(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 solely by reason of an election made under section 954(b)(4) and §1.954-1(d)(5),

(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. 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).

(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) 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)(iv)(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)(iv)(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.

[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]