product basis, or must it be made on a wide basis?

A. 2: An electing corporation is required to treat products in the same product area in the same manner. Similarly, all possessions corporations in the same affiliated group that produce any products or render any services in the same product area must make the same election for all products that fall within the same product area. However, § 1.936-7(b) provides that the electing corporation may make a different election for export sales than for domestic sales. The electing corporation or corporations may also make different elections for products that fall within different product areas.

Q. 3: May the possessions corporation elect to define product area more narrowly than the 3-digit SIC code?

A. 3: No. Certain alternatives, such as the 4-digit SIC code, would not be permitted under the statute. However, other methods for defining product area may be considered by the Commissioner in the future.

Q. 4: May a possessions corporation make an election out under the cost sharing method with respect to a product area if the affiliated group incurs no research, development or experimental costs in the product area?

A. 4: Yes. In that case the cost sharing payment will be zero.

Q. 5: If the significant business presence test is not satisfied for a product or type of service within the product area covered by the election out under section 936(h)(5) what rules will apply with respect to that product?

A. 5: With respect to the product which does not satisfy the significant business presence test, the provisions of section 936 (h)(1) through (h)(4) will apply to the allocation of income. However, if a cost sharing or a profit split election has been made with respect to the product area, the cost sharing payment or the research and development floor under section 936(h)(5)(C)(ii)(II) will not be reduced.

Q. 6: Is a taxpayer permitted to make a change of election with respect to the cost sharing and profit split methods?

A. 6: In general, once the election is properly made, it is binding for the first year in which it applies and all subsequent years (including upon any later created or acquired affiliates), and revocation is only permitted with the consent of the Commissioner of Internal Revenue. However, a taxpayer will be permitted to change its election once from the cost sharing method to the profit split method or vice versa, or from the method permitted under section 936 (h)(1) through (h)(4) to cost sharing or profit split or vice versa, without the consent of the Commissioner if the change is made on the taxpayer’s return for its first taxable year ending after June 13, 1986. Such change will apply to such taxable year and all subsequent taxable years, and, at the taxpayer’s option, may also apply to all prior taxable years for which section 936(h) was in effect. A change of election will be treated as an election subject to the procedures set forth above and to section 481 of the Internal Revenue Code.

Q. 7: If the Commissioner determines that a possessions corporation does not meet the 80-percent possession source test or the 65-percent active trade or business test (the “qualification tests”) for any taxable year beginning after 1982, under what circumstances is the possessions corporation permitted to make a distribution of property after the close of its taxable year to meet the qualification tests?

A. 7: A possessions corporation may make a pro rata distribution of property to its shareholders after the close of the taxable year if the Commissioner determines that the possessions corporation does not satisfy the qualification tests (a) by reason of the exclusion from gross income of intangible income under section 936(h)(1)(B) or section 936(h)(5)(C)(i)(II) or (b) by reason of the allocation to the shareholders of the possessions corporation of income under section 936(h)(5)(C)(ii)(III); provided, however, that the determination of the Commissioner does not contain a finding that the failure of such corporation to satisfy the qualification tests was due, in whole or in part, to fraud with intent to evade tax or willful neglect on the part of the possessions corporation. The possessions corporation must designate the distribution at the time the distribution is made as a distribution to meet qualification requirements, and it will be subject to the provisions of section 936(h)(4). Such distributions will not qualify for the dividends received deduction.

Q. 8: If a possessions corporation owns stock in a subsidiary possessions corporation, any intangible property income allocated to the parent possessions corporation under section 936(h) will be treated as U.S. source income and taxable to the parent possessions corporation. Is the intangible property income taken into consideration in determining whether the parent possessions corporation meets the income tests of section 936(a)(2)?

A. 8: While taxable to the parent possessions corporation, the intangible property income does not enter into the calculation of the 80-percent possession source test or the 65-percent active trade or business test of section 936(a)(2)(A) and (B). This would also be the case if the subsidiary possessions corporation made a qualifying distribution under section 936(h)(4).

Q. 1: What methods of computing income can a possessions corporation use under the separate election for export sales?

A. 1: The only two methods which are available under the separate election for export sales are the cost sharing method and the profit split method.

Q. 2: What is the definition of export sales for purposes of the separate election for export sales?

A. 2: The determination of export sales is based upon the destination of the product, i.e., where it is to be used or consumed. If the product is sold to a U.S. affiliate, it will be treated as an export sale only if resold or otherwise transferred abroad to a foreign person (including a foreign affiliate or foreign branch of a U.S. affiliate) within one year from the date of sale to the U.S. affiliate for ultimate use or consumption outside the United States as provided under § 1.954-3(a)(3)(ii).

Q. 3: Assume that a possessions corporation sells a product to both foreign affiliates and foreign branches of U.S. affiliates. In addition, it sells the product to its U.S. parent for resale in the U.S. The possessions corporation makes a profit split election for domestic sales and a cost sharing election of export sales. Will the sales to foreign branches of U.S. affiliates be treated as exports subject to the cost sharing method or as domestic sales subject to the profit split method?

A. 3: The sales to a foreign branch of a U.S. corporation are exports if for ultimate use or consumption outside of the United States as provided under § 1.954-3(a)(3)(ii).

Q. 4: Under what circumstances may a possessions corporation make the separate election under section 936(h)(5)(F)(iv)(II) for computing its income from products exported to a foreign person when the income derived by such foreign person on the resale of such products is included in foreign base company income under section 954(a)?

A. 4: If the income derived by a foreign person on the resale of products manufactured, in whole or in part, by a possessions corporation is included in foreign base company income under section 954(a), then the possessions corporation may make the separate export election under section 936(h)(5)(F)(iv)(II) for computing its income from such products only if such foreign person has been formed or is availed of for substantial business reasons that are unrelated to an affiliated corporation’s U.S. tax liability. For purposes of the proceding sentence, a foreign person will be considered to be formed or availed of for such substantial business reasons if the foreign person in the normal course of business purchases substantial quantities of products from both the possessions corporation and its affiliates for resale, and, in addition provides support services for affiliated companies such as centralized testing, marketing of products, management of local currency exposures, or other similar services. However, a foreign person that purchases and resells products only from a possessions corporation is presumed to be formed or availed of for other than such substantial business reasons, even if the foreign person provides additional services.

Q. 5: When will the “manufacturing” test set forth in subsection (d)(1)(A) of section 954 be applicable to the export sales of a product of a possessions corporation which makes a separate election for export sales?

A. 5: An electing corporation will be required to meet the “manufacturing” test set forth in subsection (d)(1)(A) of section 954 with respect to export sales of its product in each taxable year in which the separate election for export sales is in effect.

(d) Revocation of election under section 936(a).

Q. 1: When may an election under section 936(a) be revoked?

A. 1: An election under section 936(a) may be revoked during the first ten years of section 936 status only with the consent of the Commissioner, and without the Commissioner’s consent after that time. The Commissioner hereby consents to all requests for revocation that are made with respect to the taxapayer’s first taxable year beginning after December 31, 1982 provided that the section 936(a) election was in effect for the corporation’s last taxable year beginning before January 1, 1983, if the taxpayer agrees not to re-elect section 936(a) prior to its first taxable year beginning after December 31, 1988. A taxpayer that wishes to revoke a section 936(a) election under the terms of the blanket revocation must attach a “Statement of Revocation – Section 936” to the taxpayer’s timely filed return (including extensions) and must state that in revoking the election the taxpayer agrees not to re-elect section 936(a) prior to its first taxable year beginning after December 31, 1988. Other requests to revoke not covered by the Commissioner’s blanket consent should be addressed to the District Director having jurisdiction over the taxpayer’s tax return.

[T.D. 8090, 51 FR 21545, June 13, 1986, as amended by T.D. 9100, 68 FR 70705, Dec. 19, 2003; T.D. 9300, 71 FR 71042, Dec. 8, 2006]

§ 1.936-8T Qualified possession source investment income (temporary). [Reserved]

§ 1.936-9T Source of qualified possession source investment income (temporary). [Reserved]

§ 1.936-10 Qualified investments.

(a) In general. [Reserved]

(b) Qualified investments in Puerto Rico. [Reserved]

(c) Qualified investment in certain Caribbean Basin countries – (1) General rule. An investment of qualified funds described in this section shall be treated as a qualified investment of funds for use in Puerto Rico if the funds are used for a qualified investment in a qualified Caribbean Basin country. A qualified investment in a qualified Caribbean Basin country is a loan of qualified funds by a qualified financial institution (described in paragraph (c)(3) of this section) directly to a qualified recipient (described in paragraph (c)(9) of this section) or indirectly through a single financial intermediary for investment in active busines assets (as defined in paragraph (c)(4) of this section) in a qualified Caribbean Basin country (described in paragraph (c)(10)(ii) of this section) or for investment in development projects (as defined in paragraph (c)(5) of this section) in a qualified Caribbean Basin country, provided –

(i) The investment is authorized, prior to disbursement of the funds, by the Commissioner of Financial Institutions of Puerto Rico (or his delegate) pursuant to regulations issued by such Commissioner; and

(ii) The agreement, certification, and due diligency requirements under paragraphs (c)(11), (12), and (13) of this section are met.

A loan by a qualified financial institution shall not be disqualified merely because the loan transaction is processed by the central bank of issue of the country into which the loan is made pursuant to, and solely for purposes of complying with, the exchange control laws or regulations of such country. Further, a loan by a qualified financial institution shall not be disqualified merely because the loan is acquired by another person, provided such other person is also a qualified financial institution.

(2) Termination of qualification – (i) In general. An investment that, at any time after having met the requirements for a qualified investment in a qualified Caribbean Basin country under the terms of this paragraph (c), fails to meet any of the conditions enumerated in this paragraph (c) shall no longer be considered a qualified investment in a qualified Caribbean Basin country from the time of such failure, unless the investment satisfies the requirements for a timely cure described in paragraph (c)(2)(ii) of this section. Such a failure includes, but is not limited to, the occurrence of any of the following events:

(A) Active business assets cease to qualify as such;

(B) Proceeds from the investment are diverted for the financing of assets, projects, or operations that are not active business assets or development projects or are not the assets or the project of the qualified recipient;

(D) The qualified recipient’s qualified business activity ceases to qualify as such; or

(E) The qualified Caribbean Basin country ceases to be a country described in paragraph (c)(10)(ii) of this section.

(ii) Timely cure – (A) In general. A timely cure shall be considered to have been made if the event or events that cause disqualification of the investment are corrected within a reasonable period of time. For purposes of this section, a reasonable period of time shall not exceed 60 days after such event or events come to the attention of the qualified recipient or the qualified financial institution or should have some to their attention by the exercise of reasonable diligence.

(B) Due diligence requirements. A time cure of a failure to comply with the due diligence requirements of paragraphs (c)(11), (12), and (13) of this section shall be considered to be made if the failure to comply is due to reasonable cause and, upon request of the Commissioner of Financial Institutions of Puerto Rico (or his delegate) or of the Assistant Commissioner (International) (or his authorized representative), the qualified financial institution (and its trustee or agent), if any), the financial intermediary, or the qualified recipient establishes to the satisfaction of the Commissioner of Financial Institutions of Puerto Rico (or his delegate) or of the Assistant Commissioner (International) (or his authorized representative) that it has exercised due diligence in ensuring that the funds were property disbursed to a qualified recipient and applied by or on behalf of such qualified recipient to uses that qualify the investment as an investment in qualified business assets or a development project under the provisions of this paragraph (c).

(iii) Assumption of qualified recipient’s obligation. An investment shall not cease to qualify merely because the qualified recipient’s obligation to the qualified financial institution (or to a financial intermediary, if any) is assumed by another person, provided such other person assumes the qualified recipient’s agreement and certification requirements under paragraph (c)(11)(i) of this section and is either –

(A) A qualified recipient on the date of assumption, in which case such person shall be treated for purposes of this section as the original qualified recipient and shall be subject to all the requirements of this section for continued qualification of the loan as a qualified investment in a qualified Caribbean Basin country; or

(B) An international organization, the principal purpose of which is to foster economic development in developing countries and which is described in section 1 of the International Organizations Immunities Act (22 U.S.C. 288), if the assumption of the obligation is pursuant to a bona fide guarantee agreement.

(3) Qualified financial institution – (i) General rule. For purposes of section 936(d)(4)(A) and this section, a qualified financial institution includes only –

(A) A banking, financing, or similar business defined in § 1.864-4(c)(5)(i) that is an eligible institution described in paragraph (c)(3)(ii) of this section, but not including branches of such institution outside of Puerto Rico;

(B) A single-purpose entity described in paragraph (c)(3)(iii) of this section;

(D) The Puerto Rico Economic Development Bank; and

(E) Such other entity as may be determined by the Commissioner by Revenue Procedure or other guidance published in the Internal Revenue Bulletin.

(ii) Eligible institution. An eligible institution means an institution –

(A) That is an entity organized under the laws of the Commonwealth of Puerto Rico or is the Puerto Rican branch of an entity organized under the laws of another jurisdiction, if such entity is engaged in a banking, financing, or similar business defined in § 1.864-4(c)(5)(i), and

(B) That is licensed as an eligible institution under Regulation No. 3582 (or any successor regulation) issued by the Commissioner of Financial Institutions of Puerto Rico (hereinafter “Puerto Rican Regulation No. 3582”).

(iii) Single-purpose entity. A single-purpose entity is an entity that meets all of the following conditions:

(A) The entity is organized under the laws of the Commonwealth of Puerto Rico and is a corporation, a partnership or a trust, which conducts substantially all of its activities in Puerto Rico.

(B) The sole purpose of the entity is to use qualified funds from possessions corporations to make one or more qualified investments in a qualified Caribbean Basin country and the entity actually uses such funds only for such purpose.

(C) In the case of an entity that is a trust, one of the trustees is a qualified financial institution described in paragraph (c)(3)(i) of this section.

(D) The entity is licensed as an eligible institution under Puerto Rican Regulation No. 3582 (or any successor regulation).

(E) Any temporary investment by the entity for its own account of funds received from a possessions corporation, and the income from the investment thereof, and any temporary investment by the entity for its own account of principal and interest paid by a borrower to the entity, and the income from the investment thereof, are limited to investments in eligible activities, as described in section 6.2.4 of Puerto Rican Regulation No. 3582, as in effect on September 22, 1989.

(4) Investments in active business assets – (i) In general. For purposes of section 936(d)(4)(A)(i)(I) and this section and subject to the provisions of paragraph (c)(8) of this section, a loan qualifies as an investment in active business assets if –

(A) The amounts disbursed to a qualified recipient under the loan or bond issue are promptly applied (as defined in paragraphs (c)(6) and (7) of this section) by (or on behalf of) the qualified recipient solely for capital expenditures for the construction, rehabilitation (including demolition associated therewith), improvement, or upgrading of qualified assets described in paragraphs (c)(4)(ii)(A), (B), (E), and (F) of this section, for the acquisition of qualified assets described in paragraphs (c)(4)(ii)(B), (C), (E), and (F) of this section, for the expenditures described in paragraphs (c)(4)(ii)(D), (E), and (F) of this section, and, if applicable, for the financing of incidental expenditures described in paragraph (c)(4)(iii) of this section;

(B) The qualified recipient owns the assets for United States income tax purposes and uses them in a qualified business activity (as defined in paragraph (c)(4)(iv)); and

(C) The requirements of paragraph (c)(6) of this section (regarding temporary investments and time periods within which the funds must be invested) and of paragraph (c)(7) of this section (regarding the refinancing of existing funding and the time periods within which funding for investments must be secured) are satisfied.

(ii) Definition of qualified assets. For purposes of this paragraph (c), qualified assets mean –

(A) Real property;

(B) Tangible personal property (such as furniture, machinery, or equipment) that is not property described in section 1221(1) and that is either new property or property which at no time during the period specified in paragraph (c)(4)(v) of this section was used in a business activity in the qualified Caribbean Basin country in which the property is to be used;

(C) Rights to intangible property that is a patent, invention, formula, process, design, pattern, know-how, or similar item, or rights under a franchise agreement, provided that such rights –

(1) Were not at any time during the period specified in paragraph (c)(4)(v) of this section used in a business activity in the qualified Caribbean Basin country in which the rights are to be used,

(2) Are not rights the use of which gives rise, or would give rise if used, to United States source income, and

(3) Are not rights acquired by the qualified recipient from a person related (within the meaning of section 267(b), using “10 percent” instead of “50 percent” in the places where it appears) to the qualified recipient;

(D) Exploration and development expenditures incurred by a qualified recipient for the purpose of ascertaining the existence, location, extent or quality of any deposit of ore, oil, gas, or other mineral in a qualified Caribbean Basin country, as well as for purposes of developing such deposit (within the meaning of section 616 of the Code and the regulations thereunder);

(E) Living plants and animals (other than crops, plants, and animals that are acquired primarily to hold as inventory by the qualified recipient for resale in the ordinary course of trade or business) acquired in connection with a farming business (as defined in § 1.263-1T(c)(4)(i)), expenditures of a preparatory nature to prepare the land or area for farming (such as planting trees, drilling wells, clearing brush, leveling land, laying pipes, building roads, constructing tanks and reservoirs), expenditures for soil and water conservation of a type described in section 175(c)(1), and expenditures of a development nature incurred in connection with, and during, the preproductive period of property produced in a farming business (as defined in § 1.263-1T(c)(4)(ii));

(F) Other assets or expenditures that are not described in paragraphs (c)(4)(ii)(A) through (E) of this section and that the Commissioner may, by Revenue Procedure or other guidance published in the Internal Revenue Bulletin or by ruling issued to a qualified financial institution or qualified recipient upon its request, determine to be qualified assets.

(iii) Incidental expenditures. An amount in addition to the loan proceeds borrowed to make an investment in active business assets shall be considered an investment in active business assets if such amount is applied to finance expenditures that are incidental to making the investment in active business assets, provided such amount is disbursed at or about the same time the proceeds for making the investment in active business assets are disbursed. For purposes of this section, expenditures incidental to an investment in active business assets include only the following items:

(A) A reasonable amount of costs (other than the cost of credit enhancement or bond insurance premiums) associated with arranging the financing of an investment in active business assets, not to exceed 3.5 percent of the proceeds of the loan or bond issue.

(B) A reasonable amount of installation costs and other reasonable costs associated with placing an active business asset in service in the qualified business activity.

(C) An amount not in excess of 10 percent of the total amount of investment in qualified assets to finance the acquisition of inventory, and other working capital requirements, but if an investment is in connection with a manufacturing or farming business, the percentage limitation shall be 50 percent rather than 10 percent provided the excess over the 10 percent limitation is used to finance inventory property. For purposes of this paragraph (c), whether a business is a manufacturing business shall be determined under principles similar to those described in section 954(d)(1)(A) and the regulations thereunder; whether a business is a farming business shall be determined under § 1.263-1T(c)(4)(i).

(D) An amount not in excess of 5 percent of the sum of the investment in active business assets and the costs described in paragraphs (c)(4)(iii)(A), (B), and (C) of this section for the refinancing of an existing debt of the qualified recipient if such refinancing is incidental to an investment in active business assets. For this purpose, the replacement of an existing loan arrangement shall not be considered the refinancing of an existing indebtedness to the extent that the funds under such loan arrangement have not yet been disbursed to the qualified recipient.

(iv) Qualified business activity. A qualified business activity is a lawful industrial or commercial activity that is conducted as an active trade or business (under principles similar to those described in § 1.367(a)-2T(b) (2) and (3)) in a qualified Caribbean Basin country. A trade or business for purposes of this paragraph (c)(4)(iv) is any business activity meeting the principles of section 367 of the Code and described in Divisions A through I (excluding group 43 in Division E (relating to the United States Postal Service) and groups 84 (relating to museums, art galleries, and botanical and zoological gardens), 86 (relating to membership organizations), and 88 (relating to private households in Division I) of the 1987 Standard Industrial Classification Manual issued by the Executive Office of the President, Office of Management and Budget, or in the comparable provisions of any successor Standard Industrial Classification Manual that is adopted by the Commissioner of Internal Revenue in a notice, regulation, or other document published in the Internal Revenue Cumulative Bulletin.

(v) Period of use. The period referred to in paragraphs (c)(4)(ii)(B) and (C) of this section shall be a five year period preceding the date of acquisition with the loan proceeds, if the date of acquisition is on or before May 13, 1991. If the date of acquisition is after May 13, 1991, then the period specified in this paragraph (c)(4)(v) shall be three years preceding the date of acquisition with the loan proceeds.

(5) Investments in development projects – (i) In general. Subject to the provisions of paragraph (c)(8) of this section, this paragraph (c)(5)(i) describes the requirements in order for a loan by a qualified financial institution to qualify as an investment in a development project for purposes of section 936(d)(4)(A)(i)(II) and for this section.

(A) The amounts disbursed under the loan or bond issue must be promptly applied (as defined in paragraphs (c)(6) and (7) of this section) by (or on behalf of) the qualified recipient solely for one or more investments described in paragraph (c)(4)(i)(A) of this section and in any land, buildings, or other property functionally related and subordinate to a facility described in paragraph (c)(5)(ii) of this section (determined under principles similar to those described in § 1.103-8(a)(3)), for use (under principles similar to those described in § 1.367(a)-2T(b)(5)) in connection with one or more activities described in paragraph (c)(5)(i)(B) of this section.

(B) The activities referred to in paragraph (c)(5)(i)(A) of this section are –

(1) A development project described in paragraph (c)(5)(ii) of this section in a qualified Caribbean Basin country; or

(2) The performance in a qualified Caribbean Basin country of a non-commercial governmental function described in paragraph (c)(5)(iv) of this section;

(D) The requirements of paragraph (c)(6) of this section (regarding temporary investments and time periods within which the funds must be invested) and of paragraph (c)(7) of this section (regarding the refinancing of existing funding and time periods within which funding for investments must be secured) must be satisfied.

(ii) Development project. For purposes of this paragraph (c), a development project is one or more facilities in a qualified Caribbean Basin country that support economic development in that country and that satisfy the public use requirement of paragraph (c)(5)(iii) of this section. Examples of facilities that may meet the public use requirement include, but are not limited to –

(A) Transportation systems and equipment, including sea, surface, and air, such as roads, railways, air terminals, runways, harbor facilities, and ships and aircraft;

(B) Communications facilities;

(D) Industrial parks, including necessary support facilities such as roads; transmission lines for water, gas, electricity, and sewage; docks; plant sites preparations; power generation; sewage disposal; and water treatment;

(E) Sports facilities;

(F) Convention or trade show facilities;

(G) Sewage, solid waste, water, and electric facilities;

(H) Housing projects pursuant to a government program designed to provide affordable housing to low or moderate income families, based upon local standards; and

(I) Hydroelectric generating facilities.

(iii) Public use requirement. To satisfy the public use requirement in paragraph (c)(5)(ii) of this section, a facility must serve or be available on a regular basis for general public use, as contrasted with similar types of facilities which are constructed for the exclusive use of a limited number of persons as determined under principles similar to those described in § 1.103-8(a)(2).

(iv) Non-commercial governmental functions. For purposes of paragraph (c)(5)(i)(B) of this section, the term “non-commercial governmental functions” refers to activities that, under U.S. standards, are not customarily attributable to or carried on by private enterprises for profit and are performed for the general public with respect to the common welfare or which relate to the administration of some phase of government. For example, the operation of libraries, toll bridges, or local transportation services, and activities substantially equivalent to those carried out by the Federal Aviation Authority, Interstate Commerce Commission, or United States Postal Service, are considered non-commercial governmental functions. For purposes of this section, non-commercial government functions shall not include military activities.

(v) [Reserved]

(6) Prompt application of borrowed proceeds. This paragraph (c)(6) provides rules for determining whether amounts disbursed to a qualified recipient by a qualified financial institution (or a financial intermediary) shall be considered to have been promptly applied for the purpose of paragraphs (c)(4)(i)(A) and (c)(5)(i)(A) of this section.

(i) In general. Except as otherwise provided in paragraphs (c)(6)(ii) and (c)(7)(iii)(B) of this section, amounts disbursed to a qualified recipient by a qualified financial institution (or a financial intermediary) shall be considered to have been promptly applied for the purpose of paragraphs (c)(4)(i)(A) and (c)(5)(i)(A) of this section if the amounts are fully expended for any of the purposes described in paragraphs (c)(4)(i)(A) or (c)(5)(i)(A) of this section no later than six months from the date of such disbursement and any temporary investment of such funds by the qualified recipient during such period complies with the rules of paragraph (c)(6)(iii)(A) of this section. Where the amounts disbursed are bond proceeds described in paragraph (c)(6)(iv)(A) of this section, the six-month period shall begin on the date of issuance of the bonds. In the event the qualified financial institution (or financial intermediary) invests any part of the bond proceeds before disbursement of those proceeds to the qualified recipient, all earnings from any such investment shall be paid to the qualified recipient or applied for its benefit.

(ii) Special rules for long term projects financed out of bond proceeds. In the case of a long term project described in paragraph (c)(6)(iv)(B) of this section that is financed out of bond proceeds, the six-month period described in paragraph (c)(6)(i) of this section shall be extended with respect to the amount of bond proceeds used to fund the project for such reasonable period of time as shall be necessary until completion of the project or until beginning of production (in the case of a farming business), but, in any event, not to exceed three years from the date of issuance of the bonds, and only if –

(A) The project that is financed out of bond proceeds was identified as of the date of issue;

(B) A construction and expenditure plan certified by an independent expert (such as an engineer, an architect, or a farming expert) is filed with, and approved by, the Commissioner of Financial Institutions of Puerto Rico (or his delegate) prior to the date of issue, which makes a reasonable estimate, as of the date of filing of the plan, of the amounts and uses of the bond proceeds and the time of completion or production, and includes a schedule of progress payments until such time;

(C) The terms of the construction and expenditure plan are disclosed in the public offering memorandum, private placement memorandum, or similar document prepared for information or disclosure purposes in relation to the issuance of bonds; and

(D) Any temporary investment of the bond proceeds complies with the rules of paragraph (c)(6)(iii)(A) and (B) of this section.

(iii) Temporary investments – (A) During six-month period. During the six-month period described in paragraph (c)(6)(i) of this section, during the first six months of the period described in paragraph (c)(6)(ii) of this section, and during the 30-day period described in paragraph (c)(7)(iii)(A) of this section, loan proceeds disbursed to a qualified recipient, bond proceeds, and income from the investment thereof, may be held in unrestricted yield investments, provided such yield reflects normal market yield for such type of investments and provided the income from such investments, if any, is or would be sourced either in Puerto Rico or in a country in which the investment in active business assets or development project is to be made.

(B) During other periods. During any other period, any temporary investment of bond proceeds, and of income from such investments, shall be limited to investments in eligible activities. For purposes of this paragraph (c)(6)(iii)(B), the term “eligible activities” shall mean those investments described in section 6.2.4 of Puerto Rican Regulation No. 3582, as in effect on September 22, 1989.

(iv) Definitions – (A) Bond proceeds. For purposes of this paragraph (c), bond proceeds shall mean the proceeds from the issuance of obligations by way of a public offering or a private placement by a qualified financial institution for investment in active business assets or a development project that has been identified at the time of issue and is described in a public offering memorandum, private placement memorandum, or similar document prepared for information or disclosure purposes in relation to the issuance of the bonds.

(B) Long term project. For purposes of this section, the term long term project means –

(1) A project, whether or not under a contract, for the construction, rehabilitation, improvement, upgrading, or production of qualified assets, or for expenditures, described in paragraph (c)(4)(ii) of this section (other than paragraph (c)(4)(ii)(C) of this section), which is reasonably expected to require more than 12 months to complete; or

(2) The production of property in a farming business referred to in paragraph (c)(4)(ii)(E) of this section, which is reasonably expected to require a preproductive period in excess of 12 months.

(7) Financing of previously incurred costs. Loan or bond proceeds which are disbursed after a qualified recipient has paid or incurred part or all of the costs of acquiring active business assets or investing in a development project shall be considered to have been applied for such purposes only as provided in this paragraph (c)(7).

(i) Replacement of temporary non-section 936 financing of a qualified investment. This paragraph (c)(7)(i) prescribes the maximum time limits within which temporary non-section 936 financing of qualified investments may be replaced with section 936 funds without being considered a prohibited refinancing transaction. This paragraph (c)(7)(i) applies to the refinancing of costs incurred with respect to investments that, at the time the costs were first incurred, were either qualified investments in a qualified Caribbean Basin country or were investments by a qualified recipient in active business assets or a development project in a qualified Caribbean Basin country. This paragraph (c)(7)(i) applies also to the refinancing of costs incurred with respect to any other investment. However, in the latter case, the amount of costs that may be refinanced with section 936 funds is limited to the amount of costs that are incurred with respect to the investment after the investment becomes a qualified investment in a qualified Caribbean Basin country. For purposes of this paragraph (c)(7)(i), the time when costs are incurred shall be determined under principles similar to those applicable under section 461(h) dealing with the economic performance test for the accrual of deductible liabilities. This paragraph (c)(7)(i) applies only to the situations described in this paragraph (c)(7)(i).

(A) In the case of an investment in active business assets or a development project, a loan shall be a qualified investment for purposes of this paragraph (c) if the loan proceeds are disbursed, or the obligations are issued, no later than six months after the date on which the qualified recipient takes possession of the asset or the facility or, if earlier, places the asset or the facility in service. However, in the case of a small project described in paragraph (c)(8)(v) of this section, the six-month period shall be one year.

(B) In the case of an investment in active business assets or a development project that is part of a long term project described in paragraph (c)(6)(iv)(B) of this section, a loan shall also be a qualified investment for purposes of this paragraph (c) if the loan proceeds are disbursed, or the obligations are issued, no later than six months after completion of the project or, in the case of a farming business, after the beginning of production, and in any event, no later than three years after the date on which the first payment is made toward the eligible costs of the project. The amount of the qualified investment may not exceed the sum of –

(1) The eligible costs relating to investments described in paragraph (c)(4)(i)(A) in the case of an investment in active business assets, or the eligible costs relating to investments described in paragraph (c)(5)(i) of this section in the case of a development project, but only to the extent of the costs that are incurred after the date described in paragraph (c)(7)(i)(D) of this section, and

(2) The portion of unpaid interest that would be required to be capitalized under U.S. tax rules and that accrued on prior temporary non-section 936 financing from the date described in paragraph (c)(7)(i)(D) of this section through the date the section 936 loan proceeds are disbursed or the section 936 obligations are issued.

(C) In order to qualify for the special rules of this paragraph (c)(7)(i), a plan must be filed with the Commissioner of Financial Institutions of Puerto Rico (or his delegate) stating the qualified recipient’s intention to refinance the costs of the long term project with section funds.

(D) The date referred to in paragraph (c)(7)(i)(B) (1) and (2) of this section is a date that is the later of –

(1) The date the plan described in paragraph (c)(7)(i)(C) is filed, or

(2) The date the investment becomes a qualified investment by a qualified recipient in active business assets or a development project in a qualified Caribbean Basin country.

(ii) Refinancing of section 936 financing. A section 936 loan or bond issue used to finance a qualified investment described in paragraph (c)(1) of this section may be refinanced with section 936 funds through a new loan or bond issue to the extent of the remaining principal balance on such existing qualified financing, increased by the amount of unpaid interest accrued through the date the new loan proceeds are disbursed or the new obligations are issued and that would be required to be capitalized under U.S. tax rules.

(iii) Prompt application of borrowed proceeds – (A) In general. In the case of a loan or bond issue described in paragraph (c)(7)(i) or (ii) of this section, the rules of paragraph (c)(6) of this section shall apply but the six-month period described in paragraph (c)(6)(i) of this section shall be limited to 30 days from the date of disbursement of loan proceeds to the qualified recipient or from the date of issuance in the case of a bond issue.

(B) Special rules for long term projects financed out of bond proceeds. In the case of a long term project described in paragraph (c)(6)(iv)(B) of this section that is financed out of bond proceeds, the 30-day period described in paragraph (c)(7)(iii)(A) of this section shall be extended with respect to the amount of bond proceeds used for the permanent financing of the long term project for such reasonable period of time as shall be necessary until completion of the project or beginning of production (in the case of a farming business), but, in any event, not to exceed three years from the date of issuance of the bonds. For purposes of this paragraph (c)(7)(iii)(B), the period of time shall be considered reasonable only if –

(1) A construction and expenditure plan certified by an independent expert (such as an engineer, an architect, or a farming expert) is filed with, and approved by, the Commissioner of Financial Institutions of Puerto Rico (or his delegate) prior to the date of issue, which makes a reasonable estimate, as of the date of issue, of the amounts and uses of the bond proceeds and the time of completion or production, and includes a schedule of progress payments until such time; and

(2) The terms of the construction and expenditure plan are disclosed in the public offering memorandum, private placement memorandum, or similar document prepared for information or disclosure purposes in relation to the bond issue.

(8) Miscellaneous operating rules – (i) Sale and leaseback. An asset that is acquired and leased back to the person from whom acquired does not constitute an investment in an active business asset or an investment in a development project.

(ii) Use of asset in qualified business activity. For purposes of paragraph (c)(4)(i)(B), an asset shall be considered used or held for use in a qualified business activity if it is used or held for use in such activity under principles similar to those described in § 1.367(a)-2T(b)(5), or a successor provision.

(iii) Definition of capital expenditures. For purposes of this paragraph (c), capital expenditures mean those expenditures described in section 263(a) of the Code (without regard to paragraphs (A) through (G) of section 263(a)(1)), and those costs required to be capitalized under section 263A with respect to property described in section 263A(b)(1), relating to self-constructed assets.

(iv) Loans through certain financial intermediaries. A loan by a qualified financial institution shall not be disqualified from being an investment in active business assets or in a development project merely because the proceeds are first lent to a financial intermediary (as defined in paragraph (c)(8)(iv)(H) of this section) which, in turn, on-lends the proceeds directly to a qualified recipient, provided the requirements of this paragraph (c)(8)(iv) are satisfied.

(A) The loan to the qualified recipient must satisfy the requirements of paragraph (c)(4)(i) of this section in the case of an investment in active business assets, or of paragraph (c)(5)(i) of this section in the case of an investment in a development project.

(B) The qualified recipient and the active business assets or development project in which the proceeds are to be invested must be identified prior to disbursement of any part of the proceeds by the qualified financial institution to the financial intermediary.

(C) The effective interest rate charged by the qualified financial institution to the financial intermediary must not exceed the average interest rate paid by the qualified financial institution with respect to its eligible funds, increased by such number of basis points as is required to provide reasonable compensation to the qualified financial institution for services performed and risks assumed with respect to the loan to the financial intermediary that are not ordinarily required to be performed or assumed with respect to a deposit, loan, repurchase agreement or other transfer of eligible funds with another qualified financial institution. The average interest rate shall be the average rate, determined on a daily basis, paid by the qualified financial institution on its eligible funds over the most recent quarter preceding the date on which the rate on the loan to the financial intermediary is committed.

(D) The effective interest rate charged by the financial intermediary to the qualified recipient must not exceed the effective interest rate charged to the financial intermediary by the qualified financial institution, increased by such number of basis points as is required to provide reasonable compensation to the financial intermediary for services performed and risks assumed with respect to the loan to the qualified recipient.

(E) The financial intermediary must borrow from the qualified financial institution under substantially the same terms as it lends to the qualified recipient. In particular, both loans must have disbursement terms, repayment schedules and maturity dates for interest and principal amounts such that the financial intermediary does not retain for more than 48 hours any of the funds disbursed by the qualified financial institution nor any of the funds paid by the qualified recipient in repayment of principal or interest on the loan.

(F) The financial institution and the financial intermediary must agree to comply with the due diligence requirements described in paragraphs (c)(11), (12), and (13) of this section;

(G) The time periods and temporary investments rules in paragraphs (c)(6) and (7) of this section must be complied with; and

(H) For purposes of this paragraph (c), the financial intermediary must be –

(1) An active trade or business which a person maintains in a qualified Caribbean Basin country and which consists of a banking, financing or similar business as defined in § 1.864-4(c)(5)(i) (other than a central bank of issue); or

(2) A public international organization, the principal purpose of which is to foster economic development in developing countries and which is described in section 1 of the International Organizations Immunities Act (22 U.S.C. 288).

For purposes of paragraphs (c)(8)(iv)(C) and (D) of this section, the determination of whether compensation is reasonable shall be made in relation to normal commercial practices for comparable transactions carrying a similar degree of commercial, currency and political risk. Reasonable credit enhancement fees and other reasonable fees and amounts charged to the financial intermediary or the qualified recipient with respect to the loan transaction in addition to interest shall be added to the interest cost in determining the effective interest rate.

(v) Small project. For purposes of this paragraph (c), a small project shall be a project (including the acquisition of an asset) for which the total amount of section 936 funds used for its financing does not exceed $1,000,000 in the aggregate, or such other amount as the Commissioner may publish, from time to time, in the Internal Revenue Bulletin.

(9) Qualified recipient. For purposes of this section, a qualified recipient is any person described in paragraph (c)(9)(i) or (ii) of this section. The term “person” means a person described in section 7701(a)(1) or a government (within the meaning of § 1.892-2T(a)(1)) of a qualified Caribbean Basin country.

(i) In the case of an investment described in paragraph (c)(4) of this section (relating to investments in active business assets), a qualified recipient is a person that carries on a qualified business activity in a qualified Caribbean Basin country, and complies with the agreement and certification requirements described in paragraph (c)(11)(i) of this section at all times during the period in which the investment remains outstanding.

(ii) In the case of an investment described in pargraph (c)(5) of this section (relating to investments in development projects), a qualified recipient is the borrower (including a person empowered by the borrower to authorize expenditures for the investment in the development project) that has authority to comply, and complies, with the agreement and certification requirements described in paragraph (c)(11)(i) of this section at all times during the period in which the investment remains outstanding.

(10) Investments in a qualified Caribbean Basin country – (i) Rules for determining the place of an investment. The rules of this paragraph (c)(10)(i) shall apply to determine the extent to which an investment in an active business asset or a development project will be considered made in qualified Caribbean Basin Country.

(A) An investment in real property is considered made in the qualified Caribbean Basin country in which the real property is located.

(B) Except as otherwise provided in this paragraph (c)(10)(i)(B), an investment in tangible personal property is considered made in a qualified Caribbean Basin Country so long as the tangible personal property is predominantly used in that country. Whether property is used predominantly in a qualified Caribbean Basin country shall be determined under principles similar to those described in § 1.48-1(g)(1), (g)(2)(ii), (g)(2)(iv), (g)(2)(vi), (g)(2)(viii), and (g)(2)(x) (relating to investment tax credits for property used outside the United States) as in effect on December 31, 1985. A vessel, container, or aircraft shall be considered for use predominantly in a qualified Caribbean Basin country in any year if it is used for transport to and from such country with some degree of frequency during that year and at least 30 percent of the income from the use of such vessel, container or aircraft for that year is sourced in such country under principles similar to those described in section 863(c)(1) and (2) (relating to source rules for certain transportation income). Cables and pipelines which are premanently installed as part of a communication or transportation system between a qualified Caribbean Basin country and another country or among several countries which include a qualified Caribbean Basin country shall be considered used in a qualified Caribbean Basin country to the extent of 50 percent of the portion of the facility that directly links the qualified country to another country or to a hub, unless it is established by notice or other guidance published in the Internal Revenue Bulletin or by ruling issued to a qualified institution or qualified recipient upon request that it is appropriate to attribute a greater portion of the cost of the facility to the qualified Caribbean Basin country.

(C) An investment in rights to intangible property is considered made in a qualified Caribbean Basin country to the extent such rights are used in that country. Where rights to intangible property are used shall be determined under principles similar to those described in § 1.954-2T(b)(3)(vii) or a successor provision.

(ii) Qualified Caribbean Basin country. For purposes of this section, the term “qualified Caribbean Basin country” means any beneficiary country (within the meaning of section 212(a)(1)(A) of the Caribbean Basin Economic Recovery Act, Public Law 98-67 (Aug. 5, 1983), 97 Stat. 384, 19 U.S.C. 2702(a)(1)(A)), which meets the requirements of section 274(h)(6)(A)(i) and (ii) and the U.S. Virgin Islands, and includes the territorial waters and continental shelf thereof.

(11) Agreements and certifications by qualified recipients and financial intermediaries – (i) In general. In order for an investment to be considered a qualified investment under section 936(d)(4) and paragraph (c)(1) of this section, a qualified recipient must certify to the qualified financial institution (or to the financial intermediary, if the loan is made through a financial intermediary) on the date of closing of the loan agreement and on each anniversary date thereof, that it is a qualified recipient described in paragraph (c)(9) of this section. In addition, the qualified recipient must agree in the loan agreement with the qualified financial institution (or with the financial intermediary, if the loan is made through a financial intermediary) –

(A) To use the funds at all times during the period the loan is outstanding solely for the purposes and in the manner described in paragraph (c)(4) of this section (regarding investment in active business assets) or in paragraph (c)(5) of this section (regarding investment in development projects);

(B) To comply with the requirements of paragraph (c)(6) of this section (regarding temporary investments and time periods within which the funds must be invested) and paragraph (c)(7) of this section (regarding the refinancing of existing funding and the time periods within which funding for investments must be secured);

(C) To notify the Assistant Commissioner (International), the qualified financial institution (or the financial intermediary, if the loan is made through a financial intermediary), and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) pursuant to paragraph (c)(14) of this section if it no longer is a qualified recipient or if, for any other reason, the investment has ceased to qualify as a qualified investment described in paragraph (c)(1) of this section, promptly upon the occurrence of such disqualifying event; and

(D) To permit examination by the office of the Assistant Commissioner (International) (or by the office of any District Director authorized by the Assistant Commissioner (International)) and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) of all necessary books and records that are sufficient to verify that the funds were used for investments in active business assets or development projects in conformity with the terms of the loan agreement.

(ii) Certification by a financial intermediary. In the case of a loan by a qualified financial institution to a financial intermediary, the financial intermediary must certify to the qualified financial institution (using the procedures described in paragraph (c)(11)(i) of this section) that it is a financial intermediary described in paragraph (c)(8)(iv)(H) of this section, and must furnish to the qualified financial institution a copy of the qualified recipient’s certification described in paragraph (c)(11)(i) of this section and of its loan agreement with the qualified recipient. In addition, the financial intermediary must agree in the loan agreement with the qualified financial institution:

(A) To comply with the requirements of paragraph (c)(8)(iv) of this section; and

(B) To permit examination by the office of the Assistant Commissioner (International) (or by the office of any District Director authorized by the Assistant Commissioner (International)) and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) of all its necessary books and records that are sufficient to verify that the funds were used in conformity with the terms of the loan agreements.

(12) Certification requirements. In order for an investment to be considered a qualified investment under section 936(d)(4), section 936(d)(4)(C)(i) requires that both the person in whose trade or business such investment is made and the financial institution certify to the Secretary of the Treasury and the Commissioner of Financial Institutions of Puerto Rico that the proceeds of the loan will be promptly used to acquire active business assets or to make other authorized expenditures. This certification requirement is satisfied as to the qualified financial institution, the financial intermediary (if any), and the qualified recipient if the qualified financial institution submits a certificate to both the Assistant Commissioner (International) and to the Commissioner of Financial Institutions of Puerto Rico (or his delegate) pursuant to paragraph (c)(14) of this section upon authorization of the investment by the Commissioner of Financial Institutions and, in any event, prior to the first disbursement of the loan proceeds to the qualified recipient or to the financial intermediary (if any), in which the qualified financial institution –

(i) Represents that, as of the date of the certification, the qualified recipient and the financial intermediary (if any) have complied with the requirements described in paragraph (c)(11) of this section;

(ii) Describes the important terms of the loan to the financial intermediary (if any) and to the qualified recipient, including the amount of the loan, the nature of the investment, the basis for its qualification as an investment in active business assets or a development project under this section, the identity of the financial intermediary (if any) and of the qualified recipient, the qualified Caribbean Basin country involved, and the nature of the collateral or other security used, including any guarantee;

(iii) Agrees to permit examination by the Assistant Commissioner (International) (or by the office of any District Director authorized by the Assistant Commissioner (International)) and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) of all its necessary books and records that are sufficient to verify that the funds were used for investments in active business assets or development projects in conformity with the terms of the loan agreement or agreements with the financial intermediary (if any) and with the qualified recipient; and

(iv) In the case of a single-purpose entity that is a qualified financial institution, discloses the name and address of the entity’s trustee or agent, if any, that assists the qualified financial institution in the performance of its due diligence requirement under paragraph (c) of this section, and represents that the trustee or agent has agreed with the qualified financial institution to permit examination by the Assistant Commissioner (International) (or by the office of any District Director authorized by the Assistant Commissioner (International)) and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) of all necessary books and records of such trustee or agent that are sufficient to verify that the funds were used for investments in active business assets or development projects in conformity with the terms of the loan agreement or agreements with the financial intermediary (if any) and with the qualified recipient.

(13) Continuing due diligence requirements. In order to maintain the qualification for an investment under paragraph (c)(1) of this section, the continuing due diligence requirements described in this paragraph (c)(13) must be satisfied.

(i) Requirements of qualified recipient. A qualified recipient must –

(A) Submit annually to the qualified financial institution or to the financial intermediary from which its qualified funds were obtained a copy of its most recent annual financial statement accompanied by an opinion of an independent accountant familiar with the financials of the qualified recipient disclosing the amount of the loan, the current outstanding balance of the loan, describing the assets financed with such loan and the qualified business activity in which such assets are used or the development project for which the loan is used, and stating that there are no reasons to doubt that the loan proceeds have been properly used and continue to be properly used, and

(B) Act in a manner consistent with its representations and agreements described in paragraph (c)(11) of this section.

(ii) Requirements of qualified financial institutions. Except as otherwise provided in paragraph (c)(13)(iii) of this section, a qualified financial institution described in paragraph (c)(3) of this section must maintain in its records and have available for inspection the documentation described in paragraph (c)(13)(ii)(A) or (B) of this section. In addition, the qualified financial institution is required to notify the Assistant Commissioner (International) and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) pursuant to paragraph (c)(14) of this section upon becoming aware that a loan has ceased to be an investment in active business assets or a development project under this section. For purposes of this paragraph (c)(13)(ii), multiple loans for investment in a single qualified business activity or development project will be aggregated in determining what due diligence requirements apply.

(A) In the case of a small project described in paragraph (c)(8)(v) of this section, the following documents must be maintained and available for inspection:

(1) The loan application or other similar document;

(2) The financial statements of the qualified recipient filed as part of the loan application;

(3) The statement required by section 6.4.3(a)(iii) of Puerto Rican Regulation No. 3582 or any successor thereof, signed by the qualified recipient (or its duly authorized representative), acknowledging the receipt of the loan proceeds, describing the assets financed with such loan and the business activity in which such assets are to be used or the development project for which the funds will be utilized, the collateral to be provided for the transaction including any guarantee, and the basis for its qualification as a qualified recipient;

(4) The loan documents; and

(5) In the case of a qualified financial institution that is a single-purpose entity, a copy of the agreement with the entity’s trustee or agent, if any, described in paragraph (c)(12)(iv) of this section.

(B) In the case of a disbursement concerning a project that is not a small project described in paragraph (c)(8)(v) of this section, the following documents must be maintained and available for inspection, in addition to the documents required by paragraph (c)(13)(ii)(A) of this section:

(1) A memorandum of credit prepared by an officer of the qualified financial institution (or, in the case of a single purpose entity, an agent of the entity or a trustee for the entity, if any) and signed by the officer of the qualified financial institution, containing the details of the investigation and review that the qualified financial institution, or its trustee or agent, if any, conducted in order to evaluate whether the investment is qualified under paragraph (c)(1) of this section and the opinion of the officer of the qualified financial institution, or the opinion of an officer of the agent of, or of the trustee for, the qualified financial institution, if any, that there is no reasonable ground for belief that the qualified funds will be diverted to a use that is not permitted under the provisions of this section; in making this investigation and review, factors that must be utilized are ones similar to those listed in Puerto Rico Regulation No. 3582, section 6.4.2;

(2) The annual financial statement of the qualified recipient; and

(3) The written report of an officer of the qualified financial institution, or of an officer of an agent of, or of the trustee for, the qualified financial institution, if any, documenting discussions, both before and after the disbursement of the loan proceeds, with each recipient’s accounting, financial and executive personnel with respect to the proposed and actual use of the loan proceeds and his analysis of the annual financial statements of the qualified recipient including an analysis of the statement of sources and uses of funds. After the loan disbursement, such discussions and review shall occur annually during the term of the loan. Such report shall include the conclusion that in such officer’s opinion there is no reasonable ground for belief that the qualified recipient is improperly utilizing the funds.

(iii) Requirements in the case of a financial intermediary. Where a qualified financial institution lends funds to a financial intermediary which are on-lent to a qualified recipient –

(A) The obligation to maintain the documentation described in paragraph (c)(13)(ii)(A) or (B) of this section shall apply only to the financial intermediary and not to the qualified financial institution and the provisions of paragraph (c)(13)(ii)(A) or (B) of this section shall be read so as to impose on the financial intermediary any obligation imposed on the qualified financial institution.

(B) The financial intermediary shall forward annually to the qualified financial institution a copy of the documentation it is required to maintain in its records pursuant to the provisions of this paragraph (c)(13)(iii) and shall notify the Assistant Commissioner (International), the Commissioner of Financial Institutions of Puerto Rico (or his delegate) and the qualified financial institution pursuant to paragraph (c)(14) of this section upon becoming aware that a loan has ceased to be an investment in active business assets or a development project under this section. The qualified financial institution must maintain in its records and have available for inspection the documentation furnished by the financial intermediary pursuant to this paragraph (c)(13)(iii)(B).

(C) The qualified financial institution shall cause one of its officers (or one of the officers of its agent or trustee, if any) to prepare a written report documenting his analysis of the documentation furnished by the financial intermediary pursuant to paragraph (c)(13)(iii)(B) of this section, his discussions, both before and after the disbursement of the loan proceeds, with the financial intermediary’s accounting, financial and executive personnel with respect to the proposed and actual use of the loan proceeds, and his analysis of the annual financial statements of the qualified recipient including an analysis of the statement of sources and uses of funds. After the loan disbursement, such discussions and review shall occur annually during the term of the loan. Such report shall include the conclusion that in such officer’s opinion there is no reasonable ground for belief that the qualified recipient is improperly utilizing the funds.

(14) Procedures for notices and certifications. Notices and certifications to the Assistant Commissioner (International) required under paragraphs (c)(11), (12) and (13) of this section shall be addressed to the attention of the Assistant Commissioner (International), Office of Taxpayer Service and Compliance, IN:C, 950 L’Enfant Plaza South, SW., Washington, DC 20024. Notices and certifications to the Commissioner of Financial Institutions of Puerto Rico required under paragraphs (c)(11), (12), and (13) of this section shall be addressed as follows: Commissioner of Financial Institutions, GPO Box 70324, San Juan, Puerto Rico 00936.

(15) Effective date. This paragraph (c) is effective May 13, 1991. It is applicable to investments by a possessions corporation in a financial institution that are used by a financial institution for investments in accordance with a specific authorization granted by the Commissioner of Financial Institutions of Puerto Rico (or his delegate) after September 22, 1989. However, the taxpayer may choose to apply § 1.936-10T(c) for periods before June 12, 1991.

[T.D. 8350, 56 FR 21927, May 13, 1991]

§ 1.936-11 New lines of business prohibited.

(a) In general. A possessions corporation that is an existing credit claimant, as defined in section 936(j)(9)(A) and this section, that adds a substantial new line of business during a taxable year, or that has a new line of business that becomes substantial during the taxable year, loses its status as an existing credit claimant for that year and all years subsequent.

(b) New line of business – (1) In general. A new line of business is any business activity of the possessions corporation that is not closely related to a pre-existing business of the possessions corporation. The term closely related is defined in paragraph (b)(2) of this section. The term pre-existing business is defined in paragraph (b)(3) of this section.

(2) Closely related. To determine whether a new activity is closely related to a pre-existing business of the possessions corporation all the facts and circumstances must be considered, including those set forth in paragraphs (b)(2)(i)(A) through (G) of this section.

(i) Factors. The following factors will help to establish that a new activity is closely related to a pre-existing business activity of the possessions corporation –

(A) The new activity provides products or services very similar to the products or services provided by the pre-existing business;

(B) The new activity markets products and services to the same class of customers;

(D) The new activity requires the use of similar operating assets;

(E) The new activity’s economic success depends on the success of the pre-existing business;

(F) The new activity is of a type that would normally be treated as a unit with the pre-existing business’ in the business accounting records; and

(G) The new activity and the pre-existing business are regulated or licensed by the same or similar governmental authority.

(ii) Safe harbors. An activity is not a new line of business if –

(A) If the activity is within the same six-digit North American Industry Classification System (NAICS) code (or four-digit Standard Industrial Classification (SIC) code). The similarity of the NAICS or SIC codes may not be relied upon to determine whether the activity is closely related to a pre-existing business where the code indicates a miscellaneous category;

(B) If the new activity is within the same five-digit NAICS code (or three-digit SIC code) and the facts relating to the new activity also satisfy at least three of the factors listed in paragraphs (b)(2)(i)(A) through (G) of this section; or

(C) If the pre-existing business is making a component product or end-product form, as defined in § 1.936-5(a)(1),Q&A1, and the new business activity is making an integrated product, or an end-product form with fewer excluded components, that is not within the same six-digit NAICS code (or four-digit SIC code) as the pre-existing business solely because the component product and the integrated product (or two end-product forms) have different end-uses.

(3) Pre-existing business – (i) In general. Except as provided in paragraph (b)(3)(ii) of this section, a business activity is a pre-existing business of the existing credit claimant if –

(A) The existing credit claimant was actively engaged in the activity within the possession on or before October 13, 1995; and

(B) The existing credit claimant had elected the benefits of the Puerto Rico and possession tax credit pursuant to an election which was in effect for the taxable year that included October 13, 1995.

(ii) Acquisition of an existing credit claimant. (A) If all the assets of one or more trades or businesses of a corporation of an existing credit claimant are acquired by an affiliated or non-affiliated existing credit claimant which carries on the business activity of the predecessor existing credit claimant, the acquired business activity will be treated as a pre-existing business of the acquiring corporation. A non-affiliated acquiring corporation will not be bound by any section 936(h) election made by the predecessor existing credit claimant with respect to that business activity.

(B) Where all of the assets of one or more trades or businesses of a corporation of an existing credit claimant are acquired by a corporation that is not an existing credit claimant, the acquiring corporation may make a section 936(e) election for the taxable year in which the assets are acquired with the following effects –

(1) The acquiring corporation will be treated as an existing

(2) The activity will be considered a pre-existing business of the acquiring corporation;

(3) The acquiring corporation will be deemed to satisfy the rules of section 936(a)(2) for the year of acquisition; and

(4) After making an election under section 936(e), a non-affiliated acquiring corporation will not be bound by elections under sections 936(a)(4) and (h) made by the predecessor existing credit claimant.

(C) For purposes of this section the assets of a trade or business are determined at the time of acquisition provided that the transferee actively conducts the trade or business acquired.

(D) A mere change in the stock ownership of a possessions corporation will not affect its status as an existing credit claimant for purposes of this section.

(4) Leasing of Assets. (i) The leasing of assets (and employees to operate leased assets) will not, for purposes of this section, be considered a new line of business of the existing credit claimant if –

(A) The existing credit claimant used the leased assets in an active trade or business for at least five years;

(B) The existing credit claimant does not through its own officers or staff of employees perform management or operational functions (but not including operational functions performed through leased employees) with respect to the leased assets; and

(ii) Any income from the leasing of assets not considered a new line of business pursuant to paragraph (b)(4)(i) of this section will not be income from the active conduct of a trade or business (and, therefore, the existing credit claimant may not receive a possession tax credit with respect to such income).

(5) Timing rule. The tests for a new line of business in this paragraph (whether the new activity is closely related to a pre-existing business) are applied only at the end of the taxable year during which the new activity is added.

(i) The taxable year in which the possessions corporation derives more than 15 percent of its gross income from that new line of business (gross income test); or

(ii) The taxable year in which the possessions corporation directly uses in that new line of business more than 15 percent of its assets (assets test).

(2) Gross income test. The denominator in the gross income test is the amount that is the gross income of the possessions corporation for the current taxable year, while the numerator is the amount that is the gross income of the new line of business for the current taxable year. The gross income test is applied at the end of each taxable year. For purposes of this test, if a new line of business is added late in the taxable year, the income is not to be annualized in that year. In the case of a new line of business acquired through the purchase of assets, the gross income of such new line of business for the taxable year of the acquiring corporation that includes the date of acquisition is determined from the date of acquisition through the end of the taxable year. In the case of a consolidated group election made pursuant to section 936(i)(5), the test applies on a company by company basis and not on a consolidated basis.

(3) Assets test – (i) Computation. The denominator is the adjusted tax basis of the total assets of the possessions corporation for the current taxable year. The numerator is the adjusted tax basis of the total assets utilized in the new line of business for the current taxable year. The assets test is computed annually using all assets including cash and receivables.

(ii) Exception. A new line of business of a possessions corporation will not be treated as substantial as a result of meeting the assets test if an event that is not reasonably anticipated causes assets used in the new line of business of the possessions corporation to exceed 15 percent of the adjusted tax basis of the possessions corporation’s total assets. For example, an event that is not reasonably anticipated would include the destruction of plant and equipment of the pre-existing business due to a hurricane or other natural disaster, or other similar circumstances beyond the control of the possessions corporation. The expiration of a patent is not such an event and will not permit use of this exception.

(d) Examples. The following examples illustrate the rules described in paragraphs (a), (b), and (c) of this section. In the following examples, X Corp. is an existing credit claimant unless otherwise indicated:

Example 1.X Corp. is a pharmaceutical corporation which manufactured bulk chemicals (a component product). In March 1997, X Corp. began to also manufacture pills (e.g., finished dosages or an integrated product). The new activity provides products very similar to the products provided by the pre-existing business. The new activity is of a type that is normally conducted in the same business location as the pre-existing business. The activity’s economic success depends on the success of the pre-existing business. The manufacture of bulk chemicals is in NAICS code 325411, Medicinal and Botanical Manufacturing, while the manufacture of the pills is in NAICS code 325412, Pharmaceutical Preparation Manufacturing. Although the products have a different end-use, may be marketed to a different class of customers, and may not use similar operating assets, they are within the same five-digit NAICS code and the activity also satisfies paragraphs (b)(2)(i)(A), (C), and (E) of this section. The manufacture of the pills by X Corp. will be considered closely related to the manufacture of the bulk chemicals. Therefore, X Corp. will not be considered to have added a new line of business for purposes of paragraph (b) of this section because it falls within the safe harbor rule of (b)(2)(ii)(B).

Example 2.X Corp. currently manufactures printed circuit boards in a possession. As a result of a technological breakthrough, X Corp. could produce the printed circuit boards more efficiently if it modified its existing production methods. Because demand for its products was high, X Corp. expanded when it modified its production methods. After these modifications to the facilities and production methods, the products produced through the new technology were in the same six-digit NAICS code as products produced previously by X Corp. See paragraph (b)(2)(ii)(A) of this section. Therefore, X Corp. will not be considered to have added a new line of business for purposes of paragraph (b) of this section because it falls within the safe harbor rule of (b)(2)(ii)(A).

Example 3.X Corp. has manufactured Device A in Puerto Rico for a number of years and began to manufacture Device B in Puerto Rico in 1997. Device A and Device B are both used to conduct electrical current to the heart and are both sold to cardiologists. There is no significant change in the type of activity conducted in Puerto Rico after the transfer of the manufacturing of Device B to Puerto Rico. Similar manufacturing equipment, manufacturing processes and skills are used in the manufacture of both devices. Both are regulated and licensed by the Food and Drug Administration. The economic success of Device B is dependent upon the success of Device A only to the extent that the liability and manufacturing prowess with respect to one reflects favorably on the other. Depending upon the heart abnormality, the cardiologist may choose to use Device A, Device B or both on a patient. The manufacture of Device B is treated as a unit with the manufacture of Device A in X Corp.’s accounting records. The manufacture of Device A is in the six-digit NAICS code 339112, Surgical and Medical Instrument Manufacturing. The manufacture of Device B is in the six-digit NAICS code 334510, Electromedical and Electrotherapeutic Apparatus Manufacturing. (The manufacture of Device A is in the four-digit SIC code 3845, Electromedical and Electrotherapeutic Apparatus. The manufacture of Device B is in the four-digit SIC code 3841, Surgical and Medical Instruments and Apparatus.) The safe harbor of paragraph (b)(2)(ii)(B) of this section applies because the two activities are within the same three-digit SIC code and Corp. X satisfies paragraphs (b)(2)(i)(A), (B), (C), (D), (F), and (G) of this section.

Example 4.X Corp. has been manufacturing house slippers in Puerto Rico since 1990. Y Corp. is a U.S. corporation that is not affiliated with X Corp. and is not an existing credit claimant. Y Corp. has been manufacturing snack food in the United States. In 1997, X Corp. purchased the assets of Y Corp. and began to manufacture snack food in Puerto Rico. House slipper manufacturing is in the six-digit NAICS code 316212 (Four-digit SIC code 3142, House Slippers). The manufacture of snack foods falls under the six-digit NAICS code 311919, Other Snack Food Manufacturing (four-digit SIC code 2052, Cookies and Crackers (pretzels)). Because these activities are not within the same five or six digit NAICS code (or the same three or four-digit SIC code), and because snack food is not an integrated product that contains house slippers, the safe harbor of paragraph (b)(2)(ii) of this section cannot apply. Considering all the facts and circumstances, including the seven factors of paragraph (b)(2)(i) of this section, the snack food manufacturing activity is not closely related to the manufacture of house slippers, and is a new line of business, within the meaning of paragraph (b) of this section.

Example 5.X Corp., a calendar year taxpayer, is an existing credit claimant that has elected the profit-split method for computing taxable income. P Corp. was not an existing credit claimant and manufactured a product in a different five-digit NAICS code than the product manufactured by X Corp. In 1997, X Corp. acquired the stock of P Corp. and liquidated P Corp. in a tax-free liquidation under section 332, but continued the business activity of P Corp. as a new business segment. Assume that this new business segment is a new line of business within the meaning of paragraph (c) of this section. In 1997, X Corp. has gross income from the active conduct of a trade or business in a possession computed under section 936(a)(2) of $500 million and the adjusted tax basis of its assets is $200 million. The new business segment had gross income of $60 million, or 12 percent of the X Corp. gross income, and the adjusted basis of the new segment’s assets was $20 million, or 10 percent of the X Corp. total assets. In 1997, X Corp. does not derive more than 15 percent of its gross income, or directly use more that 15 percent of its total assets, from the new business segment. Thus, the new line of business acquired from P Corp. is not a substantial new line of business within the meaning of paragraph (c) of this section, and the new activity will not cause X Corp. to lose its status as an existing credit claimant during 1997. In 1998, however, the gross income of X Corp. grew to $750 million while the gross income of the new line of business grew to $150 million, or 20% of the X Corp. 1998 gross income. Thus, in 1998, the new line of business is substantial within the meaning of paragraph (c) of this section, and X Corp. loses its status as an existing credit claimant for 1998 and all years subsequent.

(e) Loss of status as existing credit claimant. An existing credit claimant that adds a substantial new line of business in a taxable year, or that has a new line of business that becomes substantial in a taxable year, loses its status as an existing credit claimant for that year and all years subsequent.

(f) Effective date – (1) General rule. This section applies to taxable years of a possessions corporation beginning on or after January 25, 2000.

(2) Election for retroactive application. Taxpayers may elect to apply retroactively all the provisions of this section for any open taxable year beginning after December 31, 1995. Such election will be effective for the year of the election and all subsequent taxable years. This section will not apply to activities of pre-existing businesses for taxable years beginning before January 1, 1996.

[T.D. 8868, 65 FR 3815, Jan. 25, 2000]

§ 1.937-1 Bona fide residency in a possession.

(a) Scope – (1) In general. Section 937(a) and this section set forth the rules for determining whether an individual qualifies as a bona fide resident of a particular possession (the relevant possession) for purposes of subpart D, part III, Subchapter N, Chapter 1 of the Internal Revenue Code as well as section 865(g)(3), section 876, section 881(b), paragraphs (2) and (3) of section 901(b), section 957(c), section 3401(a)(8)(C), and section 7654(a).

(2) Definitions. For purposes of this section and §§ 1.937-2 and 1.937-3 –

(i) Possession means one of the following United States possessions: American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, or the Virgin Islands. When used in a geographical sense, the term comprises only the territory of each such possession (without application of sections 932(c)(3) and 935(c)(2) (as in effect before the effective date of its repeal)).

(ii) United States, when used in a geographical sense, is defined in section 7701(a)(9), and without application of sections 932(a)(3) and 935(c)(1) (as in effect before the effective date of its repeal).

(b) Bona fide resident – (1) General rule. An individual qualifies as a bona fide resident of the relevant possession if such individual satisfies the requirements of paragraphs (c) through (e) of this section with respect to such possession.

(2) Special rule for members of the Armed Forces. A member of the Armed Forces of the United States who qualified as a bona fide resident of the relevant possession in a prior taxable year is deemed to have satisfied the requirements of paragraphs (c) through (e) of this section for a subsequent taxable year if such individual otherwise is unable to satisfy such requirements by reason of being absent from such possession or present in the United States during such year solely in compliance with military orders. Conversely, a member of the Armed Forces of the United States who did not qualify as a bona fide resident of the relevant possession in a prior taxable year is not considered to have satisfied the requirements of paragraphs (c) through (e) of this section for a subsequent taxable year by reason of being present in such possession solely in compliance with military orders. Armed Forces of the United States is defined (and members of the Armed Forces are described) in section 7701(a)(15).

(3) Juridical persons. Except as provided in § 1.881-5(f):

(i) Only natural persons may qualify as bona fide residents of a possession; and

(ii) The rules governing the tax treatment of bona fide residents of a possession do not apply to juridical persons (including corporations, partnerships, trusts, and estates).

(4) Transition rule. For taxable years beginning before October 23, 2004, and ending after October 22, 2004, an individual is considered to qualify as a bona fide resident of the relevant possession if that individual would be a bona fide resident of the relevant possession by applying the principles of §§ 1.871-2 through 1.871-5.

(5) Special rule for cessation of bona fide residence in Puerto Rico. See paragraph (f)(2)(ii) of this section for a special rule applicable to a citizen of the United States who ceases to be a bona fide resident of Puerto Rico during a taxable year.

(c) Presence test – (1) In general. A United States citizen or resident alien individual (as defined in section 7701(b)(1)(A)) satisfies the requirements of this paragraph (c) for a taxable year if that individual –

(i) Was present in the relevant possession for at least 183 days during the taxable year;

(ii) Was present in the relevant possession for at least 549 days during the three-year period consisting of the taxable year and the two immediately preceding taxable years, provided that the individual was also present in the relevant possession for at least 60 days during each taxable year of the period;

(iii) Was present in the United States for no more than 90 days during the taxable year;

(iv) During the taxable year had earned income (as defined in § 1.911-3(b)) in the United States, if any, not exceeding in the aggregate the amount specified in section 861(a)(3)(B) and was present for more days in the relevant possession than in the United States; or

(v) Had no significant connection to the United States during the taxable year. See paragraph (c)(5) of this section.

(2) Special rule for alien individuals. A nonresident alien individual (as defined in section 7701(b)(1)(B)) satisfies the requirements of this paragraph (c) for a taxable year if during that taxable year that individual satisfies the substantial presence test of § 301.7701(b)-1(c) of this chapter (except for the substitution of the name of the relevant possession for the term United States where appropriate).

(3) Days of presence. For purposes of paragraph (c)(1) of this section –

(i) An individual is considered to be present in the relevant possession on:

(A) Any day that the individual is physically present in that possession at any time during the day;

(B) Any day that an individual is outside of the relevant possession to receive, or to accompany on a full-time basis a parent, spouse, or child (as defined in section 152(f)(1)) who is receiving, qualifying medical treatment as defined in paragraph (c)(4) of this section; and

(C) Any day that an individual is outside the relevant possession because the individual leaves or is unable to return to the relevant possession during any –

(1) 14-day period within which a major disaster occurs in the relevant possession for which a Federal Emergency Management Agency Notice of a Presidential declaration of a major disaster is issued in the Federal Register; or

(2) Period for which a mandatory evacuation order is in effect for the geographic area in the relevant possession in which the individual’s place of abode is located.

(ii) An individual is considered to be present in the United States on any day that the individual is physically present in the United States at any time during the day. Notwithstanding the preceding sentence, the following days will not count as days of presence in the United States:

(A) Any day that an individual is temporarily present in the United States under circumstances described in paragraph (c)(3)(i)(B) or (C) of this section;

(B) Any day that an individual is in transit between two points outside the United States (as described in § 301.7701(b)-3(d) of this chapter), and is physically present in the United States for fewer than 24 hours;

(C) Any day that an individual is temporarily present in the United States as a professional athlete to compete in a charitable sports event (as described in § 301.7701(b)-3(b)(5) of this chapter);

(D) Any day that an individual is temporarily present in the United States as a student (as defined in section 152(f)(2)); and

(E) In the case of an individual who is an elected representative of the relevant possession, or who serves full time as an elected or appointed official or employee of the government of the relevant possession (or any political subdivision thereof), any day spent serving the relevant possession in that role.

(iii) If, during a single day, an individual is physically present –

(A) In the United States and in the relevant possession, that day is considered a day of presence in the relevant possession;

(B) In two possessions, that day is considered a day of presence in the possession where the individual’s tax home is located (applying the rules of paragraph (d) of this section).

(4) Qualifying medical treatment – (i) In general. The term qualifying medical treatment means medical treatment provided by (or under the supervision of) a physician (as defined in section 213(d)(4)) for an illness, injury, impairment, or physical or mental condition that satisfies the documentation and production requirements of paragraph (c)(4)(iii) of this section and that involves –

(A) Any period of inpatient care in a hospital or hospice and any period immediately before or after that inpatient care to the extent it is medically necessary; or

(B) Any temporary period of inpatient care in a residential medical care facility for medically necessary rehabilitation services;

(ii) Inpatient care. The term inpatient care means care requiring an overnight stay in a hospital, hospice, or residential medical care facility, as the case may be.

(iii) Documentation and production requirements. In order to satisfy the documentation and production requirements of this paragraph, an individual must, with respect to each qualifying medical treatment, prepare (or obtain), maintain, and, upon a request by the Commissioner (or the person responsible for tax administration in the relevant possession), make available within 30 days of such request:

(A) Records that provide –

(1) The patient’s name and relationship to the individual (if the medical treatment is provided to a person other than the individual);

(2) The name and address of the hospital, hospice, or residential medical care facility where the medical treatment was provided;

(3) The name, address, and telephone number of the physician who provided the medical treatment;

(4) The date(s) on which the medical treatment was provided; and

(5) Receipt(s) of payment for the medical treatment;

(B) Signed certification by the providing or supervising physician that the medical treatment was qualified medical treatment within the meaning of paragraph (c)(4)(i) of this section, and setting forth –

(1) The patient’s name;

(2) A reasonably detailed description of the medical treatment provided by (or under the supervision of) the physician;

(3) The dates on which the medical treatment was provided; and

(4) The medical facts that support the physician’s certification and determination that the treatment was medically necessary; and

(C) Such other information as the Commissioner may prescribe by notice, form, instructions, or other publication (see § 601.601(d)(2) of this chapter).

(5) Significant connection. For purposes of paragraph (c)(1)(v) of this section –

(i) The term significant connection to the United States means –

(A) A permanent home in the United States;

(B) Current registration to vote in any political subdivision of the United States; or

(C) A spouse or child (as defined in section 152(f)(1)) who has not attained the age of 18 whose principal place of abode is in the United States other than –

(1) A child who is in the United States because the child is living with a custodial parent under a custodial decree or multiple support agreement; or

(2) A child who is in the United States as a student (as defined in section 152(f)(2)).

(ii) Permanent home – (A) General rule. For purposes of paragraph (c)(5)(i)(A) of this section, except as provided in paragraph (c)(5)(ii)(B) of this section, the term permanent home has the same meaning as in § 301.7701(b)-2(d)(2) of this chapter.

(B) Exception for rental property. If an individual or the individual’s spouse owns property and rents it to another person at any time during the taxable year, then notwithstanding that the rental property may constitute a permanent home under § 301.7701(b)-2(d)(2) of this chapter, it is not a permanent home under this paragraph (c)(5)(ii) unless the taxpayer uses any portion of it as a residence during the taxable year under the principles of section 280A(d). In applying the principles of section 280A(d) for this purpose, an individual is treated as using the rental property for personal purposes on any day determined under the principles of section 280A(d)(2) or on any day that the rental property (or any portion of it) is not rented to another person at fair rental for the entire day. The rental property is not used for personal purposes on any day on which the principal purpose of the use of the rental property is to perform repair or maintenance work on the property. Whether the principal purpose of the use of the rental property is to perform repair or maintenance work is determined in light of all the facts and circumstances including, but not limited to, the following: The amount of time devoted to repair and maintenance work, the frequency of the use for repair and maintenance purposes during a taxable year, and the presence and activities of companions.

(iii) For purposes of this paragraph (c)(5), the term spouse does not include a spouse from whom the individual is legally separated under a decree of divorce or separate maintenance.

(d) Tax home test – (1) General rule. Except as provided in paragraph (d)(2) of this section, an individual satisfies the requirements of this paragraph (d) for a taxable year if that individual did not have a tax home outside the relevant possession during any part of the taxable year. For purposes of section 937 and this section, an individual’s tax home is determined under the principles of section 911(d)(3) without regard to the second sentence thereof. Thus, under section 937, an individual’s tax home is considered to be located at the individual’s regular or principal (if more than one regular) place of business. If the individual has no regular or principal place of business because of the nature of the business, or because the individual is not engaged in carrying on any trade or business within the meaning of section 162(a), then the individual’s tax home is the individual’s regular place of abode in a real and substantial sense.

(2) Exceptions – (i) Year of move. See paragraph (f) of this section for a special rule applicable to an individual who becomes or ceases to be a bona fide resident of the relevant possession during a taxable year.

(ii) Special rule for seafarers. For purposes of section 937 and this section, an individual is not considered to have a tax home outside the relevant possession solely by reason of employment on a ship or other seafaring vessel that is predominantly used in local and international waters. For this purpose, a vessel is considered to be predominantly used in local and international waters if, during the taxable year, the aggregate amount of time it is used in international waters and in the waters within three miles of the relevant possession exceeds the aggregate amount of time it is used in the territorial waters of the United States, another possession, and a foreign country.

(iii) Special rule for students and government officials. Any days described in paragraphs (c)(3)(ii)(D) and (E) of this section are disregarded for purposes of determining whether an individual has a tax home outside the relevant possession under paragraph (d)(1) of this section during any part of the taxable year.

(e) Closer connection test – (1) General rule. Except as provided in paragraph (e)(2) of this section, an individual satisfies the requirements of this paragraph (e) for a taxable year if that individual did not have a closer connection to the United States or a foreign country than to the relevant possession during any part of the taxable year. For purposes of this paragraph (e) –

(i) The principles of section 7701(b)(3)(B)(ii) and § 301.7701(b)-2(d) of this chapter apply (without regard to the final sentence of § 301.7701(b)-2(b) of this chapter); and

(ii) An individual’s connections to the relevant possession are compared to the aggregate of the individual’s connections with the United States and foreign countries.

(2) Exception for year of move. See paragraph (f) of this section for a special rule applicable to an individual who becomes or ceases to be a bona fide resident of the relevant possession during a taxable year.

(f) Year of move – (1) Move to a possession. For the taxable year in which an individual’s residence changes to the relevant possession, the individual satisfies the requirements of paragraphs (d)(1) and (e)(1) of this section if –

(i) For each of the 3 taxable years immediately preceding the taxable year of the change of residence, the individual is not a bona fide resident of the relevant possession;

(ii) For each of the last 183 days of the taxable year of the change of residence, the individual does not have a tax home outside the relevant possession or a closer connection to the United States or a foreign country than to the relevant possession; and

(iii) For each of the 3 taxable years immediately following the taxable year of the change of residence, the individual is a bona fide resident of the relevant possession.

(2) Move from a possession – (i) General rule. Except for a bona fide resident of Puerto Rico to whom § 1.933-1(b) and paragraph (f)(2)(ii) of this section apply, for the taxable year in which an individual ceases to be a bona fide resident of the relevant possession, the individual satisfies the requirements of paragraphs (d)(1) and (e)(1) of this section if –

(A) For each of the 3 taxable years immediately preceding the taxable year of the change of residence, the individual is a bona fide resident of the relevant possession;

(B) For each of the first 183 days of the taxable year of the change of residence, the individual does not have a tax home outside the relevant possession or a closer connection to the United States or a foreign country than to the relevant possession; and

(C) For each of the 3 taxable years immediately following the taxable year of the change of residence, the individual is not a bona fide resident of the relevant possession.

(ii) Year of move from Puerto Rico. Notwithstanding an individual’s failure to satisfy the presence, tax home, or closer connection test prescribed under paragraph (b)(1) of this section for the taxable year, the individual is a bona fide resident of Puerto Rico for that part of the taxable year described in paragraph (f)(2)(ii)(E) of this section if the individual –

(A) Is a citizen of the United States;

(B) Is a bona fide resident of Puerto Rico for a period of at least 2 taxable years immediately preceding the taxable year;

(D) Ceases to have a tax home in Puerto Rico during the taxable year; and

(E) Has a closer connection to Puerto Rico than to the United States or a foreign country throughout the part of the taxable year preceding the date on which the individual ceases to have a tax home in Puerto Rico.

(g) Examples. The principles of this section are illustrated by the following examples:

Example 1. Presence test.H, a U.S. citizen, is engaged in a profession that requires frequent travel. H spends 195 days of each of the years 2005 and 2006 in Possession N. In 2007, H spends 160 days in Possession N. Under paragraph (c)(1)(ii), H satisfies the presence test of paragraph (c) of this section with respect to Possession N for taxable year 2007. Assuming that in 2007 H does not have a tax home outside of Possession N and does not have a closer connection to the United States or a foreign country under paragraphs (d) and (e) of this section respectively, then regardless of whether H was a bona fide resident of Possession N in 2005 and 2006, H is a bona fide resident of Possession N for taxable year 2007.

Example 2. Presence test.W, a U.S. citizen, lives for part of the taxable year in a condominium, which she owns, located in Possession P. W also owns a house in State N where she lives for 120 days every year to be near her grown children and grandchildren. W is retired and her income consists solely of pension payments, dividends, interest, and Social Security benefits. For 2006, W is only present in Possession P for a total of 175 days because of a 70-day vacation to Europe and Asia. Thus, for taxable year 2006, W is not present in Possession P for at least 183 days, is present in the United States for more than 90 days, and has a significant connection to the United States by reason of her permanent home. However, under paragraph (c)(1)(iv) of this section, W still satisfies the presence test of paragraph (c) of this section with respect to Possession P because she has no earned income in the United States and is present for more days in Possession P than in the United States.

Example 3. Presence test.T, a U.S. citizen, was born and raised in State A, where his mother still lives in the house in which T grew up. T is a sales representative for a company based in Possession V. T lives with his wife and minor children in their house in Possession V. T is registered to vote in Possession V and not in the United States. In 2006, T spends 120 days in State A and another 120 days in foreign countries. When traveling on business to State A, T often stays at his mother’s house in the bedroom he used when he was a child. T’s stays are always of short duration, and T asks for his mother’s permission before visiting to make sure that no other guests are using the room and that she agrees to have him as a guest in her house at that time. Therefore, under paragraph (c)(5)(ii) of this section, T’s mother’s house is not a permanent home of T. Assuming that no other accommodations in the United States constitute a permanent home with respect to T, then under paragraphs (c)(1)(v) and (c)(5) of this section, T has no significant connection to the United States. Accordingly, T satisfies the presence test of paragraph (c) of this section for taxable year 2006.

Example 4. Alien resident of possession – presence test.F is a citizen of Country G. F’s tax home is in Possession C and F has no closer connection to the United States or a foreign country than to Possession C. F is present in Possession C for 123 days and in the United States for 110 days every year. Accordingly, F is a nonresident alien with respect to the United States under section 7701(b), and a bona fide resident of Possession C under paragraphs (b), (c)(2), (d), and (e) of this section.

Example 5. Seafarers – tax home.S, a U.S. citizen, is employed by a fishery and spends 250 days at sea on a fishing vessel in 2006. When not at sea, S resides with his wife at a house they own in Possession G. The fishing vessel upon which S works departs and arrives at various ports in Possession G, other possessions, and foreign countries, but is in international and local waters (within the meaning of paragraph (d)(2) of this section) for 225 days in 2006. Under paragraph (d)(2) of this section, for taxable year 2006, S will not be considered to have a tax home outside Possession G for purposes of section 937 and this section solely by reason of S’s employment on board the fishing vessel.

Example 6. Seasonal workers – tax home and closer connection.P, a U.S. citizen, is a permanent employee of a hotel in Possession I, but works only during the tourist season. For the remainder of each year, P lives with her husband and children in Possession Q, where she has no outside employment. Most of P’s personal belongings, including her automobile, are located in Possession Q. P is registered to vote in, and has a driver’s license issued by, Possession Q. P does her personal banking in Possession Q and P routinely lists her address in Possession Q as her permanent address on forms and documents. P satisfies the presence test of paragraph (c) of this section with respect to both Possession Q and Possession I, because, among other reasons, under paragraph (c)(1)(iii) of this section she does not spend more than 90 days in the United States during the taxable year. P satisfies the tax home test of paragraph (d) of this section only with respect to Possession I, because her regular place of business is in Possession I. P satisfies the closer connection test of paragraph (e) of this section with respect to both Possession Q and Possession I, because she does not have a closer connection to the United States or to any foreign country (and possessions generally are not treated as foreign countries). Therefore, P is a bona fide resident of Possession I for purposes of the Internal Revenue Code.

Example 7. Closer connection to United States than to possession.Z, a U.S. citizen, relocates to Possession V in a prior taxable year to start an investment consulting and venture capital business. Z’s wife and two teenage children remain in State C to allow the children to complete high school. Z travels back to the United States regularly to see his wife and children, to engage in business activities, and to take vacations. He has an apartment available for his full-time use in Possession V, but he remains a joint owner of the residence in State C where his wife and children reside. Z and his family have automobiles and personal belongings such as furniture, clothing, and jewelry located at both residences. Although Z is a member of the Possession V Chamber of Commerce, Z also belongs to and has current relationships with social, political, cultural, and religious organizations in State C. Z receives mail in State C, including brokerage statements, credit card bills, and bank advices. Z conducts his personal banking activities in State C. Z holds a State C driver’s license and is registered to vote in State C. Based on the totality of the particular facts and circumstances pertaining to Z, Z is not a bona fide resident of Possession V because he has a closer connection to the United States than to Possession V and therefore fails to satisfy the requirements of paragraphs (b)(1) and (e) of this section.

Example 8. Year of move to possession.D, a U.S. citizen, files returns on a calendar year basis. From January 2003 through May 2006, D resides in State R. In June 2006, D moves to Possession N, purchases a house, and accepts a permanent position with a local employer. D’s principal place of business from July 1 through December 31, 2006 is in Possession N, and during that period (which totals at least 183 days) D does not have a closer connection to the United States or a foreign country than to Possession N. For the remainder of 2006, and throughout years 2007 through 2009, D continues to live and work in Possession N and maintains a closer connection to Possession N than to the United States or any foreign country. D satisfies the tax home and closer connection tests for 2006 under paragraphs (d)(2), (e)(2), and (f)(1) of this section. Accordingly, assuming that D also satisfies the presence test in paragraph (c) of this section, D is a bona fide resident of Possession N for all of taxable year 2006.

Example 9. Year of move from possession (other than Puerto Rico).J, a U.S. citizen, files returns on a calendar year basis. From January 2007 through December 2009, J is a bona fide resident of Possession C because she satisfies the requirements of paragraph (b)(1) of this section for each year. J continues to reside in Possession C until September 6, 2010, when she accepts new employment and moves to State H. J’s principal place of business from January 1 through September 5, 2010 is in Possession C, and during that period (which totals at least 183 days) J does not have a closer connection to the United States or a foreign country than to Possession C. For the remainder of 2010 and throughout years 2011 through 2013, D continues to live and work in State H and is not a bona fide resident of Possession C. J satisfies the tax home and closer connection tests for 2010 with respect to Possession C under paragraphs (d)(2)(i), (e)(2), and (f)(2)(i) of this section. Accordingly, assuming that J also satisfies the presence test of paragraph (c) of this section, J is a bona fide resident of Possession C for all of taxable year 2010.

Example 10. Year of move from Puerto Rico.R, a U.S. citizen who files returns on a calendar year basis satisfies the requirements of paragraphs (b) through (e) of this section for years 2006 and 2007. From January through April 2008, R continues to reside and maintain his principal place of business in and closer connection to Puerto Rico. On May 5, 2008, R moves and changes his principal place of business (tax home) to State N and later that year establishes a closer connection to the United States than to Puerto Rico. R does not satisfy the presence test of paragraph (c) for 2008 with respect to Puerto Rico. Moreover, because R had a tax home outside of Puerto Rico and establishes a closer connection to the United States in 2008, R does not satisfy the requirements of paragraph (d)(1) or (e)(1) of this section for 2008. However, because R was a bona fide resident of Puerto Rico for at least two taxable years before his change of residence to State N in 2008, he is a bona fide resident of Puerto Rico from January 1 through May 4, 2008 under paragraphs (b)(5) and (f)(2)(ii) of this section. See section 933(2) and § 1.933-1(b) for rules on attribution of income.

(h) Information reporting requirement. The following individuals are required to file notice of their new tax status in such time and manner as the Commissioner may prescribe by notice, form, instructions, or other publication (see § 601.601(d)(2) of this chapter):

(1) Individuals who take the position for U.S. tax reporting purposes that they qualify as bona fide residents of a possession for a tax year subsequent to a tax year for which they were required to file Federal income tax returns as citizens or residents of the United States who did not so qualify.

(2) Citizens and residents of the United States who take the position for U.S. tax reporting purposes that they do not qualify as bona fide residents of a possession for a tax year subsequent to a tax year for which they were required to file income tax returns (with the Internal Revenue Service, the tax authorities of a possession, or both) as individuals who did so qualify.

(3) Bona fide residents of Puerto Rico or a section 931 possession (as defined in § 1.931-1(c)(1)) who take a position for U.S. tax reporting purposes that they qualify as bona fide residents of that possession for a tax year subsequent to a tax year for which they were required to file income tax returns as bona fide residents of the U.S. Virgin Islands or a section 935 possession (as defined in § 1.935-1(a)(3)(i)).

(i) Effective/applicability date. Except as provided in this paragraph (i), this section applies to taxable years ending after January 31, 2006. Paragraph (h) of this section also applies to a taxpayer’s 3 taxable years immediately preceding the taxpayer’s first taxable year ending after October 22, 2004. Taxpayers also may choose to apply this section in its entirety to all taxable years ending after October 22, 2004 for which the statute of limitations under section 6511 is open.

[T.D. 9248, 71 FR 5001, Jan. 31, 2006, as amended by T.D. 9297, 71 FR 66234, Nov. 14, 2006; T.D. 9391, 73 FR 19370, Apr. 9, 2008]

§ 1.937-2 Income from sources within a possession.

(a) Scope. Section 937(b) and this section set forth the rules for determining whether income is considered to be from sources within a particular possession (the relevant possession) for purposes of the Internal Revenue Code, including section 957(c) and Subpart D, Part III, Subchapter N, Chapter 1 of the Internal Revenue Code, as well as section 7654(a) of the 1954 Internal Revenue Code (until the effective date of its repeal). Paragraphs (c)(1)(ii) and (c)(2) of this section do not apply, however, for purposes of sections 932(a) and (b) and 935(a)(3) (as in effect before the effective date of its repeal). In the case of a possession or territory that administers income tax laws that are identical (except for the substitution of the name of the possession or territory for the term “United States” where appropriate) to those in force in the United States, these rules do not apply for purposes of the application of such laws. These rules also do not affect the determination of whether income is considered to be from sources without the United States for purposes of the Internal Revenue Code.

(b) In general. Except as provided in paragraphs (c) through (i) of this section, the principles of sections 861 through 865 and the regulations under those provisions (relating to the determination of the gross and the taxable income from sources within and without the United States) generally will be applied in determining the gross and the taxable income from sources within and without the relevant possession. In the application of such principles, it generally will be sufficient to substitute, where appropriate, the name of the relevant possession for the term “United States,” and to substitute, where appropriate, the term “bona fide resident of” followed by the name of the relevant possession for the term “United States resident.” Furthermore, the term domestic will be construed to mean created or organized in the relevant possession. In applying these principles, additional substitutions may be necessary to accomplish the intent of section 937(b) and this section. For example, in applying the principles of sections 863(d) and (e) to individuals under this paragraph (b), the term “bona fide resident of a possession” will be used instead of the term “United States person.” In no case, however, will a bona fide resident or other person have, as a result of the application of these principles, more income from sources within the relevant possession than the amount of income from sources within the United States that a similarly situated U.S. person who is not a bona fide resident would have under sections 861 through 865.

(c) U.S. income – (1) In general. Except as provided in paragraph (d) of this section, income from sources within the relevant possession will not include any item of income determined under the rules of sections 861 through 865 and the regulations under those provisions to be –

(i) From sources within the United States; or

(ii) Effectively connected with the conduct of a trade or business within the United States.

(2) Conduit arrangements. Income will be considered to be from sources within the United States for purposes of paragraph (c)(1) of this section if, pursuant to a plan or arrangement –

(i) The income is received in exchange for consideration provided to another person; and

(ii) Such person (or another person) provides the same consideration (or consideration of a like kind) to a third person in exchange for one or more payments constituting income from sources within the United States.

(d) Income from certain sales of inventory property. For special rules that apply to determine the source of income from certain sales of inventory property, see § 1.863-3(e).

(e) Service in the Armed Forces. In the case of a member of the Armed Forces of the United States, the following rules will apply for determining the source of compensation for services performed in compliance with military orders:

(1) If the individual is a bona fide resident of a possession and such services are performed in the United States or in another possession, the compensation constitutes income from sources within the possession of which the individual is a bona fide resident (and not from sources within the United States or such other possession).

(2) If the individual is not a bona fide resident of a possession and such services are performed in a possession, the compensation constitutes income from sources within the United States (and not from sources within such possession).

(f) Gains from certain dispositions of property – (1) Property of former U.S. residents. (i) Except to the extent an election is made under paragraph (f)(1)(vi) of this section, income from sources within the relevant possession will not include gains from the disposition of property described in paragraph (f)(1)(ii) of this section by an individual described in paragraph (f)(1)(iii) of this section. See also section 1277(e) of the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085) (providing that gains from the disposition of certain property by individuals who acquired residency in certain possessions will be considered to be from sources within the United States).

(ii) Property is described in this paragraph (f)(1)(ii) when the following conditions are satisfied –

(A) The property is of a kind described in section 731(c)(3)(C)(i) or 954(c)(1)(B); and

(B) The property was owned by the individual before such individual became a bona fide resident of the relevant possession.

(iii) An individual is described in this paragraph (f)(1)(iii) when the following conditions are satisfied –

(A) For the taxable year for which the source of the gain must be determined, the individual is a bona fide resident of the relevant possession; and

(B) For any of the 10 years preceding such year, the individual was a citizen or resident of the United States (other than a bona fide resident of the relevant possession).

(iv) If an individual described in paragraph (f)(1)(iii) of this section exchanges property described in paragraph (f)(1)(ii) of this section for other property in a transaction in which gain or loss is not required to be recognized (in whole or in part) under U.S. income tax principles, such other property will also be considered property described in paragraph (f)(1)(ii) of this section.

(v) If an individual described in paragraph (f)(1)(iii) of this section owns, directly or indirectly, at least 10 percent (by value) of any entity to which property described in paragraph (f)(1)(ii) of this section is transferred in a transaction in which gain or loss is not required to be recognized (in whole or in part) under U.S. income tax principles, any gain recognized upon a disposition of the property by such entity will be treated as income from sources outside the relevant possession if any gain recognized upon a direct or indirect disposition of the individual’s interest in such entity would have been so treated under paragraph (f)(1)(iv) of this section.

(vi) Notwithstanding the general rule of paragraph (f)(1)(i) of this section and section 1277(e) of the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085), an individual described in paragraph (f)(1)(iii) of this section may elect to treat as gain from sources within the relevant possession the portion of the gain attributable to the individual’s possession holding period. The election under this paragraph (f)(1)(vi) will be considered made if the individual’s income tax return for the year of disposition of the property reports the portion of gain attributable to the taxpayer’s possession holding period as determined in accordance with paragraph (f)(1)(vi)(A) or paragraph (f)(1)(vi)(B) of this section, as the case may be.

(A) In the case of marketable securities, the portion of gain attributable to the possession holding period will be determined by reference to the fair market value of the marketable security at the close of the market on the first day of the individual’s possession holding period. In the event that the individual is a bona fide resident of the relevant possession for more than a single continuous period, the portion of gain described in this paragraph (f)(1)(vi)(A) will be the aggregate of the portions of gain (or offsetting loss) attributable to each possession holding period.

(B) In the case of property other than marketable securities, the portion of gain attributable to the possession holding period in the relevant possession will be determined by multiplying the total gain on disposition of the property by a fraction, the numerator of which is the number of days in the possession holding period and the denominator of which is the total number of days in the individual’s holding period for the property. For purposes of the preceding sentence, in the event that the individual is a bona fide resident of the relevant possession for more than a single continuous period, the number of days in the numerator will be the aggregate of the number of days in each possession holding period. For purposes of this paragraph (f)(1)(vi)(B), the denominator will include days that are required to be included in an individual’s holding period under section 735(b), section 1223, and any other applicable holding period rule in the Internal Revenue Code.

(vii) For purposes of paragraph (f)(1)(vi) of this section –

(A) The term marketable securities means property described in paragraph (f)(1)(ii) of this section that is, throughout the individual’s holding period, actively traded within the meaning of § 1.1092(d)-1(a); and

(B) The term possession holding period means the part of the individual’s holding period for the property during which the individual is a bona fide resident of the relevant possession. However, for this purpose, the possession holding period will be considered to commence in all cases on the first day during such period that the individual does not have a tax home outside the relevant possession. In the event that the individual is a bona fide resident of the relevant possession for more than a single continuous period, each possession holding period prior to the one ending on the date of sale or other disposition will be considered to end on the first day that the individual has a tax home outside the relevant possession. With respect to the determination of tax home, see § 1.937-1(d).

(2) Special rules under section 865 for possessions – (i) Except as provided in paragraph (f)(1) of this section –

(A) Gain that is considered to be derived from sources outside of the United States under section 865(g)(3) will be considered income from sources within Puerto Rico; and

(B) Gain that is considered to be derived from sources outside of the United States under section 865(h)(2)(B) will be considered income from sources within the possession in which the liquidating corporation is created or organized.

(ii) In applying the principles of section 865 and the regulations under that section pursuant to paragraph (b) of this section, the rules of section 865(g) will not apply, but the special rule of section 865(h)(2)(B) will apply with respect to gain recognized upon the liquidation of corporations created or organized in the United States.

(g) Dividends – (1) Dividends from certain possessions corporations – (i) In general. Except as provided in paragraph (g)(1)(ii) of this section, with respect to any possessions shareholder, only the possessions source ratio of any dividend paid or accrued by a corporation created or organized in a possession (possessions corporation) will be treated as income from sources within such possession. For purposes of this paragraph (g) –

(A) The possessions source ratio will be a fraction, the numerator of which is the gross income of the possessions corporation from sources within the possession in which it is created or organized (applying the rules of this section) for the testing period and the denominator of which is the total gross income of the corporation for the testing period; and

(B) The term possessions shareholder means any individual who is a bona fide resident of the possession in which the corporation is created or organized and who owns, directly or indirectly, at least 10 percent of the total voting stock of the corporation.

(ii) Dividends from corporations engaged in the active conduct of a trade or business in the relevant possession. The entire amount of any dividend paid or accrued by a possessions corporation will be treated as income from sources within the possession in which it is created or organized when the following conditions are met –

(A) 80 percent or more of the gross income of the corporation for the testing period was derived from sources within such possession (applying the rules of this section) or was effectively connected with the conduct of a trade or business in such possession (applying the rules of § 1.937-3); and

(B) 50 percent or more of the gross income of the corporation for the testing period was derived from the active conduct of a trade or business within such possession.

(iii) Testing period. For purposes of this paragraph (g)(1), the term testing period means the 3-year period ending with the close of the taxable year of the payment of the dividend (or for such part of such period as the corporation has been in existence).

(iv) Subsidiary look-through rule. For purposes of this paragraph (g)(1), if a possessions corporation owns (directly or indirectly) at least 25 percent (by value) of the stock of another corporation, such possessions corporation will be treated as if it –

(A) Directly received its proportionate share of the income of such other corporation; and

(B) Actively conducted any trade or business actively conducted by such other corporation.

(2) Dividends from other corporations. In applying the principles of section 861 and the regulations under that section pursuant to paragraph (b) of this section, the special rules relating to dividends for which deductions are allowable under section 243 or 245 will not apply.

(h) Income inclusions. For purposes of determining whether an amount described in section 904(h)(1)(A) constitutes income from sources within the relevant possession –

(1) If the individual owns (directly or indirectly) at least 10 percent of the total voting stock of the corporation from which such amount is derived, the principles of section 904(h)(2) will apply. In the case of an individual who is not a possessions shareholder (as defined in paragraph (g)(1)(i)(B) of this section), the preceding sentence will apply only if the corporation qualifies as a “United States-owned foreign corporation” for purposes of section 904(h); and

(2) In all other cases, the amount will be considered income from sources in the jurisdiction in which the corporation is created or organized.

(i) Interest – (1) Interest from certain possessions corporations – (i) In general. Except as provided in paragraph (i)(1)(ii) of this section, with respect to any possessions shareholder (as defined in paragraph (g)(1)(i)(B) of this section), interest paid or accrued by a possessions corporation will be treated as income from sources within the possession in which it is created or organized to the extent that such interest is allocable to assets that generate, have generated, or could reasonably have been expected to generate income from sources within such possession (under the rules of this section) or income effectively connected with the conduct of a trade or business within such possession (under the rules of § 1.937-3). For purposes of the preceding sentence, the principles of §§ 1.861-9 through 1.861-12 will apply.

(ii) Interest from corporations engaged in the active conduct of a trade or business in the relevant possession. The entire amount of any interest paid or accrued by a possessions corporation will be treated as income from sources within the possession in which it is created or organized when the conditions of paragraphs (g)(1)(ii)(A) and (B) of this section are met (applying the rules of paragraphs (g)(1)(iii) and (iv) of this section).

(2) Interest from partnerships. Interest paid or accrued by a partnership will be treated as income from sources within a possession only to the extent that such interest is allocable to income effectively connected with the conduct of a trade or business in such possession. For purposes of the preceding sentence, the principles of § 1.882-5 will apply (as if the partnership were a foreign corporation and as if the trade or business in the possession were a trade or business in the United States).

(j) Indirect ownership. For purposes of this section, the rules of section 318(a)(2) will apply except that the language “5 percent” will be used instead of “50 percent” in section 318(a)(2)(C).

(k) Examples. The provisions of this section may be illustrated by the following examples:

Example 1.(i) X, a U.S. citizen, resides in State N and acquires stock of Corporation C, a domestic corporation, in 2008 for $10x. X moves to the Northern Mariana Islands (NMI) on March 1, 2009 and changes his principal place of business to NMI on that same date. Assume for purposes of this example that, under § 1.937-1(b) and (f)(1) (year-of-move exception), X is considered a bona fide resident of NMI for 2009 through 2012. On March 1, 2009, the closing value of X’s stock in Corporation C, a marketable security (within the meaning of paragraph (f)(1)(vii)(A) of this section), is $20x. On January 3, 2012, X sells all his Corporation C stock for $70x.

(ii) Pursuant to section 1277(e) of the Tax Reform Act of 1986, and absent an election under paragraph (f)(1)(vi) of this section, all of X’s gain ($60x) will be treated as income from sources within the United States for all purposes of the Internal Revenue Code (including section 7654, as in effect with respect to the NMI), and (under paragraph (f)(1)(i) of this section) not as income from sources in the NMI. However, pursuant to paragraph (f)(1)(vi) of this section, X may elect on his 2012 income tax return filed with NMI to treat the portion of this gain attributable to X’s possession holding period with respect to NMI as gain from sources within NMI. X’s possession holding period with respect to NMI begins on March 1, 2009, the date his tax home changes to the NMI. Under paragraph (f)(1)(vi)(A) of this section, the portion of X’s gain attributable to this possession holding period is $50x, the excess of the sale price of the stock ($70x) over its closing value ($20x) on the first day of the possession holding period. By reporting $50x of gain on his 2012 NMI return, X will elect under paragraph (f)(1)(vi) of this section to treat that amount as NMI source income.

Example 2.(i) R, a U.S. citizen, resides in State F and acquires a 5 percent interest in Partnership P on January 1, 2009. R moves to Puerto Rico on June 1, 2010 and changes her principal place of business to Puerto Rico on that same date. Assume for purposes of this example that under § 1.937-1(b) and (f)(1) (year-of-move exception), R is considered a bona fide resident of Puerto Rico for 2010 through 2012. On June 1, 2010, R’s interest in Partnership P is not a marketable security within the meaning of paragraph (f)(1)(vii)(A) of this section. On December 31, 2012, having owned the interest in Partnership P for a period of 4 years (1461 days), R sells it, recognizing gain of $100x.

(ii) Pursuant to paragraph (f)(1) of this section, and absent an election under paragraph (f)(1)(vi) of this section, the gain will not be treated as income from sources within Puerto Rico for purposes of the Internal Revenue Code (including section 933(1)). However, pursuant to paragraph (f)(1)(vi) of this section, R may elect on her 2012 return filed with the IRS to treat the portion of this gain attributable to R’s possession holding period with respect to Puerto Rico as gain from sources within Puerto Rico. R’s possession holding period with respect to Puerto Rico is the 945-day period from June 1, 2010, the date her tax home changes to Puerto Rico, through December 31, 2012, the date of sale. Under paragraph (f)(1)(vi)(B) of this section, the portion of R’s gain attributable to this possession holding period is $64.68x, computed as follows:

(iii) By reporting $64.68x of gain on her 2012 Federal return, R will elect under paragraph (f)(1)(vi) of this section to treat that amount as Puerto Rico source income.

Example 3.X, a bona fide resident of Possession S, a section 931 possession (as defined in § 1.931-1(c)(1)), is engaged in a trade or business in the United States through an office in State H. In 2008, this office materially participates in the sale of inventory property in Possession S, such that the income from these inventory sales is considered effectively connected to this trade or business in the United States under section 864(c)(4)(B)(iii). This income will not be treated as income from sources within Possession S for purposes of section 931(a)(1) pursuant to paragraph (c)(1)(ii) of this section, but nonetheless will continue to be treated as income from sources without the United States under section 862 (for example, for purposes of section 904).

Example 4.(i) X, a bona fide resident of Possession I, owns 25 percent of the outstanding shares of A Corp, a corporation organized under the laws of Possession I. In 2010, X receives a dividend of $70x from A Corp. During 2008 through 2010, A Corp has gross income from the following sources:

	Possession I sources	Sources outside possession I
2008	$10x	$20x
2009	20x	10x
2010	25x	15x

(ii) A Corp owns 50 percent of the outstanding shares of B Corp, a corporation organized under the laws of Country FC. During 2008 through 2010, B Corp has gross income from the following sources:

	Possession I sources	Sources outside possession I
2008	$10x	$6x
2009	14x	8x
2010	10x	4x

(iii) A Corp is treated as having received 50 percent of the gross income of B Corp. Therefore, for 2008 through 2010, the gross income of A Corp is from the following sources:

	Possession I sources	Sources outside possession I
2008	$15x	$23x
2009	27x	14x
2010	30x	17x
Totals	$72x	$54x

(iv) Pursuant to paragraph (g) of this section, the portion of the dividend of $70x that X receives from Corp A in 2010 that is treated as income from sources within Possession I is 72/126 of $70x, or $40x.

Example 5.X is a U.S. citizen and a bona fide resident of the Northern Mariana Islands (NMI). In 2008, X receives compensation for services performed as a member of the crew of a fishing boat. Ten percent of the services for which X receives compensation are performed in the NMI, and 90 percent of X’s services are performed in international waters. Under the principles of section 861(a)(3) as applied pursuant to paragraph (b) of this section, the compensation that X receives for services performed in the NMI is treated as income from sources within the NMI. Under the principles of section 863(d)(1)(A) as applied pursuant to paragraph (b) of this section, the compensation that X receives for services performed in international waters is treated as income from sources within the NMI for purposes of the Internal Revenue Code (including section 7654, as in effect with respect to the NMI). Thus, all of X’s compensation for services during 2008 is treated as income from sources within the NMI.

Example 6.X, a U.S. citizen, resides in State L and receives $2,500 of compensation for services performed in Possession J during 2008 for Y, X’s employer. X is temporarily present in Possession J in 2008 for a period (or periods) not exceeding a total of 90 days. Y, a U.S. citizen, is not a bona fide resident of Possession J and is not engaged in a trade or business within Possession J. Under the principles of section 861(a)(3) as applied pursuant to paragraph (b) of this section, the compensation that X receives for services performed in Possession J during 2008 is not treated as income from sources within Possession J.

Example 7.(i) Company Y, a corporation organized in State C, produces, markets, and distributes music products. Y enters into a recording contract with Z, a recording artist who is a bona fide resident of the U.S. Virgin Islands (USVI). Pursuant to the contract between Y and Z, Z agrees to perform services as writer, musician, and vocalist on the recording of a new musical composition and related music video. Under the contract, all songs, recordings and related artwork, packaging copy, and liner notes, together with copyrights and other intellectual property in those works, are the sole property of Y, and Z obtains no proprietary rights in that property. As compensation for Z’s services, all of which are performed at a recording studio or other locations in the USVI, Y agrees to pay amounts designated as the “writer’s share” to Z based on a percentage of the music products sold. Y also agrees to make an upfront payment to Z as an advance against future portions of Z’s writer’s share.

(ii) To the extent that Z performs personal services within the USVI, the compensation that Z receives for his services is sourced to the USVI under the principles of section 861(a)(3) and § 1.861-4 as applied pursuant to § 1.937-2(b). If all of Z’s services are performed in the USVI, none of the writer’s share is derived from sources within the United States under section 861(a)(3) and § 1.861-4, nor is it effectively connected with the conduct of a trade or business in the United States under section 864(c)(3). Accordingly, the U.S. income rule of section 937(b)(2) and paragraph (c)(1) of this section would not operate to prevent Z’s services income from being USVI source or USVI effectively connected income within the meaning of section 937(b)(1). If Z also performs services in the United States, however, then the U.S. income rule would apply to the part of Z’s compensation that is sourced to the United States under section 861(a)(3) and § 1.861-4. In the event that Y and Z are controlled taxpayers within the meaning of § 1.482-1(i)(5), section 482 and the regulations under that section, including § 1.482-9T(i), would apply to evaluate the arm’s length amount charged for Z’s controlled services.

(l) Effective/applicability dates. Except as otherwise provided in this paragraph (l), this section applies to income earned in taxable years ending after April 9, 2008. Taxpayers may choose to apply paragraph (b) of this section to income earned in open taxable years ending after October 22, 2004. Taxpayers may choose to apply paragraph (f)(1) of this section to dispositions made after April 11, 2005.

[T.D. 9391, 73 FR 19370, Apr. 9, 2008, as amended at T.D. 9391, 73 FR 27728, May 14, 2008; T.D. 9391, 73 FR 36594, June 27, 2008; T.D. 9921, 85 FR 79853, Dec. 11, 2020]

§ 1.937-3 Income effectively connected with the conduct of a trade or business in a possession.

(a) Scope. Section 937(b) and this section set forth the rules for determining whether income is effectively connected with the conduct of a trade or business within a particular possession (the relevant possession) for purposes of the Internal Revenue Code, including sections 881(b) and 957(c) and Subpart D, Part III, Subchapter N, Chapter 1 of the Internal Revenue Code. Paragraph (c) of this section does not apply, however, for purposes of section 881(b). In the case of a possession or territory that administers income tax laws that are identical (except for the substitution of the name of the possession or territory for the term “United States” where appropriate) to those in force in the United States, these rules do not apply for purposes of the application of such laws.

(b) In general. Except as provided in paragraphs (c) and (d) of this section, the principles of section 864(c) and the regulations under that section (relating to the determination of income, gain or loss that is effectively connected with the conduct of a trade or business within the United States) generally will be applied in determining whether income is effectively connected with the conduct of a trade or business within the relevant possession, without regard to whether the taxpayer qualifies as a nonresident alien individual or a foreign corporation with respect to such possession. Subject to the rules of this section, the principles of section 864(c)(4) will apply for purposes of determining whether income from sources without the relevant possession is effectively connected with the conduct of a trade or business in the relevant possession. For purposes of the preceding sentence, all income other than income from sources within the relevant possession (as determined under the rules of § 1.937-2) will be considered income from sources without the relevant possession in the application of the principles of section 864(c) under this paragraph (b), it generally will be sufficient to substitute the name of the relevant possession for the term “United States” where appropriate, but additional substitutions may be necessary to accomplish the intent of section 937(b) and this section. In no case, however, will a bona fide resident or other person have, as a result of the application of these principles, more income effectively connected with the conduct of a trade or business in the relevant possession than the amount of U.S. effectively connected income that a similarly situated U.S. person who is not a bona fide resident would have under section 864(c).

(c) U.S. income – (1) In general. Except as provided in paragraph (d) of this section, income considered to be effectively connected with the conduct of a trade or business within the relevant possession will not include any item of income determined under the rules of sections 861 through 865 and the regulations under those provisions to be –

(i) From sources within the United States; or

(ii) Effectively connected with the conduct of a trade or business within the United States.

(2) Conduit arrangements. Income will be considered to be from sources within the United States for purposes of paragraph (c)(1) of this section if, pursuant to a plan or arrangement –

(i) The income is received in exchange for consideration provided to another person; and

(d) Income from certain sales of inventory property. Paragraph (c) of this section will not apply to income from sales of inventory property described in § 1.863-3(e).

(e) Examples. The provisions of this section may be illustrated by the following examples:

Example 1.X is a bona fide resident of Possession I, a section 931 possession (as defined in § 1.931-1(c)(1)). X has an office in Possession I from which X conducts a business consisting of the development and sale of specialized computer software. A purchaser of software will frequently pay X an additional amount to install the software on the purchaser’s operating system and to ensure that the software is functioning properly. X performs the installation services at the purchaser’s place of business, which may be in Possession I, in the United States, or in another country. The provision of such services is not de minimis and constitutes a separate transaction under the rules of § 1.861-18. Under the principles of section 864(c)(4) as applied pursuant to paragraph (b) of this section, the compensation that X receives for personal services performed outside of Possession I is not considered to be effectively connected with the conduct of a trade or business in Possession I for purposes of section 931(a)(2).

Example 2.(i) F Bank is organized under the laws of Country FC and operates an active banking business from offices in the U.S. Virgin Islands (USVI). In connection with this banking business, F Bank makes loans to and receives interest payments from borrowers who reside in the USVI, in the United States, and in Country FC.

(ii) Under the principles of section 861(a)(1) as applied pursuant to § 1.937-2(b), interest payments received by F Bank from borrowers who reside in the United States or in Country FC constitute income from sources outside of the USVI. Under the principles of section 864(c)(4) as applied pursuant to paragraph (b) of this section, interest income from sources outside of the USVI generally may constitute income that is effectively connected with the conduct of a trade or business within the USVI for purposes of the Internal Revenue Code. However, interest payments received by F Bank from borrowers who reside in the United States constitute income from sources within the United States under section 861(a)(1). Accordingly, under paragraph (c)(1) of this section, such interest income will not be treated as effectively connected with the conduct of a trade or business in the USVI for purposes of the Internal Revenue Code (for example, for purposes of section 934(b)). Interest payments received by F Bank from borrowers who reside in Country FC, however, may be treated as effectively connected with the conduct of a trade or business in the USVI for purposes of the Internal Revenue Code (including section 934(b)).

(iii) To the extent that, as described in section 934(a), the USVI administers income tax laws that are identical (except for the substitution of the name of the USVI for the term “United States” where appropriate) to those in force in the United States, interest payments received by F Bank from borrowers who reside in the United States or in Country FC may be treated as income that is effectively connected with the conduct of a trade or business in the USVI for purposes of F Bank’s income tax liability to the USVI under mirrored section 882.

Example 3.(i) G is a partnership that is organized under the laws of, and that operates an active financing business from offices in, Possession I. Interests in G are owned by D, a bona fide resident of Possession I, and N, an alien individual who resides in Country FC. Pursuant to a pre-arrangement, G loans $x to T, a business entity organized under the laws of Country FC, and T in turn loans $y to E, a U.S. resident. In accordance with the arrangement, E pays interest to T, which in turn pays interest to G.

(ii) The arrangement constitutes a conduit arrangement under paragraph (c)(2) of this section, and the interest payments received by G are treated as income from sources within the United States for purposes of paragraph (c)(1) of this section. Accordingly, the interest received by G will not be treated as effectively connected with the conduct of a trade or business in Possession I for purposes of the Internal Revenue Code (including sections 931(a)(2) and 934(b), if applicable with respect to D). Whether such interest constitutes income from sources within the United States for other purposes of the Internal Revenue Code under generally applicable conduit principles will depend on the facts and circumstances. See, for example, Aiken Indus., Inc. v. Commissioner, 56 T.C. 925 (1971).

(iii) If Possession I administers income tax laws that are identical (except for the substitution of the name of the possession for the term “United States” where appropriate) to those in force in the United States, the interest received by G may be treated as income effectively connected with the conduct of a trade or business in Possession I under mirrored section 864(c)(4) for purposes of determining the Possession I territorial income tax liability of N under mirrored section 871.

Example 4.(i) Corporation A, a corporation organized in Possession X, is engaged in a business consisting of the development of computer software and the sale of that software. Corporation A has its sole place of business in Possession X and is not engaged in the conduct of a trade or business in the United States. Corporation A receives orders for its software from customers in the United States and around the world. After orders are accepted, Corporation A’s software is either loaded onto compact discs at Corporation A’s Possession X facility and shipped via common carrier, or downloaded from Corporation A’s server in Possession X. The sales contract provides that the rights, title, and interest in the product will pass from Corporation A to the customer either at Corporation A’s place of business in Possession X (if shipped in compact disc form) or at Corporation A’s server in Possession X (if electronically downloaded). Assume for purposes of this example that each transaction is classified as a sale of a copyrighted article under § 1.861-18(c)(1)(ii) and (f)(2).

(ii) Under the principles of section 863(a), as applied pursuant to § 1.937-2(b), because Corporation A passes the rights, title, and interest to the copyrighted articles in Possession X, Corporation A’s sales income is sourced to Possession X. Corporation A’s sales income is also effectively connected with the conduct of a trade or business in Possession X, under the principles of section 864(c)(3) as applied pursuant to § 1.937-3(b). Corporation A’s income is not from sources within the United States, nor is it effectively connected with the conduct of a trade or business in the United States. Accordingly, the U.S. income rule of section 937(b)(2), § 1.937-2(c)(1), and paragraph (c)(1) of this section does not operate to prevent Corporation A’s sales income from being Possession X source and Possession X effectively connected income under section 937(b)(1).

Example 5.(i) Corporation B, a corporation organized in Possession X, has its sole place of business in Possession X and is not engaged in the conduct of a trade or business in the United States. Corporation B employs a software business model generally referred to as an application service provider. Employees of Corporation B in Possession X develop software and maintain it on Corporation B’s server in Possession X. Corporation B’s customers in the United States and around the world transmit detailed data about their own customers to Corporation B’s server and electronic storage facility in Possession X. The customers pay a monthly fee to Corporation B under a Subscription Agreement, and they can use the software to generate reports analyzing the data at any time but do not receive a copy of the software. Corporation B’s software allows its customers to generate the reports from their location and to keep track of their relationships with their own customers. Assume for purposes of this example that Corporation B’s income from these transactions is derived from the provision of services.

(ii) Under the principles of section 861(a)(3) and § 1.861-4(a), as applied pursuant to § 1.937-2(b), because Corporation B performs personal services wholly within Possession X, the compensation Corporation B receives for services is sourced to Possession X. Corporation B’s services income is also effectively connected with the conduct of a trade or business in Possession X, under the principles of section 864(c)(3) as applied pursuant to § 1.937-3(b). Corporation B’s income is not from sources within the United States, nor is it effectively connected with the conduct of a trade or business in the United States. Accordingly, the U.S. income rule of section 937(b)(2), § 1.937-2(c)(1), and paragraph (c)(1) of this section does not operate to prevent Corporation B’s services income from being Possession X source or Possession X effectively connected income within the meaning of section 937(b)(1).

(f) Effective/applicability date. Except as otherwise provided in this paragraph (f), this section applies to income earned in taxable years ending after April 9, 2008. Taxpayers may choose to apply paragraph (b) of this section to income earned in open taxable years ending after October 22, 2004.

[T.D. 9391, 73 FR 19374, Apr. 9, 2008, as amended at T.D. 9391, 73 FR 27728, May 14, 2008; T.D. 9921, 85 FR 79853, Dec. 11, 2020]

controlled foreign corporations

§ 1.951-1 Amounts included in gross income of United States shareholders.

(a) In general. If a foreign corporation is a controlled foreign corporation (within the meaning of section 957) at any time during any taxable year of such corporation, every person –

(1) Who is a United States shareholder (as defined in section 951(b) and paragraph (g) of this section) of such corporation at any time during such taxable year, and

(2) Who owns (within the meaning of section 958(a)) stock in such corporation on the last day, in such year, on which such corporation is a controlled foreign corporation shall include in his gross income for his taxable year in which or with which such taxable year of the corporation ends, the sum of –

(i) Such shareholder’s pro rata share (determined under paragraph (b) of this section) of the corporation’s subpart F income (as defined in section 952) for such taxable year of the corporation,

(ii) Such shareholder’s pro rata share (determined under paragraph (c)(1) of this section) of the corporation’s previously excluded subpart F income withdrawn from investment in less developed countries for such taxable year of the corporation,

(iii) Such shareholder’s pro rata share (determined under paragraph (c)(2) of this section) of the corporation’s previously excluded subpart F income withdrawn from investment in foreign base company shipping operations for such taxable year of the corporation, and

(iv) The amount determined under section 956 with respect to such shareholder for such taxable year of the corporation (but only to the extent not excluded from gross income under section 959(a)(2)).

(3) For purposes of determining whether a United States shareholder which is a domestic corporation is a personal holding company under section 542 and § 1.542-1, the character of the amount includible in gross income of such domestic corporation under this paragraph shall be determined as if such amount were realized directly by such corporation from the source from which it is realized by the controlled foreign corporation. See paragraph (a) of § 1.957-2 for special limitation on the amount of subpart F income in the case of a controlled foreign corporation described in section 957(b). See section 970(a) and § 1.970-1 which provides for the reduction of subpart F income of export trade corporations.

(4) See § 1.958-1(d) for rules regarding the ownership of stock of a foreign corporation through a domestic partnership for purposes of section 951 and for purposes of any provision that specifically applies by reference to section 951 or the regulations in this part under section 951.

(b) Limitation on a United States shareholder’s pro rata share of subpart F income – (1) In general. For purposes of paragraph (a)(2)(i) of this section, a United States shareholder’s pro rata share (determined in accordance with the rules of paragraph (e) of this section) of the foreign corporation’s subpart F income for the taxable year of such corporation is –

(i) The amount which would have been distributed with respect to the stock which such shareholder owns (within the meaning of section 958(a)) in such corporation if on the last day, in such corporation’s taxable year, on which such corporation is a controlled foreign corporation it had distributed pro rata to its shareholders an amount which bears the same ratio to its subpart F income for such taxable year as the part of such year during which such corporation is a controlled foreign corporation bears to the entire taxable year, reduced by –

(ii) The lesser of –

(A) The amount of distributions received by any other person during such taxable year as a dividend with respect to such stock multiplied by a fraction, the numerator of which is the subpart F income of such corporation for the taxable year and the denominator of which is the sum of the subpart F income and the tested income (as defined in section 951A(c)(2)(A) and § 1.951A-2(b)(1)) of such corporation for the taxable year, and

(B) The dividend which would have been received by such other person if the distributions by such corporation to all its shareholders had been the amount which bears the same ratio to the subpart F income of such corporation for the taxable year as the part of such year during which such shareholder did not own (within the meaning of section 958(a)) such stock bears to the entire taxable year.

(2) Examples. The following examples illustrate the application of this paragraph (b).

(i) Facts. The following facts are assumed for purposes of the examples.

(A) A is a United States shareholder.

(B) M is a foreign corporation that has only one class of stock outstanding.

(C) B is a nonresident alien individual, and stock owned by B is not considered owned by a domestic entity under section 958(b).

(D) P and R are foreign corporations.

(E) All persons use the calendar year as their taxable year.

(F) Year 1 ends on or after October 3, 2018, and has 365 days.

(ii) Example 1 – (A) Facts. A owns 100% of the stock of M throughout Year 1. For Year 1, M derives $100x of subpart F income, has $100x of earnings and profits, and makes no distributions.

(B) Analysis. Under section 951(a)(2) and paragraph (b)(1) of this section, A’s pro rata share of the subpart F income of M for Year 1 is $100x.

(iii) Example 2 – (A) Facts. The facts are the same as in paragraph (b)(2)(ii)(A) of this section (the facts in Example 1), except that instead of holding 100% of the stock of M for the entire year, A sells 60% of such stock to B on May 26, Year 1. Thus, M is a controlled foreign corporation for the period January 1, Year 1, through May 26, Year 1.

(B) Analysis. Under section 951(a)(2)(A) and paragraph (b)(1)(i) of this section, A’s pro rata share of the subpart F income of M is limited to the subpart F income of M which bears the same ratio to its subpart F income for such taxable year ($100x) as the part of such year during which M is a controlled foreign corporation bears to the entire taxable year (146/365). Accordingly, under section 951(a)(2) and paragraph (b)(1) of this section, A’s pro rata share of the subpart F income of M for Year 1 is $40x ($100x × 146/365).

(iv) Example 3 – (A) Facts. The facts are the same as in paragraph (b)(2)(ii)(A) of this section (the facts in Example 1), except that instead of holding 100% of the stock of M for the entire year, A holds 60% of such stock on December 31, Year 1, having acquired such stock on May 26, Year 1, from B, who owned such stock from January 1, Year 1. Before A’s acquisition of the stock, M had distributed a dividend of $15x to B in Year 1 with respect to the stock so acquired by A. M has no tested income for Year 1.

(B) Analysis. Under section 951(a)(2) and paragraph (b)(1) of this section, A’s pro rata share of the subpart F income of M for Year 1 is $21x, such amount being determined as follows:

Table 1 to paragraph (b)(2)(iv)(B)


M’s subpart F income for Year 1		$100x
Less: Reduction under section 951(a)(2)(A) for period (1-1 through 5-26) during which M is not a controlled foreign corporation ($100x × 146/365)		40x
Subpart F income for Year 1 as limited by section 951(a)(2)(A)		60x
A’s pro rata share of subpart F income as determined under section 951(a)(2)(A) (0.6 × $60x)		36x
Less: Reduction under section 951(a)(2)(B) for dividends received by B during Year 1 with respect to the stock of M acquired by A:
(i) Dividend received by B ($15x), multiplied by a fraction ($100x/$100x), the numerator of which is the subpart F income of such corporation for the taxable year ($100x) and the denominator of which is the sum of the subpart F income and the tested income of such corporation for the taxable year ($100x) ($15x × ($100x/$100x))	15x
(ii) B’s pro rata share (60%) of the amount which bears the same ratio to the subpart F income of such corporation for the taxable year ($100x) as the part of such year during which A did not own (within the meaning of section 958(a)) such stock bears to the entire taxable year (146/365) (0.6 × $100x × (146/365))	24x
(iii) Amount of reduction under section 951(a)(2)(B) (lesser of (i) or (ii))		15x
A’s pro rata share of subpart F income as determined under section 951(a)(2)		21x

(v) Example 4 – (A) Facts. A owns 100% of the only class of stock of P throughout Year 1, and P owns 100% of the only class of stock of R throughout Year 1. For Year 1, R derives $100x of subpart F income, has $100x of earnings and profits, and distributes a dividend of $20x to P. R has no gross tested income. P has no income for Year 1 other than the dividend received from R.

(B) Analysis. Under section 951(a)(2) and paragraph (b)(1) of this section, A’s pro rata share of the subpart F income of R for Year 1 is $100x. A’s pro rata share of the subpart F income of R is not reduced under section 951(a)(2)(B) and paragraph (b)(1)(ii) of this section for the dividend of $20x paid to P because there was no part of Year 1 during which A did not own (within the meaning of section 958(a)) the stock of R. Under section 959(b), the $20x distribution from R to P is not again includible in the gross income of A under section 951(a). The $20x distribution from R to P is not includible in the gross tested income of P.

(vi) Example 5 – (A) Facts. The facts are the same as in paragraph (b)(2)(v)(A) of this section (the facts in Example 4), except that instead of holding 100% of the stock of R for the entire year, P holds 60% of such stock on December 31, Year 1, having acquired such stock on March 14, Year 1, from B. Before P’s acquisition of the stock, R had distributed a dividend of $100x to B in Year 1 with respect to the stock so acquired by P. The stock interest so acquired by P was owned by B from January 1, Year 1, until acquired by P. R also has $300x of tested income for Year 1.

(B) Analysis – (1) Limitation of pro rata share of subpart F income. Under section 951(a)(2) and paragraph (b)(1) of this section, A’s pro rata share of the subpart F income of M for Year 1 is $28x, such amount being determined as follows:

Table 1 to paragraph (b)(2)(vi)(B)(1)

R’s subpart F income for Year 1		$100x
Less: Reduction under section 951(a)(2)(A) for period (1-1 through 3-14) during which R is not a controlled foreign corporation ($100x × 73/365)		20x
Subpart F income for Year 1 as limited by section 951(a)(2)(A)		80x
A’s pro rata share of subpart F income as determined under section 951(a)(2)(A) (0.6 × $80x)		48x
Less: Reduction under section 951(a)(2)(B) for dividends received by B during Year 1 with respect to the stock of R indirectly acquired by A:
(i) Dividend received by B ($100x) multiplied by a fraction ($100x/$400x), the numerator of which is the subpart F income of such corporation for the taxable year ($100x) and the denominator of which is the sum of the subpart F income and the tested income of such corporation for the taxable year ($400x) ($100x × ($100x/$400x))	25x
(ii) B’s pro rata share (60%) of the amount which bears the same ratio to the subpart F income of such corporation for the taxable year ($100x) as the part of such year during which A did not own (within the meaning of section 958(a)) such stock bears to the entire taxable year (73/365) (0.6 × $100x × (73/365))	12x
(iii) Amount of reduction under section 951(a)(2)(B) (lesser of (i) or (ii))		12x
A’s pro rata share of subpart F income as determined under section 951(a)(2)		36x

(2) Limitation of pro rata share of tested income. Under section 951A(e)(1) and § 1.951A-1(d)(2), A’s pro rata share of the tested income of M for Year 1 is $108x, such amount being determined as follows:

Table 1 to paragraph (b)(2)(vi)(B)(2)

R’s tested income for Year 1		$300x
Less: Reduction under section 951(a)(2)(A) for period (1-1 through 3-14) during which R is not a controlled foreign corporation ($300x × 73/365)		60x
Tested income for Year 1 as limited by under section 951(a)(2)(A)		240x
A’s pro rata share of tested income as determined under § 1.951A-1(d)(2) (0.6 × $240x)		144x
Less: Reduction under section 951(a)(2)(B for dividends received by B during Year 1 with respect to the stock of R indirectly acquired by A:
(i) Dividend received by B ($100x) multiplied by a fraction ($300x/$400x), the numerator of which is the tested income of such corporation for the taxable year ($300x) and the denominator of which is the sum of the subpart F income and the tested income of such corporation for the taxable year ($400x) ($100x × ($300x/$400x))	75x
(ii) B’s pro rata share (60%) of the amount which bears the same ratio to the tested income of such corporation for the taxable year ($300x) as the part of such year during which A did not own (within the meaning of section 958(a)) such stock bears to the entire taxable year (73/365) (0.6 × $300x × (73/365))	36x
(iii) Amount of reduction under section 951(a)(2)(B) (lesser of (i) or (ii))		36x
A’s pro rata share of tested income under section 951A(e)(1)		108x

(c)-(d) [Reserved]

(e) Pro rata share of subpart F income defined – (1) In general – (i) Hypothetical distribution. For purposes of paragraph (b) of this section, a United States shareholder’s pro rata share of a controlled foreign corporation’s subpart F income for a taxable year is the amount that bears the same ratio to the corporation’s subpart F income for the taxable year as the amount of the corporation’s allocable earnings and profits that would be distributed with respect to the stock of the corporation which the United States shareholder owns (within the meaning of section 958(a)) for the taxable year bears to the total amount of the corporation’s allocable earnings and profits that would be distributed with respect to the stock owned by all the shareholders of the corporation if all the allocable earnings and profits of the corporation for the taxable year (not reduced by actual distributions during the year) were distributed (hypothetical distribution) on the last day of the corporation’s taxable year on which such corporation is a controlled foreign corporation (hypothetical distribution date).

(ii) Definition of allocable earnings and profits. For purposes of this paragraph (e), the term allocable earnings and profits means, with respect to a controlled foreign corporation for a taxable year, the amount that is the greater of –

(A) The earnings and profits of the corporation for the taxable year determined under section 964; and

(B) The sum of the subpart F income (as determined under section 952 after the application of section 951A(c)(2)(B)(ii) and § 1.951A-6(b)) of the corporation for the taxable year and the tested income (as defined in section 951A(c)(2)(A) and § 1.951A-2(b)(1)) of the corporation for the taxable year.

(2) One class of stock. If a controlled foreign corporation for a taxable year has only one class of stock outstanding on the hypothetical distribution date, the amount of the corporation’s allocable earnings and profits distributed in the hypothetical distribution with respect to each share in the class of stock is determined as if the hypothetical distribution were made pro rata with respect to each share in the class of stock.

(3) More than one class of stock. If a controlled foreign corporation for a taxable year has more than one class of stock outstanding on the hypothetical distribution date, the amount of the corporation’s allocable earnings and profits distributed in the hypothetical distribution with respect to each class of stock is determined based on the distribution rights of each class of stock on the hypothetical distribution date, which amount is then further distributed pro rata with respect to each share in the class of stock. Subject to paragraphs (e)(4) through (6) of this section, the distribution rights of a class of stock are determined taking into account all facts and circumstances related to the economic rights and interest in the allocable earnings and profits of the corporation of each class, including the terms of the class of stock, any agreement among the shareholders and, if and to the extent appropriate, the relative fair market value of shares of stock. For purposes of this paragraph (e)(3), facts and circumstances do not include actual distributions (including distributions by redemption) or any amount treated as a dividend under any other provision of subtitle A of the Internal Revenue Code (for example, under section 78, 356(a)(2), 367(b), or 1248) made during the taxable year that includes the hypothetical distribution date.

(4) Special rules – (i) Redemptions, liquidations, and returns of capital. No amount of allocable earnings and profits is distributed in the hypothetical distribution with respect to a particular class of stock based on the terms of the class of stock of the controlled foreign corporation or any agreement or arrangement with respect thereto that would result in a redemption (even if such redemption would be treated as a distribution of property to which section 301 applies pursuant to section 302(d)), a distribution in liquidation, or a return of capital.

(ii) Certain cumulative preferred stock. If a controlled foreign corporation has outstanding a class of redeemable preferred stock with cumulative dividend rights and dividend arrearages on such stock do not compound at least annually at a rate that equals or exceeds the applicable Federal rate (as defined in section 1274(d)(1)) that applies on the date the stock is issued for the term from such issue date to the mandatory redemption date based on a comparable compounding assumption (the relevant AFR), the amount of the corporation’s allocable earnings and profits distributed in the hypothetical distribution with respect to the class of stock may not exceed the amount of dividends actually paid during the taxable year with respect to the class of stock plus the present value at the end of the controlled foreign corporation’s taxable year of the unpaid current dividends with respect to the class determined using the relevant AFR and assuming the dividends will be paid at the mandatory redemption date. For purposes of this paragraph (e)(4)(ii), if the class of preferred stock does not have a mandatory redemption date, the mandatory redemption date is the date that the class of preferred stock is expected to be redeemed based on all facts and circumstances.

(iii) Dividend arrearages. If there is an arrearage in dividends for prior taxable years with respect to a class of preferred stock of a controlled foreign corporation, an amount of the corporation’s allocable earnings and profits is distributed in the hypothetical distribution to the class of preferred stock by reason of the arrearage only to the extent the arrearage exceeds the accumulated earnings and profits of the controlled foreign corporation remaining from prior taxable years beginning after December 31, 1962, as of the beginning of the taxable year, or the date on which such stock was issued, whichever is later (the applicable date). If there is an arrearage in dividends for prior taxable years with respect to more than one class of preferred stock, the previous sentence is applied to each class in order of priority, except that the accumulated earnings and profits remaining after the applicable date are reduced by the allocable earnings and profits necessary to satisfy arrearages with respect to classes of stock with a higher priority. For purposes of this paragraph (e)(4)(iii), the amount of any arrearage with respect to stock described in paragraph (e)(4)(ii) of this section is determined in the same manner as the present value of unpaid current dividends on such stock under paragraph (e)(4)(ii) of this section.

(5) Restrictions or other limitations on distributions – (i) In general. A restriction or other limitation on distributions of an amount of earnings and profits by a controlled foreign corporation is not taken into account in determining the amount of the corporation’s allocable earnings and profits distributed in a hypothetical distribution to a class of stock of the controlled foreign corporation.

(ii) Definition. For purposes of paragraph (e)(5)(i) of this section, a restriction or other limitation on distributions includes any limitation that has the effect of limiting the distribution of an amount of earnings and profits by a controlled foreign corporation with respect to a class of stock of the corporation, other than currency or other restrictions or limitations imposed under the laws of any foreign country as provided in section 964(b).

(iii) Exception for certain preferred distributions. For purposes of paragraph (e)(5)(i) of this section, the right to receive periodically a fixed amount (whether determined by a percentage of par value, a reference to a floating coupon rate, a stated return expressed in terms of a certain amount of U.S. dollars or foreign currency, or otherwise) with respect to a class of stock the distribution of which is a condition precedent to a further distribution of earnings and profits that year with respect to any class of stock (not including a distribution in partial or complete liquidation) is not a restriction or other limitation on the distribution of earnings and profits by a controlled foreign corporation.

(iv) Illustrative list of restrictions and limitations. Except as provided in paragraph (e)(5)(iii) of this section, restrictions or other limitations on distributions include, but are not limited to –

(A) An arrangement that restricts the ability of a controlled foreign corporation to pay dividends on a class of stock of the corporation until a condition or conditions are satisfied (for example, until another class of stock is redeemed);

(B) A loan agreement entered into by a controlled foreign corporation that restricts or otherwise affects the ability to make distributions on its stock until certain requirements are satisfied; or

(C) An arrangement that conditions the ability of a controlled foreign corporation to pay dividends to its shareholders on the financial condition of the corporation.

(6) Transactions and arrangements with a principal purpose of changing pro rata shares. Appropriate adjustments must be made to the allocation of allocable earnings and profits that would be distributed (without regard to this paragraph (e)(6)) in a hypothetical distribution with respect to any share of stock outstanding as of the hypothetical distribution date to disregard the effect on the hypothetical distribution of any transaction or arrangement that is undertaken as part of a plan a principal purpose of which is the avoidance of Federal income taxation by changing the amount of allocable earnings and profits distributed in any hypothetical distribution with respect to such share. This paragraph (e)(6) also applies for purposes of the pro rata share rules described in § 1.951A-1(d) that reference this paragraph (e), including the rules in § 1.951A-1(d)(3) that determine the pro rata share of qualified business asset investment based on the pro rata share of tested income.

(7) Examples. The following examples illustrate the application of this paragraph (e).

(i) Facts. Except as otherwise stated, the following facts are assumed for purposes of the examples:

(A) FC1 is a controlled foreign corporation.

(B) USP1 and USP2 are domestic corporations.

(D) All persons use the calendar year as their taxable year.

(E) Any ownership of FC1 by any shareholder is for all of Year 1.

(F) The common shareholders of FC1 are entitled to dividends when declared by FC1’s board of directors.

(G) There are no accrued but unpaid dividends with respect to preferred shares, the preferred stock is not described in paragraph (e)(4)(ii) of this section, and common shares have positive liquidation value.

(H) There are no other facts and circumstances related to the economic rights and interest of any class of stock in the allocable earnings and profits of a foreign corporation, and no transaction or arrangement was entered into as part of a plan a principal purpose of which is the avoidance of Federal income taxation.

(I) FC1 has neither tested income within the meaning of section 951A(c)(2)(A) and § 1.951A-2(b)(1) nor tested loss within the meaning of section 951A(c)(2)(B)(i) and § 1.951A-2(b)(2).

(ii) Example 1: Single class of stock – (A) Facts. FC1 has outstanding 100 shares of one class of stock. USP1 owns 60 shares of FC1. USP2 owns 40 shares of FC1. For Year 1, FC1 has $1,000x of earnings and profits and $100x of subpart F income within the meaning of section 952.

(B) Analysis. FC1 has one class of stock. Therefore, under paragraph (e)(2) of this section, FC1’s allocable earnings and profits of $1,000x are distributed in the hypothetical distribution pro rata to each share of stock. Accordingly, under paragraph (e)(1) of this section, for Year 1, USP1’s pro rata share of FC1’s subpart F income is $60x ($100x × $600x/$1,000x) and USP2’s pro rata share of FC1’s subpart F income is $40x ($100x × $400x/$1,000x).

(iii) Example 2: Common and preferred stock – (A) Facts. FC1 has outstanding 70 shares of common stock and 30 shares of 4% nonparticipating, voting preferred stock with a par value of $10x per share. USP1 owns all of the common shares. Individual A owns all of the preferred shares. For Year 1, FC1 has $100x of earnings and profits and $50x of subpart F income within the meaning of section 952.

(B) Analysis. The distribution rights of the preferred shares are not a restriction or other limitation within the meaning of paragraph (e)(5) of this section. Under paragraph (e)(3) of this section, the amount of FC1’s allocable earnings and profits distributed in the hypothetical distribution with respect to Individual A’s preferred shares is $12x (0.04 × $10x × 30) and with respect to USP1’s common shares is $88x ($100x−$12x). Accordingly, under paragraph (e)(1) of this section, USP1’s pro rata share of FC1’s subpart F income is $44x ($50x − $88x/$100x) for Year 1.

(iv) Example 3: Restriction based on cumulative income – (A) Facts. FC1 has outstanding 10 shares of common stock and 400 shares of 2% nonparticipating, voting preferred stock with a par value of $1x per share. USP1 owns all of the common shares. FC2 owns all of the preferred shares. USP1 and FC2 cause the governing documents of FC1 to provide that no dividends may be paid to the common shareholders until FC1 cumulatively earns $100,000x of income. For Year 1, FC1 has $50x of earnings and profits and $50x of subpart F income within the meaning of section 952.

(B) Analysis. The agreement restricting FC1’s ability to pay dividends to common shareholders until FC1 cumulatively earns $100,000x of income is a restriction or other limitation within the meaning of paragraph (e)(5) of this section. Therefore, the restriction is disregarded for purposes of determining the amount of FC1’s allocable earnings and profits distributed in the hypothetical distribution to a class of stock. The distribution rights of the preferred shares are not a restriction or other limitation within the meaning of paragraph (e)(5) of this section. Under paragraph (e)(3) of this section, the amount of FC1’s allocable earnings and profits distributed in the hypothetical distribution with respect to FC2’s preferred shares is $8x (0.02 × $1x × 400) and with respect to USP1’s common shares is $42x ($50x − $8x). Accordingly, under paragraph (e)(1) of this section, USP1’s pro rata share of FC1’s subpart F income is $42x for Year 1.

(v) Example 4: Redemption rights – (A) Facts. FC1 has outstanding 40 shares of common stock and 10 shares of 4% nonparticipating, preferred stock with a par value of $50x per share. Pursuant to the terms of the preferred stock, FC1 has the right to redeem at any time, in whole or in part, the preferred stock. FC2 owns all of the preferred shares. USP1, wholly owned by FC2, owns all of the common shares. Pursuant to the governing documents of FC1, no dividends may be paid to the common shareholders while the preferred stock is outstanding. For Year 1, FC1 has $100x of earnings and profits and $100x of subpart F income within the meaning of section 952.

(B) Analysis. The agreement restricting FC1’s ability to pay dividends to common shareholders while the preferred stock is outstanding is a restriction or other limitation within the meaning of paragraph (e)(5) of this section. Therefore, the restriction is disregarded for purposes of determining the amount of FC1’s allocable earnings and profits distributed in the hypothetical distribution to a class of stock. Under paragraph (e)(4)(i) of this section, no amount of allocable earnings and profits is distributed in the hypothetical distribution to the preferred shareholders on the hypothetical distribution date as a result of FC1’s right to redeem the preferred shares. This is the case regardless of the restriction on paying dividends to the common shareholders while the preferred stock is outstanding, and regardless of the fact that a redemption of FC2’s preferred shares would be treated as a distribution to which section 301 applies under section 302(d) (due to FC2’s constructive ownership of the common shares). Thus, neither the restriction on paying dividends to the common shareholders while the preferred stock is outstanding nor FC1’s redemption rights with respect to the preferred shares affects the distribution of allocable earnings and profits in the hypothetical distribution to FC1’s shareholders. However, the distribution rights of the preferred shares are not a restriction or other limitation within the meaning of paragraph (e)(5) of this section. As a result, the amount of FC1’s allocable earnings and profits distributed in the hypothetical distribution with respect to FC2’s preferred shares is $20x (0.04 × $50x × 10) and with respect to USP1’s common shares is $80x ($100x−$20x). Accordingly, under paragraph (e)(1) of this section, USP1’s pro rata share of FC1’s subpart F income is $80x for Year 1.

(vi) Example 5: Shareholder owns common and preferred stock – (A) Facts. FC1 has outstanding 40 shares of common stock and 60 shares of 6% nonparticipating, nonvoting preferred stock with a par value of $100x per share. USP1 owns 30 shares of the common stock and 15 shares of the preferred stock during Year 1. The remaining 10 shares of common stock and 45 shares of preferred stock of FC1 are owned by Individual A. For Year 1, FC1 has $1,000x of earnings and profits and $500x of subpart F income within the meaning of section 952.

(B) Analysis. The right of the holder of the preferred stock to receive 6% of par value is not a restriction or other limitation within the meaning of paragraph (e)(5) of this section. The amount of FC1’s allocable earnings and profits distributed in the hypothetical distribution with respect to FC1’s preferred shares is $360x (0.06 × $100x × 60) and with respect to its common shares is $640x ($1,000x−$360x). As a result, the amount of FC1’s allocable earnings and profits distributed in the hypothetical distribution to USP1 is $570x, the sum of $90x ($360x × 15/60) with respect to its preferred shares and $480x ($640x × 30/40) with respect to its common shares. Accordingly, under paragraph (e)(1) of this section, USP1’s pro rata share of the subpart F income of FC1 is $285x ($500x × $570x/$1,000x).

(vii) Example 6: Subpart F income and tested income – (A) Facts. FC1 has outstanding 700 shares of common stock and 300 shares of 4% nonparticipating, voting preferred stock with a par value of $100x per share. USP1 owns all of the common shares. USP2 owns all of the preferred shares. For Year 1, FC1 has $10,000x of earnings and profits, $2,000x of subpart F income within the meaning of section 952, and $9,000x of tested income within the meaning of section 951A(c)(2)(A) and § 1.951A-2(b)(1).

(B) Analysis – (1) Hypothetical distribution. The allocable earnings and profits of FC1 determined under paragraph (e)(1)(ii) of this section are $11,000x, the greater of FC1’s earnings and profits as determined under section 964 ($10,000x) or the sum of FC1’s subpart F income and tested income ($2,000x + $9,000x). The amount of FC1’s allocable earnings and profits distributed in the hypothetical distribution with respect to USP2’s preferred shares is $1,200x (0.04 × $100x × 300) and with respect to USP1’s common shares is $9,800x ($11,000x−$1,200x).

(2) Pro rata share of subpart F income. Accordingly, under paragraph (e)(1) of this section, USP1’s pro rata share of FC1’s subpart F income is $1,782x ($2,000x × $9,800x/$11,000x), and USP2’s pro rata share of FC1’s subpart F income is $218x ($2,000x × $1,200x/$11,000x).

(3) Pro rata share of tested income. Accordingly, under § 1.951A-1(d)(2), USP1’s pro rata share of FC1’s tested income is $8,018x ($9,000x × $9,800x/$11,000x), and USP2’s pro rata share of FC1’s tested income is $982x ($9,000x × $1,200x/$11,000x) for Year 1.

(viii) Example 7: Subpart F income and tested loss – (A) Facts. The facts are the same as in paragraph (e)(7)(vii)(A) of this section (the facts in Example 6), except that for Year 1, FC1 has $8,000x of earnings and profits, $10,000x of subpart F income within the meaning of section 952 (but without regard to the limitation in section 952(c)(1)(A)), and $2,000x of tested loss within the meaning of section 951A(c)(2)(B)(i) and § 1.951A-2(b)(2). Under section 951A(c)(2)(B)(ii) and § 1.951A-6(b), the earnings and profits of FC1 are increased for purposes of section 952(c)(1)(A) by the amount of FC1’s tested loss. Accordingly, after the application of section 951A(c)(2)(B)(ii) and § 1.951A-6(b), the subpart F income of FC1 is $10,000x.

(B) Analysis – (1) Pro rata share of subpart F income. The allocable earnings and profits determined under paragraph (e)(1)(ii) of this section are $10,000x, the greater of the earnings and profits of FC1 determined under section 964 ($8,000x) or the sum of FC1’s subpart F income and tested income ($10,000x + $0). The amount of FC1’s allocable earnings and profits distributed in the hypothetical distribution with respect to USP2’s preferred shares is $1,200x (.04 × $100x × 300) and with respect to USP1’s common shares is $8,800x ($10,000x−$1,200x). Accordingly, under paragraph (e)(1) of this section, for Year 1, USP1’s pro rata share of FC1’s subpart F income is $8,800x and USP2’s pro rata share of FC1’s subpart F income is $1,200x.

(2) Pro rata share of tested loss. The allocable earnings and profits determined under § 1.951A-1(d)(4)(i)(B) are $2,000x, the amount of FC1’s tested loss. Under § 1.951A-1(d)(4)(i)(C), the entire $2,000x of tested loss is allocated in the hypothetical distribution to USP1’s common shares. Accordingly, USP1’s pro rata share of the tested loss is $2,000x.

(f) Determination of holding period. For purposes of sections 951 through 964, the holding period of an asset (including stock of a controlled foreign corporation) shall be determined by excluding the day on which such asset is acquired and including the day on which such asset is disposed of. The application of this paragraph may be illustrated by the following example:

Example.On June 30, 1963, United States person E acquires 70 of the 100 shares of the only class of stock of foreign corporation A from nonresident alien B, who until such time owns all such 100 shares. E sells 10 shares of stock of such corporation on November 30, 1963, and 60 shares on December 31, 1963, to nonresident alien F. Corporation A is a controlled foreign corporation for the period beginning with July 1, 1963, and extending through December 31, 1963. As to the 10 shares of stock sold on November 30, 1963, E is treated as not owning such shares at any time after November 30, 1963, nor before July 1, 1963. As to the remaining 60 shares of stock, E is treated as not owning them before July 1, 1963, or after December 31, 1963.

(g) United States shareholder defined – (1) In general. For purposes of sections 951 through 964, the term United States shareholder means, with respect to a foreign corporation, a United States person (as defined in section 957(c)) who owns within the meaning of section 958(a), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation.

(2) Percentage of total combined voting power owned by United States person – (i) Meaning of combined voting power. In determining for purposes of subparagraph (1) of this paragraph whether a United States person owns the requisite percentage of voting power of all classes of stock entitled to vote, consideration will be given to all the facts and circumstances in each case. In any case where –

(a) A foreign corporation has more than one class of stock outstanding, and

(b) One or more United States persons own (within the meaning of section 958) shares of any one class of stock which possesses the power to elect, appoint, or replace a person, or persons, who with respect to such corporation, exercise the powers ordinarily exercised by a member of the board of directors of a domestic corporation, the percentage of the total combined voting power with respect to such corporation owned by any such United States person shall be his proportionate share of the percentage of the persons exercising the powers ordinarily exercised by members of the board of directors of a domestic corporation (described in (b) of this subdivision) which such class of stock (as a class) possesses the power to elect, appoint, or replace. In all cases, however, a United States person will be deemed to own 10 percent or more of the total combined voting power with respect to a foreign corporation if such person owns (within the meaning of section 958) 20 percent or more of the total number of shares of a class of stock of such corporation possessing one or more powers enumerated in paragraph (b)(1) of § 1.957-1. Whether a foreign corporation is a controlled foreign corporation for purposes of sections 951 through 964 shall be determined by applying the rules of section 957 and §§ 1.957-1 through 1.957-4.

(ii) Illustration. The application of this paragraph may be illustrated by the following examples:

Example 1.Foreign corporation S has two classes of capital stock outstanding, consisting of 60 shares of class A stock and 40 shares of class B stock. Each class of the outstanding stock is entitled to participate on a share for share basis in any dividend distributions by S Corporation. The owners of a majority of the class A stock are entitled to elect 7 of the 10 corporate directors, and the owners of a majority of the class B stock are entitled to elect the other 3 of the 10 directors. Thus, the class A stock (as a class) possesses 70 percent of the total combined voting power of all classes of stock entitled to vote of S Corporation, and the class B stock (as a class) possesses 30 percent of such voting power. D, a United States person, owns 31 shares of the class A stock and thus owns 36,167 percent (31/60 × 70 percent) of the total combined voting power of all classes of stock entitled to vote of S Corporation. By reason of the ownership of such voting power, D is a United States shareholder of S Corporation under section 951(b). For purposes of section 957, S Corporation is a controlled foreign corporation by reason of D’s ownership of a majority of the class A stock, as illustrated in example 2 of paragraph (c) of § 1.957-1. E, a United States person, owns eight shares of the class A stock and thus owns 9.333 percent (8/60 × 70 percent) of the total combined voting power of all classes of stock entitled to vote of S Corporation. Since E owns only 9.333 percent of such voting power and less than 20 percent of the number of shares of the class A stock, he is not a United States shareholder of S Corporation under section 951(b). F, a United States person, owns 14 shares of the class B stock and thus owns 10.5 percent (14/40 × 30 percent) of the total combined voting power of all classes of stock entitled to vote of S Corporation. By reason of the ownership of such voting power, F is a United States shareholder of S Corporation under section 951(b).

Example 2.Foreign corporation R has three classes of stock outstanding, consisting of 10 shares of class A stock, 20 shares of class B stock, and 300 shares of class C stock. Each class of the outstanding stock is entitled to participate on a share for share basis in any distribution by R Corporation. The owners of a majority of the class A stock are entitled to elect 6 of the 10 corporate directors, and the owners of a majority of the class B stock are entitled to elect the other 4 of the 10 directors. The class C stock is not entitled to vote. D, E, and F, United States persons, each own 2 shares of the class A stock and 100 shares of the class C stock. As owners of a majority of the class A stock, D, E, and F elect 6 members of the board of directors. D, E, and F are United States shareholders of R Corporation under section 951(b) since each owns 20 percent of the total number of shares of the class A stock which possesses the power to elect a majority of the board of directors of R Corporation. For purposes of section 957, R Corporation is a controlled foreign corporation by reason of the ownership by D, E, and F of a majority of the class A stock, as illustrated in example 2 of paragraph (c) of § 1.957-1.

(h) Applicability dates. Paragraphs (a), (b)(1)(ii), (b)(2), (e)(1)(ii)(B), and (g)(1) of this section apply to taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of United States shareholders in which or with which such taxable years of foreign corporations end. Except for paragraph (e)(1)(ii)(B) of this section, paragraph (e) of this section applies to taxable years of United States shareholders ending on or after October 3, 2018.

[T.D. 6795, 30 FR 935, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 22507, May 19, 1983; T.D. 9222, 70 FR 49866, Aug. 25, 2005; 70 FR 67906, Nov. 9, 2005; T.D. 9251, 71 FR 8944, Feb. 22, 2006; T.D. 9866, 84 FR 29337, June 21, 2019; 84 FR 44223, Aug. 23, 2019; 84 FR 53052, Oct. 4, 2019; T.D. 9960, 87 FR 3654, Jan. 25, 2022]

§ 1.951-2 [Reserved]

§ 1.951-3 Coordination of subpart F with foreign personal holding company provisions.

A United States shareholder (as defined in section 951(b)) who is required under section 551(b) to include in his gross income for his taxable year his share of the undistributed foreign personal holding company income for the taxable year of a foreign personal holding company (as defined in section 552) which for that taxable year is a controlled foreign corporation (as defined in section 957) shall not be required to include in his gross income for his taxable year under section 951(a) and paragraph (a) of § 1.951-1 any amount attributable to the earnings and profits of such corporation for that taxable year of such corporation. If a foreign corporation is both a foreign personal holding company and a controlled foreign corporation for the same period which is only a part of its taxable year, then, for purposes of applying the immediately preceding sentence, such corporation shall be deemed to be, for such part of such year, a foreign personal holding company and not a controlled foreign corporation and the earnings and profits of such corporation for the taxable year shall be deemed to be that amount which bears the same ratio to its earnings and profits for the taxable year as such part of the taxable year bears to the entire taxable year. The application of this section may be illustrated by the following examples:

Example 1.A, a United States shareholder, owns 100 percent of the only class of stock of controlled foreign corporation M which, in turn, owns 100 percent of the only class of stock of controlled foreign corporation N. A and Corporations M and N use the calendar year as a taxable year. During 1963, N Corporation derives $40,000 of gross income all of which is foreign personal holding company income within the meaning of section 553; thus, N Corporation is a foreign personal holding company for such year within the meaning of section 552(a). For 1963, N Corporation has undistributed foreign personal holding company income (as defined in section 556(a)) of $30,000, derives $25,000 of subpart F income, and has earnings and profits of $32,000. During 1963, M Corporation derives $100,000 of gross income (including as a dividend under section 555(c)(2) the $30,000 of N Corporation’s undistributed foreign personal holding company income), 65 percent of which is foreign personal holding company income within the meaning of section 553. Therefore, M Corporation is a foreign personal holding company for such year. For 1963, M Corporation has undistributed foreign personal holding company income (as defined in section 556(a)) of $90,000, determined by taking into account under section 552(c)(1) N Corporation’s $30,000 of undistributed foreign personal holding company income for such year; in addition, M Corporation derives $50,000 of subpart F income and has earnings and profits of $92,000. Neither M Corporation nor N Corporation makes any actual distributions during 1963. A is required under section 551(b) to include in his gross income for 1963 as a dividend the $90,000 of M Corporation’s undistributed foreign personal holding company income for such year. For 1963, A is not required to include in his gross income under section 951(a) any of the $50,000 subpart F income of M Corporation or of the $25,000 subpart F income of N Corporation.

Example 2.The facts are the same as in example 1, except that only 45 percent of M Corporation’s gross income (determined by including under section 555(c)(2) the $30,000 of N Corporation’s undistributed foreign personal holding company income) is foreign personal holding company income within the meaning of section 553; accordingly, M Corporation is not a foreign personal holding company for 1963. Since for such year M Corporation is not a foreign personal holding company, the undistributed foreign personal holding company income ($30,000) of N Corporation is not required under section 555(b) to be included in the gross income of M Corporation for 1963; as a result, such income is not required under section 551(b) to be included in the gross income of A for such year even though N Corporation is a foreign personal holding company for that year. For 1963, A is required to include $75,000 in his gross income under section 951(a)(1)(A)(i) and paragraph (a) of § 1.951-1, consisting of the $50,000 subpart F income of M Corporation and the $25,000 subpart F income of N Corporation.

Example 3.The facts are the same as in example 1, except that in 1963 N Corporation actually distributes $30,000 to M Corporation and M Corporation, in turn, actually distributes $90,000 to A. Under section 556 the undistributed foreign personal holding company income of both M corporation and N Corporation is thus reduced to zero; accordingly, no amount is included in the gross income of A under section 551(b) by reason of his interest in corporations M and N. A must include $75,000 in his gross income for 1963 under section 951(a)(1)(A)(i) and paragraph (a) of § 1.951-1, consisting of the $50,000 subpart F income of M Corporation and the $25,000 subpart F income of N Corporation. Of the $90,000 distribution received by A from M Corporation, $75,000 is excludable from his gross income under section 959(a)(1) as previously taxed earnings and profits; the remaining $15,000 is includible in his gross income for 1963 as a dividend.

Example 4.(a) A, a United States shareholder, owns 100 percent of the only class of stock of controlled foreign corporation P, organized on January 1, 1963. Both A and P Corporation use the calendar year as a taxable year. During 1963, 1964, and 1965, P Corporation is not a foreign personal holding company as defined in section 552(a); in each of such years, P Corporation derives dividend income of $10,000 which constitutes foreign personal holding company income (within the meaning of § 1.954-2) but under 26 CFR 1.954-1(b)(1) (Revised as of April 1, 1975) excludes such amounts from foreign base company income as dividends received from, and reinvested in, qualified investments in less developed countries. Corporation P’s earnings and profits accumulated for 1963, 1964, and 1965 and determined under paragraph (b)(2) of § 1.955-1 are $40,000. For 1966, P Corporation is a foreign personal holding company, has predistribution earnings and profits of $10,000, derives $10,000 of income which is both foreign personal holding company income within the meaning of section 553 and subpart F income within the meaning of section 952, distributes $8,000 to A, and has undistributed foreign personal holding company income of $2,000 within the meaning of section 556. In addition, for 1966 P Corporation has a withdrawal (determined under section 955(a) as in effect before the enactment of the Tax Reduction Act of 1975 but without regard to its earnings and profits for such year) of $25,000 of previously excluded subpart F income from investment in less developed countries. A is required under section 551(b) to include in his gross income for 1966 as a dividend the $2,000 undistributed foreign personal holding company income. The $8,000 distribution is includible in A’s gross income for 1966 under sections 61(a)(7) and 301 as a distribution to which section 316(a)(2) applies. Corporation P’s $25,000 withdrawal of previously excluded subpart F income from investment in less developed countries is includible in A’s gross income for 1966 under section 951(a)(1)(A)(ii) and paragraph (a)(2) of § 1.951-1.

(b) If P Corporation’s earnings and profits accumulated for 1963, 1964, and 1965 were $15,000, instead of $40,000, the result would be the same as in paragraph (a) of this example, except that a withdrawal of only $15,000 of previously excluded subpart F income from investment in less developed countries would be includible in A’s gross income for 1966 under section 951(a)(1)(A)(ii) and paragraph (a)(2) of § 1.951-1.

(c) The principles of this example also apply to withdrawals (determined under section 955(a), as in effect before the enactment of the Tax Reduction Act of 1975) of previously excluded subpart F income from investment in less developed countries effected after the effective date of such Act, and to withdrawals (determined under section 955(a), as amended by such Act) of previously excluded subpart F income from investment in foreign base company shipping operations.

Example 5.(a) The facts are the same as in paragraph (a) of example 4, except that, instead of having a $25,000 decrease in qualified investments in less developed countries for 1966, P Corporation invests $20,000 in tangible property (not described in section 956(b)(2)) located in the United States and such investment constitutes an increase (determined under section 956(a) but without regard to the earnings and profits of P Corporation for 1966) in earnings invested in United States property. Corporation P’s earnings and profits accumulated for 1963, 1964, and 1965 and determined under paragraph (b)(1) of § 1.956-1 are $22,000. The result is the same as in paragraph (a) of example 4, except that instead of including the $25,000 withdrawal, A must include $20,000 in his gross income for 1966 under section 951(a)(1)(B) and paragraph (a)(2)(iv) of § 1.951-1 as an investment of earnings in United States property.

(b) If P Corporation’s earnings and profits accumulated for 1963, 1964, and 1965 were $9,000 instead of $22,000, the result would be the same as in paragraph (a) of this example, except that only $9,000 would be includible in A’s gross income for 1966 under section 951(a)(1)(B) and paragraph (a)(2)(iv) of § 1.951-1 as an investment of earnings in United States property.

[T.D. 6795, 30 FR 937, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 22508, May 19, 1983]

§ 1.951A-1 General provisions.

(a) Overview – (1) In general. This section and §§ 1.951A-2 through 1.951A-7 (collectively, the section 951A regulations) provide rules to determine a United States shareholder’s income inclusion under section 951A, describe certain consequences of an income inclusion under section 951A with respect to controlled foreign corporations and their United States shareholders, and define certain terms for purposes of section 951A and the section 951A regulations. This section provides general rules for determining a United States shareholder’s inclusion of global intangible low-taxed income, including a rule relating to the application of section 951A and the section 951A regulations to domestic partnerships and their partners. Section 1.951A-2 provides rules for determining a controlled foreign corporation’s tested income or tested loss. Section 1.951A-3 provides rules for determining a controlled foreign corporation’s qualified business asset investment. Section 1.951A-4 provides rules for determining a controlled foreign corporation’s tested interest expense and tested interest income. Section 1.951A-5 provides rules relating to the treatment of the inclusion of global intangible low-taxed income for certain purposes. Section 1.951A-6 provides certain adjustments to earnings and profits and basis of a controlled foreign corporation related to a tested loss. Section 1.951A-7 provides dates of applicability.

(2) Scope. Paragraph (b) of this section provides the general rule requiring a United States shareholder to include in gross income its global intangible low-taxed income for a U.S. shareholder inclusion year. Paragraph (c) of this section provides rules for determining the amount of a United States shareholder’s global intangible low-taxed income for the U.S. shareholder inclusion year, including a rule for the application of section 951A and the section 951A regulations to consolidated groups. Paragraph (d) of this section provides rules for determining a United States shareholder’s pro rata share of certain items for purposes of determining the United States shareholder’s global intangible low-taxed income. Paragraph (e) of this section provides rules for the treatment of a domestic partnership and its partners for purposes of section 951A and the section 951A regulations. Paragraph (f) of this section provides additional definitions for purposes of this section and the section 951A regulations.

(b) Inclusion of global intangible low-taxed income. Each person who is a United States shareholder of any controlled foreign corporation and owns section 958(a) stock of any such controlled foreign corporation includes in gross income in the U.S. shareholder inclusion year the shareholder’s GILTI inclusion amount, if any, for the U.S. shareholder inclusion year.

(c) Determination of GILTI inclusion amount – (1) In general. Except as provided in paragraph (c)(4) of this section, the term GILTI inclusion amount means, with respect to a United States shareholder and a U.S. shareholder inclusion year, the excess (if any) of –

(i) The shareholder’s net CFC tested income (as defined in paragraph (c)(2) of this section) for the year, over

(ii) The shareholder’s net deemed tangible income return (as defined in paragraph (c)(3) of this section) for the year.

(2) Definition of net CFC tested income. The term net CFC tested income means, with respect to a United States shareholder and a U.S. shareholder inclusion year, the excess (if any) of –

(i) The aggregate of the shareholder’s pro rata share of the tested income of each tested income CFC (as defined in § 1.951A-2(b)(1)) for a CFC inclusion year that ends with or within the U.S. shareholder inclusion year, over

(ii) The aggregate of the shareholder’s pro rata share of the tested loss of each tested loss CFC (as defined in § 1.951A-2(b)(2)) for a CFC inclusion year that ends with or within the U.S. shareholder inclusion year.

(3) Definition of net deemed tangible income return – (i) In general. The term net deemed tangible income return means, with respect to a United States shareholder and a U.S. shareholder inclusion year, the excess (if any) of –

(A) The shareholder’s deemed tangible income return (as defined in paragraph (c)(3)(ii) of this section) for the U.S. shareholder inclusion year, over

(B) The shareholder’s specified interest expense (as defined in paragraph (c)(3)(iii) of this section) for the U.S. shareholder inclusion year.

(ii) Definition of deemed tangible income return. The term deemed tangible income return means, with respect to a United States shareholder and a U.S. shareholder inclusion year, 10 percent of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (as defined in § 1.951A-3(b)) of each tested income CFC for a CFC inclusion year that ends with or within the U.S. shareholder inclusion year.

(iii) Definition of specified interest expense. The term specified interest expense means, with respect to a United States shareholder and a U.S. shareholder inclusion year, the excess (if any) of –

(A) The aggregate of the shareholder’s pro rata share of the tested interest expense (as defined in § 1.951A-4(b)(1)) of each controlled foreign corporation for a CFC inclusion year that ends with or within the U.S. shareholder inclusion year, over

(B) The aggregate of the shareholder’s pro rata share of the tested interest income (as defined in § 1.951A-4(b)(2)) of each controlled foreign corporation for a CFC inclusion year that ends with or within the U.S. shareholder inclusion year.

(4) Determination of GILTI inclusion amount for consolidated groups. For purposes of section 951A and the section 951A regulations, a member of a consolidated group (as defined in § 1.1502-1(h)) determines its GILTI inclusion amount taking into account the rules provided in § 1.1502-51.

(d) Determination of pro rata share – (1) In general. For purposes of paragraph (c) of this section, each United States shareholder that owns section 958(a) stock of a controlled foreign corporation as of a hypothetical distribution date determines its pro rata share (if any) of each tested item of the controlled foreign corporation for the CFC inclusion year that includes the hypothetical distribution date and ends with or within the U.S. shareholder inclusion year. Except as otherwise provided in this paragraph (d), a United States shareholder’s pro rata share of each tested item is determined independently of its pro rata share of each other tested item. In no case may the sum of the pro rata share of any tested item of a controlled foreign corporation for a CFC inclusion year allocated to stock under this paragraph (d) exceed the amount of such tested item of the controlled foreign corporation for the CFC inclusion year. Except as modified in this paragraph (d), a United States shareholder’s pro rata share of any tested item is determined under the rules of section 951(a)(2) and § 1.951-1(b) and (e) in the same manner as those provisions apply to subpart F income. Under section 951(a)(2) and § 1.951-1(b) and (e), as modified by this paragraph (d), a United States shareholder’s pro rata share of any tested item for a U.S. shareholder inclusion year is determined with respect to the section 958(a) stock of the controlled foreign corporation owned by the United States shareholder on a hypothetical distribution date with respect to a CFC inclusion year that ends with or within the U.S. shareholder inclusion year. A United States shareholder’s pro rata share of any tested item is translated into United States dollars using the average exchange rate for the CFC inclusion year of the controlled foreign corporation. Paragraphs (d)(2) through (5) of this section provide rules for determining a United States shareholder’s pro rata share of each tested item of a controlled foreign corporation.

(2) Tested income – (i) In general. Except as provided in paragraph (d)(2)(ii) of this section, a United States shareholder’s pro rata share of the tested income of each tested income CFC for a U.S. shareholder inclusion year is determined under section 951(a)(2) and § 1.951-1(b) and (e), substituting “tested income” for “subpart F income” each place it appears, other than in § 1.951-1(e)(1)(ii)(B) and the denominator of the fraction described in § 1.951-1(b)(1)(ii)(A).

(ii) Special rule for prior allocation of tested loss. In any case in which tested loss has been allocated to any class of stock in a prior CFC inclusion year under paragraph (d)(4)(iii) of this section, tested income is first allocated to each such class of stock in the order of its liquidation priority to the extent of the excess (if any) of the sum of the tested loss allocated to each such class of stock for each prior CFC inclusion year under paragraph (d)(4)(iii) of this section, over the sum of the tested income allocated to each such class of stock for each prior CFC inclusion year under this paragraph (d)(2)(ii). Paragraph (d)(2)(i) of this section applies for purposes of determining a United States shareholder’s pro rata share of the remainder of the tested income, except that, for purposes of the hypothetical distribution of section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i), the amount of allocable earnings and profits of the tested income CFC is reduced by the amount of tested income allocated under the first sentence of this paragraph (d)(2)(ii). For an example of the application of this paragraph (d)(2), see paragraph (d)(4)(iv)(B) of this section (Example 2).

(3) Qualified business asset investment – (i) In general. Except as provided in paragraphs (d)(3)(ii) of this section, a United States shareholder’s pro rata share of the qualified business asset investment of a tested income CFC for a U.S. shareholder inclusion year bears the same ratio to the total qualified business asset investment of the tested income CFC for the CFC inclusion year as the United States shareholder’s pro rata share of the tested income of the tested income CFC for the U.S. shareholder inclusion year bears to the total tested income of the tested income CFC for the CFC inclusion year.

(ii) Special rule for excess hypothetical tangible return – (A) In general. If the tested income of a tested income CFC for a CFC inclusion year is less than the hypothetical tangible return of the tested income CFC for the CFC inclusion year, a United States shareholder’s pro rata share of the qualified business asset investment of the tested income CFC for a United States shareholder inclusion year bears the same ratio to the qualified business asset investment of the tested income CFC as the United States shareholder’s pro rata share of the hypothetical tangible return of the CFC for the U.S. shareholder inclusion year bears to the total hypothetical tangible return of the CFC for the CFC inclusion year.

(B) Determination of pro rata share of hypothetical tangible return. For purposes of paragraph (d)(3)(ii)(A) of this section, a United States shareholder’s pro rata share of the hypothetical tangible return of a CFC for a CFC inclusion year is determined in the same manner as the United States shareholder’s pro rata share of the tested income of the CFC for the CFC inclusion year under paragraph (d)(2) of this section by treating the amount of the hypothetical tangible return as the amount of tested income.

(C) Definition of hypothetical tangible return. For purposes of this paragraph (d)(3)(ii), the term hypothetical tangible return means, with respect to a tested income CFC for a CFC inclusion year, 10 percent of the qualified business asset investment of the tested income CFC for the CFC inclusion year.

(iii) Examples. The following examples illustrate the application of paragraphs (d)(2) and (3) of this section. See also § 1.951-1(e)(7)(vii) (Example 6) (illustrating a United States shareholder’s pro rata share of tested income).

(A) Example 1 – (1) Facts. FS, a controlled foreign corporation, has outstanding 70 shares of common stock and 30 shares of 4% nonparticipating, cumulative preferred stock with a par value of $10x per share. P Corp, a domestic corporation and a United States shareholder of FS, owns all of the common shares. Individual A, a United States citizen and a United States shareholder, owns all of the preferred shares. Individual A, FS, and P Corp use the calendar year as their taxable year. Individual A and P Corp are shareholders of FS for all of Year 4. At the beginning of Year 4, FS had no dividend arrearages with respect to its preferred stock. For Year 4, FS has $100x of earnings and profits, $120x of tested income, and no subpart F income within the meaning of section 952. FS also has $750x of qualified business asset investment for Year 4.

(2) Analysis – (i) Determination of pro rata share of tested income. For purposes of determining P Corp’s pro rata share of FS’s tested income under paragraph (d)(2) of this section, the amount of FS’s allocable earnings and profits for purposes of the hypothetical distribution described in § 1.951-1(e)(1)(i) is $120x, the greater of its earnings and profits as determined under section 964 ($100x) and the sum of its subpart F income and tested income ($0 + $120x). Under paragraph (d)(2) of this section and § 1.951-1(e)(3), the amount of FS’s allocable earnings and profits distributed in the hypothetical distribution with respect to Individual A’s preferred shares is $12x (0.04 × $10x × 30) and the amount distributed with respect to P Corp’s common shares is $108x ($120x − $12x). Accordingly, under paragraph (d)(2) of this section and § 1.951-1(e)(1), Individual A’s pro rata share of FS’s tested income is $12x, and P Corp’s pro rata share of FS’s tested income is $108x for Year 4.

(ii) Determination of pro rata share of qualified business asset investment. The special rule of paragraph (d)(3)(ii)(A) of this section does not apply because FS’s tested income of $120x is not less than FS’s hypothetical tangible return of $75x, which is 10% of FS’s qualified business asset investment of $750x. Accordingly, under the general rule of paragraph (d)(3)(i) of this section, Individual A’s and P Corp’s respective pro rata shares of FS’s qualified business asset investment bears the same ratio to FS’s total qualified business asset investment as their respective pro rata shares of FS’s tested income bears to FS’s total tested income. Thus, Individual A’s pro rata share of FS’s qualified business asset investment is $75x ($750x × $12x/$120x), and P Corp’s pro rata share of FS’s qualified business asset investment is $675x ($750x × $108x/$120x).

(B) Example 2 – (1) Facts. The facts are the same as in paragraph (d)(3)(iv)(A)(1) of this section (the facts in Example 1 of this section), except that FS has $1,500x of qualified business asset investment for Year 4.

(2) Analysis – (i) Determination of pro rata share of tested income. The analysis and the result are the same as in paragraph (d)(3)(iv)(A)(2)(i) of this section (paragraph (i) of the analysis in Example 1 of this section).

(ii) Determination of pro rata share of qualified business asset investment. The special rule of paragraph (d)(3)(ii)(A) of this section applies because FS’s tested income of $120x is less than FS’s hypothetical tangible return of $150x, which is 10% of FS’s qualified business asset investment of $1,500x. Under paragraph (d)(3)(ii)(A) of this section, Individual A’s and P Corp’s respective pro rata shares of FS’s qualified business asset investment bears the same ratio to FS’s qualified business asset investment as their respective pro rata shares of the hypothetical tangible return of FS bears to the total hypothetical tangible return of FS. Under paragraph (d)(3)(ii)(B) of this section, P Corp’s and Individual A’s respective pro rata share of FS’s hypothetical tangible return is determined under paragraph (d)(2) of this section in the same manner as their respective pro rata shares of the tested income of FS by treating the hypothetical tangible return as the amount of tested income. The amount of FS’s allocable earnings and profits for purposes of the hypothetical distribution described in § 1.951-1(e)(1)(i) is $150x, the greater of its earnings and profits as determined under section 964 ($100x) and the sum of its subpart F income and hypothetical tangible return ($0 + $150x). The amount of FS’s allocable earnings and profits distributed in the hypothetical distribution is $12x (.04 × $10x × 30) with respect to Individual A’s preferred shares and $138x ($150x − $12x) with respect to P Corp’s common shares. Accordingly, Individual A’s pro rata share of FS’s qualified business asset investment is $120x ($1,500x × $12x/$150x), and P Corp’s pro rata share of FS’s qualified business asset investment is $1,380x ($1,500x × $138x/$150x).

(C) Example 3 – (1) Facts. P Corp, a domestic corporation and a United States shareholder, owns 100% of the only class of stock of FS, a controlled foreign corporation, from January 1 of Year 1, until May 26 of Year 1. On May 26 of Year 1, P Corp sells all of its FS stock to R Corp, a domestic corporation that is not related to P Corp, and recognizes no gain or loss on the sale. R Corp, a United States shareholder of FS, owns 100% of the stock of FS from May 26 through December 31 of Year 1. For Year 1, FS has $50x of earnings and profits, $50x of tested income, and no subpart F income within the meaning of section 952. FS also has $1,500x of qualified business asset investment for Year 1. On May 1 of Year 1, FS distributes a $20x dividend to P Corp. P Corp, R Corp, and FS all use the calendar year as their taxable year.

(2) Analysis – (i) Determination of pro rata share of tested income. For purposes of determining R Corp’s pro rata share of FS’s tested income under paragraph (d)(2) of this section, the amount of FS’s allocable earnings and profits for purposes of the hypothetical distribution described in § 1.951-1(e)(1)(i) is $50x, the greater of its earnings and profits as determined under section 964 ($50x) or the sum of its subpart F income and tested income ($0 + $50x). Under paragraph (d)(2) of this section and § 1.951-1(e)(1), FS’s allocable earnings and profits of $50x are distributed in the hypothetical distribution pro rata to each share of stock. R Corp’s pro rata share of FS’s tested income for Year 1 is its pro rata share under section 951(a)(2)(A) and § 1.951-1(b)(1)(i) ($50x), reduced under section 951(a)(2)(B) and § 1.951-1(b)(1)(ii) by $20x, which is the lesser of $20x, the dividend received by P Corp during Year 1 with respect to the FS stock acquired by R Corp ($20x), multiplied by a fraction, the numerator of which is the tested income ($50x) of FS for Year 1 and the denominator of which is the sum of the subpart F income ($0) and the tested income ($50x) of FS for Year 1 ($20x × $50x/$50x), and $20x, which is P Corp’s pro rata share (100%) of the amount which bears the same ratio to FS’s tested income for Year 1 ($50x) as the period during which R Corp did not own (within the meaning of section 958(a)) the FS stock (146 days) bears to the entire taxable year

(1 × $50x × 146/365). Accordingly, R Corp’s pro rata share of tested income of FS for Year 1 is $30x ($50x − $20x).

(ii) Determination of pro rata share of qualified business asset investment. The special rule of paragraph (d)(3)(ii) of this section applies because FS’s tested income of $50x is less than FS’s hypothetical tangible return of $150x, which is 10% of FS’s qualified business asset investment of $1,500x. Under paragraph (d)(3)(ii) of this section, R Corp’s pro rata share of FS’s qualified business asset investment is the amount that bears the same ratio to FS’s qualified business asset investment as R Corp’s pro rata share of the hypothetical tangible return of FS bears to the total hypothetical tangible return of FS. R Corp’s pro rata share of FS’s hypothetical tangible return is its pro rata share under section 951(a)(2)(A) and § 1.951-1(b)(1)(i) ($150x), reduced under section 951(a)(2)(B) and § 1.951-1(b)(1)(ii) by $20x, which is the lesser of $20x, the dividend received by P Corp during Year 1 with respect to the FS stock acquired by R Corp ($20x) multiplied by a fraction, the numerator of which is the hypothetical tangible return ($150x) of FS for Year 1 and the denominator of which is the sum of the subpart F income ($0) and the hypothetical tangible return ($150x) of FS for Year 1 ($20x × $150x/$150x), and $60x, which is P Corp’s pro rata share (100%) of the amount which bears the same ratio to FS’s hypothetical tangible return for Year 1 ($150x) as the period during which R Corp did not own (within the meaning of section 958(a)) the FS stock (146 days) bears to the entire taxable year (1 × $150x × 146/365). Accordingly, R Corp’s pro rata share of the hypothetical tangible return of FS for Year 1 is $130x ($150x − $20x), and R Corp’s pro rata share of FS’s qualified business asset investment is $1,300x ($1,500x × $130x/$150x).

(4) Tested loss – (i) In general. A United States shareholder’s pro rata share of the tested loss of each tested loss CFC for a U.S. shareholder inclusion year is determined under section 951(a)(2) and § 1.951-1(b) and (e) with the following modifications –

(A) “Tested loss” is substituted for “subpart F income” each place it appears;

(B) For purposes of the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i), the amount of allocable earnings and profits of a controlled foreign corporation for a CFC inclusion year is treated as being equal to the tested loss of the tested loss CFC for the CFC inclusion year;

(C) Except as provided in paragraphs (d)(4)(ii) and (iii) of this section, the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i) is treated as made solely with respect to the common stock of the tested loss CFC; and

(D) In lieu of applying section 951(a)(2)(B) and § 1.951-1(b)(1)(ii), the United States shareholder’s pro rata share of the tested loss allocated to section 958(a) stock of the tested loss CFC is reduced by an amount that bears the same ratio to the amount of the tested loss as the part of such year during which such shareholder did not own (within the meaning of section 958(a)) such stock bears to the entire taxable year.

(ii) Special rule in case of accrued but unpaid dividends. If a tested loss CFC’s earnings and profits that have accumulated since the issuance of preferred shares are reduced below the amount necessary to satisfy any accrued but unpaid dividends with respect to such preferred shares, then the amount by which the tested loss reduces the earnings and profits below the amount necessary to satisfy the accrued but unpaid dividends is allocated in the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i) to the preferred stock of the tested loss CFC and the remainder of the tested loss is allocated in the hypothetical distribution to the common stock of the tested loss CFC.

(iii) Special rule for stock with no liquidation value. If a tested loss CFC’s common stock has a liquidation value of zero and there is at least one other class of equity with a liquidation preference relative to the common stock, then the tested loss is allocated in the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i) to the most junior class of equity with a positive liquidation value to the extent of such liquidation value. Thereafter, tested loss is allocated to the next most junior class of equity to the extent of its liquidation value and so on. All determinations of liquidation value are to be made as of the beginning of the CFC inclusion year of the tested loss CFC.

(iv) Examples. The following examples illustrate the application of this paragraph (d)(4). See also § 1.951-1(e)(7)(viii) (Example 7) (illustrating a United States shareholder’s pro rata share of subpart F income and tested loss).

(A) Example 1 – (1) Facts. FS, a controlled foreign corporation, has outstanding 70 shares of common stock and 30 shares of 4% nonparticipating, cumulative preferred stock with a par value of $10x per share. P Corp, a domestic corporation and a United States shareholder of FS, owns all of the common shares. Individual A, a United States citizen and a United States shareholder, owns all of the preferred shares. FS, Individual A, and P Corp all use the calendar year as their taxable year. Individual A and P Corp are shareholders of FS for all of Year 5. At the beginning of Year 5, FS had earnings and profits of $120x, which accumulated after the issuance of the preferred stock. At the end of Year 5, the accrued but unpaid dividends with respect to the preferred stock are $36x. For Year 5, FS has a $100x tested loss, and no other items of income, gain, deduction or loss. At the end of Year 5, FS has earnings and profits of $20x.

(2) Analysis. FS is a tested loss CFC for Year 5. Before taking into account the tested loss in Year 5, FS had sufficient earnings and profits to satisfy the accrued but unpaid dividends of $36x. The amount of the reduction in earnings below the amount necessary to satisfy the accrued but unpaid dividends attributable to the tested loss is $16x ($36x − ($120x − $100x)). Accordingly, under paragraph (d)(4)(ii) of this section, $16x of the tested loss is allocated to Individual A’s preferred stock in the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i), and $84x ($100x − $16x) of the tested loss is allocated to P Corp’s common shares in the hypothetical distribution.

(B) Example 2 – (1) Facts. FS, a controlled foreign corporation, has outstanding 100 shares of common stock and 50 shares of 4% nonparticipating, cumulative preferred stock with a par value of $100x per share. P Corp, a domestic corporation and a United States shareholder of FS, owns all of the common shares. Individual A, a United States citizen and a United States shareholder, owns all of the preferred shares. FS, Individual A, and P Corp all use the calendar year as their taxable year. Individual A and P Corp are shareholders of FS for all of Year 1 and Year 2. At the beginning of Year 1, the common stock has no liquidation value and the preferred stock has a liquidation value of $5,000x and no accrued but unpaid dividends. In Year 1, FS has a tested loss of $1,000x and no other items of income, gain, deduction, or loss. In Year 2, FS has tested income of $3,000x and no other items of income, gain, deduction, or loss. FS has earnings and profits of $3,000x for Year 2. At the end of Year 2, FS has accrued but unpaid dividends of $400x with respect to the preferred stock, the sum of $200x for Year 1 (0.04 × $100x × 50) and $200x for Year 2 (0.04 × $100x × 50).

(2) Analysis – (i) Year 1. FS is a tested loss CFC in Year 1. The common stock of FS has liquidation value of zero, and the preferred stock has a liquidation preference relative to the common stock. The tested loss ($1,000x) does not exceed the liquidation value of the preferred stock ($5,000x). Accordingly, under paragraph (d)(4)(iii) of this section, the tested loss is allocated to the preferred stock in the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i). Individual A’s pro rata share of the tested loss is $1,000x, and P Corp’s pro rata share of the tested loss is $0.

(ii) Year 2. FS is a tested income CFC in Year 2. Because $1,000x of tested loss was allocated to the preferred stock in Year 1 under paragraph (d)(4)(iii) of this section, the first $1,000x of tested income in Year 2 is allocated to the preferred stock under paragraph (d)(2)(ii) of this section. P Corp’s and Individual A’s pro rata shares of the remaining $2,000x of tested income are determined under the general rule of paragraph (d)(2)(i) of this section, except that for purposes of the hypothetical distribution the amount of FS’s allocable earnings and profits is reduced by the tested income allocated under paragraph (d)(2)(ii) of this section to $2,000x ($3,000x − $1,000x). Accordingly, under paragraph (d)(2)(i) of this section and § 1.951-1(e), the amount of FS’s allocable earnings and profits distributed in the hypothetical distribution with respect to Individual A’s preferred stock is $400x ($400x of accrued but unpaid dividends) and with respect to P Corp’s common stock is $1,600x ($2,000x − $400x). Individual A’s pro rata share of the tested income is $1,400x ($1,000x + $400x), and P Corp’s pro rata share of the tested income is $1,600x.

(5) Tested interest expense. A United States shareholder’s pro rata share of tested interest expense of a controlled foreign corporation for a U.S. shareholder inclusion year is equal to the amount by which the tested interest expense reduces the shareholder’s pro rata share of tested income of the controlled foreign corporation for the U.S. shareholder inclusion year, increases the shareholder’s pro rata share of tested loss of the controlled foreign corporation for the U.S. shareholder inclusion year, or both.

(6) Tested interest income. A United States shareholder’s pro rata share of tested interest income of a controlled foreign corporation for a U.S. shareholder inclusion year is equal to the amount by which the tested interest income increases the shareholder’s pro rata share of tested income of the controlled foreign corporation for the U.S. shareholder inclusion year, reduces the shareholder’s pro rata share of tested loss of the controlled foreign corporation for the U.S. shareholder inclusion year, or both.

(e) Stock owned through domestic partnerships. See § 1.958-1(d) for rules regarding the ownership of stock of a foreign corporation through a domestic partnership for purposes of section 951A and for purposes of any provision that specifically applies by reference to section 951A or the section 951A regulations.

(f) Definitions. This paragraph (f) provides additional definitions that apply for purposes of this section and the section 951A regulations. Other definitions relevant to the section 951A regulations are included in §§ 1.951A-2 through 1.951A-4.

(1) CFC inclusion year. The term CFC inclusion year means any taxable year of a foreign corporation beginning after December 31, 2017, at any time during which the corporation is a controlled foreign corporation.

(2) Controlled foreign corporation. The term controlled foreign corporation has the meaning set forth in section 957(a).

(3) Hypothetical distribution date. The term hypothetical distribution date has the meaning set forth in § 1.951-1(e)(1)(i).

(4) Section 958(a) stock. The term section 958(a) stock means stock of a controlled foreign corporation owned (directly or indirectly) by a United States shareholder within the meaning of section 958(a), as modified by paragraph (e)(1) of this section.

(5) Tested item. The term tested item means tested income, tested loss, qualified business asset investment, tested interest expense, or tested interest income.

(6) United States shareholder. The term United States shareholder has the meaning set forth in section 951(b).

(7) U.S. shareholder inclusion year. The term U.S. shareholder inclusion year means any taxable year of a United States shareholder in which or with which a CFC inclusion year of a controlled foreign corporation ends.

[T.D. 9866, 84 FR 29341, June 21, 2019, as amended by T.D. 9960, 87 FR 3654, Jan. 25, 2022]

§ 1.951A-2 Tested income and tested loss.

(a) Scope. This section provides rules for determining the tested income or tested loss of a controlled foreign corporation for purposes of determining a United States shareholder’s net CFC tested income under § 1.951A-1(c)(2). Paragraph (b) of this section provides definitions related to tested income and tested loss. Paragraph (c) of this section provides rules for determining the gross tested income of a controlled foreign corporation and the deductions that are properly allocable to gross tested income.

(b) Definitions related to tested income and tested loss – (1) Tested income and tested income CFC. The term tested income means the excess (if any) of a controlled foreign corporation’s gross tested income for a CFC inclusion year, over the allowable deductions (including taxes) properly allocable to the gross tested income for the CFC inclusion year (a controlled foreign corporation with tested income for a CFC inclusion year, a tested income CFC).

(2) Tested loss and tested loss CFC. The term tested loss means the excess (if any) of a controlled foreign corporation’s allowable deductions (including taxes) properly allocable to gross tested income (or that would be allocable to gross tested income if there were gross tested income) for a CFC inclusion year, over the gross tested income of the controlled foreign corporation for the CFC inclusion year (a controlled foreign corporation without tested income for a CFC inclusion year, a tested loss CFC).

(c) Rules relating to the determination of tested income and tested loss – (1) Definition of gross tested income. The term gross tested income means the gross income of a controlled foreign corporation for a CFC inclusion year determined without regard to –

(i) Items of income described in section 952(b),

(ii) Gross income taken into account in determining the subpart F income of the corporation,

(iii) Gross income excluded from the foreign base company income (as defined in section 954) or the insurance income (as defined in section 953) of the corporation by reason of the exception described in section 954(b)(4) pursuant to an election under § 1.954-1(d)(5), or a tentative gross tested income item of the corporation that qualifies for the exception described in section 954(b)(4) pursuant to an election under paragraph (c)(7) of this section,

(iv) Dividends received by the corporation from related persons (as defined in section 954(d)(3)), and

(v) Foreign oil and gas extraction income (as defined in section 907(c)(1)) of the corporation.

(2) Determination of gross income and allowable deductions – (i) In general. For purposes of determining tested income and tested loss, the gross income and allowable deductions of a controlled foreign corporation for a CFC inclusion year are determined under the rules of § 1.952-2 for determining the subpart F income of the controlled foreign corporation, except, for a controlled foreign corporation which is engaged in the business of reinsuring or issuing insurance or annuity contracts and which, if it were a domestic corporation engaged only in such business, would be taxable as an insurance company to which subchapter L of chapter 1 of the Code applies, substituting “the rules of sections 953 and 954(i)” for “the principles of §§ 1.953-4 and 1.953-5” in § 1.952-2(b)(2).

(ii) Deemed payment under section 367(d). The allowable deductions of a controlled foreign corporation include a deemed payment of the controlled foreign corporation under section 367(d)(2)(A).

(3) Allocation of deductions to gross tested income – (i) In general. Except as provided in paragraph (c)(5) of this section, any deductions of a controlled foreign corporation allowable under paragraph (c)(2) of this section are allocated and apportioned to gross tested income under the principles of section 954(b)(5) and § 1.954-1(c), by treating gross tested income that falls within a single separate category (as defined in § 1.904-5(a)(4)(v)) as a single item of gross income, separate and in addition to the items set forth in § 1.954-1(c)(1)(iii). Losses in other separate categories of income resulting from the application of § 1.954-1(c)(1)(i) cannot reduce any separate category of gross tested income, and losses in a separate category of gross tested income cannot reduce income in a category of subpart F income. In addition, deductions of a controlled foreign corporation that are allocated and apportioned to gross tested income under this paragraph (c)(3) are not taken into account for purposes of determining a qualified deficit as defined in section 952(c)(1)(B)(ii).

(ii) Coordination with the high-tax exclusion – (A) In general. In the case of a taxpayer that has made an election under paragraph (c)(7) of this section, in allocating and apportioning deductions under this paragraph (c)(3), the taxpayer must apply the rules of sections 861 through 865 and 904(d) (taking into account the rules of section 954(b)(5) and § 1.954-1(c)) in a manner that achieves results consistent with those under paragraph (c)(7) of this section.

(B) Application of consistency rule to deductions allocated and apportioned to the residual grouping in applying the high-tax exclusion. Deductions that are allocated and apportioned to the residual income group under paragraph (c)(7)(iii)(A) of this section for purposes of applying the high-tax exclusion to a controlled foreign corporation’s tentative gross tested income items are allocated and apportioned for purposes of determining the controlled foreign corporation’s net income in each relevant statutory grouping using a method that provides for a consistent allocation and apportionment of deductions to gross income in the relevant groupings. See §§ 1.954-1(c) and 1.960-1(d)(3) for rules relating to the allocation and apportionment of expenses for purposes of determining subpart F income, which is included in the residual grouping for purposes of applying the high-tax exclusion of sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(7) of this section. Therefore, for example, interest expense that is apportioned under the modified gross income method to a tentative gross tested income item of a lower-tier corporation under paragraph (c)(7)(iii)(A) of this section may be allocated and apportioned to the tested income of the upper-tier corporation or to the residual grouping, depending on whether the lower-tier corporation’s tentative gross tested income item is an item of gross tested income or is excluded from gross tested income under the high-tax exclusion. See paragraph (c)(8)(iii)(C) (Example 3) of this section for an example illustrating the rules of this paragraph (c)(3).

(4) Gross income taken into account in determining subpart F income – (i) In general. Except as provided in paragraph (c)(4)(iii) of this section, gross income of a controlled foreign corporation for a CFC inclusion year described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section is gross income described in paragraphs (c)(4)(ii)(A) through (E) of this section.

(ii) Items of gross income included in subpart F income – (A) Insurance income. Gross income described in this paragraph (c)(4)(ii)(A) is any item of gross income included in the insurance income (adjusted net insurance income as defined in § 1.954-1(a)(6)) of the controlled foreign corporation for the CFC inclusion year.

(B) Foreign base company income. Gross income described in this paragraph (c)(4)(ii)(B) is any item of gross income included in the foreign base company income (adjusted net foreign base company income as defined in § 1.954-1(a)(5)) of the controlled foreign corporation for the CFC inclusion year.

(C) International boycott income. Gross income described in this paragraph (c)(4)(ii)(C) is the product of the gross income of the controlled foreign corporation for the CFC inclusion year that gives rise to the income described in section 952(a)(3)(A) multiplied by the international boycott factor described in section 952(a)(3)(B).

(D) Illegal bribes, kickbacks, or other payments. Gross income described in this paragraph (c)(4)(ii)(D) is the sum of the amounts of the controlled foreign corporation for the CFC inclusion year described in section 952(a)(4).

(E) Income earned in certain foreign countries. Gross income described in this paragraph (c)(4)(ii)(E) is income of the controlled foreign corporation for the CFC inclusion year described in section 952(a)(5).

(iii) Coordination rules – (A) Coordination with E&P limitation. Gross income of a controlled foreign corporation for a CFC inclusion year described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section includes any item of gross income that is excluded from subpart F income of the controlled foreign corporation for the CFC inclusion year, or that is otherwise excluded from the amount included under section 951(a)(1)(A) in the gross income of a United States shareholder of the controlled foreign corporation for the U.S. shareholder inclusion year in which or with which the CFC inclusion year ends, under section 952(c)(1) and § 1.952-1(c), (d), or (e).

(B) Coordination with E&P recapture. Gross income of a controlled foreign corporation for a CFC inclusion year described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section does not include any item of gross income that results in the recharacterization of earnings and profits as subpart F income of the controlled foreign corporation for the CFC inclusion year under section 952(c)(2) and § 1.952-1(f)(2).

(C) Coordination with full inclusion rule and high tax exception. Gross income of a controlled foreign corporation for a CFC inclusion year described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section does not include full inclusion foreign base company income that is excluded from subpart F income under § 1.954-1(d)(6). Full inclusion foreign base company income that is excluded from subpart F income under § 1.954-1(d)(6) is also not included in gross income of a controlled foreign corporation for a CFC inclusion year described in section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section.

(iv) Examples. The following examples illustrate the application of this paragraph (c)(4).

(A) Example 1 – (1) Facts. A Corp, a domestic corporation, owns 100% of the single class of stock of FS, a controlled foreign corporation. Both A Corp and FS use the calendar year as their taxable year. In Year 1, FS has passive category foreign personal holding company income of $100x, a general category loss in foreign oil and gas extraction income of $100x, and earnings and profits of $0. FS has no other income. In Year 2, FS has general category gross income of $100x and earnings and profits of $100x. Without regard to section 952(c)(2), in Year 2 FS has no income described in any of the categories of income excluded from gross tested income in paragraphs (c)(1)(i) through (v) of this section. FS has no allowable deductions properly allocable to gross tested income for Year 2.

(2) Analysis – (i) Year 1. As a result of the earnings and profits limitation of section 952(c)(1)(A), FS has no subpart F income in Year 1, and A Corp has no inclusion with respect to FS under section 951(a)(1)(A). Under paragraph (c)(4)(iii)(A) of this section, gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section includes any item of gross income excluded from the subpart F income of FS for Year 1 under section 952(c)(1)(A) and § 1.952-1(c). Therefore, the $100x foreign personal holding company income of FS in Year 1 is excluded from gross tested income by reason of section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, and FS has no gross tested income in Year 1.

(ii) Year 2. In Year 2, under section 952(c)(2) and § 1.952-1(f)(2), FS’s general category earnings and profits ($100x) in excess of its subpart F income ($0) give rise to the recharacterization of its passive category recapture account as subpart F income. Therefore, FS has passive category subpart F income of $100x in Year 2, and A Corp has an inclusion of $100x with respect to FS under section 951(a)(1)(A). Under paragraph (c)(4)(iii)(B) of this section, gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section does not include any item of gross income that results in the recharacterization of earnings and profits as subpart F income in FS’s taxable year under section 952(c)(2) and § 1.952-1(f)(2). Accordingly, the $100x of general category gross income of FS in Year 2 is not excluded from gross tested income by reason of section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, and FS has $100x of general category gross tested income in Year 2.

(B) Example 2 – (1) Facts. A Corp, a domestic corporation, owns 100% of the single class of stock of FC1 and FC2, controlled foreign corporations. A Corp, FC1, and FC2 use the calendar year as their taxable year. In Year 1, FC1 has gross income of $290x from product sales to unrelated persons within its country of incorporation, gross interest income of $10x (an amount that is less than $1,000,000) that does not qualify for an exception to foreign personal holding company income, and earnings and profits of $300x. In Year 1, FC2 has gross income of $45x for performing consulting services within its country of incorporation for unrelated persons, gross interest income of $150x (an amount that is not less than $1,000,000) that does not qualify for an exception to foreign personal holding company income, and earnings and profits of $195x.

(2) Analysis – (i) FC1. In Year 1, by application of the de minimis rule of section 954(b)(3)(A) and § 1.954-1(b)(1)(i), the $10x of gross interest income earned by FC1 is not treated as foreign base company income ($10x of gross foreign base company income is less than $15x, the lesser of 5% of $300x, FC’s total gross income for Year 1, or $1,000,000). Accordingly, FC1 has no subpart F income in Year 1, and A Corp has no inclusion with respect to FC1 under section 951(a)(1)(A). Under paragraph (c)(4)(i) of this section, gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section is any item of gross income included in foreign base company income, and thus gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section does not include any item of gross income excluded from foreign base company income under the de minimis rule in section 954(b)(3)(A) and § 1.954-1(b)(1)(i). Accordingly, FS’s $10x of gross interest income in Year 1 is not excluded from gross tested income by reason of section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, and FC1 has $300x ($290x of gross sales income and $10x of gross interest income) of gross tested income in Year 1.

(ii) FC2. In Year 1, by application of the full inclusion rule in section 954(b)(3)(B) and § 1.954-1(b)(1)(ii), the $45x of gross income earned by FC2 for performing consulting services within its country of incorporation for unrelated persons is treated as foreign base company income ($150x of gross foreign base company income exceeds $136.5x, which is 70% of $195x, FC2’s total gross income for Year 1). Therefore, FC2 has $195x of foreign base company income in Year 1, including $45x of full inclusion foreign base company income as defined in § 1.954-1(b)(2), and A Corp has an inclusion of $195x with respect to FC2 under section 951(a)(1)(A). Under paragraph (c)(4)(i) of this section, gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section is any item of gross income included in foreign base company income, and thus gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section includes any item of gross income included as foreign base company income under the full inclusion rule in section 954(b)(3)(B) and § 1.954-1(b)(1)(ii). Accordingly, FC2’s $45x of gross services income and its $150x of gross interest income in Year 1 are excluded from gross tested income by reason of section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, and FC2 has no gross tested income in Year 1.

(C) Example 3 – (1) Facts. A Corp, a domestic corporation, owns 100% of the single class of stock of FS, a controlled foreign corporation. A Corp and FS use the calendar year as their taxable year. In Year 1, FS has gross income of $1,000x, of which $720x is general category foreign base company sales income and $280x is general category income from sales within its country of incorporation; FS has expenses of $650x (including creditable foreign income taxes), of which $500x are allocated and apportioned to foreign base company sales income and $150x are allocated and apportioned to sales income from sales within FS’s country of incorporation; and FS has earnings and profits of $350x for Year 1. Foreign income tax of $55x is considered imposed on the $220x ($720x−$500x) of net foreign base company sales income, and $26x is considered imposed on the $130x ($280x−$150x) of net income from sales within FS’s country of operation. The maximum rate of tax in section 11 for the taxable year is 21%, and FS elects the high tax exception of section 954(b)(4) under § 1.954-1(d)(1) for Year 1 for its foreign base company sales income. In a prior taxable year, FS had losses with respect to income other than foreign base company or insurance income that, by reason of the limitation in section 952(c)(1)(A), reduced the subpart F income of FS (consisting entirely of foreign source general category income) by $600x; as of the beginning of Year 1, such amount has not been recharacterized as subpart F income in a subsequent taxable year under section 952(c)(2).

(2) Analysis – (i) Foreign base company income. In Year 1, by application of the full inclusion rule in section 954(b)(3)(B) and § 1.954-1(b)(1)(ii), the $280x of gross income earned by FS for sales within its country of incorporation is treated as foreign base company income ($720x of gross foreign base company income exceeds $700x, which is 70% of $1,000x, FS’s total gross income for the taxable year). However, the $220x of foreign base company sales income qualifies for the high tax exception of section 954(b)(4) and § 1.954-1(d)(1), because the effective rate of tax with respect to the net foreign base company sales income ($220x) is 20% ($55x/($220x + $55x)) which is greater than 18.9% (90% of 21%, the maximum rate of tax in section 11 for the taxable year). Because the $220x of net foreign base company sales income qualifies for the high tax exception of section 954(b)(4) and § 1.954-1(d)(1), the $130x of full inclusion foreign base company income is also excluded from subpart F income under § 1.954-1(d)(6).

(ii) Recapture of subpart F income. Under section 952(c)(2) and § 1.952-1(f)(2), FS’s general category earnings and profits ($350x) in excess of its subpart F income ($0) give rise to the recharacterization of its general category recapture account ($600x) as subpart F income to the extent of current year earnings and profits. Therefore, FS has general category subpart F income of $350x in Year 1, and A Corp has an inclusion of $350x with respect to FS under section 951(a)(1)(A).

(iii) Gross tested income. The $720x of gross foreign base company income is excluded from gross tested income under section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section. However, the $280x of gross sales income earned from sales within FS’s country of incorporation is not excluded from gross tested income under either section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section or section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section. Under paragraph (c)(4)(iii)(B) of this section, the $280x of gross sales income earned from sales within FS’s country of incorporation is not excluded from gross tested income under section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, because gross income described in paragraph (c)(1)(ii) of this section does not include any item of gross income that results in the recharacterization of earnings and profits as subpart F income under section 952(c)(2) and § 1.952-1(f)(2). Further, under paragraph (c)(4)(iii)(C) of this section, the $280x of gross sales income earned from sales within FS’s country of incorporation is not excluded from gross tested income under either section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section or section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section, because gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section or section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section does not include full inclusion foreign base company income that is excluded from subpart F income under § 1.954-1(d)(6). Accordingly, FS has $280x of gross tested income for Year 1.

(5) Allocation of deduction or loss attributable to disqualified basis – (i) In general. A deduction or loss attributable to disqualified basis is allocated and apportioned solely to residual CFC gross income, and any depreciation, amortization, or cost recovery allowances attributable to disqualified basis is not properly allocable to property produced or acquired for resale under section 263, 263A, or 471.

(ii) Determination of deduction or loss attributable to disqualified basis. Except as otherwise provided in this paragraph (c)(5)(ii), in the case of a depreciation or amortization deduction with respect to property with disqualified basis and adjusted basis other than disqualified basis, the deduction or loss is treated as attributable to the disqualified basis in the same proportion that the disqualified basis bears to the total adjusted basis in the property. In the case of a loss from a taxable sale or exchange of property with disqualified basis and adjusted basis other than disqualified basis, the loss is treated as attributable to disqualified basis to the extent thereof.

(iii) Definitions. The following definitions apply for purposes of this paragraph (c)(5).

(A) Disqualified basis. The term disqualified basis has the meaning set forth in § 1.951A-3(h)(2)(ii).

(B) Residual CFC gross income. The term residual CFC gross income means gross income other than gross tested income, gross income taken into account in determining subpart F income, or gross income that is effectively connected, or treated as effectively connected, with the conduct of a trade or business in the United States (as described in § 1.882-4(a)(1)).

(iv) Reductions to disqualified basis pursuant to coordination rules. See § 1.245A-7(b) or § 1.245A-8(b), as applicable, for reductions to disqualified basis resulting from the application of § 1.245A-5.

(v) Examples. The following examples illustrate the application of this paragraph (c)(5).

(A) Example 1: Sale of intangible property during the disqualified period – (1) Facts. USP, a domestic corporation, owns all of the stock in CFC1 and CFC2, each a controlled foreign corporation. Both USP and CFC2 use the calendar year as their taxable year. CFC1 uses a taxable year ending November 30. On November 1, 2018, before the start of its first CFC inclusion year, CFC1 sells Asset A to CFC2 in exchange for $100x of cash. Asset A is intangible property that is amortizable under section 197. Immediately before the sale, the adjusted basis in Asset A is $20x, and CFC1 recognizes $80x of gain as a result of the sale ($100x−$20x). CFC1’s gain is not subject to U.S. tax or taken into account in determining an inclusion to USP under section 951(a)(1)(A).

(2) Analysis. The sale by CFC1 is a disqualified transfer (within the meaning of § 1.951A-3(h)(2)(ii)(C)(2)) because it is a transfer of property in which gain was recognized by CFC1, CFC1 and CFC2 are related persons, and the transfer occurs during the disqualified period (within the meaning of § 1.951A-3(h)(2)(ii)(C)(1)). The disqualified basis in Asset A is $80x, the excess of CFC2’s adjusted basis in Asset A immediately after the disqualified transfer ($100x), over the sum of CFC1’s basis in Asset A immediately before the transfer ($20x) and the qualified gain amount (as defined in § 1.951A-3(h)(2)(ii)(C)(3)) ($0). Accordingly, under paragraph (c)(5)(i) of this section, any deduction or loss of CFC2 attributable to the disqualified basis is allocated and apportioned solely to residual CFC gross income of CFC2 and, therefore, is not taken into account in determining the tested income, tested loss, subpart F income, or effectively connected income of CFC2 for any CFC inclusion year.

(B) Example 2: Related party transfer after the disqualified period; gain recognition – (1) Facts. The facts are the same as in paragraph (c)(5)(v)(A)(1) of this section (the facts in Example 1), except that, on November 30, 2020, CFC2 sells Asset A to CFC3, a controlled foreign corporation wholly-owned by CFC2, in exchange for $120x of cash. Immediately before the sale, the adjusted basis in Asset A is $90x, $72x of which is disqualified basis. The gain recognized by CFC2 on the sale of Asset A is not described in paragraphs (c)(1)(i) through (v) of this section.

(2) Analysis. Paragraph (c)(5)(i) of this section does not apply to the sale of Asset A from CFC2 to CFC3 because the sale does not give rise to a deduction or loss attributable to disqualified basis, but instead gives rise to gain. Therefore, CFC2 recognizes $30x ($120x−$90x) of gain that is included in gross tested income for its CFC inclusion year ending November 30, 2019. Under § 1.951A-3(h)(2)(ii)(B)(1)(ii), because CFC2 sold Asset A to CFC3, a related person, and CFC2 did not recognize a deduction or loss on the sale, the disqualified basis in Asset A is not reduced or eliminated by reason of the sale. Accordingly, under paragraph (c)(5)(i) of this section, any deduction or loss of CFC3 attributable to the $72x of disqualified basis in Asset A is allocated and apportioned solely to residual CFC gross income of CFC3.

(C) Example 3: Related party transfer after the disqualified period; loss recognition – (1) Facts. The facts are the same as in paragraph (c)(5)(v)(B)(1) of this section (the facts in Example 2), except that CFC2 sells Asset A to CFC3 in exchange for $70x of cash.

(2) Analysis. Under paragraph (c)(5)(ii) of this section, the $20x loss recognized by CFC2 on the sale is attributable to disqualified basis, to the extent thereof, notwithstanding that the loss may be deferred under section 267(f). Thus, under paragraph (c)(5)(i) of this section, the loss is allocated and apportioned solely to residual CFC gross income of CFC2 in the CFC inclusion year in which the loss is taken into account pursuant to section 267(f). Under § 1.951A-3(h)(2)(ii)(B)(1)(ii), the disqualified basis in Asset A is reduced by $20x, the loss of CFC2 that is attributable to disqualified basis under paragraph (c)(5)(ii) of this section. Accordingly, under paragraph (c)(5)(i) of this section, any deduction or loss of CFC3 attributable to the remaining $52x of disqualified basis in Asset A is allocated and apportioned solely to residual CFC gross income of CFC3.

(6) Allocation of deductions attributable to disqualified payments – (i) In general. A deduction related directly or indirectly to a disqualified payment is allocated and apportioned solely to residual CFC gross income, and any deduction related to a disqualified payment is not properly allocable to property produced or acquired for resale under section 263, 263A, or 471.

(ii) Definitions. The following definitions apply for purposes of this paragraph (c)(6).

(A) Disqualified payment. The term disqualified payment means a payment made by a person to a related recipient CFC during the disqualified period with respect to the related recipient CFC, to the extent the payment would constitute income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to whether section 951A applies.

(B) Disqualified period. The term disqualified period has the meaning provided in § 1.951A-3(h)(2)(ii)(C)(1), substituting “related recipient CFC” for “transferor CFC.”

(C) Related recipient CFC. The term related recipient CFC means, with respect to a payment by a person, a recipient of the payment that is a controlled foreign corporation that bears a relationship to the payor described in section 267(b) or 707(b) immediately before or after the payment.

(iii) Treatment of partnerships. For purposes of determining whether a payment is made by a person to a related recipient CFC for purposes of paragraph (c)(6)(ii)(A) of this section, a payment by or to a partnership is treated as made proportionately by or to its partners, as applicable.

(iv) Reductions to disqualified payments pursuant to coordination rules. See §§ 1.245A-5(j)(8) and 1.245A-7(b) or § 1.245A-8(b), as applicable, for reductions to disqualified payments resulting from the application of § 1.245A-5.

(v) Examples. The following examples illustrate the application of this paragraph (c)(6).

(A) Example 1: Deduction related directly to disqualified payment to related recipient CFC – (1) Facts. USP, a domestic corporation, owns all of the stock in CFC1 and CFC2, each a controlled foreign corporation. Both USP and CFC2 use the calendar year as their taxable year. CFC1 uses a taxable year ending November 30. On October 15, 2018, before the start of its first CFC inclusion year, CFC1 receives and accrues a payment from CFC2 of $100x of prepaid royalties with respect to a license. The $100x payment is excluded from subpart F income pursuant to section 954(c)(6) and would constitute income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to whether section 951A applies.

(2) Analysis. CFC1 is a related recipient CFC (within the meaning of paragraph (c)(6)(ii)(C) of this section) with respect to the royalty prepayment by CFC2 because it is related to CFC2 within the meaning of section 267(b). The royalty prepayment is received by CFC1 during its disqualified period (within the meaning of paragraph (c)(6)(ii)(B) of this section) because it is received during the period beginning January 1, 2018, and ending November 30, 2018. Because it would constitute income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to whether section 951A applies, the payment is a disqualified payment. Accordingly, CFC2’s deductions related to such payment accrued during taxable years ending on or after April 7, 2020, are allocated and apportioned solely to residual CFC gross income under paragraph (c)(6)(i) of this section.

(B) Example 2: Deduction related indirectly to disqualified payment to partnership in which related recipient CFC is a partner – (1) Facts. The facts are the same as in paragraph (c)(6)(v)(A)(1) of this section (the facts in Example 1), except that CFC1 and USP own 99% and 1%, respectively of FPS, a foreign partnership, which has a taxable year ending November 30. USP receives a prepayment of $110x from CFC2 for the performance of future services. USP subcontracts the performance of these future services to FPS for which FPS receives and accrues a $100x prepayment from USP. The services will be performed in the same country under the laws of which CFC1 and FPS are created or organized, and the $100x prepayment is not foreign base company services income under section 954(e) and § 1.954-4(a). The $100x prepayment would constitute income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to whether section 951A applies.

(2) Analysis. CFC1 is a related recipient CFC (within the meaning of paragraph (c)(6)(ii)(C) of this section) with respect to the services prepayment by USP because, under paragraph (c)(6)(iii) of this section, it is treated as receiving $99x (99% of $100x) of the services prepayment from USP, and it is related to USP within the meaning of section 267(b). The services prepayment is received by CFC1 during its disqualified period (within the meaning of paragraph (c)(6)(ii)(B) of this section) because it is received during the period beginning January 1, 2018, and ending November 30, 2018. Because it would constitute income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to whether section 951A applies, the prepayment is a disqualified payment. In addition, CFC2’s deductions related to its prepayment to USP are indirectly related to the disqualified payment by USP. Accordingly, CFC2’s deductions related to such payment accrued during taxable years ending on or after April 7, 2020 are allocated and apportioned solely to residual CFC gross income under paragraph (c)(6)(i) of this section.

(7) Election to apply high-tax exception of section 954(b)(4) – (i) In general. For purposes of section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section, a tentative gross tested income item of a controlled foreign corporation for a CFC inclusion year qualifies for the exception described in section 954(b)(4) only if –

(A) An election made under paragraph (c)(7)(viii) of this section is effective with respect to the controlled foreign corporation for the CFC inclusion year; and

(B) The tentative tested income item with respect to the tentative gross tested income item was subject to an effective rate of foreign tax, as determined under paragraph (c)(7)(vi) of this section, that is greater than 90 percent of the maximum rate of tax specified in section 11.

(ii) Calculation of tentative gross tested income item – (A) In general. A tentative gross tested income item with respect to a controlled foreign corporation for a CFC inclusion year is the aggregate of all items of gross income of the controlled foreign corporation attributable to a tested unit (as defined in paragraph (c)(7)(iv) of this section) of the controlled foreign corporation in the CFC inclusion year that would be gross tested income without regard to this paragraph (c)(7) and would be in a single tested income group (as defined in § 1.960-1(d)(2)(ii)(C)). A controlled foreign corporation may have multiple tentative gross tested income items. See paragraphs (c)(8)(iii)(A)(2)(i) (Example 1) and (c)(8)(iii)(B)(2)(i) (Example 2) of this section for illustrations of the application of the rule set forth in this paragraph (c)(7)(ii)(A).

(B) Gross income attributable to a tested unit – (1) Items properly reflected on separate set of books and records. Items of gross income of a controlled foreign corporation are attributable to a tested unit of the controlled foreign corporation to the extent they are properly reflected on the separate set of books and records of the tested unit, as modified under paragraph (c)(7)(ii)(B)(2) of this section. Each item of gross income of a controlled foreign corporation is attributable to a tested unit (and not to more than one tested unit) of the controlled foreign corporation. See paragraphs (c)(8)(iii)(D)(2) and (c)(8)(iii)(D)(5) (Example 4) of this section for illustrations of the application of the rule set forth in this paragraph (c)(7)(ii)(B).

(2) Gross income determined under federal income tax principles, as adjusted for disregarded payments. For purposes of paragraph (c)(7)(ii)(B)(1) of this section, gross income must be determined under federal income tax principles, except that the principles of § 1.904-4(f)(2)(vi) apply to adjust gross income of the tested unit, to the extent thereof, to reflect disregarded payments. For purposes of this paragraph (c)(7)(ii)(B)(2), the principles of § 1.904-4(f)(2)(vi) are applied taking into account the rules in paragraphs (c)(7)(ii)(B)(2)(i) through (v) of this section.

(i) The controlled foreign corporation is treated as the foreign branch owner and any other tested units of the controlled foreign corporation are treated as foreign branches.

(ii) The principles of the rules in § 1.904-4(f)(2)(vi)(A) apply in the case of disregarded payments between a foreign branch and another foreign branch without regard to whether either foreign branch makes a disregarded payment to, or receives a disregarded payment from, the foreign branch owner.

(iii) The exclusion for interest and interest equivalents described in § 1.904-4(f)(2)(vi)(C)(1) does not apply to the extent of the amount of a disregarded payment that is deductible in the country of tax residence (or location, in the case of a branch) of the tested unit that is the payor.

(iv) In the case of an amount described in paragraph (c)(7)(ii)(B)(2)(iii) of this section, the rules for determining how a disregarded payment is allocated to gross income of a foreign branch or foreign branch owner in § 1.904-4(f)(2)(vi)(B) are applied by treating the disregarded payment as allocated and apportioned ratably to all of the gross income attributable to the tested unit that is making the disregarded payment. If a tested unit is both a payor and payee of an amount described in paragraph (c)(7)(ii)(B)(2)(iii) of this section, gross income to which the disregarded payments are allocable include gross income allocated to the payor tested unit as a result of the receipt of amounts described in paragraph (c)(7)(ii)(B)(2)(iii) of this section, to the extent thereof. If a tested unit makes and receives payments described in paragraph (c)(7)(ii)(B)(2)(iii) of this section to and from the same tested unit, the payments are netted so that paragraph (c)(7)(ii)(B)(2)(iii) of this section and the principles of § 1.904-4(f)(2)(vi) apply only to the net amount of such payments between the two tested units.

(v) In the case of multiple disregarded payments, in lieu of § 1.904-4(f)(2)(vi)(F), disregarded payments are taken into account under paragraph (c)(7)(ii)(B)(2) of this section and the principles of § 1.904-4(f)(2)(vi) under the rules provided in this paragraph (c)(7)(ii)(B)(2)(v). Adjustments are made with respect to a disregarded payment received by a tested unit before payments made by that tested unit. Except as provided in paragraph (c)(7)(ii)(B)(2)(iv) of this section, if a tested unit both makes and receives disregarded payments, adjustments are first made with respect to disregarded payments that would be definitely related to a single class of gross income under the principles of § 1.861-8; second, adjustments are made with respect to disregarded payments that would be definitely related to multiple classes of gross income under the principles of § 1.861-8, but that are not definitely related to all gross income of the tested unit; third, adjustments are made with respect to disregarded payments (other than interest described in paragraph (c)(7)(ii)(B)(2)(iii) of this section) that would be definitely related to all gross income under the principles of § 1.861-8; and fourth, adjustments are made with respect to interest described in paragraph (c)(7)(ii)(B)(2)(iii) and disregarded payments that would not be definitely related to any gross income under the principles of § 1.861-8.

(iii) Calculation of tentative tested income item – (A) In general. A tentative tested income item with respect to the tentative gross tested income item described in paragraph (c)(7)(ii)(A) of this section is determined by allocating and apportioning deductions for the CFC inclusion year (including expense for current year taxes (as defined in § 1.960-1(b)(4)), and not including any items described in § 1.951A-2(c)(5) or (c)(6)) to the tentative gross tested income item under the principles of § 1.960-1(d)(3) and the rules of § 1.861-20. For purposes of this paragraph (c)(7)(iii), each tentative gross tested income item (if any) is treated as assigned to a separate tested income group, as that term is described in § 1.960-1(d)(2)(ii)(C), and all other income is treated as assigned to a residual income group. For purposes of applying §§ 1.861-9 and 1.861-9T under the principles of § 1.960-1(d)(3), the amount of interest deductions that are allocated and apportioned to the assets (or gross income, in the case of a taxpayer that has elected the modified gross income method) of a lower-tier corporation, such as a corporation the stock of which is owned by the controlled foreign corporation indirectly through the tested unit, are allocated and apportioned to the residual income category and not to any tentative gross tested income item of the controlled foreign corporation. See paragraphs (c)(8)(iii)(A)(2)(iii) (Example 1), (c)(8)(iii)(B)(2)(iv) (Example 2), and (c)(8)(iii)(C)(2)(iv) (Example 3) of this section for illustrations of the application of the rules set forth in this paragraph (c)(7)(iii)(A).

(B) Effect of potential and actual changes in taxes paid or accrued. Except as otherwise provided in this paragraph (c)(7)(iii)(B), the amount of current year taxes paid or accrued by a controlled foreign corporation for purposes of this paragraph (c)(7) does not take into account any potential reduction in foreign income taxes that may occur by reason of a future distribution to shareholders of all or part of such income. However, to the extent the foreign income taxes paid or accrued by the controlled foreign corporation are reasonably certain to be returned to a shareholder by the foreign country imposing such taxes, directly or indirectly, through any means (including, but not limited to, a refund, credit, payment, discharge of an obligation, or any other method) on a subsequent distribution to such shareholder, the foreign income taxes are not treated as paid or accrued for purposes of this paragraph (c)(7). In addition, foreign income taxes that have not been paid or accrued because they are contingent on a future distribution of earnings (or other similar transaction, such as a loan to a shareholder) are not taken into account for purposes of this paragraph (c)(7). If, pursuant to section 905(c) and § 1.905-3, a redetermination of U.S. tax liability is required to account for the effect of a foreign tax redetermination (as defined in § 1.905-3(a)), this paragraph (c)(7) is applied in the adjusted year taking into account the adjusted amount of the redetermined foreign tax.

(iv) Tested unit rules – (A) In general. Subject to the combination rule in paragraph (c)(7)(iv)(C) of this section, the term tested unit means any corporation, interest, or branch described in paragraphs (c)(7)(iv)(A)(1) through (3) of this section. See paragraph (c)(8)(iii)(D) (Example 4) of this section for an example that illustrates the application of the tested unit rules set forth in this paragraph (c)(7)(iv).

(1) A controlled foreign corporation (as defined in section 957(a)).

(2) An interest held directly or indirectly by a controlled foreign corporation in a pass-through entity that is –

(i) A tax resident (as described in § 1.267A-5(a)(23)(i)) of any foreign country; or

(ii) Not treated as fiscally transparent (as determined under the principles of § 1.267A-5(a)(8)) for purposes of the tax law of the foreign country of which the controlled foreign corporation is a tax resident or, in the case of an interest in a pass-through entity held by a controlled foreign corporation indirectly through one or more other tested units, for purposes of the tax law of the foreign country of which the tested unit that directly (or indirectly through the fewest number of transparent interests) owns the interest is a tax resident.

(3) A branch (as described in § 1.267A-5(a)(2)) the activities of which are carried on directly or indirectly (through one or more pass-through entities) by a controlled foreign corporation. However, in the case of a branch that does not give rise to a taxable presence under the tax law of the foreign country where the branch is located, the branch is a tested unit only if, under the tax law of the foreign country of which the controlled foreign corporation is a tax resident (or, if applicable, under the tax law of a foreign country of which the tested unit that directly (or indirectly, through the fewest number of transparent interests) carries on the activities of the branch is a tax resident), an exclusion, exemption, or other similar relief (such as a preferential rate) applies with respect to income attributable to the branch. For purposes of this paragraph (c)(7)(iv)(A)(3), similar relief does not include a credit (for example, a foreign tax credit) against the tax imposed under such tax law. If a controlled foreign corporation carries on directly or indirectly (through one or more pass-through entities) less than all of the activities of a branch (for example, if the activities are carried on indirectly through an interest in a partnership), then the rules in this paragraph apply separately with respect to the portion (or portions, if carried on indirectly through more than one chain of pass-through entities) of the activities carried on by the controlled foreign corporation. See paragraphs (c)(8)(iii)(D)(3) and (c)(8)(iii)(D)(4) (Example 4) of this section for illustrations of the application of the rules set forth in this paragraph (c)(7)(iv)(A)(3).

(B) Items attributable to only one tested unit. For purposes of paragraph (c)(7) of this section, if an item is attributable to more than one tested unit in a tier of tested units, the item is considered attributable only to the lowest-tier tested unit. Thus, for example, if a controlled foreign corporation directly owns a branch tested unit described in paragraph (c)(7)(iv)(A)(3) of this section, and an item of gross income is (under the rules of paragraph (c)(7)(ii)(B) of this section) attributable to both the branch tested unit and the controlled foreign corporation tested unit, then the item is considered attributable only to the branch tested unit.

(C) Combination rule – (1) In general. Except as provided in paragraph (c)(7)(iv)(C)(2) of this section, tested units of a controlled foreign corporation (including the controlled foreign corporation tested unit) are treated as a single tested unit if the tested units are tax residents of, or located in (in the case of a tested unit that is a branch, or a portion of the activities of a branch, that gives rise to a taxable presence under the tax law of a foreign country), the same foreign country. For purposes of this paragraph (c)(7)(iv)(C)(1), in the case of a tested unit that is an interest in a pass-through entity or a portion of the activities of a branch, a reference to the tax residency or location of the tested unit means the tax residency of the entity the interest in which is the tested unit or the location of the branch, as applicable. See paragraphs (c)(8)(iii)(D)(2) and (c)(8)(iii)(D)(5) (Example 4) of this section for illustrations of the application of the rule set forth in this paragraph (c)(7)(iv)(C)(1).

(2) Exception for nontaxed branches. The rule in paragraph (c)(7)(iv)(C)(1) of this section does not apply to a tested unit that is described in paragraph (c)(7)(iv)(A)(3) of this section if the branch described in paragraph (c)(7)(iv)(A)(3) of this section does not give rise to a taxable presence under the tax law of the foreign country where the branch is located. See paragraph (c)(8)(iii)(D)(4) (Example 4) of this section for an illustration of the application of the rule set forth in this paragraph (c)(7)(v)(C)(2).

(3) Effect of combination rule. If, pursuant to paragraph (c)(7)(iv)(C)(1) of this section, tested units are treated as a single tested unit, then, solely for purposes of paragraph (c)(7) of this section, items of gross income attributable to such tested units, and items of deduction and foreign taxes allocated and apportioned to such gross income, are aggregated for purposes of determining the combined tested unit’s tentative gross tested income item, tentative tested income item, and foreign income taxes paid or accrued with respect to such tentative tested income item.

(v) Separate set of books and records – (A) In general. For purposes of this paragraph (c)(7), the term separate set of books and records has the meaning set forth in § 1.989(a)-1(d). In addition, for purposes of this paragraph (c)(7), in the case of a tested unit or a transparent interest that is an interest in a pass-through entity or a portion of the activities of a branch, a reference to the separate set of books and records of the tested unit or the transparent interest means the separate set of books and records of the entity or the branch, as applicable.

(B) Failure to maintain separate set of books and records. If a separate set of books and records is not maintained for a tested unit or transparent interest, the items of gross income, disregarded payments, and any other items required to apply paragraph (c)(7) of this section that would be reflected on a separate set of books and records of the tested unit or transparent interest must be determined. Such items are treated as properly reflected on the separate set of books and records of the tested unit or transparent interest for purposes of applying paragraph (c)(7) of this section.

(C) Transparent interests. If a tested unit of a controlled foreign corporation or an entity an interest in which is a tested unit of a controlled foreign corporation holds a transparent interest, either directly or indirectly through one or more other transparent interests, then, for purposes of paragraph (c)(7) of this section (and subject to the rule of paragraph (c)(7)(iv)(C) of this section), items of the controlled foreign corporation properly reflected on the separate set of books and records of the transparent interest are treated as being properly reflected on the separate set of books and records of the tested unit, as modified under paragraph (c)(7)(ii)(B)(2) of this section. See paragraph (c)(8)(iii)(D)(6) (Example 4) of this section for an illustration of the application of the rule set forth in this paragraph (c)(7)(v)(C).

(D) Items not taken into account for financial accounting purposes. For purposes of this paragraph (c)(7), an item of gross income in a CFC inclusion year that is not taken into account in such year for financial accounting purposes, and therefore not properly reflected on a separate set of books and records of a tested unit or a transparent interest, or an entity an interest in which is a tested unit or a transparent interest, is treated as properly reflected on a separate set of books and records to the extent it would have been so reflected if the item were taken into account for financial accounting purposes in such CFC inclusion year.

(vi) Effective rate at which foreign taxes are imposed. For a CFC inclusion year of a controlled foreign corporation, the effective rate of foreign tax with respect to the tentative tested income items of the controlled foreign corporation is determined separately for each such item. See paragraphs (c)(8)(iii)(A)(2)(v) (Example 1), (c)(8)(iii)(B)(2)(vi) (Example 2), and (c)(8)(iii)(C)(2)(vi) (Example 3) of this section for illustrations of the application of the rules set forth in this paragraph (c)(7)(vi). The effective rate at which foreign income taxes are imposed on a tentative tested income item is –

(A) The U.S. dollar amount of foreign income taxes paid or accrued with respect to the tentative tested income item, determined by applying paragraph (c)(7)(vii) of this section; divided by

(B) The U.S. dollar amount of the tentative tested income item, increased by the amount of foreign income taxes referred to in paragraph (c)(7)(vi)(A) of this section.

(vii) Foreign income taxes paid or accrued with respect to a tentative tested income item. For a CFC inclusion year, the amount of foreign income taxes paid or accrued by a controlled foreign corporation with respect to a tentative tested income item of the controlled foreign corporation for purposes of this paragraph (c)(7) is the U.S. dollar amount of the controlled foreign corporation’s eligible current year taxes (as defined in § 1.960-1(b)(5)) that are allocated and apportioned to the related tentative gross tested income item under the rules of paragraph (c)(7)(iii) of this section. See paragraphs (c)(8)(iii)(A)(2)(iv) (Example 1), (c)(8)(iii)(B)(2)(v) (Example 2), and (c)(8)(iii)(C)(2)(v) (Example 3) of this section for illustrations of the application of the rule set forth in this paragraph (c)(7)(vii).

(viii) Rules regarding the high-tax election – (A) Manner – (1) An election is made under this paragraph (c)(7)(viii) by the controlling domestic shareholders (as defined in § 1.964-1(c)(5)) with respect to a controlled foreign corporation for a CFC inclusion year (a high-tax election) in accordance with the rules provided in forms or instructions and by –

(i) Filing the statement required under § 1.964-1(c)(3)(ii) with a timely filed original federal income tax return, or with an amended federal income tax return in accordance with paragraph (c)(7)(viii)(A)(2) of this section, for the U.S. shareholder inclusion year of each controlling domestic shareholder in which or with which such CFC inclusion year ends;

(ii) Providing any notices required under § 1.964-1(c)(3)(iii); and

(iii) Providing any additional information required by applicable administrative pronouncements.

(2) In the case of an election (or revocation) made with an amended federal income tax return –

(i) The election (or revocation) must be made on an amended federal income tax return duly filed within 24 months of the unextended due date of the original federal income tax return for the U.S. shareholder inclusion year with or within which the CFC inclusion year ends;

(ii) Each United States shareholder that owns within the meaning of section 958(a) (including both domestic partnerships that are United States shareholders that own stock within the meaning of section 958(a) without regard to § 1.951A-1(e)(1) and partners of a domestic partnership that are United States shareholders that are treated as owning stock withing the meaning of section 958(a) by reason of § 1.951A-1(e)(1)) stock of the controlled foreign corporation as of the end of the CFC’s taxable year to which the election relates must file amended Federal income tax returns (or timely original federal income tax returns if a return has not yet been filed) reflecting the effect of such election (or revocation) for the U.S. shareholder inclusion year with or within which the CFC inclusion year ends as well as for any other taxable year in which the U.S. tax liability of the United States shareholder would be increased by reason of the election (or revocation) (or in the case of a partnership if any item reported by the partnership or any partnership-related item would change as a result of the election (or revocation)) within a single period no greater than six months within the 24-month period described in paragraph (c)(7)(viii)(A)(2)(i) of this section; and

(iii) Each United States shareholder in the controlled foreign corporation as of the end of the controlled foreign corporation’s taxable year to which the election relates must pay any tax due as a result of such adjustments within a single period no greater than six months within the 24-month period described in paragraph (c)(7)(viii)(A)(2)(i) of this section.

(3) In the case of a United States shareholder that is a partnership, paragraphs (c)(7)(viii)(A)(1) and (2) and (c)(7)(viii)(C) of this section are applied by substituting “Form 1065 (or successor form)” for “federal income tax return” and by substituting “amended Form 1065 (or successor form) or administrative adjustment request (as described in § 301.6227-1), as applicable,” for “amended federal income tax return”, each place that it appears.

(4) A United States shareholder that is a partner in a partnership that is also a United States shareholder in the controlled foreign corporation must generally file an amended return, as required under paragraph (c)(7)(viii)(A)(2)(ii) of this section, and must generally pay any additional tax owed as required under paragraph (c)(7)(viii)(A)(2)(iii) of this section. However, in the case of a United States shareholder that is a partner in a partnership that duly files an administrative adjustment request under paragraph (c)(7)(viii)(A)(2) of this section, the partner is treated as having satisfied the requirements of paragraphs (c)(7)(viii)(A)(2)(ii) and (iii) of this section with respect to the interest held through that partnership if:

(i) The partnership timely files an administrative adjustment request described in paragraph (c)(7)(viii)(A)(2)(i) or (ii) of this section, as applicable; and,

(ii) Both the partnership and its partners timely comply with the requirements of section 6227 with respect to the administrative adjustment request. See §§ 301.6227-1 through -3 for rules relating to administrative adjustment requests.

(B) Scope. A high-tax election applies with respect to each tentative gross tested income item of the controlled foreign corporation for the CFC inclusion year and is binding on all United States shareholders of the controlled foreign corporation.

(C) Revocation. A high-tax election may be revoked by the controlling domestic shareholders of the controlled foreign corporation in the same manner as prescribed for an election made on an amended return as described in paragraph (c)(7)(viii)(A) of this section.

(D) Failure to satisfy election requirements. A high-tax election (or revocation) is valid only if all of the requirements in paragraph (c)(7)(viii)(A) of this section, including the requirement to provide notice under paragraph (c)(7)(viii)(A)(1)(ii) of this section, are satisfied.

(E) Rules applicable to CFC groups – (1) In general. In the case of a controlled foreign corporation that is a member of a CFC group, a high-tax election is made under paragraph (c)(7)(viii)(A) of this section, or revoked under paragraph (c)(7)(viii)(C) of this section, with respect to all controlled foreign corporations that are members of the CFC group and the rules in paragraphs (c)(7)(viii)(A) through (D) of this section apply by reference to the CFC group.

(2) Determination of the CFC group – (i) Definition. Subject to the rules in paragraphs (c)(7)(viii)(E)(2)(ii) and (iii) of this section, the term CFC group means an affiliated group as defined in section 1504(a) without regard to section 1504(b)(1) through (6), except that section 1504(a) is applied by substituting “more than 50 percent” for “at least 80 percent” each place it appears, and section 1504(a)(2)(A) is applied by substituting “or” for “and.” For purposes of this paragraph (c)(7)(viii)(E)(2)(i), stock ownership is determined by applying the constructive ownership rules of section 318(a), other than section 318(a)(3)(A) and (B), by applying section 318(a)(4) only to options (as defined in § 1.1504-4(d)) that are reasonably certain to be exercised as described in § 1.1504-4(g), and by substituting in section 318(a)(2)(C) “5 percent” for “50 percent.

(ii) Member of a CFC group. The determination of whether a controlled foreign corporation is included in a CFC group is made as of the close of the CFC inclusion year of the controlled foreign corporation that ends with or within the taxable years of the controlling domestic shareholders. One or more controlled foreign corporations are members of a CFC group if the requirements of paragraph (c)(7)(viii)(E)(2) of this section are satisfied as of the end of the CFC inclusion year of at least one of the controlled foreign corporations, even if the requirements are not satisfied as of the end of the CFC inclusion year of all controlled foreign corporations. If the controlling domestic shareholders do not have the same taxable year, the determination of whether a controlled foreign corporation is a member of a CFC group is made with respect to the CFC inclusion year that ends with or within the taxable year of the majority of the controlling domestic shareholders (determined based on voting power) or, if no such majority taxable year exists, the calendar year. See paragraph (c)(8)(iii)(E) (Example 5) of this section for an example that illustrates the application of the rule set forth in this paragraph (c)(7)(viii)(E)(2)(ii). Notwithstanding the rule set forth in this paragraph (c)(7)(viii)(E)(2)(ii), a controlled foreign corporation is not a member of a CFC group if, as of the close of its CFC inclusion year, the controlled foreign corporation does not have a controlling domestic shareholder.

(iii) Controlled foreign corporations included in only one CFC group. A controlled foreign corporation cannot be a member of more than one CFC group. If a controlled foreign corporation would be a member of more than one CFC group under paragraph (c)(7)(viii)(E)(2) of this section, then ownership of stock of the controlled foreign corporation is determined by applying paragraph (c)(7)(viii)(E)(2) of this section without regard to section 1504(a)(2)(B) or, if applicable, by reference to the ownership existing as of the end of the first CFC inclusion year of a controlled foreign corporations that would cause a CFC group to exist.

(ix) Definitions. The following definitions apply for purposes of this paragraph (c)(7).

(A) Indirectly. The term indirectly, when used in reference to ownership, means ownership through one or more pass-through entities.

(B) Pass-through entity. The term pass-through entity means a partnership, a disregarded entity, or any other person (whether domestic or foreign) other than a corporation to the extent that income, gain, deduction or loss of the person is taken into account in determining the income or loss of a controlled foreign corporation that owns, directly or indirectly, interests in the person.

(C) Transparent interest. The term transparent interest means an interest in a pass-through entity (or the activities of a branch) that is not a tested unit.

(8) Examples – (i) Scope. This paragraph (c)(8) provides examples illustrating the application of the rules in paragraph (c)(7) of this section.

(ii) Presumed facts. For purposes of the examples in paragraph (c)(8)(iii) of this section, except as otherwise stated, the following facts are presumed:

(A) USP is a domestic corporation.

(B) CFC1X and CFC2X are controlled foreign corporations organized in, and tax residents of, Country X.

(D) FDEX is a disregarded entity that is a tax resident of Country X.

(E) FDE1Y and FDE2Y are disregarded entities that are tax residents of Country Y.

(F) FPSY is an entity that is organized in, and a tax resident of, Country Y but is classified as a partnership for federal income tax purposes.

(G) CFC1X, CFC2X, CFC3Z, and the interests in FDEX, FDE1Y, FDE2Y, and FPSY are tested units (the CFC1X tested unit, CFC2X tested unit, CFC3Z tested unit, FDEX tested unit, FDE1Y tested unit, FDE2Y tested unit, and FPSY tested unit, respectively).

(H) CFC1X, CFC2X, CFC3Z, FDEX, FDE1Y, and FDE2Y conduct activities in the foreign country in which they are tax resident, and properly reflect items of income, gain, deduction, and loss on separate sets of books and records.

(I) All entities have calendar taxable years (for both federal income tax purposes and for purposes of the relevant foreign country) and use the Euro (€) as their functional currency. At all relevant times €1 = $1.

(J) The maximum rate of tax specified in section 11 for the CFC inclusion year is 21 percent.

(K) Neither CFC1X, CFC2X, nor CFC3Z directly or indirectly earns income described in section 952(b), has any items of income, gain, deduction, or loss, or makes or receives disregarded payments. In addition, no tested unit of CFC1X, CFC2X, or CFC3Z makes or receives disregarded payments.

(L) An election made under section 954(b)(4) and paragraph (c)(7)(viii) of this section is effective with respect to CFC1X and CFC2X, as applicable, for the CFC inclusion year.

(M) The same amounts of regarded items of income and deduction that are accrued under federal income tax law are also accrued under foreign law.

(iii) Examples – (A) Example 1: Effect of disregarded interest – (1) Facts – (i) Ownership. USP owns all of the stock of CFC1X, and CFC1X owns all of the interests of FDE1Y.

(ii) Gross income and deductions (other than for foreign income taxes). In Year 1, CFC1X generates €100x of gross income from services to unrelated parties that would be gross tested income without regard to paragraph (c)(7) of this section and that is properly reflected on the books and records of FDE1Y. The €100x of services income is general category income under § 1.904-4(d). In Year 1, FDE1Y accrues and pays €20x of interest to CFC1X that is deductible for Country Y tax purposes but is disregarded for federal income tax purposes. The €20x of disregarded interest income received by CFC1X from FDE1Y is properly reflected on CFC1X’s books and records, and the €20x of disregarded interest expense paid from FDE1Y to CFC1X is properly reflected on FDE1Y’s books and records.

(iii) Foreign income taxes. Country X imposes no tax on net income, and Country Y imposes a 25% tax on net income. For Country Y tax purposes, FDE1Y (which is not disregarded under Country Y tax law) has €80x of taxable income (€100x of services income from the unrelated parties, less a €20x deduction for the interest paid to CFC1X). Accordingly, FDE1Y incurs a Country Y income tax liability with respect to Year 1 of €20x (€80x x 25%), the U.S. dollar amount of which is $20x.

(2) Analysis – (i) Tentative gross tested income items. Under paragraph (c)(7)(ii)(A) of this section, the tentative gross tested income item with respect to each of the CFC1X tested unit and the FDE1Y tested unit is the aggregate of the gross income of CFC1X that is attributable to the tested unit, that would be gross tested income (without regard to this paragraph (c)(7)), and that would be in a single tested income group. Under paragraphs (c)(7)(ii)(B)(1) and (2) of this section, items of gross income of CFC1X are attributable to the CFC1X tested unit, or the FDE1Y tested unit, to the extent properly reflected on its separate set of books and records, as determined under federal income tax principles and adjusted to take into account disregarded payments. Without regard to the €20x disregarded interest payment from FDE1Y to CFC1X, gross income attributable to the CFC1X tested unit would be €0 (that is, the €20x of interest income reflected on the books and records of CFC1X would be reduced by €20x, the amount attributable to the payment that is disregarded for federal income tax purposes). Similarly, without regard to the €20x disregarded interest payment from FDE1Y to CFC1X, gross income attributable to the FDE1Y tested unit would be €100x (that is, €100x of services income reflected on the books and records of FDE1Y, unreduced by the €20x disregarded interest payment from FDE1Y to CFC1X). However, under paragraph (c)(7)(ii)(B)(2) of this section, the gross income attributable to each of the CFC1X tested unit and the FDE1Y tested unit is adjusted by €20x, the amount of the disregarded interest payment from FDE1Y to CFC1X that is deductible for Country Y tax purposes. Accordingly, the tentative gross tested income item attributable to the CFC1X tested unit (the “CFC1X tentative gross tested income item”) is €20x (€0 + €20x), and the tentative gross tested income item attributable to the FDE1Y tested unit (the “FDE1Y tentative gross tested income item”) is €80x (€100x − €20x).

(ii) Foreign income tax deduction. Under paragraph (c)(7)(iii)(A) of this section, CFC1X’s tentative tested income items are computed by treating the CFC1X tentative gross tested income item and the FDE1Y tentative gross tested income item each as income in a separate tested income group (the “CFC1X income group” and the “FDE1Y income group”) and by allocating and apportioning CFC1X’s deductions for current year taxes under § 1.861-20 (CFC1X has no other deductions to allocate and apportion). Under paragraph (c)(7)(iii)(A) of this section and § 1.861-20(d)(3)(v), the €20x deduction for Country Y income taxes is allocated and apportioned solely to the FDE1Y income group (the “FDE1Y group tax”) and none of the Country Y taxes are allocated and apportioned to the CFC1X income group.

(iii) Tentative tested income items. Under paragraph (c)(7)(iii) of this section, the tentative tested income item with respect to the CFC1X income group (the “CFC1X tentative tested item”), is €20x. The tentative tested income item with respect to the FDE1Y income group (the “CFC1X tentative tested item”) is €60x (the FDE1Y tentative gross tested income item of €80x, less the €20x deduction for the FDE1Y group tax).

(iv) Foreign income tax paid or accrued with respect to a tentative tested income item. Under paragraph (c)(7)(vii) of this section, the foreign income taxes paid or accrued with respect to a tentative tested income item is the U.S. dollar amount of the eligible current year taxes that are allocated and apportioned to the related tentative gross tested income item under the rules of paragraph (c)(7)(iii) of this section. Therefore, the foreign income taxes paid or accrued with respect to the FDE1Y tentative tested income item is $20x, the U.S. dollar amount of the FDE1Y group tax. The foreign income tax paid or accrued with respect to the CFC1X tentative tested income item is $0, the U.S. dollar amount of the foreign tax allocated and apportioned to the CFC1X tentative gross tested income item under paragraph (c)(7)(iii) of this section.

(v) Effective foreign tax rate. The effective foreign tax rate is determined under paragraph (c)(7)(vi) of this section by dividing the U.S. dollar amount of foreign income taxes paid or accrued with respect to each respective tentative tested income item by the U.S. dollar amount of the tentative tested income item increased by the U.S. dollar amount of the relevant foreign income taxes. Therefore, the effective foreign tax rate with respect to the FDE1Y tentative tested income item is 25%, computed by dividing $20x (the U.S. dollar amount of the foreign income taxes paid or accrued with respect to the FDE1Y tentative tested income item under paragraph (c)(7)(vii) of this section) by $80x (the sum of $60x, the U.S. dollar amount of the FDE1Y tentative tested income item, and $20x, the U.S. dollar amount of the foreign income taxes paid or accrued with respect to the FDE1Y tentative tested income item). The CFC1X tentative tested income item is not subject to any foreign income tax, so is subject to an effective foreign tax rate of 0%, calculated as $0 (the U.S. dollar amount of the foreign income taxes paid or accrued with respect to the CFC1X tentative tested income item) divided by $20x (the U.S. dollar amount of the CFC1X tentative tested income item).

(vi) Gross income items excluded under sections 954(b)(4) and 951A(c)(2)(A)(i)(III). The FDE1Y tentative tested income item is subject to an effective foreign tax rate (25%) that is greater than 18.9% (90% of the maximum rate of tax specified in section 11). Therefore, the requirement of paragraph (c)(7)(i)(B) of this section is satisfied, and the FDE1Y tentative gross tested income item qualifies under paragraph (c)(7)(i) of this section for the high-tax exception of section 954(b)(4) and is excluded from tested income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(iii) of this section. The CFC1X tentative tested income item is subject to an effective foreign tax rate of 0%. Therefore, the CFC1X tentative tested income item does not satisfy the requirement of paragraph (c)(7)(i)(B) of this section, and the CFC1X tentative gross tested income item does not qualify under paragraph (c)(7)(i) of this section for the high-tax exception of section 954(b)(4) and is not excluded from tested income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(iii) of this section.

(B) [Reserved]

(C) Example 3: Interest expense allocated and apportioned with respect to the income of a lower-tier CFC – (1) Facts – (i) Ownership. USP owns all of the stock of CFC1X. CFC1X directly owns all the interests of FDE1Y. FDE1Y owns all of the stock of CFC3Z. Pursuant to § 1.861-9(j) and § 1.861-9T(j), CFC1X uses the modified gross income method to allocate and apportion its interest expense.

(ii) Gross income and deductions (including for foreign income taxes). During Year 1, CFC1X generates €4,000x of gross income from services that would be gross tested income without regard to paragraph (c)(7) of this section, €3,000x of which is properly reflected on the books and records of the CFC1X tested unit and €1,000x of which is properly reflected on the books and records of the FDE1Y tested unit. CFC1X also accrues €1,000x of interest expense to an unrelated person. Country X imposes €200x of income taxes with respect to the €3,000x of gross income properly reflected on the books and records of the CFC1X tested unit, and Country Y imposes €200x of income taxes with respect to the €1,000x of gross income properly reflected on the books and records of the FDE1Y tested unit. CFC3Z generates €1,000x of gross income from services that would be gross tested income without regard to paragraph (c)(7) of this section, and such gross income is properly reflected on the books and records of the CFC3Z tested unit. CFC3Z accrues no expenses, and Country Z imposes €100x of income taxes with respect to the €1,000x of gross income generated by CFC3Z.

(2) Analysis – (i) Tentative gross tested income items. Under paragraph (c)(7)(ii) of this section, the €3,000x of gross income that is reflected on the books and records of the CFC1X tested unit, and the €1,000x of gross income that is reflected on the books and records of the FDE1Y tested unit, are attributable to the CFC1X tested unit and the FDE1Y tested unit, respectively. Under paragraph (c)(7)(ii) of this section, each of these amounts is a separate tentative gross tested income item of CFC1X (the “CFC1X tentative gross tested income item” and the “FDE1Y tentative gross tested income item,” respectively). Under paragraph (c)(7)(ii) of this section, the €1,000x item of tentative gross tested income that is properly reflected on the books and records of the CFC3Z tested unit is attributable to the CFC3Z tested unit. Under paragraph (c)(7)(ii) of this section, the amount attributable to the CFC3Z tested unit is a tentative gross tested income item of CFC3Z (the “CFC3Z tentative gross tested income item”).

(ii) Allocation and apportionment of interest expense. To compute CFC1X’s tentative tested income items, the principles of § 1.960-1(d)(3) apply by treating each of CFC1X’s tentative gross tested income items as income in a separate tested income group (the “CFC1X income group” and the “FDE1Y income group”) and allocate and apportion its deductions among those income groups under federal income tax principles. Because CFC1X uses the modified gross income method under § 1.861-9(j) and § 1.861-9T(j) to allocate and apportion interest expense, it must allocate and apportion its interest expense between the CFC1X income group and the FDE1Y income group based on a combined gross income amount that includes both the gross income of CFC1X (including the gross income attributable to both the CFC1X tested unit and the FDE1Y tested unit) and the gross income of CFC3Z, adjusted as provided under § 1.861-9(j) and § 1.861-9T(j). Under § 1.861-9(j) and § 1.861-9T(j), the adjusted combined gross income of CFC1X comprises the CFC1X tentative gross tested income item (€3,000x), or 60% of the combined adjusted gross income amount, the FDE1Y tentative gross tested income item (€1,000x), or 20% of the combined adjusted gross income amount, and the CFC3Z gross tentative tested income item (€1,000x), or 20% of the combined adjusted gross income amount. Under paragraph (c)(7)(iii) of this section, interest expense of CFC1X that is allocated and apportioned to the gross income of CFC3Z under § 1.861-9(j) and § 1.861-9T(j) is not allocated and apportioned to either the CFC1X income group or the FDE1Y income group. Therefore, €600x of interest expense (60% of the €1,000x of interest expense) is allocated and apportioned to the CFC1X income group, and €200x of interest expense (20% of the €1,000x of interest expense) is allocated and apportioned to the FDE1Y income group. The €200x of interest expense that is allocated and apportioned to the €1,000x of gross tentative tested income of CFC3Z is allocated and apportioned to the residual income group for purposes of paragraph (c)(7) of this section, but can still be allocated and apportioned to a statutory grouping of tested income of CFC1X for purposes of paragraph (c)(3) of this section. See paragraph (c)(7)(iii) of this section.

(iii) Foreign income tax deduction. Under paragraph (c)(7)(iii) of this section, deductions for foreign income taxes paid or accrued by CFC1X are allocated and apportioned under § 1.861-20 to the CFC1X income group and the FDE1Y income group. Similarly, foreign income taxes paid or accrued by CFC3Z are allocated and apportioned under § 1.861-20 to the tentative gross tested income item of CFC3Z (the “CFC3Z income group”). Under § 1.861-20, €200x of Country X income taxes are allocated and apportioned to the CFC1X income group (the “CFC1X group tax”), the €200x of Country Y income taxes are allocated and apportioned to the FDE1Y income group (the “FDE1Y group tax”), and the €100x of Country Z income taxes are allocated and apportioned to the CFC3Z income group (the “CFC3Z group tax”).

(iv) Tentative tested income items. After the allocation and apportionment of deductions to reduce the tentative gross tested income in each income group, under paragraph (c)(7)(iii) of this section, CFC1X has a tentative tested income item with respect to the CFC1X tested unit of €2,200x (€3,000x, less €600x of interest expense and €200x of foreign income tax expense, the “CFC1X tentative tested income item”) and a tentative tested income item with respect to the FDE1Y tested unit of €600x (€1,000x, less €200x of interest expense and €200x of foreign income tax expense, the “FDE1Y tentative tested income item”). CFC3Z has a tentative tested income item of €900x (€1,000x, less €100x of foreign income tax expense, the “CFC3Z tentative tested income item”).

(v) Foreign income taxes paid or accrued with respect to a tentative tested income item. Under paragraph (c)(7)(vii) of this section, the foreign income taxes paid or accrued with respect to a tentative tested income item is the U.S. dollar amount of the eligible current year taxes that are allocated and apportioned to the related tentative gross tested income item under the rules of paragraph (c)(7)(iii) of this section. Therefore, the foreign income tax paid or accrued with respect to the CFC1X tentative tested income item is $200x, the U.S. dollar amount of the CFC1X group tax. Similarly, the foreign income tax paid or accrued with respect to the FDE1Y tentative tested income item is $200x, the U.S. dollar amount of the FDE1Y group tax, and the foreign income tax paid or accrued with respect to the CFC3Z tentative tested income item is $100x, the U.S. dollar amount of the CFC3Z group tax.

(vi) Effective foreign tax rate. The effective foreign tax rate is determined under paragraph (c)(7)(vi) of this section by dividing the U.S. dollar amount of foreign income taxes paid or accrued with respect to each respective tentative tested income item by the U.S. dollar amount of the tentative tested income item increased by the U.S. dollar amount of the relevant foreign income taxes. Therefore, the effective foreign tax rate for the CFC1X tentative tested income item is 8.3%, computed by dividing $200x (the U.S. dollar amount of the foreign income taxes paid or accrued with respect to the CFC1X tentative tested income item), by $2,400x (the sum of $2,200x, the U.S. dollar amount of the CFC1X tentative tested income item and $200x, the U.S. dollar amount of the foreign taxes paid or accrued with respect to the CFC1X tentative tested income item). The effective foreign tax rate for the FDE1Y tentative tested income item is 25%, computed by dividing $200x (the U.S. dollar amount of the foreign taxes paid or accrued with respect to the FDE1Y tentative tested income item) by $800x (the sum of $600x, the U.S. dollar amount of the FDE1Y tentative tested income item, and $200x, the U.S. dollar amount of the foreign taxes paid or accrued with respect to the FDE1Y tentative tested income item). The effective foreign tax rate for the CFC3Z tentative tested income item is 10%, computed by dividing $100x (the U.S. dollar amount of the foreign taxes paid or accrued with respect to the CFC3Z tentative tested income item) by $1,000x (the sum of $900x, the U.S. dollar amount of the CFC3Z tentative tested income item, and $100x, the U.S. dollar amount of the foreign taxes paid or accrued with respect to the CFC3Z tentative tested income item).

(vii) Gross income items excluded under sections 954(b)(4) and 951A(c)(2)(A)(i)(III). The FDE1Y tentative tested income item is subject to tax at an effective foreign tax rate (25%) that is greater than 18.9% (90% of the maximum rate of tax specified in section 11). Therefore, the requirement of paragraph (c)(7)(i)(B) of this section is satisfied, and the FDE1Y tentative gross tested income item qualifies under paragraph (c)(7)(i) of this section for the high-tax exception of section 954(b)(4) and is excluded from tested income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(iii) of this section. In computing the tested income of CFC1X under paragraph (c)(3) of this section, the deductions of CFC1X that were allocated and apportioned to the FDE1Y tentative gross tested income item (that is, the €200x of interest expense and the €200x of FDE1Y group taxes) are allocated and apportioned to this item of tentative gross tested income. As a result, the €1,000x of tentative gross tested income excluded from tested income under section 954(b)(4), as well as the €200x of interest expense and €200x of foreign tax expense allocable to that gross income, are allocated and apportioned to the residual category under paragraph (c)(3) of this section for purposes of determining the tested income of CFC1X. Under § 1.960-1(d)(3), the $200x of foreign income taxes allocated and apportioned to the excluded gross income would also be assigned to the residual income group for purposes of determining CFC1X’s tested taxes for purposes of section 960(d). The CFC1X tentative tested income item and CFC3Z tentative tested income item each have effective foreign tax rates (8.3% and 10%, respectively) that are not greater than 90% of the maximum rate of tax specified in section 11. Therefore, the CFC1X tentative gross tested income item and the CFC3Z tentative gross tested income item do not qualify under paragraph (c)(7)(i) of this section for the high-tax exception of section 954(b)(4), and are not excluded from tested income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(i) of this section. Under paragraph (c)(3) of this section, the corresponding deductions are allocated and apportioned to that gross tested income in a manner that achieves a result that is consistent the result of the allocation and apportionment of those deductions under paragraph (c)(7) of this section. Accordingly, because CFC3Z’s tentative gross tested income is not excluded from gross tested income under sections 951A(c)(2)(A)(i)(IIII) and 954(b)(4) and paragraph (c)(1)(i) of this section, under paragraph (c)(3) of this section the €200x of CFC1X’s interest expense that was apportioned to tentative gross tested income of CFC3Z under the modified gross income method in § 1.861-9 is allocated and apportioned to gross tested income of CFC1X and therefore reduces CFC1X’s tested income. In contrast, if the CFC3Z tentative gross tested item had been excluded from gross tested income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(i) of this section, then the €200x of CFC1X’s interest expense that was allocated and apportioned to that income would be assigned to the residual category.

(D) Example 4: Application of tested unit rules – (1) Facts – (i) Ownership. USP owns all of the stock of CFC1X. CFC1X directly owns all the interests of FDEX and FDE1Y. In addition, CFC1X directly carries on activities in Country Y that constitute a branch (as described in § 1.267A-5(a)(2)) and that give rise to a taxable presence under Country Y tax law and Country X tax law (such branch, “FBY”).

(ii) Items reflected on books and records. For the CFC inclusion year, CFC1X had a €20x item of gross income (Item A), which is properly reflected on the books and records of FBY, and a €30x item of gross income (Item B), which is properly reflected on the books and records of FDEX.

(2) Analysis – (i) Identifying the tested units of CFC1X. Without regard to the combination rule of paragraph (c)(7)(iv)(C) of this section, CFC1X, CFC1X’s interest in FDEX, CFC1X’s interest in FDE1Y, and FBY would each be a tested unit of CFC1X. See paragraph (c)(7)(iv)(A) of this section. Pursuant to the combination rule, however, the FDE1Y tested unit is combined with the FBY tested unit and treated as a single tested unit because FDE1Y is a tax resident of Country Y, the same country in which FBY is located (the “Country Y tested unit”). See paragraph (c)(7)(iv)(C)(1) of this section. The CFC1X tested unit (without regard to any items attributable to the FDEX, FDE1Y, or FBY tested units) is also combined with the FDEX tested unit and treated as a single tested unit because CFC1X and FDEX are both tax residents of County X (the “Country X tested unit”). See paragraph (c)(7)(iv)(C)(1) of this section.

(ii) Computing the items of CFC1X. Under paragraph (c)(7)(ii)(A) of this section, a tentative gross tested income item is determined with respect to each of the Country Y tested unit and the Country X tested unit. To determine the tentative gross tested income item of each tested unit, the item of gross income that is attributable to the tested unit is determined under paragraph (c)(7)(ii)(B) of this section. Under paragraph (c)(7)(ii)(B) of this section, only Item A is attributable to the Country Y tested unit. Item A is not attributable to the Country X tested unit because it is not reflected on the separate set of books and records of the CFC1X tested unit or the FDEX tested unit, and an item of gross income is only attributable to one tested unit. See paragraph (c)(7)(ii)(B)(1) of this section. Under paragraph (c)(7)(ii)(B) of this section, only Item B is attributable to the Country X tested unit.

(3) Alternative facts – branch does not give rise to a taxable presence in country where located – (i) Facts. The facts are the same as in paragraph (c)(8)(iii)(D)(1) of this section (the original facts in this Example 4), except that FBY does not give rise to a taxable presence under Country Y tax law; moreover, Country X tax law does not provide an exclusion, exemption, or other similar relief with respect to income attributable to FBY.

(ii) Analysis. FBY is not a tested unit but is a transparent interest. See paragraphs (c)(7)(iv)(A)(3) and (c)(7)(ix)(C) of this section. CFC1X has a tested unit in Country X that includes the CFC1X tested unit (without regard to any items related to the interest in FDEX or FDE1Y, but that includes FBY since it is a transparent interest and not a tested unit) and the interest in FDEX. See paragraph (c)(7)(iv)(C) of this section. CFC1X has another tested unit in Country Y, the interest in FDE1Y.

(4) Alternative facts – branch is a tested unit but is not combined – (i) Facts. The facts are the same as in paragraph (c)(8)(iii)(D)(1) of this section (the original facts in this Example 4), except that FBY does not give rise to a taxable presence under Country Y tax law but Country X tax law provides an exclusion, exemption, or other similar relief (such as a preferential rate) with respect to income attributable to FBY.

(ii) Analysis. FBY is a tested unit. See paragraph (c)(7)(iv)(A)(3) of this section. CFC1X has two tested units in Country Y, the interest in FDE1Y and FBY. The interest in FDE1Y and FBY tested units are not combined because FBY does not give rise to a taxable presence under the tax law of Country Y. See paragraph (c)(7)(iv)(C)(2) of this section. CFC1X also has a tested unit in Country X that includes the activities of CFC1X (without regard to any items related to the interest in FDEX, the interest in FDE1Y, or FBY) and the interest in FDEX.

(5) Alternative facts – split ownership of tested unit – (i) Facts. The facts are the same as in paragraph (c)(8)(iii)(D)(1) of this section (the original facts in this Example 4), except that USP also owns CFC2X, CFC1X does not own FDE1Y, and CFC1X and CFC2X own 60% and 40%, respectively, of the interests of FPSY.

(ii) Analysis for CFC1X. Under paragraph (c)(7)(iv)(C)(1) of this section, FBY and CFC1X’s 60% interest in FPSY are combined and treated as a single tested unit of CFC1X (“CFC1X’s Country Y tested unit”), and CFC1X’s interest in FDEX and CFC1X’s other activities are combined and treated as a single tested unit of CFC1X (“CFC1X’s Country X tested unit”). CFC1X’s Country Y tested unit is attributed any item of CFC1X that is derived through its interest in FPSY to the extent the item is properly reflected on the books and records of FPSY. See paragraph (c)(7)(ii)(B)(1) of this section.

(iii) Analysis for CFC2X. Under paragraphs (c)(7)(iv)(A)(1) and (c)(7)(iv)(A)(2)(i) of this section, CFC2X and CFC2X’s 40% interest in FPSY are tested units of CFC2X. CFC2X’s interest in FPSY is attributed any item of CFC2X that is derived through FPSY to the extent that it is properly reflected on the books and records of FPSY. See paragraph (c)(7)(ii)(B)(1) of this section.

(iv) Analysis for not combining CFC1X and CFC2X tested units. None of the tested units of CFC1X are combined with the tested units of CFC2X under paragraph (c)(7)(iv)(C)(1) of this section because they are tested units of different controlled foreign corporations, and the combination rule only combines tested units of the same controlled foreign corporation.

(6) Alternative facts – split ownership of transparent interest – (i) Facts. The facts are the same as in paragraph (c)(8)(iii)(D)(1) of this section (the original facts in this Example 4), except that USP also owns CFC2X, CFC1X does not own FDE1Y, and CFC1X and CFC2X own 60% and 40%, respectively, of the interests in FPSY, but FPSY is not a tax resident of any foreign country and is fiscally transparent for Country X tax law purposes.

(ii) Analysis for CFC1X. CFC1X’s interest in FPSY is not a tested unit but is a transparent interest. See paragraphs (c)(7)(iv)(A)(2) and (c)(7)(ix)(C) of this section. Under paragraph (c)(7)(v)(C) of this section, any item of CFC1X that is derived through its interest in FPSY and is properly reflected on the books and records of FPSY is treated as properly reflected on the books and records of CFC1X.

(iii) Analysis for CFC2X. CFC2X’s interest in FPSY is not a tested unit but is a transparent interest. See paragraphs (c)(7)(iv)(A)(2) and (c)(7)(ix)(C) of this section. Under paragraph (c)(7)(v)(C) of this section, any item of CFC2X that is derived through its interest in FPSY and is properly reflected on the books and records of FPSY is treated as properly reflected on the books and records of CFC2X.

(E) Example 5: CFC group – Controlled foreign corporations with different taxable years – (1) Facts. USP owns all the stock of CFC1X and CFC2X. CFC2X has a taxable year ending November 30. On December 15, Year 1, USP sells all the stock of CFC2X to an unrelated party for cash.

(2) Analysis. The determination of whether CFC1X and CFC2X are in a CFC group is made as of the close of their CFC inclusion years that end with or within the taxable year ending December 31, Year 1, the taxable year of USP, the controlling domestic shareholder. See paragraph (c)(7)(viii)(E)(2)(ii) of this section. Under paragraph (c)(7)(viii)(E)(2)(i) of this section, USP directly owns more than 50% of the stock of CFC1X as of December 31, Year 1, the end of CFC1X’s CFC inclusion year. USP also directly owns more than 50% of the stock of CFC2X as of November 30, Year 1, the end of CFC2X’s CFC inclusion year. Therefore, CFC1X and CFC2X are members of a CFC group, and USP must consistently make high-tax elections, or revocations, under paragraph (c)(7)(viii) of this section with respect to CFC1X’s taxable year ending December 31, Year 1, and CFC2X’s taxable year ending November 30, Year 1. This is the case notwithstanding that USP does not directly own more than 50% of the stock of CFC2X as of December 31, Year 1, the end of CFC1X’s CFC inclusion year. See paragraph (c)(7)(viii)(E)(2)(ii) of this section.

[T.D. 9866, 84 FR 29341, June 21, 2019; 84 FR 44694, Aug. 27, 2019, as amended by T.D. 9882, 84 FR 69107, Dec. 17, 2019; T.D. 9902, 85 FR 44638, July 23, 2020; T.D. 9902, 85 FR 64040, Oct. 9, 2020; T.D. 9922, 85 FR 72069, Nov. 12, 2020; T.D. 9934, 85 FR 76975, Dec. 1, 2020; T.D. 9902, 85 FR 79853, Dec. 11, 2020; T.D. 9959, 87 FR 373, Jan. 4, 2022; 87 FR 45020, July 27, 2022]

§ 1.951A-3 Qualified business asset investment.

(a) Scope. This section provides rules for determining the qualified business asset investment of a controlled foreign corporation for purposes of determining a United States shareholder’s deemed tangible income return under § 1.951A-1(c)(3)(ii). Paragraph (b) of this section defines qualified business asset investment. Paragraph (c) of this section defines tangible property and specified tangible property. Paragraph (d) of this section provides rules for determining the portion of tangible property that is specified tangible property when the property is used in the production of both gross tested income and gross income that is not gross tested income. Paragraph (e) of this section provides rules for determining the adjusted basis in specified tangible property. Paragraph (f) of this section provides rules for determining qualified business asset investment of a tested income CFC with a short taxable year. Paragraph (g) of this section provides rules for increasing the qualified business asset investment of a tested income CFC by reason of property owned by a partnership. Paragraph (h) of this section provides anti-avoidance rules that disregard the basis in property transferred in certain transactions when determining the qualified business asset investment of a tested income CFC.

(b) Qualified business asset investment. The term qualified business asset investment means the average of a tested income CFC’s aggregate adjusted bases as of the close of each quarter of a CFC inclusion year in specified tangible property that is used in a trade or business of the tested income CFC and is of a type with respect to which a deduction is allowable under section 167. In the case of partially depreciable property, only the depreciable portion of the property is of a type with respect to which a deduction is allowable under section 167. A tested loss CFC has no qualified business asset investment.

(c) Specified tangible property – (1) In general. The term specified tangible property means, with respect to a tested income CFC and a CFC inclusion year, tangible property of the tested income CFC used in the production of gross tested income for the CFC inclusion year. For purposes of the preceding sentence, tangible property of a tested income CFC is used in the production of gross tested income for a CFC inclusion year if some or all of the depreciation or cost recovery allowance with respect to the tangible property is either allocated and apportioned to the gross tested income of the tested income CFC for the CFC inclusion year under § 1.951A-2(c)(3) or capitalized to inventory or other property held for sale, some or all of the gross income or loss from the sale of which is taken into account in determining tested income of the tested income CFC for the CFC inclusion year. None of the tangible property of a tested loss CFC is specified tangible property.

(2) Tangible property. The term tangible property means property for which the depreciation deduction provided by section 167(a) is eligible to be determined under section 168 without regard to section 168(f)(1), (2), or (5), section 168(k)(2)(A)(i)(II), (IV), or (V), and the date placed in service.

(d) Dual use property – (1) In general. The amount of the adjusted basis in dual use property of a tested income CFC for a CFC inclusion year that is treated as adjusted basis in specified tangible property for the CFC inclusion year is the average of the tested income CFC’s adjusted basis in the property multiplied by the dual use ratio with respect to the property for the CFC inclusion year.

(2) Definition of dual use property. The term dual use property means, with respect to a tested income CFC and a CFC inclusion year, specified tangible property of the tested income CFC that is used in both the production of gross tested income and the production of gross income that is not gross tested income for the CFC inclusion year. For purposes of the preceding sentence, specified tangible property of a tested income CFC is used in the production of gross tested income and the production of gross income that is not gross tested income for a CFC inclusion year if less than all of the depreciation or cost recovery allowance with respect to the property is either allocated and apportioned to the gross tested income of the tested income CFC for the CFC inclusion year under § 1.951A-2(c)(3) or capitalized to inventory or other property held for sale, the gross income or loss from the sale of which is taken into account in determining the tested income of the tested income CFC for the CFC inclusion year.

(3) Dual use ratio. The term dual use ratio means, with respect to dual use property, a tested income CFC, and a CFC inclusion year, a ratio (expressed as a percentage) calculated as –

(i) The sum of –

(A) The depreciation deduction or cost recovery allowance with respect to the property that is allocated and apportioned to the gross tested income of the tested income CFC for the CFC inclusion year under § 1.951A-2(c)(3), and

(B) The depreciation or cost recovery allowance with respect to the property that is capitalized to inventory or other property held for sale, the gross income or loss from the sale of which is taken into account in determining the tested income of the tested income CFC for the CFC inclusion year, divided by

(ii) The sum of –

(A) The total amount of the tested income CFC’s depreciation deduction or cost recovery allowance with respect to the property for the CFC inclusion year, and

(B) The total amount of the tested income CFC’s depreciation or cost recovery allowance with respect to the property capitalized to inventory or other property held for sale, the gross income or loss from the sale of which is taken into account in determining the income or loss of the tested income CFC for the CFC inclusion year.

(4) Example. The following example illustrates the application of this paragraph (d).

(i) Facts. FS is a tested income CFC and a wholesale distributor of Product A. FS owns a warehouse and trucks that store and deliver Product A, respectively. The warehouse has an average adjusted basis for Year 1 of $20,000x. The depreciation with respect to the warehouse for Year 1 is $2,000x, which is capitalized to inventory of Product A. Of the $2,000x depreciation capitalized to inventory of Product A, $500x is capitalized to FS’s ending inventory of Product A, $1,200x is capitalized to inventory of Product A, the gross income or loss from the sale of which is taken into account in determining FS’s tested income for Year 1, and $300x is capitalized to inventory of Product A, the gross income or loss from the sale of which is taken into account in determining FS’s foreign base company sales income for Year 1. The trucks have an average adjusted basis for Year 1 of $4,000x. FS does not capitalize depreciation with respect to the trucks to inventory or other property held for sale. FS’s depreciation deduction with respect to the trucks is $20x for Year 1, $15x of which is allocated and apportioned to FS’s gross tested income under § 1.951A-2(c)(3).

(ii) Analysis – (A) Dual use property. The warehouse and trucks are property for which the depreciation deduction provided by section 167(a) is eligible to be determined under section 168 (without regard to section 168(f)(1), (2), or (5), section 168(k)(2)(A)(i)(II), (IV), or (V), and the date placed in service). Therefore, under paragraph (c)(2) of this section, the warehouse and trucks are tangible property. Furthermore, because the warehouse and trucks are used in the production of gross tested income in Year 1 within the meaning of paragraph (c)(1) of this section, the warehouse and trucks are specified tangible property. Finally, because the warehouse and trucks are used in both the production of gross tested income and the production of gross income that is not gross tested income in Year 1 within the meaning of paragraph (d)(2) of this section, the warehouse and trucks are dual use property. Therefore, under paragraph (d)(1) of this section, the amount of FS’s adjusted basis in the warehouse and trucks that is treated as adjusted basis in specified tangible property for Year 1 is determined by multiplying FS’s adjusted basis in the warehouse and trucks by FS’s dual use ratio with respect to the warehouse and trucks determined under paragraph (d)(3) of this section.

(B) Depreciation not capitalized to inventory. Because none of the depreciation with respect to the trucks is capitalized to inventory or other property held for sale, FS’s dual use ratio with respect to the trucks is determined entirely by reference the depreciation deduction with respect to the trucks. Therefore, under paragraph (d)(3) of this section, FS’s dual use ratio with respect to the trucks for Year 1 is 75%, which is FS’s depreciation deduction with respect to the trucks that is allocated and apportioned to gross tested income under § 1.951A-2(c)(3) for Year 1 ($15x), divided by the total amount of FS’s depreciation deduction with respect to the trucks for Year 1 ($20x). Accordingly, under paragraph (d)(1) of this section, $3,000x ($4,000x × 0.75) of FS’s average adjusted bases in the trucks is taken into account under paragraph (b) of this section in determining FS’s qualified business asset investment for Year 1.

(C) Depreciation capitalized to inventory. Because all of the depreciation with respect to the warehouse is capitalized to inventory, FS’s dual use ratio with respect to the warehouse is determined entirely by reference to the depreciation with respect to the warehouse that is capitalized to inventory and included in cost of goods sold. Therefore, under paragraph (d)(3) of this section, FS’s dual use ratio with respect to the warehouse for Year 1 is 80%, which is FS’s depreciation with respect to the warehouse that is capitalized to inventory of Product A, the gross income or loss from the sale of which is taken into account in determining in FS’s tested income for Year 1 ($1,200x), divided by FS’s depreciation with respect to the warehouse that is capitalized to inventory of Product A, the gross income or loss from the sale of which is taken into account in determining FS’s income for Year 1 ($1,500x). Accordingly, under paragraph (d)(1) of this section, $16,000x ($20,000x × 0.8) of FS’s average adjusted basis in the warehouse is taken into account under paragraph (b) of this section in determining FS’s qualified business asset investment for Year 1.

(e) Determination of adjusted basis in specified tangible property – (1) In general. Except as provided in paragraph (e)(3)(ii) of this section, the adjusted basis in specified tangible property for purposes of this section is determined by using the cost capitalization methods of accounting used by the controlled foreign corporation for purposes of determining the gross income and allowable deductions of the controlled foreign corporation under § 1.951A-2(c)(2) and the alternative depreciation system under section 168(g), and by allocating the depreciation deduction with respect to such property for a CFC inclusion year ratably to each day during the period in the CFC inclusion year to which such depreciation relates. For purposes of the preceding sentence, the period in the CFC inclusion year to which such depreciation relates is determined without regard to the applicable convention under section 168(d).

(2) Effect of change in law. The adjusted basis in specified tangible property is determined without regard to any provision of law enacted after December 22, 2017, unless such later enacted law specifically and directly amends the definition of qualified business asset investment under section 951A. For purposes of applying section 951A(d)(3) and this paragraph (e), the technical amendment to section 168(g) (to provide a recovery period of 20 years for qualified improvement property for purposes of the alternative depreciation system) enacted in section 2307(a) of the Coronavirus Aid, Relief, and Economic Security Act, Public Law 116-136 (2020) is treated as enacted on December 22, 2017.

(3) Specified tangible property placed in service before enactment of section 951A – (i) In general. Except as provided in paragraph (e)(3)(ii) of this section, the adjusted basis in specified tangible property placed in service before December 22, 2017, is determined using the alternative depreciation system under section 168(g), as if this system had applied from the date that the property was placed in service.

(ii) Election to use income and earnings and profits depreciation method for property placed in service before the first taxable year beginning after December 22, 2017 – (A) In general. If a controlled foreign corporation is not required to use, and does not in fact use, the alternative depreciation system under section 168(g) for purposes of determining income under § 1.952-2 and earnings and profits under § 1.964-1 with respect to property placed in service before the first taxable year beginning after December 22, 2017, and the controlling domestic shareholders (as defined in § 1.964-1(c)(5)) of the controlled foreign corporation make an election described in this paragraph (e)(3)(ii), the adjusted basis in specified tangible property of the controlled foreign corporation that was placed in service before the first taxable year of the controlled foreign corporation beginning after December 22, 2017, and the partner adjusted basis in partnership specified tangible property of any partnership of which the controlled foreign corporation is a partner that was placed in service before the first taxable year of the partnership beginning after December 22, 2017, is determined for purposes of this section based on the method of accounting for depreciation used by the controlled foreign corporation for purposes of determining income under § 1.952-2, subject to the modification described in this paragraph (e)(3)(ii)(A). If the controlled foreign corporation’s method of accounting for depreciation takes into account salvage value of the property, the salvage value is reduced to zero by allocating the salvage value ratably to each day of the taxable year immediately after the last taxable year in which the method of accounting determined an amount of depreciation deduction for the property.

(B) Manner of making the election. The controlling domestic shareholders making the election described in this paragraph (e)(3) must file a statement that meets the requirements of § 1.964-1(c)(3)(ii) with their income tax returns for the taxable year that includes the last day of the controlled foreign corporation’s applicable taxable year and follow the notice requirements of § 1.964-1(c)(3)(iii). The controlled foreign corporation’s applicable taxable year is the first CFC inclusion year that begins after December 31, 2017, and ends within the controlling domestic shareholder’s taxable year. For purposes of § 301.9100-3 of this chapter (addressing requests for extensions of time for filing certain regulatory elections), a controlling domestic shareholder is qualified to make the election described in this paragraph (e)(3) only if the shareholder determined the adjusted basis in specified tangible property placed in service before the first taxable year beginning after December 22, 2017, by applying the method described in paragraph (e)(3)(ii)(A) of this section with respect to the first taxable year of the controlled foreign corporation beginning after December 22, 2017, and each subsequent taxable year. The election statement must be filed in accordance with the rules provided in forms or instructions.

(f) Special rules for short taxable years – (1) In general. In the case of a tested income CFC that has a CFC inclusion year that is less than twelve months (a short taxable year), the rules for determining the qualified business asset investment of the tested income CFC under this section are modified as provided in paragraphs (f)(2) and (3) of this section with respect to the CFC inclusion year.

(2) Determination of quarter closes. For purposes of determining quarter closes, in determining the qualified business asset investment of a tested income CFC for a short taxable year, the quarters of the tested income CFC for purposes of this section are the full quarters beginning and ending within the short taxable year (if any), determining quarter length as if the tested income CFC did not have a short taxable year, plus one or more short quarters (if any).

(3) Reduction of qualified business asset investment. The qualified business asset investment of a tested income CFC for a short taxable year is the sum of –

(i) The sum of the tested income CFC’s aggregate adjusted bases in specified tangible property as of the close of each full quarter (if any) in the CFC inclusion year divided by four, plus

(ii) The tested income CFC’s aggregate adjusted bases in specified tangible property as of the close of each short quarter (if any) in the CFC inclusion year multiplied by the sum of the number of days in each short quarter divided by 365.

(4) Example. The following example illustrates the application of this paragraph (f).

(i) Facts. USP1, a domestic corporation, owns all of the stock of FS, a controlled foreign corporation. USP1 owns FS from the beginning of Year 1. On July 15, Year 1, USP1 sells FS to USP2, an unrelated person. USP2 makes a section 338(g) election with respect to the purchase of FS, as a result of which FS’s taxable year is treated as ending on July 15. USP1, USP2, and FS all use the calendar year as their taxable year. FS’s aggregate adjusted bases in specified tangible property is $250x as of March 31, $300x as of June 30, $275x as of July 15, $500x as of September 30, and $450x as of December 31.

(ii) Analysis – (A) Determination of short taxable years and quarters. FS has two short taxable years in Year 1. The first short taxable year is from January 1 to July 15, with two full quarters (January 1 through March 31 and April 1 through June 30) and one short quarter (July 1 through July 15). The second taxable year is from July 16 to December 31, with one short quarter (July 16 through September 30) and one full quarter (October 1 through December 31).

(B) Calculation of qualified business asset investment for the first short taxable year. Under paragraph (f)(2) of this section, for the first short taxable year in Year 1, FS has three quarter closes (March 31, June 30, and July 15). Under paragraph (f)(3) of this section, the qualified business asset investment of FS for the first short taxable year is $148.80x, the sum of $137.50x (($250x + $300x)/4) attributable to the two full quarters and $11.30x ($275x × 15/365) attributable to the short quarter.

(C) Calculation of qualified business asset investment for the second short taxable year. Under paragraph (f)(2) of this section, for the second short taxable year in Year 1, FS has two quarter closes (September 30 and December 31). Under paragraph (f)(3) of this section, the qualified business asset investment of FS for the second short taxable year is $217.98x, the sum of $112.50x ($450x/4) attributable to the one full quarter and $105.48x ($500x × 77/365) attributable to the short quarter.

(g) Partnership property – (1) In general. If a tested income CFC holds an interest in one or more partnerships during a CFC inclusion year (including indirectly through one or more partnerships that are partners in a lower-tier partnership), the qualified business asset investment of the tested income CFC for the CFC inclusion year (determined without regard to this paragraph (g)(1)) is increased by the sum of the tested income CFC’s partnership QBAI with respect to each partnership for the CFC inclusion year. A tested loss CFC has no partnership QBAI for a CFC inclusion year.

(2) Determination of partnership QBAI. For purposes of paragraph (g)(1) of this section, the term partnership QBAI means, with respect to a partnership, a tested income CFC, and a CFC inclusion year, the sum of the tested income CFC’s partner adjusted basis in each partnership specified tangible property of the partnership for each partnership taxable year that ends with or within the CFC inclusion year. If a partnership taxable year is less than twelve months, the principles of paragraph (f) of this section apply in determining a tested income CFC’s partnership QBAI with respect to the partnership.

(3) Determination of partner adjusted basis – (i) In general. For purposes of paragraph (g)(2) of this section, the term partner adjusted basis means the amount described in paragraph (g)(3)(ii) of this section with respect to sole use partnership property or paragraph (g)(3)(iii) of this section with respect to dual use partnership property. The principles of section 706(d) apply to this determination.

(ii) Sole use partnership property – (A) In general. The amount described in this paragraph (g)(3)(ii), with respect to sole use partnership property, a partnership taxable year, and a tested income CFC, is the sum of the tested income CFC’s proportionate share of the partnership adjusted basis in the sole use partnership property for the partnership taxable year and the tested income CFC’s partner-specific QBAI basis in the sole use partnership property for the partnership taxable year.

(B) Definition of sole use partnership property. The term sole use partnership property means, with respect to a partnership, a partnership taxable year, and a tested income CFC, partnership specified tangible property of the partnership that is used in the production of only gross tested income of the tested income CFC for the CFC inclusion year in which or with which the partnership taxable year ends. For purposes of the preceding sentence, partnership specified tangible property of a partnership is used in the production of only gross tested income for a CFC inclusion year if all the tested income CFC’s distributive share of the partnership’s depreciation deduction or cost recovery allowance with respect to the property (if any) for the partnership taxable year that ends with or within the CFC inclusion year is allocated and apportioned to the tested income CFC’s gross tested income for the CFC inclusion year under § 1.951A-2(c)(3) and, if any of the partnership’s depreciation or cost recovery allowance with respect to the property is capitalized to inventory or other property held for sale, all the tested income CFC’s distributive share of the partnership’s gross income or loss from the sale of such inventory or other property for the partnership taxable year that ends with or within the CFC inclusion year is taken into account in determining the tested income of the tested income CFC for the CFC inclusion year.

(iii) Dual use partnership property – (A) In general. The amount described in this paragraph (g)(3)(iii), with respect to dual use partnership property, a partnership taxable year, and a tested income CFC, is the sum of the tested income CFC’s proportionate share of the partnership adjusted basis in the property for the partnership taxable year and the tested income CFC’s partner-specific QBAI basis in the property for the partnership taxable year, multiplied by the tested income CFC’s dual use ratio with respect to the property for the partnership taxable year determined under the principles of paragraph (d)(3) of this section, except that the ratio described in paragraph (d)(3) of this section is determined by reference to the tested income CFC’s distributive share of the amounts described in paragraph (d)(3) of this section.

(B) Definition of dual use partnership property. The term dual use partnership property means partnership specified tangible property other than sole use partnership property.

(4) Determination of proportionate share of the partnership’s adjusted basis in partnership specified tangible property – (i) In general. For purposes of paragraph (g)(3) of this section, the tested income CFC’s proportionate share of the partnership adjusted basis in partnership specified tangible property for a partnership taxable year is the partnership adjusted basis in the property multiplied by the tested income CFC’s proportionate share ratio with respect to the property for the partnership taxable year. Solely for purposes of determining the proportionate share ratio under paragraph (g)(4)(ii) of this section, the partnership’s calculation of, and a partner’s distributive share of, any income, loss, depreciation, or cost recovery allowance is determined under section 704(b).

(ii) Proportionate share ratio. The term proportionate share ratio means, with respect to a partnership, a partnership taxable year, and a tested income CFC, the ratio (expressed as a percentage) calculated as –

(A) The sum of –

(1) The tested income CFC’s distributive share of the partnership’s depreciation deduction or cost recovery allowance with respect to the property for the partnership taxable year, and

(2) The amount of the partnership’s depreciation or cost recovery allowance with respect to the property that is capitalized to inventory or other property held for sale, the gross income or loss from the sale of which is taken into account in determining the tested income CFC’s distributive share of the partnership’s income or loss for the partnership taxable year, divided by

(B) The sum of –

(1) The total amount of the partnership’s depreciation deduction or cost recovery allowance with respect to the property for the partnership taxable year, and

(2) The total amount of the partnership’s depreciation or cost recovery allowance with respect to the property capitalized to inventory or other property held for sale, the gross income or loss from the sale of which is taken into account in determining the partnership’s income or loss for the partnership taxable year.

(5) Definition of partnership specified tangible property. The term partnership specified tangible property means, with respect to a tested income CFC, tangible property (as defined in paragraph (c)(2) of this section) of a partnership that is –

(i) Used in the trade or business of the partnership,

(ii) Of a type with respect to which a deduction is allowable under section 167, and

(iii) Used in the production of gross income included in the tested income CFC’s gross tested income.

(6) Determination of partnership adjusted basis. For purposes of this paragraph (g), the term partnership adjusted basis means, with respect to a partnership, partnership specified tangible property, and a partnership taxable year, the amount equal to the average of the partnership’s adjusted basis in the partnership specified tangible property as of the close of each quarter in the partnership taxable year determined without regard to any adjustments under section 734(b) except for adjustments under section 734(b)(1)(B) or section 734(b)(2)(B) that are attributable to distributions of tangible property (as defined in paragraph (c)(2) of this section) and for adjustments under section 734(b)(1)(A) or 734(b)(2)(A). The principles of paragraphs (e) and (h) of this section apply for purposes of determining a partnership’s adjusted basis in partnership specified tangible property and the proportionate share of the partnership’s adjusted basis in partnership specified tangible property.

(7) Determination of partner-specific QBAI basis. For purposes of this paragraph (g), the term partner-specific QBAI basis means, with respect to a tested income CFC, a partnership, and partnership specified tangible property, the amount that is equal to the average of the basis adjustment under section 743(b) that is allocated to the partnership specified tangible property of the partnership with respect to the tested income CFC as of the close of each quarter in the partnership taxable year. For this purpose, a negative basis adjustment under section 743(b) is expressed as a negative number. The principles of paragraphs (e) and (h) of this section apply for purposes of determining the partner-specific QBAI basis with respect to partnership specified tangible property.

(8) Examples. The following examples illustrate the rules of this paragraph (g).

(i) Facts. Except as otherwise stated, the following facts are assumed for purposes of the examples:

(A) FC, FC1, FC2, and FC3 are tested income CFCs.

(B) PRS is a partnership and its allocations satisfy the requirements of section 704.

(D) All persons use the calendar year as their taxable year.

(E) There is neither disqualified basis nor partner-specific QBAI basis with respect to any property.

(ii) Example 1: Sole use partnership property – (A) Facts. FC is a partner in PRS. PRS owns two properties, Asset A and Asset B. The average of PRS’s adjusted basis as of the close of each quarter of PRS’s taxable year in Asset A is $100x and in Asset B is $500x. In Year 1, PRS’s section 704(b) depreciation deduction is $10x with respect to Asset A and $5x with respect to Asset B, and FC’s section 704(b) distributive share of the depreciation deduction is $8x with respect to Asset A and $1x with respect to Asset B. None of the depreciation with respect to Asset A or Asset B is capitalized to inventory or other property held for sale. FC’s entire distributive share of the depreciation deduction with respect to Asset A and Asset B is allocated and apportioned to FC’s gross tested income for Year 1 under § 1.951A-2(c)(3).

(B) Analysis – (1) Sole use partnership property. Because all of FC’s distributive share of the depreciation deduction with respect to Asset A and B is allocated and apportioned to gross tested income for Year 1, Asset A and Asset B are sole use partnership property within the meaning of paragraph (g)(3)(ii)(B) of this section. Therefore, under paragraph (g)(3)(ii)(A) of this section, FC’s partner adjusted basis in Asset A and Asset B is equal to the sum of FC’s proportionate share of PRS’s partnership adjusted basis in Asset A and Asset B for Year 1 and FC’s partner-specific QBAI basis in Asset A and Asset B for Year 1, respectively.

(2) Proportionate share. Under paragraph (g)(4)(i) of this section, FC’s proportionate share of PRS’s partnership adjusted basis in Asset A and Asset B is PRS’s partnership adjusted basis in Asset A and Asset B for Year 1, multiplied by FC’s proportionate share ratio with respect to Asset A and Asset B for Year 1, respectively. Because none of the depreciation with respect to Asset A or Asset B is capitalized to inventory or other property held for sale, FC’s proportionate share ratio with respect to Asset A and Asset B is determined entirely by reference to the depreciation deduction with respect to Asset A and Asset B. Therefore, FC’s proportionate share ratio with respect to Asset A for Year 1 is 80%, which is the ratio of FC’s section 704(b) distributive share of PRS’s section 704(b) depreciation deduction with respect to Asset A for Year 1 ($8x), divided by the total amount of PRS’s section 704(b) depreciation deduction with respect to Asset A for Year 1 ($10x). FC’s proportionate share ratio with respect to Asset B for Year 1 is 20%, which is the ratio of FC’s section 704(b) distributive share of PRS’s section 704(b) depreciation deduction with respect to Asset B for Year 1 ($1x), divided by the total amount of PRS’s section 704(b) depreciation deduction with respect to Asset B for Year 1 ($5x). Accordingly, under paragraph (g)(4)(i) of this section, FC’s proportionate share of PRS’s partnership adjusted basis in Asset A is $80x ($100x × 0.8), and FC’s proportionate share of PRS’s partnership adjusted basis in Asset B is $100x ($500x × 0.2).

(3) Partner adjusted basis. Because FC has no partner-specific QBAI basis with respect to Asset A and Asset B, FC’s partner adjusted basis in Asset A and Asset B is determined entirely by reference to its proportionate share of PRS’s partnership adjusted basis in Asset A and Asset B. Therefore, under paragraph (g)(3)(ii)(A) of this section, FC’s partner adjusted basis in Asset A is $80x, FC’s proportionate share of PRS’s partnership adjusted basis in Asset A, and FC’s partner adjusted basis in Asset B is $100x, FC’s proportionate share of PRS’s partnership adjusted basis in Asset A.

(4) Partnership QBAI. Under paragraph (g)(2) of this section, FC’s partnership QBAI with respect to PRS is $180x, the sum of FC’s partner adjusted basis in Asset A ($80x) and FC’s partner adjusted basis in Asset B ($100x). Accordingly, under paragraph (g)(1) of this section, FC increases its qualified business asset investment for Year 1 by $180x.

(iii) Example 2: Dual use partnership property – (A) Facts. FC owns a 50% interest in PRS. All section 704(b) and tax items are identical and are allocated equally between FC and its other partner. PRS owns three properties, Asset C, Asset D, and Asset E. PRS sells two products, Product A and Product B. All of FC’s distributive share of the gross income or loss from the sale of Product A is taken into account in determining FC’s tested income, and none of FC’s distributive share of the gross income or loss from the sale of Product B is taken into account in determining FC’s tested income.

(1) Asset C. The average of PRS’s adjusted basis as of the close of each quarter of PRS’s taxable year in Asset C is $100x. In Year 1, PRS’s depreciation is $10x with respect to Asset C, none of which is capitalized to inventory or other property held for sale. FC’s distributive share of the depreciation deduction with respect to Asset C is $5x ($10x × 0.5), $3x of which is allocated and apportioned to FC’s gross tested income under § 1.951A-2(c)(3).

(2) Asset D. The average of PRS’s adjusted basis as of the close of each quarter of PRS’s taxable year in Asset D is $500x. In Year 1, PRS’s depreciation is $50x with respect to Asset D, $10x of which is capitalized to inventory of Product A and $40x is capitalized to inventory of Product B. None of the $10x depreciation with respect to Asset D capitalized to inventory of Product A is capitalized to ending inventory. However, of the $40x capitalized to inventory of Product B, $10x is capitalized to ending inventory. Therefore, the amount of depreciation with respect to Asset D capitalized to inventory of Product A that is taken into account in determining FC’s distributive share of the income or loss of PRS for Year 1 is $5x ($10x × 0.5), and the amount of depreciation with respect to Asset D capitalized to inventory of Product B that is taken into account in determining FC’s distributive share of the income or loss of PRS for Year 1 is $15x ($30x × 0.5).

(3) Asset E. The average of PRS’s adjusted basis as of the close of each quarter of PRS’s taxable year in Asset E is $600x. In Year 1, PRS’s depreciation is $60x with respect to Asset E. Of the $60x depreciation with respect to Asset E, $20x is allowed as a deduction, $24x is capitalized to inventory of Product A, and $16x is capitalized to inventory of Product B. FC’s distributive share of the depreciation deduction with respect to Asset E is $10x ($20x × 0.5), $8x of which is allocated and apportioned to FC’s gross tested income under § 1.951A-2(c)(3). None of the $24x depreciation with respect to Asset E capitalized to inventory of Product A is capitalized to ending inventory. However, of the $16x depreciation with respect to Asset E capitalized to inventory of Product B, $10x is capitalized to ending inventory. Therefore, the amount of depreciation with respect to Asset E capitalized to inventory of Product A that is taken into account in determining FC’s distributive share of the income or loss of PRS for Year 1 is $12x ($24x × 0.5), and the amount of depreciation with respect to Asset E capitalized to inventory of Product B that is taken into account in determining FC’s distributive share of the income or loss of PRS for Year 1 is $3x ($6x × 0.5).

(B) Analysis. Because Asset C, Asset D, and Asset E are not used in the production of only gross tested income in Year 1 within the meaning of paragraph (g)(3)(ii)(B) of this section, Asset C, Asset D, and Asset E are partnership dual use property within the meaning of paragraph (g)(3)(iii)(B) of this section. Therefore, under paragraph (g)(3)(iii)(A) of this section, FC’s partner adjusted basis in Asset C, Asset D, and Asset E is the sum of FC’s proportionate share of PRS’s partnership adjusted basis in Asset C, Asset D, and Asset E, respectively, for Year 1, and FC’s partner-specific QBAI basis in Asset C, Asset D, and Asset E, respectively, for Year 1, multiplied by FC’s dual use ratio with respect to Asset C, Asset D, and Asset E, respectively, for Year 1, determined under the principles of paragraph (d)(3) of this section, except that the ratio described in paragraph (d)(3) of this section is determined by reference to FC’s distributive share of the amounts described in paragraph (d)(3) of this section.

(1) Asset C – (i) Proportionate share. Under paragraph (g)(4)(i) of this section, FC’s proportionate share of PRS’s partnership adjusted basis in Asset C is PRS’s partnership adjusted basis in Asset C for Year 1, multiplied by FC’s proportionate share ratio with respect to Asset C for Year 1. Because none of the depreciation with respect to Asset C is capitalized to inventory or other property held for sale, FC’s proportionate share ratio with respect to Asset C is determined entirely by reference to the depreciation deduction with respect to Asset C. Therefore, FC’s proportionate share ratio with respect to Asset C is 50%, which is the ratio calculated as the amount of FC’s section 704(b) distributive share of PRS’s section 704(b) depreciation deduction with respect to Asset C for Year 1 ($5x), divided by the total amount of PRS’s section 704(b) depreciation deduction with respect to Asset C for Year 1 ($10x). Accordingly, under paragraph (g)(4)(i) of this section, FC’s proportionate share of PRS’s partnership adjusted basis in Asset C is $50x ($100x × 0.5).

(ii) Dual use ratio. Because none of the depreciation with respect to Asset C is capitalized to inventory or other property held for sale, FC’s dual use ratio with respect to Asset C is determined entirely by reference to the depreciation deduction with respect to Asset C. Therefore, FC’s dual use ratio with respect to Asset C is 60%, which is the ratio calculated as the amount of FC’s distributive share of PRS’s depreciation deduction with respect to Asset C that is allocated and apportioned to FC’s gross tested income under § 1.951A-2(c)(3) for Year 1 ($3x), divided by the total amount of FC’s distributive share of PRS’s depreciation deduction with respect to Asset C for Year 1 ($5x).

(iii) Partner adjusted basis. Because FC has no partner-specific QBAI basis with respect to Asset C, FC’s partner adjusted basis in Asset C is determined entirely by reference to FC’s proportionate share of PRS’s partnership adjusted basis in Asset C, multiplied by FC’s dual use ratio with respect to Asset C. Under paragraph (g)(3)(iii)(A) of this section, FC’s partner adjusted basis in Asset C is $30x, FC’s proportionate share of PRS’s partnership adjusted basis in Asset C for Year 1 ($50x), multiplied by FC’s dual use ratio with respect to Asset C for Year 1 (60%).

(3) Asset D – (i) Proportionate share. Under paragraph (g)(4)(i) of this section, FC’s proportionate share of PRS’s partnership adjusted basis in Asset D is PRS’s partnership adjusted basis in Asset D for Year 1, multiplied by FC’s proportionate share ratio with respect to Asset D for Year 1. Because all of the depreciation with respect to Asset D is capitalized to inventory, FC’s proportionate share ratio with respect to Asset D is determined entirely by reference to the depreciation with respect to Asset D that is capitalized to inventory and included in cost of goods sold. Therefore, FC’s proportionate share ratio with respect to Asset D is 50%, which is the ratio calculated as the amount of PRS’s section 704(b) depreciation with respect to Asset D capitalized to Product A and Product B that is taken into account in determining FC’s section 704(b) distributive share of PRS’s income or loss for Year 1 ($20x), divided by the total amount of PRS’s section 704(b) depreciation with respect to Asset D capitalized to Product A and Product B that is taken into account in determining PRS’s section 704(b) income or loss for Year 1 ($40x). Accordingly, under paragraph (g)(4)(i) of this section, FC’s proportionate share of PRS’s partnership adjusted basis in Asset D is $250x ($500x × 0.5).

(ii) Dual use ratio. Because all of the depreciation with respect to Asset D is capitalized to inventory, FC’s dual use ratio with respect to Asset D is determined entirely by reference to the depreciation with respect to Asset D that is capitalized to inventory and included in cost of goods sold. Therefore, FC’s dual use ratio with respect to Asset D is 25%, which is the ratio calculated as the amount of depreciation with respect to Asset D capitalized to inventory of Product A and Product B that is taken into account in determining FC’s tested income for Year 1 ($5x), divided by the total amount of depreciation with respect to Asset D capitalized to inventory of Product A and Product B that is taken into account in determining FC’s income or loss for Year 1 ($20x).

(iii) Partner adjusted basis. Because FC has no partner-specific QBAI basis with respect to Asset D, FC’s partner adjusted basis in Asset D is determined entirely by reference to FC’s proportionate share of PRS’s partnership adjusted basis in Asset D, multiplied by FC’s dual use ratio with respect to Asset D. Under paragraph (g)(3)(iii)(A) of this section, FC’s partner adjusted basis in Asset D is $62.50x, FC’s proportionate share of PRS’s partnership adjusted basis in Asset D for Year 1 ($250x), multiplied by FC’s dual use ratio with respect to Asset D for Year 1 (25%).

(4) Asset E – (i) Proportionate share. Under paragraph (g)(4)(i) of this section, FC’s proportionate share of PRS’s partnership adjusted basis in Asset E is PRS’s partnership adjusted basis in Asset E for Year 1, multiplied by FC’s proportionate share ratio with respect to Asset E for Year 1. Because the depreciation with respect to Asset E is partly deducted and partly capitalized to inventory, FC’s proportionate share ratio with respect to Asset E is determined by reference to both the depreciation that is deducted and the depreciation that is capitalized to inventory and included in cost of goods sold. Therefore, FC’s proportionate share ratio with

E-CFR

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