(a) Increase in section 904(a) limitation for the taxable year of exclusion—(1) In general. The applicable limitation under section 904(a) for a taxpayer's taxable year (hereinafter in this section referred to as the “taxable year of exclusion”) in which the taxpayer receives an amount which is excluded from gross income under section 959(a)(1) and which is attributable to a controlled foreign corporation's earnings and profits in respect of which an amount was required to be included in the gross income of such taxpayer under section 951(a) for a taxable year (hereinafter in this section referred to as the “taxable year of inclusion”) previous to the taxable year of exclusion shall be increased under section 960(c)(1) by the amount described in paragraph (b) of this section if the conditions described in paragraph (a)(2) of this section are satisfied. For purposes of this section, an amount included in gross income under section 951A(a) is treated as an amount included in gross income under section 951(a). The amount of the increase in the foreign tax credit limitation allowed by this section is determined with regard to each separate category of income described in §1.904-5(a)(4)(v).

(2) Conditions under which increase in limitation is allowed for the taxable year of exclusion. The increase in limitation described in subparagraph (1) of this paragraph for the taxable year of exclusion shall be made only if the taxpayer—

(i) For the taxable year of inclusion either chose to claim a foreign tax credit as provided in section 901 or did not pay or accrue any foreign income taxes,

(ii) Chooses to claim a foreign tax credit as provided in section 901 for the taxable year of exclusion, and

(iii) For the taxable year of exclusion pays, accrues, or is deemed to have paid foreign income taxes with respect to the amount, described in subparagraph (1) of this paragraph, which is excluded from his gross income for such year under section 959(a)(1).

(b) Amount of increase in limitation for the taxable year of exclusion. The amount of increase under section 960 (b)(1) in the applicable limitation under section 904(a) for the taxable year of exclusion shall be—

(1) The amount by which the applicable section 904(a) limitation for the taxable year of inclusion was increased, determined as provided in paragraph (c) of this section, by reason of the inclusion of the amount in the taxpayer's income for such year under section 951(a), reduced by

(2) The amount of foreign income taxes allowed as a credit under section 901 for such taxable year of inclusion and which were allowable to such taxpayer solely by reason of the inclusion of such amount in his gross income under section 951(a), as determined under paragraph (d) of this section, and then by

(3) The additional reduction for such taxable year of inclusion arising by reason of increases in limitation under section 960(c)(1) for taxable years intervening between such taxable year of inclusion and such taxable year of exclusion, as determined under paragraph (e) of this section in respect of such inclusion under section 951(a),

except that the amount of increase determined under this paragraph for the taxable year of exclusion shall in no case exceed the amount of foreign income taxes paid, accrued, or deemed to be paid by such taxpayer for such taxable year of exclusion with respect to the amount, described in paragraph (a)(1) of this section, which is excluded from gross income for such year under section 959(a)(1).

(c) Determination of increase in limitation for the taxable year of inclusion. The amount of the increase in the applicable limitation under section 904(a) for the taxable year of inclusion which arises by reason of the inclusion of the amount in gross income under section 951(a) shall be the amount of the applicable limitation under section 904(a) for such year reduced by the amount which would have been the applicable limitation under section 904(a) for such year if the amount had not been included in gross income for such year under section 951(a).

(d) Determination of foreign income taxes allowed for taxable year of inclusion by reason of section 951(a) amount. The amount of foreign income taxes allowed as a credit under section 901 for the taxable year of inclusion which were allowable solely by reason of the inclusion of the amount in gross income for such year under section 951(a) shall be the amount of foreign income taxes allowed as a credit under section 901 for such year reduced by the amount of foreign income taxes which would have been allowed as a credit under section 901 for such year if the amount had not been included in gross income for such year under section 951(a). For purposes of this paragraph (d), the term “foreign income taxes” includes foreign income taxes paid or accrued, foreign income taxes deemed paid or accrued under section 904(c), and foreign income taxes deemed paid under section 960 (or section 902 with respect to taxable years of foreign corporations beginning before January 1, 2018), for the taxable year of inclusion.

(e) Additional reduction for the taxable year of inclusion arising by reason of increases in limitation for intervening years. The amount of increase in the applicable limitation under section 904(a) for the taxable year of inclusion shall also be reduced, after first deducting the foreign income taxes described in paragraph (b)(2) of this section, by any increases in limitation which arise under section 960(c)(1)—by reason of any earlier exclusions under section 959(a)(1) in respect of the same inclusion under section 951(a) for such taxable year of inclusion—for the first, second, third, fourth, etc., succeeding taxable years of exclusion, in that order, which follow such taxable year of inclusion and precede the taxable year of exclusion in respect of which the increase in limitation under section 960(c)(1) and paragraph (b) of this section is being determined. The amount of any increase in limitation which arises under section 960(c)(1) for any such succeeding taxable year of exclusion shall be the amount of foreign income taxes allowed as a credit under section 901 for each such taxable year reduced by the amount of foreign income taxes which would have been allowed as a credit under section 901 for each such year if the limitation for each such year were not increased under section 960(c)(1). For any such succeeding taxable year of exclusion for which the taxpayer does not choose to claim a foreign tax credit as provided in section 901, the same increase in limitation under section 960(c)(1) shall be treated as having been made, for purposes of this paragraph, which would have been made for such taxable year if the taxpayer had chosen to claim the foreign tax credit for such year.

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

(1) Example 1. USP, a domestic corporation, owns all of the one class of stock of CFC, a controlled foreign corporation that uses the U.S. dollar as its functional currency. CFC, after paying foreign income taxes of $10x, has earnings and profits for Year 1 of $90x, all of which are attributable to an amount required under section 951(a) to be included in USP's gross income for Year 1 because the income is general category foreign base company services income of CFC. Both corporations use the calendar year as the taxable year. For Year 2 and Year 3, CFC has no earnings and profits attributable to an amount required to be included in USP's gross income under section 951(a); for each such year it makes a distribution of $45x (from its section 951(a)(1)(A) PTEP within the annual PTEP account for Year 1) from which a foreign income tax of $6x is withheld. For each of Year 1, Year 2, and Year 3, USP derives taxable income of $50x from sources within the United States and claims a foreign tax credit under section 901, subject to the limitation under section 904. The U.S. tax payable by USP is determined as follows, assuming a corporate tax rate of 21%:

(2) Example 2. The facts for Year 1 and Year 2 are the same as in paragraph (f)(1) of this section (the facts in Example 1), except that in Year 0, in which USP also claimed a foreign tax credit under section 901, USP pays $11x of foreign income taxes in excess of the general category limitation and such excess is not absorbed as a carryback to the prior year under section 904(c). Therefore, there is no increase under section 960(c)(1) in the limitation for Year 2 since the amount ($21x) by which the Year 1 limitation was increased by reason of the inclusion in USP's gross income for Year 1 under section 951(a), less the foreign income taxes ($21x) allowed as a credit which were allowable solely by reason of such inclusion, is zero. The foreign income taxes so allowed as a credit for Year 1 which were allowable solely by reason of such section 951(a) inclusion consist of the $10 of foreign income taxes deemed paid for Year 1 under section 960(a) and the $11x of foreign income taxes for Year 0 carried over and deemed paid for Year 1 under section 904(c).

[T.D. 7120, 36 FR 10859, June 4, 1971, as amended by T.D. 7649, 44 FR 60089, Oct. 18, 1979; T.D. 9882, 84 FR 69117, Dec. 17, 2019]