(c) * * *

(2) Apportionment based on assets. Certain taxpayers are required by paragraph (e)(2) of this section and § 1.861-9T to apportion interest expense on the basis of assets. A taxpayer may apportion other deductions based on the comparative value of assets that generate income within each grouping, provided that this method reflects the factual relationship between the deduction and the groupings of income and is applied in accordance with the rules of § 1.861-9T(g). In general, such apportionments must be made either on the basis of the tax book value of those assets or, except in the case of interest expense, on the basis of their fair market value. See § 1.861-9(h). Taxpayers using the fair market value method for their last taxable year beginning before January 1, 2018, must change to the tax book value method (or the alternative tax book value method) for purposes of apportioning interest expense for their first taxable year beginning after December 31, 2017. The Commissioner's approval is not required for this change. In the case of any corporate taxpayer that both uses tax book value or alternative tax book value, and owns directly or indirectly (within the meaning of § 1.861-12T(c)(2)(ii)(B)) 10 percent or more of the total combined voting power of all classes of stock entitled to vote in any other corporation (domestic or foreign) that is not a member of the affiliated group (as defined in section 864(e)(5)), the taxpayer must adjust its basis in that stock in the manner described in § 1.861-12(c)(2). For the definition of related persons formerly contained in § 1.861-8T(c)(2), see paragraph (c)(4) of this section.

(4) Cross-referenced definition of related persons. The term related persons means two or more persons in a relationship described in section 267(b). In determining whether two or more corporations are members of the same controlled group under section 267(b)(3), a person is considered to own stock owned directly by such person, stock owned by with the application of section 1563(e)(1), and stock owned by application of section 267(c). In determining whether a corporation is related to a partnership under section 267(b)(10), a person is considered to own the partnership interest owned directly by such person and the partnership interest owned with the application of section 267(e)(3).

(d) * * *

(2) Allocation and apportionment to exempt, excluded, or eliminated income—(i) In general. For further guidance, see § 1.861-8T(d)(2)(i).

(ii) Exempt income and exempt asset defined—(A) In general. For purposes of this section, the term exempt income means any gross income to the extent that it is exempt, excluded, or eliminated for Federal income tax purposes. The term exempt asset means any asset to the extent income from the asset is (or is treated as under paragraph (d)(2)(ii)(B) or (C) of this section) exempt, excluded, or eliminated for Federal income tax purposes.

(B) Certain stock and dividends. For further guidance, see § 1.861-8T(d)(2)(ii)(B).

(C) Foreign-derived intangible income and inclusions under section 951A(a)—(1) Exempt income. The term “exempt income” includes an amount of a domestic corporation's gross income included in gross foreign-derived deduction eligible income (or gross FDDEI), and also includes an amount of a domestic corporation's gross income from an inclusion under section 951A(a) and the gross up under section 78 attributable to such an inclusion, in each case equal to the amount of the deduction allowed under section 250(a) for such gross income (taking into account the reduction under section 250(a)(2)(B), if any). Therefore, for purposes of apportioning deductions using a gross income method, gross income does not include gross income included in gross FDDEI, an inclusion under section 951A(a), or the gross up under section 78 attributable to an inclusion under section 951A(a), in an amount equal to the amount of the deduction allowed under section 250(a)(1)(A), (B)(i), or (B)(ii), respectively (taking into account the reduction under section 250(a)(2)(B), if any). The term gross foreign-derived deduction eligible income, or gross FDDEI, means the portion of the domestic corporation's gross income (determined without regard to the amounts described in section 250(b)(3)(A)(i)(I) through (VI)) that is derived from sales and services described in section 250(b)(4)(A) and (B).

(2) Exempt assets—(i) Assets that produce foreign-derived intangible income. The term “exempt asset” includes the portion of a domestic corporation's assets that produce gross FDDEI equal to the amount of such assets multiplied by the fraction that equals the amount of the domestic corporation's deduction allowed under section 250(a)(1)(A) (taking into account the reduction under section 250(a)(2)(B)(i), if any) divided by its gross FDDEI. No portion of the value of stock in a foreign corporation is treated as an exempt asset by reason of this paragraph (d)(2)(ii)(C)(2)(i), including by reason of a transfer of intangible property to a foreign corporation subject to section 367(d) that gives rise to gross FDDEI.

(ii) Controlled foreign corporation stock that gives rise to inclusions under section 951A(a). The term “exempt asset” includes a portion of the value of a United States shareholder's stock in a controlled foreign corporation if the United States shareholder is a domestic corporation that is eligible for a deduction under section 250(a) with respect to income described in section 250(a)(1)(B)(i) and all or a portion of the domestic corporation's stock in the controlled foreign corporation is characterized as GILTI inclusion stock. The portion of foreign corporation stock that is treated as an exempt asset for a taxable year equals the portion of the value of such foreign corporation stock (determined in accordance with §§ 1.861-9(g), 1.861-12, and 1.861-13) that is characterized as GILTI inclusion stock multiplied by a fraction that equals the amount of the domestic corporation's deduction allowed under section 250(a)(1)(B)(i) (taking into account the reduction under section 250(a)(2)(B)(ii), if any) divided by its GILTI inclusion amount (as defined in § 1.951A-1(c)(1) or, in the case of a member of a consolidated group, § 1.1502-51(b)) for such taxable year. The portion of controlled foreign corporation stock treated as an exempt asset under this paragraph (d)(2)(ii)(C)(2)(ii) is treated as attributable to the relevant categories of GILTI inclusion stock described in each of paragraphs (d)(2)(ii)(C)(3)(i) through (v) of this section based on the relative value of the portion of the stock in each such category.

(3) GILTI inclusion stock. For purposes of paragraph (d)(2)(ii)(C)(2)(ii) of this section, the term GILTI inclusion stock means the aggregate of the portions of the value of controlled foreign corporation stock that are—

(i) Assigned to the section 951A category under § 1.861-13(a)(2);

(ii) Assigned to a particular treaty category under § 1.861-13(a)(3)(i) (relating to resourced gross tested income stock);

(iii) Assigned under § 1.861-13(a)(1) to the gross tested income statutory grouping within the foreign source passive category less the amount described in § 1.861-13(a)(5)(iii)(A);

(iv) Assigned under § 1.861-13(a)(1) to the gross tested income statutory grouping within the U.S. source general category less the amount described in § 1.861-13(a)(5)(iv)(A); and

(v) Assigned under § 1.861-13(a)(1) to the gross tested income statutory grouping within the U.S. source passive category less the amount described in § 1.861-13(a)(5)(iv)(B).

(4) Non-applicability to section 250(b). Paragraphs (d)(2)(ii)(C)(1) through (3) of this section do not apply when apportioning deductions for purposes of determining deduction eligible income or foreign-derived deduction eligible income under the operative section of section 250(b).

(5) Example. The following example illustrates the application of the rules in this paragraph (d)(2)(ii)(C).

(i) Facts. USP, a domestic corporation, directly owns all of the stock of CFC1 and CFC2, both of which are controlled foreign corporations. The tax book value of CFC1 and CFC2's stock is $10,000x and $9,000x, respectively. Pursuant to § 1.861-13(a), $6,100x of the stock of CFC1 is assigned to the section 951A category under § 1.861-13(a)(2) (“section 951A category stock”) and the remaining $3,900x of the stock of CFC1 is assigned to the general category (“general category stock”). Additionally, $4,880x of the stock of CFC2 is section 951A category stock and the remaining $4,120x of the stock of CFC2 is general category stock. Under section 951A and the section 951A regulations (as defined in § 1.951A-1(a)(1)), USP's GILTI inclusion amount is $610x. The portion of USP's deduction under section 250 described in section 250(a)(1)(B)(i) is $305x. No portion of USP's deduction is reduced by reason of section 250(a)(2)(B)(ii).

(ii) Analysis. For purposes of apportioning deductions where section 904 is the operative section, under paragraph (d)(2)(ii)(C)(1) of this section, $305x of USP's gross income attributable to its GILTI inclusion amount is exempt income. Under paragraph (d)(2)(ii)(C)(3) of this section, the GILTI inclusion stock of CFC1 is the $6,100x of stock that is section 951A category stock and the GILTI inclusion stock of CFC2 is the $4,880x of stock that is section 951A category stock. Under paragraph (d)(2)(ii)(C)(2) of this section, the portion of the value of the stock of CFC1 and CFC2 that is treated as an exempt asset equals the portion of the value of the stock of CFC1 and CFC2 that is GILTI inclusion stock multiplied by 50% ($305x/$610x). Accordingly, the exempt portion of the stock of CFC1 is $3,050x (50% × $6,100x) and the exempt portion of CFC2's stock is $2,440x (50% × $4,880x). Therefore, the stock of CFC1 taken into account for purposes of apportioning deductions is $3,050x of non-exempt section 951A category stock and $3,900x of general category stock. The stock of CFC2 taken into account for purposes of apportioning deductions is $2,440x of non-exempt section 951A category stock and $4,120x of general category stock.

(iii) Income that is not considered tax exempt. For further guidance, see § 1.861-8T(d)(2)(iii).

(A) For further guidance, see § 1.861-8T(d)(2)(iii)(A) and (B).

(B) [Reserved]

(C) Dividends for which a deduction is allowed under section 245A;

(D) Foreign earned income as defined in section 911 (however, the rules of § 1.911-6 do not require the allocation and apportionment of certain deductions, including home mortgage interest, to foreign earned income for purposes of determining the deductions disallowed under section 911(d)(6)); and

(E) Inclusions for which a deduction is allowed under section 965(c). See § 1.965-6(c).

(iv) Value of stock attributable to previously taxed earnings and profits. No portion of the value of stock in a controlled foreign corporation is treated as an exempt asset by reason of the controlled foreign corporation having previously taxed earnings and profits. For example, no portion of the value of stock in a controlled foreign corporation is treated as an exempt asset by reason of the adjustment under § 1.861-12(c)(2) in respect of previously taxed earnings and profits described in section 959(c)(1) or (c)(2) (including earnings and profits described in section 959(c)(2) by reason of section 951A(f)(1) and § 1.951A-6(b)(1)). See also § 1.965-6(c).

(e) * * * (1) * * * Paragraphs (e)(13) and (14) of this section contain rules with respect to the allocation and apportionment of the deduction allowed under section 250(a). Paragraph (e)(15) of this section contains rules with respect to the allocation and apportionment of a taxpayer's distributive share of a partnership's deductions. * * *

(6) * * * (i) * * * The deduction for foreign income, war profits and excess profits taxes allowed by section 164 (including with respect to a controlled foreign corporation)) is allocated and apportioned among the applicable statutory and residual groupings under the principles of § 1.904-6(a)(1)(i), (ii), and (iv). The deduction for state and local taxes (state income taxes) allowed by section 164 is considered definitely related and allocable to the gross income with respect to which such state income taxes are imposed. * * *

(13) Foreign-derived intangible income. The portion of the deduction that is allowed for foreign-derived intangible income under section 250(a)(1)(A) (taking into account the reduction under section 250(a)(2)(B)(i), if any) is considered definitely related and allocable to the class of gross income included in the taxpayer's foreign-derived deduction eligible income (as defined in section 250(b)(4)). If necessary, the portion of the deduction is apportioned within the class ratably between the statutory grouping (or among the statutory groupings) of gross income and the residual grouping of gross income based on the relative amounts of foreign-derived deduction eligible income in each grouping.

(14) Global intangible low-taxed income and related section 78 gross up. The portion of the deduction (taking into account the reduction under section 250(a)(2)(B)(ii), if any) that is allowed for the global intangible low-taxed income amount described in section 250(a)(1)(B)(i), and that is allowed for the section 78 gross up under section 250(a)(1)(B)(ii), is considered definitely related and allocable to the class of gross income included under section 951A(a) and section 78, respectively. If necessary (for example, because a portion of the inclusion under section 951A(a) is passive category income or U.S. source income), the portion of the deduction is apportioned within the class ratably between the statutory grouping (or among the statutory groupings) of gross income and the residual grouping of gross income based on the relative amounts of gross income in each grouping.

(15) Distributive share of partnership deductions. In general, if deductions are incurred by a partnership in which the taxpayer is a partner, the taxpayer's deductions that are allocated and apportioned include the taxpayer's distributive share of the partnership's deductions. See §§ 1.861-9(e), 1.861-17(f), and 1.904-4(n)(1)(ii) for special rules for apportioning a partner's distributive share of deductions of a partnership.

(f) * * *

(1) * * *

(ii) Separate foreign tax credit limitations. Section 904(d)(1) and other sections described in § 1.904-4(m) require that a separate foreign tax credit limitation be determined with respect to each separate category of income specified in those sections. Accordingly, the foreign source income within each separate category described in § 1.904-5(a)(4)(v) constitutes a separate statutory grouping of income. U.S. source income is treated as income in the residual grouping for purposes of determining the limitation on the foreign tax credit.

(4) * * *

(ii) Example—(A) Facts. USP, a domestic corporation, purchases and sells consumer items in the United States and foreign markets. Its sales in foreign markets are made to related foreign subsidiaries. USP reported $1,500,000x as sales during the taxable year of which $1,000,000x was domestic sales and $500,000x was foreign sales. USP took a deduction for expenses incurred by its marketing department during the taxable year in the amount of $150,000x. These expenses were determined to be allocable to both domestic and foreign sales and are apportionable between such sales. On audit of USP's return for the taxable year, the IRS adjusted, under section 482, USP's sales to related foreign subsidiaries by increasing the sales price by a total of $100,000x, thereby increasing USP's foreign sales and total sales by the same amount. Before the audit, USP allocated and apportioned the marketing department deduction as follows:

(B) Analysis. As a result of the section 482 adjustment, the apportionment of the deduction for the marketing department expenses is redetermined as follows:

(g) Examples. The following examples illustrate the principles of the rules in this section. In each example, unless otherwise specified, section 904 is the operative section. In addition, in each example, where a method of allocation or apportionment is illustrated as an acceptable method, it is assumed that such method is used by the taxpayers on a consistent basis from year to year. Further, it is assumed that each party named in each example operates on a calendar year accounting basis and, where the party is a U.S. taxpayer, files returns on a calendar year basis.

(1) through (18) [Reserved]

(19) Example 19: Supportive expense—(i) Facts—(A) USP, a domestic corporation, purchases and sells products both in the United States and in foreign countries. USP has no foreign subsidiary and no international department. During the taxable year, USP incurs the following expenses with respect to its worldwide activities:

(B) USP has domestic gross receipts from sales of $750,000x and foreign gross receipts from sales of $500,000x and has gross income from such sales in the same ratio, namely $300,000x from domestic sources and $200,000x from foreign sources that is general category income.

(ii) Analysis—(A) Allocation. The above expenses are definitely related and allocable to all of USP's gross income derived from both domestic and foreign markets.

(B) Apportionment. For purposes of applying the foreign tax credit limitation, the statutory grouping is gross income from sources outside the United States in general category income and the residual grouping is gross income from sources within the United States. USP's deductions for its worldwide sales activities must be apportioned between these groupings. USP does not have a separate international division which performs essentially all of the functions required to manage and oversee its foreign activities. The president and sales manager do not maintain time records. The division of their time between domestic and foreign activities varies from day to day and cannot be estimated on an annual basis with any reasonable degree of accuracy. Similarly, there are no facts which would justify a method of apportionment of their salaries or of one of the other listed deductions based on more specific factors than gross receipts or gross income. An acceptable method of apportionment would be on the basis of gross receipts. The apportionment of the $200,000x deduction is as follows:

(20) Example 20: Supportive expense—(i) Facts. Assume the same facts as in paragraph (g)(19)(i) of this section (the facts in Example 19), except that USP's president devotes only 5% of his time to the foreign operations and 95% of his time to the domestic operations and that USP's sales manager devotes approximately 10% of her time to foreign sales and 90% of her time to domestic sales.

(ii) Analysis—(A) Allocation. The expenses incurred by USP with respect to its worldwide activities are definitely related, and therefore allocable to USP's gross income from both its foreign and domestic markets.

(B) Apportionment. On the basis of the additional facts it is not acceptable to apportion the salaries of the president and the sales manager on the basis of gross receipts. It is acceptable to apportion such salaries between the statutory grouping (gross income from sources without the United States) and residual grouping (gross income from sources within the United States) on the basis of time devoted to each sales activity. Remaining expenses may still be apportioned on the basis of gross receipts. The apportionment is as follows:

(21) Example 21: Supportive expense—(i) Facts. FC, a foreign corporation doing business in the United States, is a manufacturer of metal stamping machines. FC has no U.S. subsidiaries and no separate division to manage and oversee its business in the United States. FC manufactures and sells these machines in the United States and in foreign countries A and B and has a separate manufacturing facility in each country. Sales of these machines are FC's only source of income. In Year 1, FC incurs general and administrative expenses related to both its U.S. and foreign operations of $100,000x. It has machine sales of $500,000x, $1,000,000x, and $1,000,000x on which it earns gross income of $200,000x, $400,000x, and $400,000x in the United States, Country A, and Country B, respectively. The income from the manufacture and sale of the machines in countries A and B is not effectively connected with FC's business in the United States.

(ii) Analysis—(A) Allocation. The $100,000x of general and administrative expense is definitely related to the income to which it gives rise, namely a part of the gross income from sales of machines in the United States, in Country A, and in Country B. The expenses are allocable to this class of income, even though FC's gross income from sources outside the United States is excluded income since it is not effectively connected with a U.S. trade or business.

(B) Apportionment. Since FC is a foreign corporation, the statutory grouping is gross income effectively connected with FC's trade of business in the United States, namely gross income from sources within the United States, and the residual grouping is gross income not effectively connected with a trade or business in the United States, namely gross income from countries A and B. Since there are no facts that would require a method of apportionment other than on the basis of sales or gross income, the amount may be apportioned between the two groupings on the basis of amounts of gross income as follows:

(22) through (24) [Reserved]

(25) Example 25: Income taxes—(i) Facts. USP, a domestic corporation, is a manufacturer and distributor of electronic equipment with operations in states A, B, and C. USP also has a foreign branch, as defined in section 904(d)(1)(B) and § 1.904-4(f), in Country Y which manufactures and distributes the same type of electronic equipment. In Year 1, USP has taxable income from these activities, as described under the Code (without taking into account the deduction for state income taxes), of $1,000,000x, of which $200,000x is foreign source foreign branch category income and $800,000x is domestic source income. States A, B, and C each determine USP's income subject to tax within their state by making adjustments to USP's taxable income as determined under the Code, and then apportioning the adjusted taxable income on the basis of the relative amounts of USP's payroll, property, and sales within each state as compared to USP's worldwide payroll, property, and sales. The adjustments made by states A, B, and C all involve adding and subtracting enumerated items from taxable income as determined under the Code. However, in making these adjustments to taxable income, none of the states specifically exempts foreign source income as determined under the Code. On this basis, it is determined that USP has taxable income of $550,000x, $200,000x, and $200,000x in states A, B, and C, respectively. The corporate tax rates in states A, B, and C are 10%, 5%, and 2%, respectively, and USP has total state income tax liabilities of $69,000x ($55,000x + $10,000x + $4,000x), which it deducts as an expense for Federal income tax purposes.

(ii) Analysis—(A) Allocation. USP's deduction of $69,000x for state income taxes is definitely related and thus allocable to the gross income with respect to which the taxes are imposed. Since the statutes of states A, B, and C do not specifically exempt foreign source income (as determined under the Code) from taxation and since, in the aggregate, states A, B, and C tax $950,000x of USP's income while only $800,000x is domestic source income under the Code, it is presumed that state income taxes are imposed on $150,000x of foreign source income. The deduction for state income taxes is therefore related and allocable to both USP's foreign source and domestic source income.

(B) Apportionment. For purposes of computing the foreign tax credit limitation, USP's income is comprised of one statutory grouping, foreign source foreign branch category gross income, and one residual grouping, gross income from sources within the United States. The state income tax deduction of $69,000x must be apportioned between these two groupings. Corporation USP calculates the apportionment on the basis of the relative amounts of foreign source foreign branch category taxable income and U.S. source taxable income subject to state taxation. In this case, state income taxes are presumed to be imposed on $800,000x of domestic source income and $150,000x of foreign source general category income.

(26) Example 26: Income taxes—(i) Facts. Assume the same facts as in paragraph (g)(25)(i) of this section (the facts in Example 25), except that the language of state A's statute and the statute's operation exempt from taxation all foreign source income, as determined under the Code, so that foreign source income is not included in adjusted taxable income subject to apportionment in state A (and factors relating to USP's Country Y branch are not taken into account in computing the state A apportionment fraction).

(ii) Analysis—(A) Allocation. USP's deduction of $69,000x for state income taxes is definitely related and thus allocable to the gross income with respect to which the taxes are imposed. Since state A exempts all foreign source income by statute, state A is presumed to impose tax on $550,000x of USP's $800,000x of domestic source income. USP's state A tax of $55,000x is allocable, therefore, solely to domestic source income. Since the statutes of states B and C do not specifically exclude all foreign source income as determined under the Code, and since states B and C impose tax on $400,000x ($200,000x + $200,000x) of USP's income of which only $250,000x ($800,000x−$550,000x) is presumed to be domestic source, the deduction for the $14,000x of income taxes imposed by states B and C is related and allocable to both foreign source and domestic source income.

(B) Apportionment—(1) For purposes of computing the foreign tax credit limitation, USP's income is comprised of one statutory grouping, foreign source foreign branch category gross income, and one residual grouping, gross income from sources within the United States. The deduction of $14,000x for income taxes of states B and C must be apportioned between these two groupings.

(2) Corporation USP calculates the apportionment on the basis of the relative amounts of foreign source foreign branch category income and U.S. source income subject to state taxation.

(3) Of USP's total income taxes of $69,000x, the amount allocated and apportioned to foreign source foreign branch category income equals $5,250x. The total amount of state income taxes allocated and apportioned to U.S. source income equals $63,750x ($55,000x + $8,750x).

(27) Example 27: Income tax—(i) Facts. Assume the same facts as in paragraph (g)(25)(i) of this section (the facts in Example 25), except that state A, in which USP has significant income-producing activities, does not impose a corporate income tax or other state tax computed on the basis of income derived from business activities conducted in state A. USP therefore has a total state income tax liability in Year 1 of $14,000x ($10,000x paid to state B plus $4,000x paid to state C), all of which is subject to allocation and apportionment under paragraph (b) of this section.

(ii) Analysis—(A) Allocation—(1) USP's deduction of $14,000x for state income taxes is definitely related and allocable to the gross income with respect to which the taxes are imposed. However, in these facts, an adjustment is necessary before the aggregate state taxable incomes can be compared with U.S. source income on the Federal income tax return in the manner described in paragraphs (g)(25)(ii) and (g)(26)(ii) of this section (the analysis in Examples 25 and 26). Unlike the facts in paragraphs (g)(25)(i) and (g)(26)(i) of this section (the facts in Examples 25 and 26), state A imposes no income tax and does not define taxable income attributable to activities in state A. The total amount of USP's income subject to state taxation is, therefore, $400,000x ($200,000x in state B and $200,000x in state C). This total presumptively does not include any income attributable to activities performed in state A and therefore cannot properly be compared to total U.S. source taxable income reported by USP for Federal income tax purposes, which does include income attributable to state A activities.

(2)(i) Accordingly, before applying the method used in paragraphs (g)(25)(ii) and (g)(26)(ii) of this section (the analysis in Examples 25 and 26) to the facts of the example in this paragraph (g)(27), it is necessary first to estimate the amount of taxable income that state A could reasonably attribute to USP's activities in state A, and then to reduce federal taxable income by that amount.

(ii) Any reasonable method may be used to attribute taxable income to USP's activities in state A. For example, the rules of the Uniform Division of Income for Tax Purposes Act (“UDITPA”) attribute income to a state on the basis of the average of three ratios that are based upon the taxpayer's facts—property within the state over total property, payroll within the state over total payroll, and sales within the state over total sales—and, with adjustments, provide a reasonable method for this purpose. When applying the rules of UDITPA to estimate U.S. source income derived from state A activities, the taxpayer's UDITPA factors must be adjusted to eliminate both taxable income and factors attributable to a foreign branch. Therefore, in the example in this paragraph (g)(27) all taxable income as well as UDITPA apportionment factors (property, payroll, and sales) attributable to USP's Country Y branch must be eliminated.

(3)(i) Since it is presumed that, if state A had had an income tax, state A would not attempt to tax the income derived by USP's Country Y branch, any reasonable estimate of the income that would be taxed by state A must exclude any foreign source income.

(ii) When using the rules of UDITPA to estimate the income that would have been taxable by state A in these facts, foreign source income is excluded by starting with federally defined taxable income (before deduction for state income taxes) and subtracting any income derived by USP's Country Y branch. The hypothetical state A taxable income is then determined by multiplying the resulting difference by the average of USP's state A property, payroll, and sales ratios, determined using the principles of UDITPA (after adjustment by eliminating the Country Y branch factors). The resulting product is presumed to be exclusively U.S. source income, and the allocation and apportionment method described in paragraph (g)(26) of this section (Example 26) must then be applied.

(iii) If, for example, state A taxable income were determined to equal $550,000x, then $550,000x of U.S. source income for Federal income tax purposes would be presumed to constitute state A taxable income. Under paragraph (g)(26) of this section (Example 26), the remaining $250,000x ($800,000x−$550,000x) of U.S. source income for Federal income tax purposes would be presumed to be subject to tax in states B and C. Since states B and C impose tax on $400,000x, the application of Example 25 would result in a presumption that $150,000x is foreign source income and $250,000x is domestic source income. The deduction for the $14,000x of income taxes of states B and C would therefore be related and allocable to both foreign source and domestic source income and would be subject to apportionment.

(B) Apportionment. The deduction of $14,000x for income taxes of states B and C is apportioned in the same manner as in paragraph (g)(26) of this section (Example 26). As a result, $5,250x of the $14,000x of state B and state C income taxes is apportioned to foreign source foreign branch category income ($14,000x × $150,000x/$400,000x), and $8,750x ($14,000x × $250,000x/$400,000x) of the $14,000x of state B and state C income taxes is apportioned to U.S. source income.

(h) Applicability date. This section applies to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(c) * * *

(2) Apportionment based on assets. For further guidance, see § 1.861-8(c)(2).

(d) * * *

(2) * * *

(ii) * * *

(A) In general. For further guidance, see § 1.861-8(d)(2)(ii)(A).

(C) Foreign-derived intangible income and inclusions under section 951A(a). For further guidance, see § 1.861-8(d)(2)(ii)(C).

(iii) * * *

(C) For further guidance, see § 1.861-8(d)(2)(iii)(C) through (E).

(D) and (E) [Reserved]

(iv) Value of stock attributable to previously taxed earnings and profits. For further guidance, see § 1.861-8(d)(2)(iv).

(e) * * *

(3) Research and experimental expenditures. For further guidance, see § 1.861-8(e)(3) through (15).

(4) through (15) [Reserved]

(f) Miscellaneous matters. For further guidance, see § 1.861-8(f) through (g).

(g) [Reserved]

(a) In general. For further guidance, see § 1.861-9T(a) through (b).

(b) [Reserved]

(c) Allowable deductions. For further guidance, see § 1.861-9T(c) introductory text.

(1) Disallowed deductions. For further guidance, see § 1.861-9T(c)(1) through (4).

(2) through (4) [Reserved]

(5) Section 163(j). If a taxpayer is subject to section 163(j), the taxpayer's deduction for business interest expense is limited to the sum of the taxpayer's business interest income, 30 percent of the taxpayer's adjusted taxable income for the taxable year, and the taxpayer's floor plan financing interest expense. In the taxable year that any deduction is permitted for business interest expense with respect to a disallowed business interest carryforward, that business interest expense is apportioned for purposes of this section under rules set forth in paragraph (d), (e), or (f) of this section (as applicable) as though it were incurred in the taxable year in which the expense is deducted.

(d) Apportionment rules for individuals, estates, and certain trusts. For further guidance, see § 1.861-9T(d).

(e) Partnerships—(1) In general—aggregate rule. For further guidance, see § 1.861-9T(e)(1).

(4) Entity rule for less than 10 percent limited partners—(i) Partnership interest expense. A limited partner (whether individual or corporate), whose ownership, together with ownership by persons that bear a relationship to the partner described in section 267(b) or section 707, of the capital and profits interests of the partnership is less than 10 percent directly allocates its distributive share of partnership interest expense to its distributive share of partnership gross income. Under § 1.904-4(n)(1)(ii), such a partner's distributive share of foreign source income of the partnership is treated as passive income (subject to the high-taxed income exception of section 904(d)(2)(B)(iii)(II)), except in the case of income from a partnership interest held in the ordinary course of the partner's active trade or business, as defined in § 1.904-4(n)(1)(ii)(B). A partner's distributive share of partnership interest expense (other than partnership interest expense that is directly allocated to identified property under § 1.861-10T) is apportioned in accordance with the partner's relative distributive share of gross foreign source income in each separate category and of gross domestic source income from the partnership. To the extent that partnership interest expense is directly allocated under § 1.861-10T, a comparable portion of the income to which such interest expense is allocated is disregarded in determining the partner's relative distributive share of gross foreign source income in each separate category and domestic source income. The partner's distributive share of the interest expense of the partnership that is directly allocable under § 1.861-10T is allocated according to the treatment, after application of § 1.904-4(n)(1), of the partner's distributive share of the income to which the expense is allocated.

(ii) Other interest expense of the partner. For further guidance, see § 1.861-9T(e)(4)(ii).

(5) Tiered partnerships. For further guidance, see § 1.861-9T(e)(5) through (7).

(6) and (7) [Reserved]

(8) Special rule for downstream partnership loans—(i) In general. For purposes of apportioning interest expense that is not directly allocable under paragraph (e)(4) of this section or § 1.861-10T, the disregarded portion of a downstream partnership loan is not considered an asset of a downstream partnership loan lender (DPL lender). The disregarded portion of a downstream partnership loan is the portion of the value of the loan (as determined under paragraph (h)(4)(i) of this section) that bears the same proportion to the total value of the loan as the matching income amount that is included by the DPL lender for a taxable year with respect to the loan bears to the total amount of downstream partnership loan interest income (DPL interest income) that is included directly or indirectly in gross income by the DPL lender with respect to the loan during that taxable year.

(ii) Treatment of interest expense and interest income attributable to a downstream partnership loan. If a DPL lender (or any other person in the same affiliated group as the DPL lender) takes into account a distributive share of downstream partnership loan interest expense (DPL interest expense), the DPL lender must assign an amount of DPL interest income corresponding to the matching income amount for the taxable year that is attributable to the same loan to the same statutory and residual groupings as the statutory and residual groupings of gross income from which the DPL interest expense is deducted (or would be deducted, without regard to any limitations on the deductibility of interest, such as section 163(j)) by the DPL lender (or any other person in the same affiliated group as the DPL lender).

(iii) Anti-avoidance rule for third party back-to-back loans. If, with a principal purpose of avoiding the rules in this paragraph (e)(8), a person makes a loan to a person that is not related (within the meaning of section 267(b) or 707) to the lender, the unrelated person makes a loan to a partnership, and the first loan would constitute a downstream partnership loan if made directly to the partnership, then the rules of this paragraph (e)(8) apply as if the first loan was made directly to the partnership and the interest expense paid by the partnership is treated as made with respect to the first loan. Such a series of loans will be subject to this recharacterization rule without regard to whether there was a principal purpose of avoiding the rules in this paragraph (e)(8) if the loan to the unrelated person would not have been made or maintained on substantially the same terms but for the loan of funds by the unrelated person to the partnership. The principles of this paragraph (e)(8)(iii) also apply to similar transactions that involve more than two loans and regardless of the order in which the loans are made.

(iv) Anti-avoidance rule for loans held by CFCs. A loan receivable held by a controlled foreign corporation with respect to a loan to a partnership in which a United States shareholder (as defined in § 1.904-5(a)(4)(vi)) of the controlled foreign corporation owns an interest, directly or indirectly through one or more other partnerships or other pass-through entities (as defined in § 1.904-5(a)(4)(iv)), is recharacterized as a loan receivable held directly by the United States shareholder with respect to the loan to such partnership for purposes of this paragraph (e)(8) if the loan was made or transferred with a principal purpose of avoiding the rules in this paragraph (e)(8). An appropriate amount of income derived by the United States shareholder (or any other person in the same affiliated group as the United States shareholder) from the controlled foreign corporation is treated as DPL interest income. Appropriate adjustments must be made to the value and characterization of the stock of the controlled foreign corporation under §§ 1.861-9 and 1.861-12 in order to reflect the portion of the downstream partnership loan held by the controlled foreign corporation that is disregarded under paragraph (e)(8)(i) of this section.

(v) Interest equivalents. The principles of this paragraph (e)(8) apply in the case of a partner, or any person in the same affiliated group as the partner, that takes into account a distributive share of an expense or loss (to the extent deductible) that is allocated and apportioned in the same manner as interest expense under §§ 1.861-9(b) and 1.861-9T(b) and has a matching income amount (treating such interest equivalent as interest income or expense for purposes of paragraph (e)(8)(vi)(B) of this section) with respect to the transaction that gives rise to that expense or loss.

(vi) Definitions. For purposes of this paragraph (e)(8), the following definitions apply.

(A) Affiliated group. The term affiliated group has the meaning provided in § 1.861-11(d)(1).

(B) Matching income amount. The term matching income amount means the lesser of the total amount of the DPL interest income included directly or indirectly in gross income by the DPL lender for the taxable year with respect to a downstream partnership loan or the total amount of the distributive shares of the DPL interest expense of the DPL lender (or any other person in the same affiliated group as the DPL lender) with respect to the loan.

(C) Downstream partnership loan. The term downstream partnership loan means a loan to a partnership for which the loan receivable is held, directly or indirectly through one or more other partnerships or other pass-through entities, either by a person that owns an interest, directly or indirectly through one or more other partnerships or other pass-through entities, in the partnership, or by any person in the same affiliated group as that person.

(D) Downstream partnership loan interest expense (DPL interest expense). The term downstream partnership loan interest expense, or DPL interest expense, means an item of interest expense paid or accrued with respect to a downstream partnership loan, without regard to whether the expense was currently deductible (for example, by reason of section 163(j)).

(E) Downstream partnership loan interest income (DPL interest income). The term downstream partnership loan interest income, or DPL interest income, means an item of gross interest income received or accrued with respect to a downstream partnership loan.

(F) Downstream partnership loan lender (DPL lender). The term downstream partnership loan lender, or DPL lender, means the person that holds the receivable with respect to a downstream partnership loan. If a partnership holds the receivable, then any partner in the partnership (other than a partner described in paragraph (e)(4)(i) of this section) is also considered a DPL lender.

(vii) Examples. The following examples illustrate the application of the rules in this paragraph (e)(8).

(A) Example 1—(1) Facts. US1, a domestic corporation, directly owns 60% of PRS, a foreign partnership that is not engaged in a U.S. trade or business. The remaining 40% of PRS is directly owned by US2, a domestic corporation that is unrelated to US1. US1, US2, and PRS all use the calendar year as their taxable year. In Year 1, US1 loans $1,000x to PRS. For Year 1, US1 has $100x of interest income with respect to the loan and PRS has $100x of interest expense with respect to the loan. US1's distributive share of the interest expense is $60x. Under paragraph (e)(2) of this section, $45x of US1's distributive share of the interest expense is apportioned to U.S. source income and $15x is apportioned to foreign source foreign branch category income. Under paragraph (h)(4)(i) of this section, the total value of the loan between US1 and PRS is $1,000x.

(2) Analysis. The loan by US1 to PRS is a downstream partnership loan and US1 is a DPL lender. Under paragraph (e)(8)(vi)(B) of this section, the matching income amount is $60x, the lesser of the DPL interest income included by US1 with respect to the loan for the taxable year ($100x) and US1's distributive share of the DPL interest expense ($60x). Under paragraph (e)(8)(ii) of this section, US1 assigns $45x of the DPL interest income to U.S. source income and $15x of the DPL interest income to foreign source foreign branch category income. The source and separate category of the remaining $40x of US1's DPL interest income is determined under the generally applicable rules. Under paragraph (e)(8)(i) of this section, the disregarded portion of the downstream partnership loan is $600x ($1,000x × $60x/$100x).

(B) Example 2—(1) Facts. The facts are the same as in paragraph (e)(8)(vii)(A)(1) of this section (the facts in Example 1), except that US1 and US2 are part of the same affiliated group, US2's distributive share of the interest expense is $40x, and under paragraph (e)(2) of this section, $30x of US2's distributive share of the interest expense is apportioned to U.S. source income and $10x is apportioned to foreign source foreign branch category income.

(2) Analysis. The loan by US1 to PRS is a downstream partnership loan and US1 is a DPL lender. Under paragraph (e)(8)(vi)(B) of this section, the matching income amount is $100x, the lesser of the DPL interest income included by US1 with respect to the loan for the taxable year ($100x) and the total amount of US1 and US2's distributive shares of the DPL interest expense ($100x). Under paragraph (e)(8)(ii) of this section, US1 assigns $75x of the DPL interest income to U.S. source income and $25x of the DPL interest income to foreign source foreign branch category income. Under paragraph (e)(8)(i) of this section, the disregarded portion of the downstream partnership loan is $1,000x ($1,000x × $100x/$100x).

(C) Example 3—(1) Facts. US1, a domestic corporation, owns 80% of PRS, a foreign partnership that is not engaged in a U.S. trade or business. The remaining 20% of PRS is owned by US2, a domestic corporation that is unrelated to US1. US1, US2, and PRS all use the calendar year as their taxable year. In Year 1, US1 loans $3,000x to Bank and Bank loans $3,000x to PRS. US1 makes the loan to Bank with a principal purpose of avoiding the rules in this paragraph (e)(8). For Year 1, US1 has $150x of interest income with respect to the loan to Bank and PRS has $175x of interest expense with respect to the loan from Bank. US1's distributive share of the interest expense is $140x. Under paragraph (e)(2) of this section, $126x of US1's distributive share of the interest expense is apportioned to U.S. source income and $14x is apportioned to foreign source foreign branch category income. Under paragraph (h)(4)(i) of this section, the total value of the loan between US1 and PRS is $3,000x.

(2) Analysis. Under paragraph (e)(8)(iii) of this section, because the loan from US1 to Bank is made with a principal purpose of avoiding the rules of this paragraph (e)(8), the rules of this paragraph (e)(8) apply as if the loan by US1 to Bank was made directly to PRS. Accordingly, the loan by US1 to Bank is a downstream partnership loan and US1 is a DPL lender. Under paragraph (e)(8)(vi)(B) of this section, the matching income amount is $140x, the lesser of the DPL interest income included by US1 with respect to the loan for the taxable year ($150x) and US1's distributive share of the DPL interest expense ($140x). Under paragraph (e)(8)(ii) of this section, US1 assigns $126x of the DPL interest income to U.S. source income and $14x of the DPL interest income to foreign source foreign branch category income. The source and separate category of the remaining $10x of US1's DPL interest income is determined under the generally applicable rules. Under paragraph (e)(8)(i) of this section, the disregarded portion of the downstream partnership loan is $2,800x ($3,000x × $140x/$150x).

(D) Example 4—(1) Facts. US1, a domestic corporation, directly owns all of the outstanding stock of CFC, a controlled foreign corporation, and 90% of PRS, a foreign partnership that is not engaged in a U.S. trade or business. The remaining 10% of PRS is owned by US2, a domestic corporation that is unrelated to US1 and CFC. US1, US2, and PRS all use the calendar year as their taxable year. In Year 1, US1 loans $900x to CFC and CFC loans $900x to PRS. CFC makes the loan with a principal purpose of avoiding the rules in this paragraph (e)(8). For Year 1, CFC has $90x of interest income and $90x of interest expense with respect to the loan to PRS, and US1 has $90x of interest income with respect to the loan to CFC. PRS has $90x of interest expense with respect to the loan, and US1's distributive share of the interest expense is $81x. Under paragraph (e)(2) of this section, $54x of US1's distributive share of the interest expense is apportioned to U.S. source income and $27x is apportioned to foreign source foreign branch category income. Under paragraph (h)(4)(i) of this section, the total value of the loan between CFC and PRS is $900x.

(2) Analysis. Under paragraph (e)(8)(iv) of this section, because the loan from CFC to PRS is made with a principal purpose of avoiding the rules of this paragraph (e)(8), the loan from CFC to PRS is recharacterized as a loan receivable held directly by US1, and an appropriate amount of income derived by US1, in this case, the $90x of interest income from the loan to CFC, is treated as DPL interest income. Accordingly, the loan from CFC to PRS is a downstream partnership loan and US1 is a DPL lender. Under paragraph (e)(8)(vi)(B) of this section, the matching income amount is $81x, the lesser of the DPL interest income included by US1 ($90x) and US1's distributive share of the DPL interest expense ($81x). Under paragraph (e)(8)(ii) of this section, US1 assigns $54x of the DPL interest income to U.S. source income and $27x of the DPL interest income to foreign source foreign branch category income. The source and separate category of the remaining $9x of US1's interest income is determined under the generally applicable rules. Under paragraph (e)(8)(i) of this section, the disregarded portion of the downstream partnership loan is $810x ($900x x $81x/$90x). Appropriate adjustments are made to the value and characterization of the stock of CFC under §§ 1.861-9 and 1.861-12 in order to reflect the $810x disregarded portion of the downstream partnership loan.

(9) [Reserved]

(10) Characterizing certain partnership assets as foreign branch category assets. For purposes of applying this paragraph (e) to section 904 as the operative section, a partner that is a United States person that has a distributive share of partnership income that is treated as foreign branch category income under § 1.904-4(f)(1)(i)(B) characterizes its pro rata share of the partnership assets that give rise to such income as assets in the foreign branch category.

(f) Corporations—(1) Domestic corporations. For further guidance, see § 1.861-9T(f)(1).

(2) Section 987 QBUs of domestic corporations—(i) In general. In the application of the asset method described in paragraph (g) of this section, a domestic corporation—

(A) Takes into account the assets of any section 987 QBU (as defined in § 1.987-1(b)(2)), translated according to the rules set forth in paragraph (g) of this section; and

(B) Combines with its own interest expense any deductible interest expense incurred by a section 987 QBU, translated according to the rules under section 987.

(ii) Coordination with section 987(3). For purposes of computing foreign currency gain or loss under section 987(3) (including section 987 gain or loss recognized under § 1.987-5), the rules of this paragraph (f)(2) do not apply. See § 1.987-4.

(iii) Example. The following example illustrates the application of the rules in this paragraph (f)(2).

(A) Facts. X is a domestic corporation that operates B, a branch doing business in a foreign country. B is a section 987 QBU (as defined in § 1.987-1(b)(2)) as well as a foreign branch (as defined in § 1.904-4(f)(3)(iii)). In 2020, without regard to B, X has gross domestic source income of $1,000x and gross foreign source general category income of $500x and incurs $200 of interest expense. Using the tax book value method of apportionment, X, without regard to B, determines the value of its assets that generate domestic source income to be $6,000x and the value of its assets that generate foreign source general category income to be $1,000x. Applying the translation rules of section 987, X (through B) earned $500 of gross foreign source foreign branch category income and incurred $100x of interest expense. B incurred no other expenses. For 2020, the average functional currency book value of B's assets that generate foreign source foreign branch category income translated at the year-end rate for 2020 is $3,000x.

(B) Analysis. The combined assets of X and B for 2020 (averaged under § 1.861-9T(g)(3)) consist 60% ($6,000x/$10,000x) of assets generating domestic source income, 30% ($3,000x/$10,000x) of assets generating foreign source foreign branch category income, and 10% ($1,000x/$10,000x) of assets generating foreign source general category income. The combined interest expense of X and B is $300x. Thus, $180x ($300x x 60%) of the combined interest expense is apportioned to domestic source income, $90x ($300x × 30%) is apportioned to foreign source foreign branch category income, and $30x ($300x × 10%) is apportioned to foreign source general category income, yielding net U.S. source income of $820 ($1,000x−$180x), net foreign source foreign branch category income of $410 ($500x−$90x), and net foreign source general category income of $470x ($500x−$30x).

(3) Controlled foreign corporations—(i) In general. For purposes of computing subpart F income and tested income and computing earnings and profits for all Federal income tax purposes, the interest expense of a controlled foreign corporation may be apportioned using either the asset method described in paragraph (g) of this section or the modified gross income method described in paragraph (j) of this section, subject to the rules of paragraphs (f)(3)(ii) and (iii) of this section.

(4) Noncontrolled 10-percent owned foreign corporations. * * *

(iii) Stock characterization. The stock of a noncontrolled 10-percent owned foreign corporation is characterized under the rules in § 1.861-12(c)(4).

(5) Other relevant provisions. For further guidance, see § 1.861-9T(f)(5).

(g) Asset method—(1) In general. (i) For further guidance, see § 1.861-9T(g)(1)(i).

(ii) A taxpayer may elect to determine the value of its assets on the basis of either the tax book value or the fair market value of its assets. However, for taxable years beginning after December 31, 2017, the fair market value method is not allowed with respect to allocations and apportionments of interest expense. See section 864(e)(2). For rules concerning the application of an alternative method of valuing assets for purposes of the tax book value method, see paragraph (i) of this section. For rules concerning the application of the fair market value method, see paragraph (h) of this section.

(iii) [Reserved]

(iv) For rules relating to earnings and profits adjustments by taxpayers using the tax book value method for the stock in certain 10 percent owned corporations, see § 1.861-12(c)(2).

(v) [Reserved]

(2) Asset values—(i) General rule—(A) Average of values. For purposes of determining the value of assets under this section, an average of values (book or market) within each statutory grouping and the residual grouping is computed for the year on the basis of values of assets at the beginning and end of the year. For the first taxable year beginning after December 31, 2017 (post-2017 year), a taxpayer that determined the value of its assets on the basis of the fair market value method for purposes of apportioning interest expense in its prior taxable year may choose to determine asset values under the tax book value method (or the alternative tax book value method) by treating the value of its assets as of the beginning of the post-2017 year as equal to the value of its assets at the end of the first quarter of the post-2017 year, provided that each member of the affiliated group (as defined in § 1.861-11T(d)) determines its asset values on the same basis. Where a substantial distortion of asset values would result from averaging beginning-of-year and end-of-year values, as might be the case in the event of a major corporate acquisition or disposition, the taxpayer must use a different method of asset valuation that more clearly reflects the average value of assets weighted to reflect the time such assets are held by the taxpayer during the taxable year.

(B) Tax book value method. Under the tax book value method, the value of an asset is determined based on the adjusted basis of the asset. For purposes of determining the value of stock in a 10 percent owned corporation at the beginning and end of the year under the tax book value method, the tax book value is determined without regard to any adjustments under section 961(a) or 1293(d), see § 1.861-12(c)(2)(i)(B)(1), and before the adjustment required by § 1.861-12(c)(2)(i)(A) to the basis of stock in the 10 percent owned corporation. The average of the tax book value of the stock at the beginning and end of the year is then adjusted with respect to earnings and profits as described in § 1.861-12(c)(2)(i).

(ii) Special rule for qualified business units of domestic corporations with functional currency other than the U.S. dollar—(A) Tax book value method. For further guidance, see § 1.861-9T(g)(2)(ii)(A).

(1) Section 987 QBU. For further guidance, see § 1.861-9T(g)(2)(ii)(A)(1).

(2) U.S. dollar approximate separate transactions method. In the case of a branch to which the U.S. dollar approximate separate transactions method of accounting described in § 1.985-3 applies, the beginning-of-year dollar amount of the assets is determined by reference to the end-of-year balance sheet of the branch for the immediately preceding taxable year, adjusted for U.S. generally accepted accounting principles and Federal income tax accounting principles, and translated into U.S. dollars as provided in § 1.985-3(c). The end-of-year dollar amount of the assets of the branch is determined in the same manner by reference to the end-of-year balance sheet for the current taxable year. The beginning-of-year and end-of-year dollar tax book value of assets, as so determined, within each grouping is then averaged as provided in paragraph (g)(2)(i) of this section.

(B) Fair market value method. For further guidance, see § 1.861-9T(g)(2)(ii)(B).

(iii) Adjustment for directly allocated interest. For further guidance, see § 1.861-9T(g)(2)(iii).

(iv) Assets in intercompany transactions. For further guidance, see § 1.861-9T(g)(2)(iv).

(3) Characterization of assets. For further guidance, see § 1.861-9T(g)(3).

(4) Characterization of lower tier entities at the level of a CFC. In the case of a controlled foreign corporation that is applying the asset method, see for example § 1.861-12T(c)(3)(ii) (requiring the application of § 1.861-9T(g) at the level of the controlled foreign corporation) or paragraph (f)(3)(i) of this section, the controlled foreign corporation (and any lower-tier controlled foreign corporations) must characterize stock of a lower-tier 10 percent owned corporation by applying § 1.861-12 and treating the controlled foreign corporation as the relevant taxpayer for such purposes. In the case of a controlled foreign corporation that owns stock in one or more lower-tier corporations, in applying the asset method, the first-tier controlled foreign corporation must take into account the stock in the lower-tier corporations. Therefore, the controlled foreign corporation (and any lower-tier controlled foreign corporations) must make basis adjustments in lower-tier 10 percent owned corporations under § 1.861-12(c)(2) for purposes of valuing and characterizing the assets of such controlled foreign corporation. For purposes of this paragraph (g)(4), the stock of each such lower-tier corporation is characterized by reference to the assets owned during the lower-tier corporation's taxable year that ends during the first-tier controlled foreign corporation's taxable year. The analysis of assets under this paragraph (g)(4) and § 1.861-12 of a controlled foreign corporation that is in a chain of 10 percent owned corporations must begin at the lowest-tier 10 percent owned corporation and proceed up the chain to the first-tier controlled foreign corporation. See also § 1.861-12T(c)(3)(ii).

(h) Fair market value method. An affiliated group (as defined in § 1.861-11T(d)) or other taxpayer (the taxpayer) that elects to use the fair market value method of apportionment values its assets according to the methodology described in this paragraph (h). Effective for taxable years beginning after December 31, 2017, the fair market value method is not allowed for purposes of apportioning interest expense. See section 864(e)(2). However, a taxpayer may continue to apportion deductions other than interest expense that are properly apportioned based on fair market value according to the methodology described in this paragraph (h). See § 1.861-8(c)(2).

(1) Determination of values. For further guidance, see § 1.861-9T(h)(1) through (3).

(2) and (3) [Reserved]

(5) Characterizing stock in related persons. Stock in a related person held by the taxpayer or by another related person shall be characterized on the basis of the fair market value of the taxpayer's pro rata share of assets held by the related person attributed to each statutory grouping and the residual grouping under the stock characterization rules of § 1.861-12T(c)(3)(ii), except that the portion of the value of intangible assets of the taxpayer and related persons that is apportioned to the related person under § 1.861-9T(h)(2) shall be characterized on the basis of the net income before interest expense of the related person within each statutory grouping or residual grouping (excluding income that is passive under § 1.904-4(b)).

(i) * * *

(2) * * * (i) Except as provided in this paragraph (i)(2)(i), a taxpayer may elect to use the alternative tax book value method. For the taxpayer's first taxable year beginning after December 31, 2017, the Commissioner's approval is not required to switch from the fair market value method to the alternative tax book value method for purposes of apportioning interest expense. * * *

(j) Modified gross income method. For further guidance, see § 1.861-9T(j) introductory text.

(1) For further guidance, see § 1.861-9T(j)(1).

(2) For further guidance, see § 1.861-9T(j)(2) introductory text.

(i) Step 1. For further guidance, see § 1.861-9T(j)(2)(i).

(ii) Step 2. Moving to the next higher-tier controlled foreign corporation, combine the gross income of such corporation within each grouping with its pro rata share (as determined under principles similar to section 951(a)(2)) of the gross income net of interest expense of all lower-tier controlled foreign corporations held by such higher-tier corporation within the same grouping adjusted as follows:

(A) Exclude from the gross income of the higher-tier corporation any dividends or other payments received from the lower-tier corporation other than interest income received from the lower-tier corporation;

(B) Exclude from the gross income net of interest expense of any lower-tier corporation any gross subpart F income, net of interest expense apportioned to such income;

(C) Then apportion the interest expense of the higher-tier controlled foreign corporation based on the adjusted combined gross income amounts; and

(D) Repeat paragraphs (j)(2)(ii)(A) through (C) of this section for each next higher-tier controlled foreign corporation in the chain.

(k) Applicability date. This section applies to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(c) * * *

(5) Section 163(j). For further guidance, see § 1.861-9(c)(5).

(e) * * *

(4) * * *

(i) Partnership interest expense. For further guidance, see § 1.861-9(e)(4)(i).

(8) Special rule for downstream partnership loans. For further guidance, see § 1.861-9(e)(8) through (10).

(9) and (10) [Reserved]

(f) * * *

(2) Section 987 QBUs of domestic corporations. For further guidance, see § 1.861-9(f)(2) through (f)(3)(i).

(4) Noncontrolled 10-percent owned foreign corporations. For further guidance, see § 1.861-9(f)(4).

(g) * * *

(1) * * *

(ii) For further guidance, see § 1.861-9(g)(1)(ii) through (g)(2)(i).

(2) * * *

(ii) * * *

(A) * * *

(2) U.S. dollar approximate separate transactions method. For further guidance, see § 1.861-9(g)(2)(ii)(A)(2).

(h) Fair market value method. For further guidance, see § 1.861-9(h).

(j) * * *

(2) * * *

(ii) Step 2. For further guidance, see § 1.861-9(j)(2)(ii).

(e) * * *

(8) * * *

(vi) Classification of hybrid stock. In determining the amount of its related group indebtedness for any taxable year, a U.S. shareholder must not treat stock in a related controlled foreign corporation as related group indebtedness, regardless of whether the related controlled foreign corporation claims a deduction for interest under foreign law for distributions on such stock. For purposes of determining the foreign base period ratio under paragraph (e)(2)(iv) of this section for a taxable year that ends on or after December 4, 2018, the rules of this paragraph (e)(8)(vi) apply to determine the related group debt-to-asset ratio in each taxable year included in the foreign base period, including in taxable years that end before December 4, 2018.

(f) Applicability date. This section applies to taxable years that end on or after December 4, 2018.

(e) Treatment of certain related group indebtedness. For further guidance, see § 1.861-10(e).

(a) In general. For further guidance, see § 1.861-11T(a).

(b) Scope of application—(1) Application of section 864(e)(1) and (5) (concerning the definition and treatment of affiliated groups). Section 864(e)(1) and (5) and the portions of this section implementing section 864(e)(1) and (5) apply to the computation of foreign source taxable income for purposes of section 904 (relating to various limitations on the foreign tax credit). Section 864(e)(1) and (5) and the portions of this section implementing section 864(e)(1) and (5) also apply in connection with section 907 to determine reductions in the amount allowed as a foreign tax credit under section 901. Section 864(e)(1) and (5) and the portions of this section implementing section 864(e)(1) and (5) also apply to the computation of the combined taxable income of the related supplier and a foreign sales corporation (FSC) (under sections 921 through 927) as well as the combined taxable income of the related supplier and a domestic international sales corporation (DISC) (under sections 991 through 997).

(2) Nonapplication of section 864(e)(1) and (5) (concerning the definition and treatment of affiliated groups). For further guidance, see § 1.861-11T(b)(2).

(c) General rule for affiliated corporations. For further guidance, see § 1.861-11T(c).

(h) Applicability dates. This section applies to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(b) * * *

(1) Application of section 864(e)(1) and (5) (concerning the definition and treatment of affiliated groups). For further guidance, see § 1.861-11(b)(1).

(a) In general. The rules in this section apply to taxpayers apportioning expenses under an asset method to income in the various separate categories described in § 1.904-5(a)(4)(v), and supplement other rules provided in §§ 1.861-9 through 1.861-11T. The principles of the rules in this section also apply in apportioning expenses among statutory and residual groupings for any other operative section. See also § 1.861-8(f)(2)(i) for a rule requiring conformity of allocation methods and apportionment principles for all operative sections. Paragraph (b) of this section describes the treatment of inventories. Paragraph (c)(1) of this section concerns the treatment of various stock assets. Paragraph (c)(2) of this section describes a basis adjustment for stock in 10 percent owned corporations. Paragraph (c)(3) of this section sets forth rules for characterizing the stock in controlled foreign corporations. Paragraph (c)(4) of this section describes the treatment of stock of noncontrolled 10-percent owned foreign corporations. Paragraph (d)(1) of this section concerns the treatment of notes. Paragraph (d)(2) of this section concerns the treatment of notes of controlled foreign corporations. Paragraph (e) of this section describes the treatment of certain portfolio securities that constitute inventory or generate income primarily in the form of gains. Paragraph (f) of this section describes the treatment of assets that are funded by interest that is capitalized, deferred, or disallowed. Paragraph (g) of this section concerns the treatment of FSC stock and of assets of the related supplier generating foreign trade income. Paragraph (h) of this section concerns the treatment of DISC stock and of assets of the related supplier generating qualified export receipts.

(b) Inventories. For further guidance, see § 1.861-12T(b).

(c) Treatment of stock—(1) In general. For further guidance, see § 1.861-12T(c)(1).

(3) Characterization of stock of controlled foreign corporations—(i) Operative sections—(A) Operative sections other than section 904. For purposes of applying this section to an operative section other than section 904, stock in a controlled foreign corporation (as defined in section 957) is characterized as an asset in the relevant groupings on the basis of the asset method described in paragraph (c)(3)(ii) of this section, or the modified gross income method described in paragraph (c)(3)(iii) of this section. Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of assets is characterized in the hands of its United States shareholders under the asset method described in paragraph (c)(3)(ii) of this section. Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of modified gross income is characterized in the hands of its United States shareholders under the modified gross income method described in paragraph (c)(3)(iii) of this section.

(B) Section 904 as operative section. For purposes of applying this section to section 904 as the operative section, § 1.861-13 applies to characterize the stock of a controlled foreign corporation as an asset producing foreign source income in the separate categories described in § 1.904-5(a)(4)(v), or as an asset producing U.S. source income in the residual grouping, in the hands of the United States shareholder, and to determine the portion of the stock that gives rise to an inclusion under section 951A(a) that is treated as an exempt asset under § 1.861-8(d)(2)(ii)(C). Section 1.861-13 also provides rules for subdividing the stock in the various separate categories and the residual grouping into a section 245A subgroup and a non-section 245A subgroup in order to determine the amount of the adjustments required by section 904(b)(4) and § 1.904(b)-3(c) with respect to the section 245A subgroup, and provides rules for determining the portion of the stock that gives rise to a dividend eligible for a deduction under section 245(a)(5) that is treated as an exempt asset under § 1.861-8(d)(2)(ii)(B).

(ii) Asset method. For further guidance, see § 1.861-12T(c)(3)(ii).

(iii) Modified gross income method. Under the modified gross income method, the taxpayer characterizes the tax book value of the stock of the first-tier controlled foreign corporation based on the gross income, net of interest expense, of the controlled foreign corporation (as computed under § 1.861-9T(j) to include certain gross income, net of interest expense, of lower-tier controlled foreign corporations) within each relevant category for the taxable year of the controlled foreign corporation ending with or within the taxable year of the taxpayer. For purposes of this paragraph (c)(3)(iii), however, the gross income, net of interest expense, of the first-tier controlled foreign corporation includes the total amount of gross subpart F income, net of interest expense, of any lower-tier controlled foreign corporation that was excluded under the rules of § 1.861-9(j)(2)(ii)(B).

(4) Characterization of stock of noncontrolled 10-percent owned foreign corporations—(i) In general. Except in the case of a nonqualifying shareholder described in paragraph (c)(4)(ii) of this section, the principles of § 1.861-12(c)(3), including the relevant rules of § 1.861-13 when section 904 is the operative section, apply to characterize stock in a noncontrolled 10-percent owned foreign corporation (as defined in section 904(d)(2)(E)). Accordingly, stock in a noncontrolled 10-percent owned foreign corporation is characterized as an asset in the various separate categories on the basis of either the asset method described in § 1.861-12T(c)(3)(ii) or the modified gross income method described in § 1.861-12(c)(3)(iii). Stock in a noncontrolled 10-percent owned foreign corporation the interest expense of which is apportioned on the basis of assets is characterized in the hands of its shareholders under the asset method described in § 1.861-12T(c)(3)(ii). Stock in a noncontrolled 10-percent owned foreign corporation the interest expense of which is apportioned on the basis of gross income is characterized in the hands of its shareholders under the modified gross income method described in § 1.861-12(c)(3)(iii).

(ii) Nonqualifying shareholders. Stock in a noncontrolled 10-percent owned foreign corporation is characterized as a passive category asset in the hands of a shareholder that either is not a domestic corporation or is not a United States shareholder with respect to the noncontrolled 10-percent owned foreign corporation for the taxable year. Stock in a noncontrolled 10-percent owned foreign corporation is characterized as in the separate category described in section 904(d)(4)(C)(ii) in the hands of any shareholder with respect to whom look-through treatment is not substantiated. See also § 1.904-5(c)(4)(iii)(B). In the case of a noncontrolled 10-percent owned foreign corporation that is a passive foreign investment company with respect to a shareholder, stock in the noncontrolled 10-percent owned foreign corporation is characterized as a passive category asset in the hands of the shareholder if such shareholder does not meet the ownership requirements described in section 904(d)(2)(E)(i)(II).

(d) Treatment of notes—(1) General rule. For further guidance, see § 1.861-12T(d)(1).

(2) Characterization of related controlled foreign corporation notes. The debt of a controlled foreign corporation is characterized in the same manner as the interest income derived from that debt obligation. See §§ 1.904-4 and 1.904-5(c)(2) for rules treating interest income as income in a separate category.

(e) Portfolio securities that constitute inventory or generate primarily gains. For further guidance, see § 1.861-12T(e) through (i).

(a) In general. For further guidance, see § 1.861-12(a).

(c) * * *

(3) * * *

(i) Operative sections. For further guidance, see § 1.861-12(c)(3)(i).

(iii) Modified gross income method. For further guidance, see § 1.861-12(c)(3)(iii).

(d) * * *

(2) Characterization of related controlled foreign corporation notes. For further guidance, see § 1.861-12(d)(2).

(a) Methodology. For purposes of allocating and apportioning deductions for purposes of section 904 as the operative section, stock in a controlled foreign corporation owned directly or indirectly through a partnership or other pass-through entity by a United States shareholder is characterized by the United States shareholder under the rules described in this section. In general, paragraphs (a)(1) through (5) of this section characterize the stock of the controlled foreign corporation as an asset in the various statutory groupings and residual grouping based on the type of income that the stock of the controlled foreign corporation generates, has generated, or may reasonably be expected to generate when the income is included by the United States shareholder.

(1) Step 1: Characterize stock as generating income in statutory groupings under the asset or modified gross income method—(i) Asset method. A United States shareholder of a controlled foreign corporation that apportions its interest expense on the basis of assets must characterize stock of the controlled foreign corporation using the asset method described in § 1.861-12T(c)(3)(ii) to assign the assets of the controlled foreign corporation to the statutory groupings described in paragraphs (a)(1)(i)(A)(1) through (10) and (a)(1)(i)(B) of this section. If the controlled foreign corporation owns stock in a lower-tier noncontrolled 10-percent owned foreign corporation, the assets of the lower-tier noncontrolled 10-percent owned foreign corporation are assigned to a gross subpart F income grouping to the extent such assets generate income that, if distributed to the controlled foreign corporation, would be gross subpart F income of the controlled foreign corporation. See also § 1.861-12(c)(4).

(A) General and passive categories. Within each of the controlled foreign corporation's general category and passive category, each of the following subgroups within each category is a separate statutory grouping—

(1) Foreign source gross tested income;

(2) For each applicable treaty, U.S. source gross tested income that, when taken into account by a United States shareholder under section 951A, is resourced in the hands of the United States shareholder (resourced gross tested income);

(3) U.S. source gross tested income not described in paragraph (a)(1)(i)(A)(2) of this section;

(4) Foreign source gross subpart F income;

(5) For each applicable treaty, U.S. source gross subpart F income that, when included by a United States shareholder under section 951(a)(1), is resourced in the hands of the United States shareholder (resourced gross subpart F income);

(6) U.S. source gross subpart F income not described in paragraph (a)(1)(i)(A)(5) of this section;

(7) Foreign source gross section 245(a)(5) income;

(8) U.S. source gross section 245(a)(5) income;

(9) Any other foreign source gross income (specified foreign source general category gross income or specified foreign source passive category gross income, as the case may be); and

(10) Any other U.S. source gross income (specified U.S. source general category gross income or specified U.S. source passive category gross income, as the case may be).

(B) Section 901(j) income. For each country described in section 901(j), all gross income from sources in that country.

(ii) Modified gross income method. A United States shareholder of a controlled foreign corporation that apportions its interest expense on the basis of modified gross income must characterize stock of the controlled foreign corporation using the modified gross income method under § 1.861-12(c)(3)(iii) to assign the modified gross income of the controlled foreign corporation to the statutory groupings described in paragraphs (a)(1)(i)(A)(1) through (10) and (a)(1)(i)(B) of this section. For purposes of this paragraph (a)(1)(ii), the rules described in §§ 1.861-12(c)(3)(iii) and 1.861-9T(j)(2) apply to combine gross income in a statutory grouping that is earned by the controlled foreign corporation with gross income of lower-tier controlled foreign corporations that is in the same statutory grouping. For example, foreign source general category gross tested income (net of interest expense) earned by the controlled foreign corporation is combined with its pro rata share of the foreign source general category gross tested income (net of interest expense) of lower-tier controlled foreign corporations. If the controlled foreign corporation owns stock in a lower-tier noncontrolled 10-percent owned foreign corporation, gross income of the lower-tier noncontrolled 10-percent owned foreign corporation is assigned to a gross subpart F income grouping to the extent that the income, if distributed to the upper-tier controlled foreign corporation, would be gross subpart F income of the upper-tier controlled foreign corporation. See also § 1.861-12(c)(4).

(2) Step 2: Assign stock to the section 951A category. A controlled foreign corporation is not treated as earning section 951A category income. The portion of the value of the stock of the controlled foreign corporation that is assigned to the section 951A category (as defined in § 1.904-4(g)) equals the value of the portion of the stock of the controlled foreign corporation that is assigned to the foreign source gross tested income statutory groupings within the general category (general category gross tested income stock) multiplied by the United States shareholder's inclusion percentage. Under § 1.861-8(d)(2)(ii)(C)(2)(ii), a portion of the value of stock assigned to the section 951A category may be treated as an exempt asset. The portion of the general category gross tested income stock that is not characterized as a section 951A category asset remains a general category asset and may result in expenses being disregarded under section 904(b)(4). See paragraph (a)(5)(ii) of this section and § 1.904(b)-3. No portion of the passive category gross tested income stock or U.S. source gross tested income stock is assigned to the section 951A category.

(3) Step 3: Assign stock to a treaty category—(i) Inclusions under section 951A(a). The portion of the value of the stock of the controlled foreign corporation that is assigned to a particular treaty category due to an inclusion of U.S. source income under section 951A(a) that was resourced under a particular treaty equals the value of the portion of the stock of the controlled foreign corporation that is assigned to the resourced gross tested income statutory grouping within each of the controlled foreign corporation's general or passive categories (resourced gross tested income stock) multiplied by the United States shareholder's inclusion percentage. Under § 1.861-8(d)(2)(ii)(C)(2)(ii), a portion of the value of stock assigned to a particular treaty category by reason of this paragraph (a)(3)(i) may be treated as an exempt asset. The portion of the resourced gross tested income stock that is not characterized as a treaty category asset remains a U.S. source general or passive category asset, as the case may be, that is in the residual grouping and may result in expenses being disregarded under section 904(b)(4) for purposes of determining entire taxable income under section 904(a). See paragraph (a)(5)(iv) of this section and § 1.904(b)-3.

(ii) Inclusions under section 951(a)(1). The portion of the value of the stock of the controlled foreign corporation that is assigned to a particular treaty category due to an inclusion of U.S. source income under section 951(a)(1) that was resourced under a treaty equals the value of the portion of the stock of the controlled foreign corporation that is assigned to the resourced gross subpart F income statutory grouping within each of the controlled foreign corporation's general category or passive category.

(4) Step 4: Aggregate stock within each separate category and assign stock to the residual grouping. The portions of the value of stock of the controlled foreign corporation assigned to foreign source statutory groupings that were not specifically assigned to the section 951A category under paragraph (a)(2) of this section (Step 2) are aggregated within the general category and the passive category to characterize the stock as general category stock and passive category stock, respectively. The portions of the value of stock of the controlled foreign corporation assigned to U.S. source statutory groupings that were not specifically assigned to a particular treaty category under paragraph (a)(3) of this section (Step 3) are aggregated to characterize the stock as U.S. source category stock, which is in the residual grouping. Stock assigned to the separate category for income described in section 901(j)(1) remains in that category.

(5) Step 5: Determine section 245A and non-section 245A subgroups for each separate category and U.S. source category—(i) In general. In the case of stock of a controlled foreign corporation that is held directly or indirectly through a partnership or other pass-through entity by a United States shareholder that is a domestic corporation, stock of the controlled foreign corporation that is general category stock, passive category stock, and U.S. source category stock is subdivided between a section 245A subgroup and a non-section 245A subgroup under paragraphs (a)(5)(ii) through (v) of this section for purposes of applying section 904(b)(4) and § 1.904(b)-3(c). Each subgroup is treated as a statutory grouping under § 1.861-8(a)(4) for purposes of allocating and apportioning deductions under §§ 1.861-8 through 1.861-14T and 1.861-17 in applying section 904 as the operative section. Deductions apportioned to each section 245A subgroup are disregarded under section 904(b)(4). See § 1.904(b)-3. Deductions apportioned to the statutory groupings for gross section 245(a)(5) income are not disregarded under section 904(b)(4); however, a portion of the stock assigned to those groupings is treated as exempt under § 1.861-8T(d)(2)(ii)(B).

(ii) Section 245A subgroup of general category stock. The portion of the general category stock of the controlled foreign corporation that is assigned to the section 245A subgroup of the general category equals the value of the general category gross tested income stock of the controlled foreign corporation that is not assigned to the section 951A category under paragraph (a)(2) of this section (Step 2), plus the value of the portion of the stock of the controlled foreign corporation that is assigned to the specified foreign source general category gross income statutory grouping.

(iii) Section 245A subgroup of passive category stock. The portion of passive category stock of the controlled foreign corporation that is assigned to the section 245A subcategory of the passive category equals the sum of—

(A) The value of the portion of the stock of the controlled foreign corporation that is assigned to the gross tested income statutory grouping within foreign source passive category income multiplied by a percentage equal to 100 percent minus the United States shareholder's inclusion percentage for passive category gross tested income; and

(B) The value of the portion of the stock of the controlled foreign corporation that was assigned to the specified foreign source passive category gross income statutory grouping.

(iv) Section 245A subgroup of U.S. source category stock. The portion of U.S. source category stock of the controlled foreign corporation that is assigned to the section 245A subgroup of the U.S. source category equals the sum of—

(A) The value of the portion of the stock of the controlled foreign corporation that is assigned to the U.S. source general category gross tested income statutory grouping multiplied by a percentage equal to 100 percent minus the United States shareholder's inclusion percentage for the general category;

(B) The value of the portion of the stock of the controlled foreign corporation that is assigned to the U.S. source passive category gross tested income statutory grouping multiplied by a percentage equal to 100 percent minus the United States shareholder's inclusion percentage for the passive category;

(C) The value of the resourced gross tested income stock of the controlled foreign corporation that is not assigned to a particular treaty category under paragraph (a)(3)(i) of this section (Step 3);

(D) The value of the portion of the stock of the controlled foreign corporation that is assigned to the specified U.S. source general category gross income statutory grouping; and

(E) The value of the portion of the stock of the controlled foreign corporation that is assigned to the specified U.S. source passive category gross income statutory grouping.

(v) Non-section 245A subgroup. The value of stock of a controlled foreign corporation that is not assigned to the section 245A subgroup within the general or passive category or the residual grouping is assigned to the non-section 245A subgroup within such category or grouping. The value of stock of a controlled foreign corporation that is assigned to the section 951A category, the separate category for income described in section 901(j)(1), or a particular treaty category is always assigned to a non-section 245A subgroup.

(b) Definitions. This paragraph (b) provides definitions that apply for purposes of this section.

(1) Gross section 245(a)(5) income. The term gross section 245(a)(5) income means all items of gross income described in section 245(a)(5)(A) and (B).

(2) Gross subpart F income. The term gross subpart F income means all items of gross income that are taken into account by a controlled foreign corporation in determining its subpart F income under section 952, except for items of gross income described in section 952(a)(5).

(3) Gross tested income. The term gross tested income has the meaning provided in § 1.951A-2(c)(1).

(4) Inclusion percentage. The term inclusion percentage has the meaning provided in § 1.960-2(c)(2).

(5) Separate category. The term separate category has the meaning provided in § 1.904-5(a)(4)(v).

(6) Treaty category. The term treaty category means a category of income earned by a controlled foreign corporation for which section 904(a), (b), and (c) are applied separately as a result of income being resourced under a treaty. See, for example, section 245(a)(10), 865(h), or 904(h)(10). A United States shareholder may have multiple treaty categories for amounts of income resourced by the United States shareholder under a treaty. See § 1.904-5(m)(7).

(7) U.S. source category. The term U.S. source category means the aggregate of U.S. source income in each separate category listed in section 904(d)(1).

(c) Examples. The following examples illustrate the application of the rules in this section.

(1) Example 1: Asset method—(i) Facts—(A) USP, a domestic corporation, directly owns all of the stock of a controlled foreign corporation, CFC1. The tax book value of CFC1's stock is $20,000x. USP uses the asset method described in § 1.861-12T(c)(3)(ii) to characterize the stock of CFC1. USP's inclusion percentage is 70%.

(B) CFC1 owns the following assets with the following values as determined under §§ 1.861-9(g)(2) and 1.861-9T(g)(3): Assets that generate income described in the foreign source gross tested income statutory grouping within the general category ($4,000x), assets that generate income described in the foreign source gross subpart F income statutory grouping within the general category ($1,000x), assets that generate specified foreign source general category gross income ($3,000x), and assets that generate income described in the foreign source gross subpart F income statutory grouping within the passive category ($2,000x).

(C) CFC1 also owns all of the stock of CFC2, a controlled foreign corporation. The tax book value of CFC1's stock in CFC2 is $6,000x. CFC2 owns the following assets with the following values as determined under §§ 1.861-9(g)(2) and 1.861-9T(g)(3): Assets that generate income described in the foreign source gross subpart F income statutory grouping within the general category ($2,250x) and assets that generate specified foreign source general category gross income ($750x).

(ii) Analysis—(A) Step 1—(1) Characterization of CFC2 stock. CFC2 has total assets of $3,000x, $2,250x of which are in the foreign source gross subpart F income statutory grouping within the general category and $750x of which are in the specified foreign source general category gross income statutory grouping. Accordingly, CFC2's stock is characterized as $4,500x ($2,250x/$3,000x × $6,000x) in the foreign source gross subpart F income statutory grouping within the general category and $1,500x ($750x/$3,000x × $6,000x) in the specified foreign source general category gross income statutory grouping.

(2) Characterization of CFC1 stock. CFC1 has total assets of $16,000x, $4,000x of which are in the foreign source gross tested income statutory grouping within the general category, $5,500x of which are in the foreign source gross subpart F income statutory grouping within the general category (including the portion of CFC2 stock assigned to that statutory grouping), $4,500x of which are in the specified foreign source gross general category income statutory grouping (including the portion of CFC2 stock assigned to that statutory grouping), and $2,000x of which are in the foreign source gross subpart F income statutory grouping within the passive category. Accordingly, CFC1's stock is characterized as $5,000x ($4,000x/$16,000x × $20,000x) in the foreign source gross tested income statutory grouping within the general category, $6,875x ($5,500x/$16,000x × $20,000x) in the foreign source gross subpart F income statutory grouping within the general category, $5,625x ($4,500x/$16,000x × $20,000x) in the specified foreign source gross general category income statutory grouping, and $2,500x ($2,000x/$16,000x × $20,000x) in the foreign source gross subpart F income statutory grouping within the passive category.

(B) Step 2. The value of the portion of the stock of CFC1 that is general category gross tested income stock is $5,000x. USP's inclusion percentage is 70%. Accordingly, under paragraph (a)(2) of this section, $3,500x of the stock of CFC1 is assigned to the section 951A category and a portion thereof may be treated as an exempt asset under § 1.861-8(d)(2)(ii)(C)(2)(ii). The remainder, $1,500x, remains a general category asset.

(C) Step 3. No portion of the stock of CFC1 is resourced gross tested income stock or assigned to the resourced gross subpart F income statutory grouping in any treaty category. Accordingly, no portion of the stock of CFC1 is assigned to a treaty category under paragraph (a)(3) of this section.

(D) Step 4—(1) General category stock. The total value of the portion of the stock of CFC1 that is general category stock is $14,000x, which is equal to $1,500x (the value of the portion of the general category stock of CFC1 that was not assigned to the section 951A category in paragraph (c)(1)(ii)(B) of this section (Step 2)) plus $6,875x (the value of the portion of the stock of CFC1 assigned to the foreign source gross subpart F income statutory grouping within the general category) plus $5,625x (the value of the portion of the stock of CFC1 assigned to the specified foreign source gross income statutory grouping within the general category).

(2) Passive category stock. The total value of the portion of the stock of CFC1 that is passive category stock is $2,500x.

(3) U.S source category stock. No value of the portion of the stock of CFC1 is U.S. source category stock.

(E) Step 5—(1) General category stock. Under paragraph (a)(5)(ii) of this section, the value of the portion of the stock of CFC1 assigned to the section 245A subgroup of general category stock is $7,125x, which is equal to $1,500x (the value of the portion of the general category stock of CFC1 that was not assigned to the section 951A category in paragraph (c)(1)(ii)(B) of this section (Step 2)) plus $5,625x (the value of the portion of the stock of CFC1 assigned to the specified foreign source general category gross income statutory grouping). Under paragraph (a)(5)(v) of this section, the remainder of the general category stock of CFC1, $6,875x, is assigned to the non-section 245A subgroup of general category stock.

(2) Passive category stock. No portion of the passive category stock of CFC1 is in the foreign source gross tested income statutory grouping or the specified foreign source passive category gross income statutory grouping. Accordingly, under paragraph (a)(5)(iii) of this section, no value of the portion of the stock of CFC1 is assigned to the section 245A subgroup of passive category stock. Under paragraph (a)(5)(v) of this section, the passive category stock of CFC1, $2,500x is assigned to the non-section 245A subgroup of passive category stock.

(3) Section 951A category stock. Under paragraph (a)(5)(v) of this section, all of the section 951A category stock, $3,500x, is assigned to the non-section 245A subgroup of section 951A category stock.

(F) Summary. For purpose of the allocation and apportionment of expenses, $14,000x of the stock of CFC1 is characterized as general category stock, $7,125x of which is in the section 245A subgroup and $6,875x of which is in the non-section 245A subgroup; $2,500x of the stock of CFC1 is characterized as passive category stock, all of which is in the non-section 245A subgroup; and $3,500x of the stock of CFC1 is characterized as section 951A category stock, all of which is in the non-section 245A subgroup.

(2) Example 2: Asset method with noncontrolled 10-percent owned foreign corporation—(i) Facts. The facts are the same as in paragraph (c)(1)(i) of this section (the facts in Example 1), except that CFC1 does not own CFC2 and instead owns 20% of the stock of FC2, a foreign corporation that is a noncontrolled 10-percent owned foreign corporation. The tax book value of CFC1's stock in FC2 is $6,000x. FC2 owns assets with the following values as determined under §§ 1.861-9(g)(2) and 1.861-9T(g)(3): Assets that generate specified foreign source general category gross income ($3,000x). All of the assets of FC2 generate income that, if distributed to CFC1 as a dividend, would be foreign source gross subpart F income in the general category to CFC1.

(ii) Analysis—(A) Step 1—(1) Characterization of FC2 stock. All of the assets of FC2 generate income that, if distributed to CFC1, would be foreign source gross subpart F income in the general category to CFC1. Accordingly, under paragraph (a)(1)(i) of this section, all of CFC1's stock in FC2 ($6,000x) is characterized as in the foreign source gross subpart F income statutory grouping within the general category.

(2) Characterization of CFC1 stock. CFC1 has total assets of $16,000x, $4,000x of which are in the foreign source gross tested income statutory grouping within the general category, $7,000x of which are in the foreign source gross subpart F income statutory grouping within the general category (including the FC2 stock assigned to that statutory grouping), $3,000x of which are in the specified foreign source general category gross income statutory grouping, and $2,000x of which are in the foreign source gross subpart F income statutory grouping within the passive category. Accordingly, CFC1's stock is characterized as $5,000x ($4,000x/$16,000x × $20,000x) in the foreign source gross tested income statutory grouping within the general category, $8,750x ($7,000x/$16,000x × $20,000x) in the foreign source gross subpart F income statutory grouping within the general category, $3,750x ($3,000x/$16,000x × $20,000x) in the specified foreign source general category gross income statutory grouping, and $2,500x ($2,000x/$16,000x × $20,000x) in the foreign source gross subpart F income statutory grouping within the passive category.

(B) Step 2. The analysis is the same as in paragraph (c)(1)(ii)(B) of this section (the analysis of Step 2 in Example 1).

(C) Step 3. The analysis is the same as in paragraph (c)(1)(ii)(C) of this section (the analysis of Step 3 in Example 1).

(D) Step 4—(1) General category stock. The total value of the portion of the stock of CFC1 that is general category stock is $14,000x, which is equal to $1,500x (the value of the portion of the general category stock of CFC1 that was not assigned to the section 951A category in paragraph (c)(2)(ii)(B) of this section (Step 2)) plus $3,750x (the value of the portion of the stock of CFC1 assigned to the specified foreign source gross income statutory grouping within the general category general category) plus $8,750x (the value of the portion of the stock of CFC1 assigned to the foreign source gross subpart F income statutory grouping within the general category).

(2) Passive category stock. The analysis is the same as in paragraph (c)(1)(ii)(D)(2) of this section (the analysis of Step 4 in Example 1).

(E) Step 5—(1) General category stock. Under paragraph (a)(5)(ii) of this section, the value of the stock of CFC1 assigned to the section 245A subgroup of general category stock is $5,250x, which is equal to $1,500x (the value of the portion of the general category stock of CFC1 that was not assigned to the section 951A category in paragraph (c)(2)(ii)(B) of this section (Step 2)) plus $3,750x (the value of the portion of the stock of CFC1 assigned to the specified foreign source general category gross income statutory grouping). Under paragraph (a)(5)(v) of this section, the remainder of the general category stock of CFC1, $8,750x, is assigned to the non-section 245A subgroup of general category stock.

(2) Passive category stock. The analysis is the same as in paragraph (c)(1)(ii)(E)(2) of this section (the analysis of Step 5 in Example 1).

(3) Section 951A category stock. The analysis is the same as in paragraph (c)(1)(ii)(E)(3) of this section (the analysis of Step 5 in Example 1).

(F) Summary. For purpose of the allocation and apportionment of expenses, $14,000x of the stock of CFC1 is characterized as general category stock, $5,250x of which is in the section 245A subgroup and $8,750x of which is in the non-section 245A subgroup; $2,500x of the stock of CFC1 is characterized as passive category stock, all of which is in the non-section 245A subgroup; and $3,500x of the stock of CFC1 is characterized as section 951A category stock, all of which is in the non-section 245A subgroup.

(3) Example 3: Modified gross income method—(i) Facts—(A) USP, a domestic corporation, directly owns all of the stock of a controlled foreign corporation, CFC1. The tax book value of CFC1's stock is $100,000x. CFC1 owns all of the stock of CFC2, a controlled foreign corporation. USP uses the modified gross income method described in § 1.861-12(c)(3)(iii) to characterize the stock in CFC1. USP's inclusion percentage is 100%.

(B) CFC1 earns $1,500x of foreign source gross tested income within the general category and $500x of foreign source gross subpart F income within the passive category. CFC1 incurs $1,000x of interest expense.

(C) CFC2 earns $3,000x of foreign source gross tested income within the general category, $2,000x of foreign source gross subpart F income within the general category, and $1,000x of specified foreign source general category gross income. CFC2 incurs $3,000x of interest expense.

(ii) Analysis—(A) Step 1—(1) Determination of CFC2 gross income (net of interest expense). CFC2 has total gross income of $6,000x. CFC2's $3,000x of interest expense is apportioned among the statutory groupings of gross income based on the gross income of CFC2 to determine the gross income (net of interest expense) of CFC2 in each statutory grouping. As a result, $1,500x ($3,000x/$6,000x × $3,000x) of interest expense is apportioned to foreign source gross tested income within the general category, $1,000x ($2,000x/$6,000x × $3,000x) of interest expense is apportioned to foreign source gross subpart F income within the general category, and $500x ($1,000x/$6,000x × $3,000x) of interest expense is apportioned to specified foreign source general category gross income. Accordingly, CFC2 has the following amounts of gross income (net of interest expense): $1,500x ($3,000x − $1,500x) of foreign source gross tested income within the general category, $1,000x ($2,000x − $1,000x) of foreign source gross subpart F income within the general category, and $500x ($1,000x − $500x) of specified foreign source general category gross income.

(2) Determination of CFC1 gross income (net of interest expense). Before including the gross income consisting of subpart F income (net of interest expense) of CFC2, CFC1 has total gross income of $4,000x, including $1500x of CFC2's foreign source gross tested income within the general category and $500x of CFC2's specified foreign source general category gross income which are combined with CFC1's items of gross income under § 1.861-9(j)(2)(ii). CFC1's $1,000x of interest expense is apportioned among the statutory groupings of gross income of CFC1 to determine the gross income (net of interest expense) of CFC1 in each statutory grouping. As a result, $750x ($3,000x/$4,000x × $1,000x) of interest expense is apportioned to foreign source gross tested income within the general category, $125x ($500x/$4,000 × $1,000x) to foreign source gross subpart F income within the passive category, and $125x ($500x/$4,000x × $1,000x) to specified foreign source general category gross income. Accordingly, CFC1 has the following amounts of gross income (net of interest expense) before including the gross income consisting of subpart F income (net of interest expense) of CFC2: $2,250x ($3,000x − $750x) of foreign source gross tested income within the general category, $375x ($500x − $125x) of foreign source gross subpart F income within the passive category, and $375x ($500 − $125x) of specified foreign source general category gross income. After including the gross income consisting of subpart F income (net of interest expense) of CFC2, CFC1 has the following amounts of gross income (net of interest expense): $2,250x of foreign source gross tested income within the general category, $1,000x of foreign source gross subpart F income within the general category, $375x of specified foreign source general category gross income, and $375x of foreign source gross subpart F income within the passive category.

(3) Characterization of CFC1 stock. CFC1 is considered to have a total of $4,000x of gross income (net of interest expense) for purposes of characterizing the stock of CFC1. Accordingly, CFC1's stock is characterized as $56,250x ($2,250x/$4,000x × $100,000x) in the foreign source gross tested income statutory grouping within the general category, $25,000x ($1,000x/$4,000x × $100,000x) in the foreign source gross subpart F income statutory grouping within the general category, $9,375x ($375x/$4,000x × $100,000x) in the specified foreign source general category gross income statutory grouping, and $9,375x ($375x/$4,000x × $100,000x) in the foreign source gross subpart F income statutory grouping within the passive category.

(B) Step 2. The value of the portion of the stock of CFC1 that is general category gross tested income stock is $56,250x. USP's inclusion percentage is 100%. Accordingly, under paragraph (a)(2) of this section, all of the $56,250x of the stock of CFC1 is assigned to the section 951A category and a portion thereof may be treated as an exempt asset under § 1.861-8(d)(2)(ii)(C)(2)(ii).

(C) Step 3. No portion of the stock of CFC1 is resourced gross tested income or assigned to the resourced gross subpart F income statutory group in any treaty category. Accordingly, no portion of the stock of CFC1 is assigned to a treaty category under paragraph (a)(3) of this section.

(D) Step 4—(1) General category stock. The total value of the portion of the stock of CFC1 that is general category stock is $34,375x, which is equal to $25,000x (the value of the portion of the stock of CFC1 assigned to the subpart F income statutory grouping within the general category income statutory grouping) plus $9,375x (the value of the portion of the stock of CFC1 assigned to the specified foreign source general category gross income statutory grouping).

(2) Passive category stock. The total value of the portion of the stock of CFC1 that is passive category stock is $9,375x.

(3) U.S. source category stock. No value of the portion of the stock of CFC1 is U.S. source category stock.

(E) Step 5—(1) General category stock. All of the value of the general category gross tested income stock of CFC1 was assigned to the section 951A category in paragraph (c)(3)(ii)(B) of this section (Step 2). Accordingly, under paragraph (a)(5)(ii) of this section, the value of the stock of CFC1 assigned to the section 245A subgroup of general category stock is $9,375x, which is equal to the value of the portion assigned to the specified foreign source general category gross income statutory grouping. Under paragraph (a)(5)(v) of this section, the remainder of the general category stock of CFC1, $25,000x, is assigned to the non-section 245A subgroup of general category stock.

(2) Passive category stock. No portion of the passive category stock of CFC1 is in the foreign source gross tested income statutory grouping or the specified foreign source passive category gross income statutory grouping. Accordingly, under paragraph (a)(5)(iii) of this section, no value of the portion of the stock of CFC1 is assigned to the section 245A subgroup. Under paragraph (a)(5)(v) of this section, the passive category stock of CFC1, $9,375x, is assigned to the non-section 245A subgroup of passive category stock.

(3) Section 951A category stock. Under paragraph (a)(5)(v) of this section, all of the section 951A category stock, $56,250x, is assigned to the non-section 245A subgroup of section 951A category stock.

(F) Summary. For purposes of the allocation and apportionment of expenses, $56,250x of the stock of CFC1 is characterized as section 951A category stock, all of which is in the non-section 245A subgroup; $34,375x of the stock of CFC1 is characterized as general category stock, $9,375x of which is in the section 245A subgroup and $25,000x of which is in the non-section 245A subgroup; and $9,375x of the stock of CFC1 is characterized as passive category stock, all of which is in the non-section 245A subgroup.

(d) Applicability dates. This section applies for taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(e) * * *

(3) Change of method for taxable years beginning after December 31, 2017, and before January 1, 2020. A taxpayer otherwise subject to the binding election described in paragraph (e)(1) of this section may change its method for each taxable year beginning after December 31, 2017, and before January 1, 2020, without the prior consent of the Commissioner. The taxpayer's use of a new method constitutes a binding election to use the new method for its return filed for its last year that begins before January 1, 2020, and for four taxable years thereafter.

(i) Applicability date. This section applies to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(a) Sourcing rule for certain payments and inclusions. Any income paid or accrued through one or more entities is treated as income from sources within a country described in section 901(j)(2) if the income was, without regard to such entities, from sources within that country.

(b) Applicability date. This section applies to taxable years that end on or after December 4, 2018.

(a) In general. For each separate category described in § 1.904-5(a)(4)(v), the total credit for taxes paid or accrued (including those deemed to have been paid or accrued other than by reason of section 904(c)) does not exceed that proportion of the tax against which such credit is taken which the taxpayer's taxable income from foreign sources (but not in excess of the taxpayer's entire taxable income) in such separate category bears to the taxpayer's entire taxable income for the same taxable year.

(b) Special computation of taxable income. For purposes of computing the limitation under paragraph (a) of this section, the taxable income in the case of an individual, estate, or trust is computed without any deduction for personal exemptions under section 151 or 642(b).

(c) Joint return. In the case of spouses making a joint return, the applicable limitation prescribed by section 904(a) on the credit for taxes paid or accrued to foreign countries and possessions of the United States is applied with respect to the aggregate taxable income in each separate category from sources without the United States, and the aggregate taxable income from all sources, of the spouses.

(d) Consolidated group. For rules relating to the computation of the foreign tax credit limitation for a consolidated group, see § 1.1502-4.

(e) Applicability dates. This section applies to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(a) Credit for foreign tax carryback or carryover. A taxpayer who chooses to claim a credit under section 901 for a taxable year is allowed a credit under that section not only for taxes otherwise allowable as a credit but also for taxes deemed paid or accrued in that year as a result of a carryback or carryover of an unused foreign tax under section 904(c). However, the taxes so deemed paid or accrued are not allowed as a deduction under section 164(a). Foreign tax paid, accrued, or deemed paid under section 960 with respect to section 951A category income, including section 951A category income that is reassigned to a separate category for income resourced under a treaty, may not be carried back or carried forward or deemed paid or accrued under section 904(c). See § 1.904-6 for rules for allocating and apportioning taxes to separate categories. For special rules regarding these computations in case of taxes paid, accrued, or deemed paid with respect to foreign oil and gas extraction income or foreign oil related income, see section 907(f).

(b) Years to which foreign taxes are carried. If the taxpayer chooses the benefits of section 901 for a taxable year, any unused foreign tax paid or accrued in that year is carried first to the immediately preceding taxable year and then, as applicable, to each of the ten succeeding taxable years, in chronological order, but only to the extent not absorbed as taxes deemed paid or accrued under paragraphs (a) and (d) of this section in a prior taxable year.

(c) Definitions. This paragraph (c) provides definitions that apply for purposes of this section.

(1) Unused foreign tax. The term unused foreign tax means, with respect to each separate category for any taxable year, the excess of the amount of creditable foreign tax paid or accrued, or deemed paid under section 902 (as in effect on December 21, 2017) or section 960, in such year, over the applicable foreign tax credit limitation under section 904 for the separate category in such year. Unused foreign tax does not include any amount for which a credit is disallowed, including foreign income taxes for which a credit is disallowed or reduced when the tax is paid, accrued, or deemed paid.

(2) Separate category. The term separate category has the same meaning as provided in § 1.904-5(a)(4)(v).

(3) Excess limitation—(i) In general. The term excess limitation means, with respect to a separate category for any taxable year (the excess limitation year) and an unused foreign tax carried from another taxable year (the excess credit year), the amount (if any) by which the limitation for that separate category with respect to that excess limitation year exceeds the sum of—

(A) The creditable foreign tax actually paid or accrued or deemed paid under section 902 (as in effect on December 21, 2017) or section 960 with respect to the separate category in the excess limitation year; and

(B) The portion of any unused foreign tax for a taxable year preceding the excess credit year that is absorbed as taxes deemed paid or accrued in the excess limitation year under paragraphs (a) and (d) of this section.

(ii) Deduction years. Excess limitation for a taxable year absorbs unused foreign tax, regardless of whether the taxpayer chooses to claim a credit under section 901 for the year. In such case, the amount of the excess limitation, if any, for the year is determined in the same manner as though the taxpayer had chosen to claim a credit under section 901 for that year. For purposes of this determination, if the taxpayer has an overall foreign loss account, the excess limitation in a deduction year is determined based on the amount of the overall foreign loss the taxpayer would have recaptured if the taxpayer had chosen to claim a credit under section 901 for that year and had not made an election under § 1.904(f)-2(c)(2) to recapture more of the overall foreign loss account than is required under § 1.904(f)-2(c)(1).

(d) Taxes deemed paid or accrued—(1) Amount deemed paid or accrued. The amount of unused foreign tax with respect to a separate category that is deemed paid or accrued in any taxable year to which such unused foreign tax may be carried under paragraph (b) of this section is equal to the smaller of—

(i) The portion of the unused foreign tax that may be carried to the taxable year under paragraph (b) of this section; or

(ii) The amount, if any, of the excess limitation for such taxable year with respect to the separate category of such unused foreign tax.

(2) Carryback or carryover tax deemed paid or accrued in the same separate category. Any unused foreign tax, which is deemed to be paid or accrued under section 904(c) in the year to which it is carried, is deemed to be paid or accrued with respect to the same separate category as the category to which it was assigned in the year in which it was actually paid or accrued. However, see paragraphs (h) through (j) of this section for transition rules in the case of certain carrybacks and carryovers.

(3) No duplicate disallowance of creditable foreign tax. Foreign income taxes for which a credit is partially disallowed, including when the tax is paid, accrued, or deemed paid, are not reduced again by reason of the unused foreign tax being deemed to be paid or accrued in the year to which it is carried under section 904(c).

(h) Transition rules for carryovers of pre-2003 unused foreign tax and carrybacks of post-2002 unused foreign tax paid or accrued with respect to dividends from noncontrolled section 902 corporations. For transition rules for carryovers of pre-2003 unused foreign tax, and carrybacks of post-2002 unused foreign tax, paid or accrued with respect to dividends from noncontrolled section 902 corporations, see 26 CFR 1.904-2(h) (revised as of April 1, 2018).

(i) Transition rules for carryovers of pre-2007 unused foreign tax and carrybacks of post-2006 unused foreign tax. For transition rules for carryovers of pre-2007 unused foreign tax, and carrybacks of post-2006 unused foreign tax, see 26 CFR 1.904-2(i) (revised as of April 1, 2018).

(j) Transition rules for carryovers and carrybacks of pre-2018 and post-2017 unused foreign tax—(1) Carryover of unused foreign tax—(i) In general. For purposes of this paragraph (j), the terms post-2017 separate category, pre-2018 separate category, and specified separate category have the meanings set forth in § 1.904(f)-12(j)(1). The rules of this paragraph (j)(1) apply to reallocate to the taxpayer's post-2017 separate categories for foreign branch category income, general category income, passive category income, and specified separate categories of income, any unused foreign taxes (as defined in paragraph (c)(1) of this section) that were paid or accrued or deemed paid under sections 902 and 960 with respect to income in a pre-2018 separate category.

(ii) Allocation to the same separate category. Except as provided in paragraph (j)(1)(iii) of this section, to the extent any unused foreign taxes paid or accrued or deemed paid with respect to a separate category of income are carried forward to a taxable year beginning after December 31, 2017, such taxes are allocated to the same post-2017 separate category as the pre-2018 separate category from which the unused foreign taxes are carried.

(iii) Exception for certain general category unused foreign taxes—(A) In general. To the extent any unused foreign taxes with respect to general category income are carried forward to a taxable year beginning after December 31, 2017, a taxpayer may choose to allocate those taxes to the taxpayer's post-2017 separate category for foreign branch category income to the extent the unused foreign taxes would have been allocated to the taxpayer's post-2017 separate category for foreign branch category income, and would have been unused foreign taxes with respect to foreign branch category income if that separate category had applied in the year or years the unused foreign taxes arose. Any remaining unused foreign taxes paid or accrued or deemed paid with respect to general category income carried forward to a taxable year beginning after December 31, 2017, are allocated to the taxpayer's post-2017 separate category for general category income.

(B) Safe harbor. In lieu of applying paragraph (j)(1)(iii)(A) of this section, the taxpayer may choose to allocate the unused foreign taxes with respect to general category income in a taxable year beginning before January 1, 2018, to the taxpayer's post-2017 separate category for foreign branch category income based on a ratio equal to the amount of foreign income taxes assigned to the general category that were paid or accrued by the taxpayer's foreign branches (as defined in § 1.904-4(f)(3)(vii)) bears to all foreign income taxes assigned to the general category that were paid or accrued, or deemed paid by the taxpayer with respect to such taxable year. The amount of taxes paid or accrued by a foreign branch in a taxable year beginning before January1, 2018, means all foreign income taxes properly reflected on the separate set of books and records (as defined in § 1.989(a)-1(d)(1) and (2)) of the foreign branch as an expense (which does not include any taxes deemed paid under section 902 or 960).

(C) Rules regarding the exception. A taxpayer applying the exception described in this paragraph (j)(1)(iii) (the branch carryover exception) must apply the exception to all of its unused foreign taxes paid or accrued with respect to general category income that are carried forward to all taxable years beginning after December 31, 2017. A taxpayer may apply the branch carryover exception on a timely filed original return (including extensions) or an amended return. A taxpayer that applies the exception on an amended return must make appropriate adjustments to eliminate any double benefit arising from application of the exception to years that are not open for assessment.

(D) Coordination rule. See § 1.904(f)-12(j)(5) for coordination rule with respect to the exception described in paragraph (j)(1)(iii) of this section and the exceptions described in § 1.904(f)-12(j)(2) through (4).

(2) Carryback of unused foreign tax—(i) In general. The rules of this paragraph (j)(2) apply to any unused foreign taxes that were paid or accrued, or deemed paid under section 960, with respect to income in a post-2017 separate category.

(ii) Passive category income and specified separate categories of income described in § 1.904-4(m). Any unused foreign taxes paid or accrued or deemed paid with respect to passive category income or a specified separate category of income in a taxable year beginning after December 31, 2017, that are carried back to a taxable year beginning before January 1, 2018, are allocated to the same pre-2018 separate category as the post-2017 separate category from which the unused foreign taxes are carried.

(iii) General category income and foreign branch category income. Any unused foreign taxes paid or accrued or deemed paid with respect to general category income or foreign branch category income in a taxable year beginning after December 31, 2017, that are carried back to a taxable year beginning before January 1, 2018, are allocated to the taxpayer's pre-2018 separate category for general category income.

(k) Applicability date. Paragraphs (a) through (i) of this section apply to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018. Paragraph (j) of this section applies to taxable years beginning after December 31, 2017. Paragraph (j)(2) of this section also applies to the last taxable year beginning before January 1, 2018.

(a) * * * The rules in this section apply separately with respect to each separate category as defined in § 1.904-5(a)(4)(v).

(e) Amounts carried from or through a joint return year to or through a separate return year—(1) In general. It is necessary to allocate to each spouse the spouse's share of an unused foreign tax or excess limitation for any taxable year for which the spouses filed a joint return if—

(i) The spouses file separate returns for the current taxable year and an unused foreign tax is carried thereto from a taxable year for which they filed a joint return;

(ii) The spouses file separate returns for the current taxable year and an unused foreign tax is carried to such taxable year from a year for which they filed separate returns but is first carried through a year for which they filed a joint return; or

(iii) The spouses file a joint return for the current taxable year and an unused foreign tax is carried from a taxable year for which they filed joint returns but is first carried through a year for which they filed separate returns.

(2) Computation and adjustments. In the cases described in paragraph (e)(1) of this section, the separate carryback or carryover of each spouse to the current taxable year shall be computed in the manner described in § 1.904-2 but with the modifications set forth in paragraph (f) of this section. Where applicable, appropriate adjustments are made to take into account the fact that, for any taxable year involved in the computation of the carryback or the carryover, either spouse has combined foreign oil and gas income described in section 907(b) with respect to which the limitation in section 907(a) applies.

(f) * * * (1) Separate category limitation. The limitation in a separate category of a particular spouse for a taxable year for which a joint return is made shall be the portion of the limitation on the joint return which bears the same ratio to such limitation as such spouse's foreign source taxable income (with gross income and deductions taken into account to the same extent as taken into account on the joint return) in such separate category (but not in excess of the joint foreign source taxable income) bears to the joint foreign source taxable income in such separate category.

(2) Unused foreign tax. For purposes of this section, the term unused foreign tax means, with respect to a particular spouse and separate category for a taxable year for which a joint return is made, the excess of the foreign tax paid or accrued by that spouse with respect to that separate category over that spouse's separate category limitation.

(3) Excess limitation. For purposes of this section, the term excess limitation means, with respect to a particular spouse and separate category for a taxable year for which a joint return is made, the excess of that spouse's separate category limitation over the foreign taxes paid or accrued by such spouse with respect to such separate category for such taxable year.

(h) Applicability date. This section is applicable for taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(a) In general. A taxpayer is required to compute a separate foreign tax credit limitation for income received or accrued in a taxable year that is described in section 904(d)(1)(A) (section 951A category income), 904(d)(1)(B) (foreign branch category income), 904(d)(1)(C) (passive category income), 904(d)(1)(D) (general category income), or paragraph (m) of this section (specified separate categories). For purposes of this section, the definitions in § 1.904-5(a)(4) apply.

(b) * * *

(2) * * *

(i) * * *

(C) Distributive shares of partnership income treated as passive category income under paragraph (n)(1) of this section, and income from the sale of a partnership interest treated as passive category income under paragraph (n)(2) of this section; or

(D) Income treated as passive category income under the look-through rules in § 1.904-5.

(ii) Exceptions. Passive income does not include any export financing interest (as defined in paragraph (h) of this section), any high-taxed income (as defined in paragraph (c) of this section), financial services income (as defined in paragraph (e)(1)(ii) of this section), or any active rents and royalties (as defined in paragraph (b)(2)(iii) of this section). In addition, passive income does not include any income that would otherwise be passive but is excluded from passive category income under § 1.904-5(b)(1) or that is assigned to a separate category other than passive category income under § 1.904-5(c)(4)(iii). See also paragraph (k) of this section for rules relating to income resourced under a tax treaty. * * *

(iv) Examples. The following examples illustrate the application of this paragraph (b)(2).

(A) Example 1. For Year 1, USP, a domestic corporation, has a net foreign currency gain that would not constitute foreign personal holding company income if USP were a controlled foreign corporation because the gain is directly related to the business needs of USP. See section 954(c)(1)(D). Under paragraph (b)(2)(i)(A) of this section, the foreign currency gain is, therefore, not passive category income to USP because it is not income of a kind that would be foreign personal holding company income.

(B) Example 2. Controlled foreign corporation, CFC, is a wholly-owned subsidiary of USP, a domestic corporation. CFC is regularly engaged in the restaurant franchise business. USP licenses trademarks, tradenames, certain know-how, related services, and certain restaurant designs for which CFC pays USP an arm's length royalty. USP is regularly engaged in the development and licensing of such property. Some of the franchisees are unrelated to CFC and USP. Other franchisees are related to CFC or USP and use the licensed property outside of CFC's country of incorporation. CFC does not satisfy, but USP does satisfy, the active trade or business requirements of section 954(c)(2)(A). The royalty income earned by CFC from both its related and unrelated franchisees is foreign personal holding company income because CFC does not satisfy the active trade or business requirements of section 954(c)(2)(A) and, in addition, the royalty income from the related franchisees does not qualify for the same country exception of section 954(c)(3) or the look-through exception in section 954(c)(6). However, all of the royalty income earned by CFC is general category income to CFC under § 1.904-4(b)(2)(iii) because USP, a member of CFC's affiliated group, satisfies the active trade or business test (which is applied without regard to whether the royalties are paid by a related person). USP's inclusion under section 951(a)(1)(A) of CFC's royalty income is general category income to USP under § 1.904-5(c)(5) and paragraph (d) of this section. The royalties received by USP are general category income to USP under § 1.904-5(b)(1) and paragraph (d) of this section.

(c) * * * (1) * * * Income is considered to be high-taxed income if, after allocating expenses, losses, and other deductions of the United States person to that income under paragraph (c)(2) of this section, the sum of the foreign income taxes paid or accrued, and deemed paid under section 960, by the United States person with respect to such income (reduced by any portion of such taxes for which a credit is not allowed) exceeds the highest rate of tax specified in section 1 or 11, whichever applies (and with reference to section 15 if applicable), multiplied by the amount of such income (including the amount treated as a dividend under section 78). If, after application of this paragraph (c), income that would otherwise be passive income is determined to be high-taxed income, the income is treated as general category income, foreign branch category income, section 951A category income, or income in a specified separate category, as determined under the rules of this section, and any taxes imposed on that income are considered related to the same separate category of income under § 1.904-6. If, after application of this paragraph (c), passive income is zero or less than zero, any taxes imposed on the passive income are considered related to the same separate category of income to which the passive income (if not reduced to zero or less than zero) would have been assigned had the income been treated as high-taxed income (general category, foreign branch category, section 951A category, or a specified separate category). * * *

(2) * * *

(iii) Coordination with section 904(b), (f) and (g). The determination of whether foreign source passive income is high-taxed is made before taking into account any adjustments under section 904(b) or any allocation or recapture of a separate limitation loss, overall foreign loss, or overall domestic loss under section 904(f) and (g).

(3) * * * Paragraph (c)(4) of this section provides additional rules for inclusions under section 951(a)(1) or 951A(a) that are passive income, dividends from a controlled foreign corporation or noncontrolled 10-percent owned foreign corporation that are passive income, and income that is received or accrued by a United States person through a foreign QBU that is passive income. For purposes of this paragraph (c), a foreign QBU is a qualified business unit (as defined in section 989(a)), other than a controlled foreign corporation or noncontrolled 10-percent owned foreign corporation, that has its principal place of business outside the United States. The rules in this paragraph (c)(3) apply whether the income is received from a controlled foreign corporation of which the United States person is a United States shareholder, from a noncontrolled 10-percent owned foreign corporation of which the United States person is a United States shareholder that is a domestic corporation, or from any other person. In applying the rules in this paragraph (c)(3), passive income is not treated as subject to a withholding tax or other foreign tax when a credit is disallowed in full for such foreign tax, for example, under section 901(k). * * *

(4) Dividends and inclusions from controlled foreign corporations, dividends from noncontrolled 10-percent owned foreign corporations, and income attributable to foreign QBUs. Except as provided in paragraph (c)(5) of this section, the rules of this paragraph (c)(4) apply to all dividends and all amounts included in gross income of a United States shareholder under section 951(a)(1) or 951A(a) with respect to the foreign corporation that (after application of the look-through rules of section 904(d)(3) and § 1.904-5) are attributable to passive income received or accrued by a controlled foreign corporation, all dividends from a noncontrolled 10-percent owned foreign corporation that are received or accrued by a United States shareholder that (after application of the look-through rules of section 904(d)(4) and § 1.904-5) are treated as passive income, and all amounts of passive income received or accrued by a United States person through a foreign QBU. The grouping rules of paragraphs (c)(3)(i) through (iv) of this section apply separately to dividends, to inclusions under section 951(a)(1) and to inclusions under section 951A(a) with respect to each controlled foreign corporation of which the taxpayer is a United States shareholder, and to dividends with respect to each noncontrolled 10-percent owned foreign corporation of which the taxpayer is a United States shareholder that is a domestic corporation. The grouping rules of paragraphs (c)(3)(i) through (iv) of this section also apply separately to income attributable to each foreign QBU of a controlled foreign corporation, noncontrolled 10-percent owned foreign corporation, any other look-through entity as defined in § 1.904-5(i), or any United States person.

(5) * * *

(ii) Treatment of partnership income. A partner's distributive share of income from a foreign or domestic partnership that is treated as passive income under paragraph (n)(1)(ii) of this section (generally providing that a less than 10 percent partner's distributive share of partnership income is passive income) is treated as a single item of income and is not grouped with other amounts. A distributive share of income from a partnership that is treated as passive income under paragraph (n)(1)(i) of this section is grouped according to the rules in paragraph (c)(3) of this section, except that the portion, if any, of the distributive share of income attributable to income earned by a domestic partnership through a foreign QBU is separately grouped under the rules of paragraph (c)(4) of this section.

(iii) * * *

(C) Example. The following example illustrates the application of this paragraph (c)(5)(iii).

(1) Facts. USP, a domestic corporation, owns all of the stock of CFC, a controlled foreign corporation organized and operating in Country X that uses the “u” as its functional currency. In Year 1, when the highest rate of U.S. tax in section 11 is 21%, CFC earns 100u of passive category foreign personal holding company income subject to no foreign tax. When included in USP's income under section 951(a), the applicable exchange rate is 1u=$1x. Therefore, USP's section 951(a) inclusion is $100x and no foreign taxes are deemed paid by USP with respect to the inclusion. At the end of Year 1, CFC has previously taxed earnings and profits of 100u and USP's basis in those earnings is $100x. In Year 2, CFC has no earnings and profits and distributes 100u to USP. The value of the earnings when distributed is $150x. Assume that under section 986(c), USP must recognize $50x of passive category income attributable to the appreciation of the previously taxed earnings and profits. Country X does not recognize any gain or loss on the distribution, but imposes a 10u withholding tax on USP with respect to the distribution.

(2) Analysis. Because the section 986(c) gain is not subject to any foreign withholding tax or other foreign tax, under paragraph (c)(3)(iii) of this section the section 986(c) gain is grouped with other items of USP's income that are subject to no withholding tax or other foreign tax. Under paragraph (c)(6)(iii) of this section, the 10u withholding tax is related to passive category income. See section 960(c) and § 1.960-4 for rules relating to the increase in limitation in the year of distribution of previously taxed earnings and profits.

(6) * * * (i) * * * The determination of whether an amount included in gross income under section 951(a)(1) or 951A(a) is high-taxed income is made in the taxable year the income is included in the gross income of the United States shareholder under section 951(a) or 951A(a) (for purposes of this paragraph (c), the year of inclusion). * * *

(iii) * * * If an item of income is considered high-taxed income in the year of inclusion and paragraph (c)(6)(i) of this section applies, then any increase in foreign income taxes imposed with respect to that item are considered to be related to the same separate category to which the income was assigned in the taxable year of inclusion. * * * The taxpayer shall treat any taxes paid or accrued, or deemed paid, on the distribution in excess of this amount as taxes related to the same category of income to which such inclusion would have been assigned had the income been treated as high-taxed income in the year of inclusion (general category income, section 951A category income, or income in a specified separate category). If these additional taxes are not creditable in the year of distribution, the carryover rules of section 904(c) apply (see section 904(c) and § 1.904-2(a) for rules disallowing carryovers in the section 951A category). For purposes of this paragraph (c)(6), the foreign tax on an inclusion under section 951(a)(1) or 951A(a) is considered increased on distribution of the earnings and profits associated with that inclusion if the total of taxes paid and deemed paid on the inclusion and the distribution (taking into account any reductions in tax and any withholding taxes) exceeds the total taxes deemed paid in the year of inclusion. * * *

(iv) Increase in taxes paid by successors. If passive earnings and profits previously included in income of a United States shareholder are distributed to a person that was not a United States shareholder of the distributing corporation in the year the earnings were included, any increase in foreign taxes paid or accrued, or deemed paid, on that distribution is treated as taxes related to general category income (or income in a specified separate category, if applicable) in the case of earnings and profits previously included under section 951(a)(1), and is treated as taxes related to section 951A category income (or income in a specified separate category, if applicable) in the case of earnings and profits previously included under section 951A(a), regardless of whether the previously-taxed income was considered high-taxed income under section 904(d)(2)(F) in the year of inclusion.

(7) * * * (i) * * * If the inclusion is considered to be high-taxed income, then the taxpayer treats the inclusion as general category income, section 951A category income, or income in a specified separate category as provided in paragraph (c)(1) of this section. * * * For purposes of this paragraph (c)(7)(i), the foreign tax on an inclusion under section 951(a)(1) or 951A(a) is considered reduced on distribution of the earnings and profits associated with the inclusion if the total taxes paid and deemed paid on the inclusion and the distribution (taking into account any reductions in tax and any withholding taxes) is less than the total taxes deemed paid in the year of inclusion. * * *

(8) Examples. The following examples illustrate the application of this paragraph (c). All of the examples assume that the highest tax rate under section 11 is 21%, unless otherwise noted.

(i) Example 1. CFC, a controlled foreign corporation, is a wholly-owned subsidiary of domestic corporation USP. CFC is a single qualified business unit (QBU) operating in foreign Country X. In Year 1, CFC earns $130x of gross royalty income that is passive income from Country X sources, and incurs $30x of expenses that do not include any payments to USP. CFC's $100x of pre-tax passive income from the royalty is subject to $30x of foreign tax, and is included under section 951(a)(1) in USP's gross income for the taxable year. USP allocates $50x of expenses to the $100x (consisting of the $70x section 951(a)(1) inclusion and $30x section 78 amount), resulting in net passive income of $50x. USP does not elect to exclude from subpart F under section 954(b)(4) the $70x of CFC's net passive income. After application of the high-tax kick-out rules of paragraph (c) of this section, the $50x of USP's net passive income is treated as general category income, and the $30x of taxes deemed paid are treated as taxes imposed on general category income, because the foreign taxes paid and deemed paid on the income exceed the highest U.S. tax rate multiplied by the $50x of net passive income ($30x > $10.5x (21% × $50x)).

(ii) Example 2. CFC, a controlled foreign corporation, is a wholly-owned subsidiary of domestic corporation USP. CFC is incorporated and operating in Country Y and has a branch in Country Z. CFC has two QBUs (QBU Y and QBU Z). In Year 1, CFC earns $65x of gross royalty income that is passive income in Country Y through QBU Y and $65x of gross royalty income that is passive income in Country Z through QBU Z. CFC allocates $15x of expenses to the gross royalty income earned by each QBU, resulting in pre-tax passive income of $50x in each QBU. Country Y imposes $5x of foreign tax on the royalty income earned in Y, and Country Z imposes $10x of tax on royalty income earned in Z. All of CFC's income constitutes foreign personal holding company income that is passive income and is included under section 951(a)(1) in USP's gross income for the taxable year. USP allocates $50x of expenses pro rata to the $100x section 951(a)(1) inclusion attributable to the QBUs (consisting of the $45x section 951(a)(1) inclusion derived through QBU Y, the $5x section 78 amount attributable to QBU Y, the $40x section 951(a)(1) inclusion derived through QBU Z, and the $10x section 78 amount attributable to QBU Z), resulting in net passive income of $50x. Pursuant to paragraph (c)(4) of this section, the high-tax kickout rules must be applied separately to the subpart F inclusion attributable to the income earned by QBU Y and the income earned by QBU Z. After application of the high-tax kickout rules, the $25x of net passive income attributable to QBU Y will be treated as passive category income because the foreign taxes paid and deemed paid on the income do not exceed the highest U.S. tax rate multiplied by the $25x of net passive income ($5x < $5.25x (21% × $25x)). The $25x of net passive income attributable to QBU Z will be treated as general category income because the foreign taxes paid and deemed paid on the income exceed the highest U.S. tax rate multiplied by the $25x of net passive income ($10x > $5.25x (21% × $25x)).

(iii) Example 3. Domestic corporation USP operates in branch form in foreign countries X and Y. The branches are qualified business units (QBUs), within the meaning of section 989(a). In Year 1, QBU X earns passive royalty income, interest income, and rental income. All of the QBU X passive income is from Country Z sources. The royalty income is not subject to a withholding tax, and is not taxed by Country X, and the interest and the rental income are subject to a 4% and 10% withholding tax, respectively. QBU Y earns interest income in Country Y that is not subject to foreign tax. For purposes of determining whether USP's foreign source passive income is high-taxed income, the rental income and the interest income earned in QBU X are treated as one item of income pursuant to paragraph (c)(3)(ii) of this section. The interest income earned in QBU Y and the royalty income earned in QBU X are each treated as a separate item of income under paragraphs (c)(4) and (c)(3)(iii) of this section. If, after allocation of expenses, QBU X's items of income composed of rental income and interest income are high-taxed income, the income may be treated as foreign branch category income.

(iv) Example 4. CFC, a controlled foreign corporation incorporated in foreign Country R, is a wholly-owned subsidiary of USP, a domestic corporation. USP and CFC have calendar year taxable years for both U.S. and Country R tax purposes. The highest tax rate under section 11 is 34% and 21% in Year 1 and Year 2, respectively. For Year 1, USP is required under section 951(a)(1) to include in gross income $80x (not including the section 78 amount) attributable to the earnings and profits of CFC for such year, all of which is foreign personal holding company income that is passive rent or royalty income. CFC does not make any distributions in Year 1. Foreign income taxes paid by CFC for Year 1 that are deemed paid by USP for such year under section 960(a) with respect to the section 951(a)(1) inclusion equal $20x. USP properly allocates $30x of expenses to the section 951(a)(1) inclusion. The foreign income tax paid with respect to the section 951(a)(1) inclusion does not exceed the highest U.S. tax rate multiplied by the amount of income after allocation of USP's expenses ($20x < $23.80x (34% × $70x)). Thus, USP's section 951(a)(1) inclusion for Year 1 is included in USP's passive category income and the $20x of taxes attributable to that inclusion are treated as taxes related to passive category income. In Year 2, CFC distributes $70x to USP, and under section 959 that distribution is treated as attributable to the earnings and profits with respect to the amount included in income by USP in Year 1 and is excluded from USP's gross income. Foreign Country R imposes a withholding tax of $14x on the distribution in Year 2. Under paragraph (c)(6)(i) of this section, the withholding tax in Year 2 does not affect the characterization of the Year 1 inclusion as passive category income, nor does it affect the characterization of the $20x of taxes paid in Year 1 as taxes paid with respect to passive category income. No further expenses of USP are allocable to the receipt of that distribution. In Year 2, the foreign taxes paid ($14x) exceed the product of the highest U.S. tax rate and the amount of the inclusion reduced by taxes deemed paid in the year of inclusion ($14x > $3.80x ((34% × $70x) − $20x)). Thus, under paragraph (c)(6)(iii) of this section, $3.80x ((34% × $70x) − $20x) of the $14x withholding tax paid in Year 2 is treated as taxes related to passive category income and the remaining $10.20x ($14x − $3.80x) of the withholding tax is treated as related to general category income.

(v) through (viii) [Reserved]

(ix) Example 9. USP, a domestic corporation, earns $100x of passive royalty income from sources within the United States. Under the laws of Country X, however, that royalty is considered to be from sources within Country X, and Country X imposes a 5% withholding tax on the payment of the royalty. USP also earns $100x of foreign source passive dividend income from Country Y subject to a 10% withholding tax to which $15x of expenses are allocated. In determining whether USP's passive income is high-taxed, the $5x withholding tax on USP's royalty income is allocated to passive income, and to the group of passive income described in paragraph (c)(3)(ii) of this section (passive income subject to a withholding tax of less than 15% (but greater than zero)). For purposes of determining whether the income is high-taxed, however, only the $85x of foreign source dividend income (and not the $100x of U.S. source royalty income) is taken into account. The foreign source dividend income is treated as passive category income because the foreign taxes paid on the passive income in the group ($15x) do not exceed the highest U.S. tax rate multiplied by the $85x of net foreign source income in the group ($15x < $17.85x ($100x − $15x) × 21%).

(x) Example 10. In Year 1, P, a U.S. citizen with a tax home in Country X, earns the following items of gross income: $400x of foreign source, passive interest income not subject to foreign withholding tax but subject to Country X income tax of $100x, $200x of foreign source, passive royalty income subject to a 5% foreign withholding tax (foreign tax paid is $10x), $1,300x of foreign source, passive rental income subject to a 25% foreign withholding tax (foreign tax paid is $325x), $500x of foreign source, general category loss, and $2,000x of U.S. source capital gain that is not subject to any foreign tax. P has a $900x deduction allocable to its passive rental income. P's only other deduction is a $700x capital loss on the sale of stock that is allocated to foreign source passive category income under § 1.865-2(a)(3)(i). The $700x capital loss is initially allocated to the group of passive income described in paragraph (c)(3)(iv) of this section (passive income subject to no withholding tax but subject to foreign tax other than withholding tax). This group comprises the $400x of interest income not subject to foreign withholding tax but subject to Country X income tax. Under paragraph (c)(2)(ii) of this section, the $300x amount by which the capital loss exceeds the income in the group must be reallocated to the net income in the other groups described in paragraph (c)(3) of this section, but the $500x general category separate limitation loss is not allocated until the high-tax kickout rules are applied to determine whether the passive income is high-taxed income. P's $200x of royalty income subject to a 5% withholding tax is described in paragraph (c)(3)(i) of this section (passive income that is subject to a withholding tax of less than 15%, but greater than zero). P's $1,300x of rental income subject to a 25% withholding tax is described in paragraph (c)(3)(ii) of this section (passive income that is subject to a withholding tax of 15% or greater). The $1,300x of rental income is reduced by the $900x deduction allocable to such income. Therefore, the total net income in the other groups under paragraph (c)(3) is $600x, the $200x of royalty income and the $400x of rental income. The ($300x) net loss in the net basis tax group thus reduces the royalty income by $100x to $100x ($200x − ($300x × (200x/600x))) and the rental income by $200x to $200x ($400x − ($300x × (400x/600x))). The $100x of net royalty income is not high-taxed and remains passive category income because the foreign taxes of $10x do not exceed the highest U.S. rate of tax on that income, which is 37% for individuals ($10x < $37x (37% × $100x)). Under the high-tax kickout, the $200x of rental income and the $325x of associated foreign tax are assigned to the general category.

(xi) Example 11. The facts are the same as in paragraph (c)(8)(x) of this section (the facts in Example 10), except the amount of the capital loss that is allocated under § 1.865-2(a)(3)(i) and paragraph (c)(2) of this section to the group of foreign source passive income subject to no withholding tax but subject to foreign tax other than withholding tax is $1,200x. Under paragraph (c)(2)(ii) of this section, the excess deductions of $800x must be reallocated to the $200x of net royalty income subject to a 5% withholding tax and the $400x of net rental income subject to a 15% or greater withholding tax. The income in each of these groups is reduced to zero, and the foreign taxes imposed on the rental and royalty income are considered related to general category income. The remaining loss of $200x constitutes a separate limitation loss with respect to passive category income.

(xii) Example 12. In Year 1, USP, a domestic corporation, earns a $100x dividend that is foreign source passive income subject to a 30% withholding tax. The dividend is not paid by a specified 10-percent owned foreign corporation (as defined in section 245A(b)(1)). A foreign tax credit for the withholding tax on the dividend is disallowed under section 901(k). A deduction for the tax is allowed, however, under sections 164 and 901(k)(7). In determining whether USP's passive income is high-taxed, under paragraph (c)(3) of this section the $100x dividend and the $30x deduction are allocated to the group of income described in paragraph (c)(3)(iv) of this section (passive income subject to no withholding tax or other foreign tax).

(d) General category income. The term general category income means all income other than passive category income, foreign branch category income, section 951A category income, and income in a specified separate category. Any item that is excluded from the passive category under paragraph (c) or (h) of this section or § 1.904-5(b)(1) is included in general category income only to the extent that such item does not meet the definition of another separate category. General category income also includes income treated as general category income under the look-through rules referenced in § 1.904-5(a)(2).

(e) * * * (1) In general—(i) Treatment of financial services income. Passive income that is characterized as financial services income is not assigned to the passive category but is assigned in accordance with this paragraph (e)(1)(i). Financial services income that meets the definition of foreign branch category income (see paragraph (f)(1) of this section) is treated as income in that category. Financial services income of a controlled foreign corporation that is included in gross income of a United States shareholder under section 951A(a) is treated as section 951A category income in the hands of the United States shareholder. Financial services income that is neither treated as foreign branch category income nor treated as section 951A category income is treated as general category income. Distributions, interest, rents, or royalties received from a related person that is a financial services entity that would be assigned to the passive category under the look-through rules in § 1.904-5, but for the fact such amounts are paid by a financial services entity (and, therefore, not attributable to passive category income of the payor), are assigned to separate categories (other than the passive category) under the rules in this section.

(ii) Definition of financial services income. The term financial services income means income derived by a financial services entity, as defined in paragraph (e)(3) of this section, that is:

(A) Income derived in the active conduct of a banking, insurance, financing, or similar business (active financing income as defined in paragraph (e)(2) of this section);

(B) Passive income as defined in section 904(d)(2)(B) and paragraph (b) of this section as determined before the application of the exception for high-taxed income but after the application of the exception for export financing interest; or

(C) Incidental income as defined in paragraph (e)(4) of this section.

(f) Foreign branch category income—(1) Foreign branch category income—(i) In general. Except as provided in paragraph (f)(1)(ii) of this section, the term foreign branch category income means income of a United States person, other than a pass-through entity, that is—

(A) Income attributable to foreign branches of the United States person held directly or indirectly through disregarded entities;

(B) A distributive share of partnership income that is attributable to foreign branches held by the partnership directly or indirectly through disregarded entities, or held indirectly by the partnership through another partnership or other pass-through entity that holds the foreign branch directly or indirectly through disregarded entities; and

(C) Income from other pass-through entities determined under principles similar to those described in paragraph (f)(1)(i)(B) of this section.

(ii) Passive category income excluded from foreign branch category income. Income assigned to the passive category under paragraph (b) of this section is not foreign branch category income, regardless of whether the income is described in paragraph (f)(1)(i) of this section. Income that is treated as passive category income under the look-through rules in § 1.904-5 is also excluded from foreign branch category income, regardless of whether the income is attributable to a foreign branch. However, income that would be passive category income but for the application of section 904(d)(2)(B)(iii) (export financing interest and high-taxed income) or 904(d)(2)(C) (financial services income) and also meets the definition of foreign branch category income is foreign branch category income.

(2) Gross income attributable to a foreign branch—(i) In general. Except as provided in this paragraph (f)(2), gross income is attributable to a foreign branch to the extent the gross income (as adjusted to conform to Federal income tax principles) is reflected on the separate set of books and records (as defined in § 1.989(a)-1(d)(1) and (2)) of the foreign branch. Gross income that is not attributable to the foreign branch and is therefore attributable to the foreign branch owner is income in a separate category (other than the foreign branch category) under the other rules of this section.

(ii) Income attributable to U.S. activities. Except as provided in paragraph (f)(2)(vi) of this section, gross income attributable to a foreign branch does not include items arising from activities carried out in the United States, regardless of whether the items are reflected on the foreign branch's separate books and records.

(iii) Income arising from stock—(A) In general. Except as provided in paragraph (f)(2)(iii)(B) of this section, gross income attributable to a foreign branch does not include items of income arising from stock of a corporation (whether foreign or domestic), including gain from the disposition of such stock or any inclusion under sections 951(a), 951A(a), 1248, or 1293(a).

(B) Exception for dealer property. Paragraph (f)(2)(iii)(A) of this section does not apply to gain recognized from dispositions of stock in a corporation, if the stock would be dealer property (as defined in § 1.954-2(a)(4)(v)) if the foreign branch were a controlled foreign corporation.

(iv) Disposition of interests in certain entities—(A) In general. Except as provided in paragraph (f)(2)(iv)(B) of this section, gross income attributable to a foreign branch does not include gain from the disposition of an interest in a partnership or other pass-through entity or an interest in a disregarded entity. See also paragraph (n)(2) of this section for general rules relating to the sale of a partnership interest.

(B) Exception for sales by a foreign branch in the ordinary course of business. The rule in paragraph (f)(2)(iv)(A) of this section does not apply to gain from the sale or exchange of an interest in a partnership or other pass-through entity or an interest in a disregarded entity if the gain is reflected on the books and records of a foreign branch and the interest is held by the foreign branch in the ordinary course of its active trade or business. An interest is considered to be held in the ordinary course of the foreign branch's active trade or business only if the foreign branch—

(1) Directly engages in the same, or a related, trade or business as that partnership, other pass-through entity, or disregarded entity; and

(2) In the case of a partnership or other pass-through entity, the foreign branch owns 10 percent or more of the capital or profits interests in the partnership or other pass-through entity.

(v) Adjustments to items of gross income reflected on the books and records. If a principal purpose of recording or failing to record an item of gross income on the books and records of a foreign branch, or of making or not making a disregarded payment described in paragraph (f)(2)(vi) of this section, is the avoidance of Federal income tax, the purposes of section 904, or the purposes of section 250 (in connection with section 250(b)(3)(A)(i)(VI)), the item must be attributed to one or more foreign branches or the foreign branch owner in a manner that reflects the substance of the transaction. For purposes of this paragraph (f)(2)(v), interest received by a foreign branch from a related person is presumed to be attributable to the foreign branch owner (and not to the foreign branch) unless the interest income meets the definition of financial services income under paragraph (e)(1)(ii) of this section. For purposes of this paragraph (f)(2)(v), a related person is any person that bears a relationship to the foreign branch owner described in section 267(b) or 707.

(vi) Attribution of gross income to which disregarded payments are allocable—(A) In general. If a foreign branch makes a disregarded payment to its foreign branch owner and the disregarded payment is allocable to gross income that would be attributable to the foreign branch under the rules in paragraphs (f)(2)(i) through (v) of this section, the gross income attributable to the foreign branch is adjusted downward to reflect the allocable amount of the disregarded payment, and the gross income attributable to the foreign branch owner is adjusted upward by the same amount, translated (if necessary) from the foreign branch's functional currency to U.S. dollars at the spot rate (as defined in § 1.988-1(d)) on the date of the disregarded payment. For rules addressing multiple disregarded payments in a taxable year, see paragraph (f)(2)(vi)(F) of this section. Similarly, if a foreign branch owner makes a disregarded payment to its foreign branch and the disregarded payment is allocable to gross income attributable to the foreign branch owner, the gross income attributable to the foreign branch owner is adjusted downward to reflect the allocable amount of the disregarded payment, and the gross income attributable to the foreign branch is adjusted upward by the same amount, translated (if necessary) from U.S. dollars to the foreign branch's functional currency at the spot rate on the date of the disregarded payment. An adjustment to the attribution of gross income under this paragraph (f)(2)(vi) does not change the total amount, character, or source of the United States person's gross income; does not change the amount of a United States person's income in any separate category other than the foreign branch and general categories (or a specified separate category associated with the foreign branch and general categories); and has no bearing on the analysis of whether an item of gross income is eligible to be resourced under an income tax treaty. The principles of the rules in this paragraph (f)(2)(vi)(A) also apply in the case of disregarded payments between a foreign branch and another foreign branch with the same foreign branch owner if either foreign branch makes a disregarded payment to, or receives a disregarded payment from, the foreign branch owner.

(B) Allocation of disregarded payments—(1) In general. Except as provided in paragraph (f)(2)(vi)(B)(2) of this section, whether a disregarded payment is allocable to gross income attributable to a foreign branch or gross income attributable to its foreign branch owner, and the source and separate category of the gross income to which the disregarded payment is allocable, is determined under the following rules:

(i) Disregarded payments from a foreign branch owner to its foreign branch are allocable to gross income attributable to the foreign branch owner to the extent a deduction for that payment or any disregarded cost recovery deduction relating to that payment, if regarded, would be allocated and apportioned to gross income attributable to the foreign branch owner under the principles of §§ 1.861-8 through 1.861-14T and 1.861-17 (without regard to exclusive apportionment) by treating foreign source gross income and U.S. source gross income in each separate category (determined prior to the application of this paragraph (f)(2)(vi) to the disregarded payment at issue) each as a statutory grouping; and

(ii) Disregarded payments from a foreign branch to its foreign branch owner are allocable to gross income attributable to the foreign branch to the extent a deduction for that payment or any disregarded cost recovery deduction relating to that payment, if regarded, would be allocated and apportioned to gross income attributable to the foreign branch under the principles of §§ 1.861-8 through 1.861-14T and 1.861-17 (without regard to exclusive apportionment) by treating foreign source gross income and U.S. source gross income in each separate category (determined prior to the application of this paragraph (f)(2)(vi) to the disregarded payment at issue) each as a statutory grouping.

(2) Special rule for certain disregarded payments. Whether a disregarded payment made in connection with a sale or exchange of property is allocable to gross income attributable to a foreign branch or its foreign branch owner, and the source and separate category of the gross income to which the disregarded payment is allocable, is determined under the following rules:

(i) Except as provided in paragraph (f)(2)(vi)(D) of this section, disregarded payments from a foreign branch owner to its foreign branch in respect of non-inventory property are allocable to the gross income attributable to the foreign branch owner, if any, that is recognized with respect to a regarded sale or exchange of that property (including gross income arising in a later taxable year) to the extent of the adjusted disregarded gain with respect to the transferred property, and in the same proportions as the source and separate category of the gain recognized on the regarded sale or exchange of the transferred property;

(ii) Except as provided in paragraph (f)(2)(vi)(D) of this section, disregarded payments from a foreign branch to its foreign branch owner or to another foreign branch in respect of non-inventory property are allocable to the gross income attributable to the foreign branch, if any, that is recognized with respect to a regarded sale or exchange of that property (including gross income arising in a later taxable year) to the extent of the adjusted disregarded gain with respect to the transferred property, and in the same proportions as the source and separate category of the gain recognized on the regarded sale or exchange of the transferred property; and

(iii) The principles of paragraphs (f)(2)(vi)(B)(2)(i) and (ii) of this section apply in the case of disregarded payments in respect of inventory property between a foreign branch and its foreign branch owner or between foreign branches to the extent the disregarded payment, if regarded, would, for purposes of determining gross income, be subtracted from gross receipts that are regarded for Federal income tax purposes.

(3) Timing of reattribution—(i) In general. The gross income attributable to the foreign branch is adjusted under paragraph (f)(2)(vi)(B)(1) of this section only in the taxable year that a disregarded payment, if regarded, would be allowed as a deduction (including by giving rise to disregarded cost recovery deductions), or otherwise would be taken into account as an increase to cost of goods sold.

(ii) Disregarded sales of property. The gross income attributable to a foreign branch is adjusted under paragraph (f)(2)(vi)(B)(2) of this section only in the taxable year or years in which gain is recognized by reason of the disposition of property with an adjusted disregarded basis in a transaction that is regarded for Federal income tax purposes.

(C) Exclusion of certain disregarded payments. Paragraph (f)(2)(vi)(A) of this section does not apply to the following payments, accruals, or other transfers between a foreign branch and its foreign branch owner, or between foreign branches, that are disregarded for Federal income tax purposes:

(1) Interest, and interest equivalents that, if regarded, would be described in §§ 1.861-9(b) and 1.861-9T(b);

(2) Remittances from the foreign branch to its foreign branch owner, except as provided in paragraph (f)(2)(vi)(D) of this section;

(3) Contributions of money, securities, and other property from the foreign branch owner to its foreign branch, except as provided in paragraph (f)(2)(vi)(D) of this section; or

(4) Any disregarded payment that, if made to a foreign branch and regarded for Federal income tax purposes, could not result in the attribution of gross income to a foreign branch (for example, the sale of an interest in a partnership by a foreign branch to its foreign branch owner, unless the sale or exchange occurred in the ordinary course of business within the meaning of paragraph (f)(2)(iv)(B) of this section).

(D) Certain transfers of intangible property—(1) In general. For purposes of applying this paragraph (f)(2)(vi), the amount of gross income attributable to a foreign branch (and the amount of gross income attributable to its foreign branch owner) must be adjusted under the principles of paragraph (f)(2)(vi)(B) of this section to reflect all transactions that are disregarded for Federal income tax purposes in which property described in section 367(d)(4) is transferred to or from a foreign branch or between foreign branches, whether or not a disregarded payment is made in connection with the transfer. In determining the amount of gross income that is attributable to a foreign branch that must be adjusted by reason of this paragraph (f)(2)(vi)(D), the principles of sections 367(d) and 482 apply. For example, if a foreign branch owner transfers property described in section 367(d)(4) to a foreign branch, the principles of section 367(d) are applied by treating the foreign branch as a separate foreign corporation to which the property is transferred in exchange for stock of the corporation in a transaction described in section 351. Similarly, if a foreign branch remits property described in section 367(d)(4) to its foreign branch owner, the foreign branch is treated as having sold the transferred property to the foreign branch owner in exchange for annual payments contingent on the productivity or use of the property, the amounts of which are determined under the principles of section 367(d).

(2) Transactions occurring before December 7, 2018. Paragraph (f)(2)(vi)(D)(1) of this section does not apply to a disregarded transfer of property that occurred before December 7, 2018.

(3) Transitory ownership—(i) In general. Paragraph (f)(2)(vi)(D)(1) of this section does not apply to disregarded transfers of property by a foreign branch or a foreign branch owner (such foreign branch or foreign branch owner, the limited transferor), if the conditions in paragraphs (f)(2)(vi)(D)(3)(ii) and (iii) of this section are met.

(ii) Transitory ownership period. The limited transferor's ownership of the property is transitory.

(iii) Use of property. The limited transferor does not develop, exploit, or otherwise employ the property in a trade or business, other than in the ordinary course of the limited transferor's business during the period of transitory ownership.

(iv) Predecessors. For purposes of paragraphs (f)(2)(vi)(D)(3)(ii) and (iii) of this section, a reference to a limited transferor that is a foreign branch owner includes any predecessor to the foreign branch owner. No person is a predecessor with respect to a foreign branch under this paragraph (f)(2)(vi)(D)(3)(iv).

(E) Amount of disregarded payments. The amount of each disregarded payment used to make an adjustment under this paragraph (f)(2)(vi) (or the absence of any adjustment) must be determined in a manner that results in the attribution of the proper amount of gross income to each of a foreign branch and its foreign branch owner under the principles of section 482, applied as if the foreign branch were a corporation.

(F) Multiple disregarded payments. In the case of multiple disregarded payments, this paragraph (f)(2)(vi) is applied with respect to each disregarded payment, and under the ordering rules specified in paragraphs (f)(2)(vi)(F)(1) and (2) of this section. For purposes of this paragraph (f)(2)(vi), paragraph (f)(2)(vi)(F)(1) of this section applies before paragraph (f)(2)(vi)(F)(2) of this section.

(1) Income initially attributable to a foreign branch. In applying this paragraph (f)(2)(vi) to gross income that would, but for this paragraph (f)(2)(vi), be attributable to a foreign branch, adjustments related to disregarded payments from a foreign branch to another foreign branch are computed first, followed by adjustments related to disregarded payments from a foreign branch to its foreign branch owner, followed by adjustments related to disregarded payments from a foreign branch owner to its foreign branch.

(2) Income initially attributable to a foreign branch owner. In applying this paragraph (f)(2)(vi) to gross income that would, but for this paragraph (f)(2)(vi), be attributable to a foreign branch owner, adjustments related to disregarded payments from a foreign branch owner to a foreign branch are computed first, followed by adjustments related to disregarded payments from a foreign branch to another foreign branch, followed by adjustments related to disregarded payments from a foreign branch to its foreign branch owner.

(3) Definitions. The following definitions apply for purposes of this paragraph (f).

(i) Adjusted disregarded basis. The term adjusted disregarded basis means, with respect to property transferred in a transaction that is disregarded for Federal income tax purposes, the tentative disregarded basis of the property—

(A) Reduced by any disregarded cost recovery deductions with respect to the property; and

(B) Increased by any disregarded section 1016(a)(1) expenditures with respect to the property.

(ii) Adjusted disregarded gain—(A) In general. The term adjusted disregarded gain means, with respect to property transferred in a transaction that is disregarded for Federal income tax purposes, the lesser of—

(1) The adjusted disregarded basis of the property, reduced by the adjusted basis of the property at the time the property was transferred in a transaction that is disregarded for Federal income tax purposes; and

(2) The gain (if any) attributable to a regarded sale or exchange of the transferred property.

(B) Limitation. Adjusted disregarded gain may not be less than zero.

(iii) Disregarded cost recovery deduction. For a taxable year, the term disregarded cost recovery deduction means, with respect to property transferred in a transaction that is disregarded for Federal income tax purposes—

(A) The amounts that would be allowed as a deduction, and that would give rise to an adjustment described in section 1016(a)(2), with respect to the transferred property if the transfer (and the foreign branch) were regarded for Federal income tax purposes, to the extent that, under paragraph (f)(2)(vi)(B)(1) of this section, the deduction would be allocable to—

(1) Gross income attributable to a foreign branch owner, in the case of property transferred to a foreign branch owner; or

(2) Gross income attributable to a foreign branch, in the case of property transferred to a foreign branch; reduced by

(B) The amounts that are allowed as a deduction, and that give rise to an adjustment described in section 1016(a)(2), with respect to the transferred property to the extent that, under the principles of paragraph (f)(2)(vi)(B)(1) of this section, the deduction would be allocable to—

(1) Gross income attributable to a foreign branch owner, in the case of property transferred to a foreign branch owner; or

(2) Gross income attributable to a foreign branch, in the case of property transferred to a foreign branch.

(iv) Disregarded entity. The term disregarded entity means an entity described in § 301.7701-2(c)(2) of this chapter that is disregarded as an entity separate from its owner for Federal income tax purposes.

(v) Disregarded payment. The term disregarded payment means any amount described in paragraph (f)(3)(v)(A) or (B) of this section.

(A) Transfers to or from a disregarded entity. An amount described in this paragraph (f)(3)(v)(A) is an amount that is transferred to or from a disregarded entity in connection with a transaction that is disregarded for Federal income tax purposes and that is reflected on the separate set of books and records of a foreign branch.

(B) Other disregarded amounts. An amount described in this paragraph (f)(3)(v)(B) is any amount reflected on the separate set of books and records of a foreign branch that would constitute an item of income, gain, deduction, or loss (other than an amount described in paragraph (f)(3)(v)(A) of this section), a distribution to or contribution from the foreign branch owner, or a payment in exchange for property if the transaction to which the amount is attributable were regarded for Federal income tax purposes.

(vi) Disregarded section 1016(a)(1) expenditure. The term disregarded section 1016(a)(1) expenditure means a disregarded payment that, if regarded for Federal income tax purposes, would be described in section 1016(a)(1) and that, under the principles of paragraph (f)(2)(vi)(B)(1) of this section, would be allocable to—

(A) General category gross income, in the case of property held by a foreign branch owner; or

(B) Foreign branch category income, in the case of property held by a foreign branch.

(vii) Foreign branch—(A) In general. The term foreign branch means a qualified business unit (QBU), as defined in § 1.989(a)-1(b)(2)(ii) and (b)(3), that conducts a trade or business outside the United States. For an illustration of the principles of this paragraph (f)(3)(vii), see paragraph (f)(4)(i) of this section (Example 1).

(B) Trade or business outside the United States. Activities carried out in the United States, whether or not such activities are described in § 1.989(a)-1(b)(3), do not constitute the conduct of a trade or business outside the United States. Activities carried out outside the United States that constitute a permanent establishment under the terms of an income tax treaty between the United States and the country in which the activities are treated as carried out pursuant to a trade or business conducted outside the United States for purposes of this paragraph (f)(3)(vii)(B). In determining whether activities constitute a trade or business under § 1.989(a)-1(c), disregarded payments are taken into account and may give rise to a trade or business, provided that the activities (together with any other activities of the QBU) would otherwise satisfy the rule in § 1.989(a)-1(c).

(C) Activities of a partnership, estate, trust, or corporation—(1) Treatment as a foreign branch. For purposes of this paragraph (f)(3)(vii), the activities of a partnership, estate, trust, or corporation that conducts a trade or business that satisfies the requirements of § 1.989(a)-1(b)(2)(ii)(A) (as modified by paragraph (f)(3)(vii)(B) of this section) are—

(i) Deemed to satisfy the requirements of § 1.989(a)-1(b)(2)(ii)(B); and

(ii) Comprise a foreign branch.

(2) Separate set of books and records. A foreign branch described in this paragraph (f)(3)(vii)(C) is treated as maintaining a separate set of books and records with respect to the activities described in paragraph (f)(3)(vii)(C)(1) of this section, and must determine, as the context requires, the items of gross income, disregarded payments, and any other items that would be reflected on those books and records in applying this paragraph (f) with respect to the foreign branch. The principles of § 1.1503(d)-5(c) apply for purposes of determining which items would be reflected on such books and records.

(viii) Foreign branch owner. The term foreign branch owner means, with respect to a foreign branch, the person (including a foreign or domestic partnership or other pass-through entity) that owns the foreign branch, either directly or indirectly through one or more disregarded entities. For purposes of this paragraph (f)(3)(viii), the foreign branch owner does not include the foreign branch or another foreign branch of the person that owns the foreign branch.

(ix) Remittance. The term remittance means a transfer of property (within the meaning of section 317(a)) by a foreign branch that would be treated as a distribution if the foreign branch were treated as a separate corporation.

(x) Tentative disregarded basis. The term tentative disregarded basis means, in connection with the transfer of property in a transaction that is disregarded for Federal income tax purposes, the basis that property would have if the disregarded payment made in exchange for the transferred property were treated as the cost of such property under section 1012(a).

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

(i) Example 1: Determination of foreign branches and foreign branch owner—(A) Facts—(1) P, a domestic corporation, is a partner in PRS, a domestic partnership. All other partners in PRS are unrelated to P. PRS conducts activities solely in Country A (the Country A Business), and those activities constitute a trade or business outside the United States within the meaning of paragraph (f)(3)(vii)(B) of this section. PRS reflects items of income, gain, loss, and expense of the Country A Business on the books and records of PRS's home office. PRS is in the business of manufacturing bicycles.

(2) PRS owns FDE1, a disregarded entity organized in Country B. FDE1 conducts activities in Country B (the Country B Business), and those activities constitute a trade or business outside the United States within the meaning of paragraph (f)(3)(vii)(B) of this section. FDE1 maintains a set of books and records that are separate from those of PRS, and the separate set of books and records reflects items of income, gain, loss, and expense with respect to the Country B Business. FDE1 is in the business of selling bicycles manufactured by PRS.

(3) FDE1 owns FDE2, a disregarded entity organized in Country C. FDE2 conducts activities in Country C (the Country C Business), and those activities constitute a trade or business outside the United States within the meaning of paragraph (f)(3)(vii)(B) of this section. FDE2 maintains a set of books and records that are separate from those of PRS and FDE1, and the separate set of books and records reflects items of income, gain, loss, and expense with respect to the Country C Business. FDE2's paper business is not related to FDE1's bicycle sales business, and FDE1 does not hold its interest in FDE2 in the ordinary course of its trade or business.

(B) Analysis—(1) Country A Business's activities comprise a trade or business conducted outside the United States within the meaning of § 1.989(a)-1(b)(2)(ii)(A) and (b)(3) (in each case, as modified by paragraph (f)(3)(vii) of this section). PRS does not maintain a separate set of books and records with respect to the Country A Business. However, under paragraph (f)(3)(vii)(C) of this section, the Country A Business's activities are deemed to satisfy the requirement of § 1.989(a)-1(b)(2)(ii)(B) that a QBU maintain a separate set of books and records with respect to the relevant activities. Thus, for purposes of this paragraph (f), the activities of the Country A Business constitute a QBU as defined in § 1.989-1(b)(2)(ii) and (b)(3), as modified by paragraph (f)(3)(vii) of this section, that conducts a trade or business outside the United States. Accordingly, the activities of the Country A Business constitute a foreign branch within the meaning of paragraph (f)(3)(vii) of this section. PRS, the person that owns the Country A Business, is the foreign branch owner, within the meaning of paragraph (f)(3)(viii) of this section, with respect to the Country A Business.

(2) Country B Business's activities comprise a trade or business outside the United States within the meaning of § 1.989(a)-1(b)(2)(ii)(A) and (b)(3) (in each case, as modified by paragraph (f)(3)(vii) of this section). PRS maintains a separate set of books and records with respect to the Country B Business, as described in § 1.989(a)-1(b)(2)(ii)(B). Thus, for purposes of this section, the activities of the Country B Business constitute a QBU as defined in § 1.989-1(b)(2)(ii) and (b)(3), as modified by paragraph (f)(3)(vii) of this section, that conducts a trade or business outside the United States. Accordingly, the activities of the Country B Business constitute a foreign branch within the meaning of paragraph (f)(3)(vii) of this section. Under paragraph (f)(3)(viii) of this section, PRS, the person that owns the Country B Business indirectly through FDE1 (a disregarded entity), is the foreign branch owner with respect to the Country B Business.

(3) The same analysis that applies to the Country B Business applies to the Country C Business. Accordingly, the activities of the Country C Business constitute a foreign branch within the meaning of paragraph (f)(3)(vii) of this section. PRS, the person that owns the Country C Business indirectly through FDE1 and FDE2 (disregarded entities), is the foreign branch owner with respect to the Country C Business.

(ii) Example 2: Sale of foreign branch—(A) Facts. The facts are the same as in paragraph (f)(4)(i)(A) of this section (the facts in Example 1), except that in Year 1, FDE1 sells FDE2 to an unrelated person, recording gain from the sale on its books and records. In Year 2, PRS sells FDE1 to another unrelated person, recording gain from the sale on its books and records. In each year, PRS allocates a portion of the gain to P.

(B) Analysis—(1) Sale of FDE2. Under paragraph (f)(1)(i)(B) of this section, P's distributive share of gain recognized by PRS in connection with the sales of FDE1 and FDE2 constitutes foreign branch category income if it is attributable to a foreign branch held by PRS directly or indirectly through one or more disregarded entities. PRS's gross income from the Year 1 sale of FDE2 is reflected on the separate set of books and records maintained with respect to the Country B Business (a foreign branch) operated by FDE1. Therefore, absent an exception, under paragraph (f)(2)(i) of this section PRS's gross income from the sale of FDE2 would be attributable to the Country B Business, and would constitute foreign branch category income. However, under paragraph (f)(2)(iv) of this section, gross income attributable to the Country B Business does not include gain from the sale or exchange of an interest in FDE2, a disregarded entity, unless the interest in FDE2 is held by the Country B Business in the ordinary course of its active trade or business (within the meaning of paragraph (f)(2)(iv)(B) of this section). In this case, the Country B Business does not hold FDE2 in the ordinary course of its active trade or business within the meaning of paragraph (f)(2)(iv)(B) of this section. As a result, P's distributive share of gain from the sale of FDE2 is not attributable to a foreign branch, and is not foreign branch category income.

(2) Sale of FDE1. The analysis of PRS's sale of FDE1 in Year 2 is the same as the analysis for the sale of FDE2, except that PRS, through its Country A Business, holds FDE1 in the ordinary course of its active trade or business within the meaning of paragraph (f)(2)(iv)(B) of this section because the Country A Business engages in a trade or business that is related to the trade or business of FDE1. Therefore, P's distributive share of gain from the sale of FDE1 is attributable to a foreign branch, and is foreign branch category income.

(iii) Example 3: Disregarded payment for services—(A) Facts. P, a domestic corporation, owns FDE, a disregarded entity that is a foreign branch within the meaning of paragraph (f)(3)(vii) of this section. FDE's functional currency is the U.S. dollar. In Year 1, P accrues and records on its books and records (and not FDE's books and records) $1,000x of gross income from the performance of services to unrelated parties that is not passive category income, $400x of which is foreign source income in respect of services performed outside the United States by employees of FDE and $600x of which is U.S. source income in respect of services performed in the United States. Absent the application of paragraph (f)(2)(vi) of this section, the $1,000x of gross income earned by P would be general category income that would not be attributable to FDE. FDE provides services in support of P's gross income from services. P compensates FDE for its services with an arm's length payment of $400x, which is disregarded for Federal income tax purposes. The deduction for the payment of $400x from P to FDE would be allocated to P's $1,000x of general category gross services income and apportioned entirely to the $400x of foreign source services income under §§ 1.861-8 and 1.861-8T principles (treating foreign source general category gross income and U.S. source general category gross income each as a statutory grouping) if the payment were regarded for Federal income tax purposes.

(B) Analysis. The disregarded payment from P, a United States person, to FDE, its foreign branch, is not recorded on FDE's separate books and records (as adjusted to conform to Federal income tax principles) within the meaning of paragraph (f)(2)(i) of this section because it is disregarded for Federal income tax purposes. However, the disregarded payment is allocable to gross income attributable to P because a deduction for the payment, if it were regarded, would be allocated and apportioned to the $400x of P's foreign source services income. Accordingly, under paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section, the amount of gross income attributable to the FDE foreign branch (and the gross income attributable to P) is adjusted in Year 1 to take the disregarded payment into account. As such, $400x of P's foreign source gross income from the performance of services is attributable to the FDE foreign branch for purposes of this section. Therefore, $400x of the foreign source gross income that P earned with respect to its services in Year 1 constitutes gross income that is assigned to the foreign branch category.

(iv) Example 4: Disregarded payment for non-inventory property—(A) Facts. P, a domestic corporation, owns FDE, a disregarded entity that is a foreign branch within the meaning of paragraph (f)(3)(vii) of this section. FDE's functional currency is the U.S. dollar. P holds Asset A, a non-depreciable asset, with an adjusted basis of $200x. In Year 1, P sells Asset A, which will be used in FDE's manufacturing business, to FDE for $500x. FDE makes no other disregarded payments with respect to Asset A. No adjustments described in section 1016(a) apply with respect to Asset A while FDE holds Asset A. In Year 3, FDE sells Asset A to a third party for $600x and reflects $400x of gross income on its separate set of books and records (that is, $600x amount realized less Asset A's $200x adjusted basis). Under sections 865(e)(1) and 904(d)(2)(B)(i), the income arising from the sale of Asset A is foreign source income that is not treated as passive category income. Asset A is not inventory property. Absent the application of paragraph (f)(2)(vi) of this section, the entire $400x of gross income earned by P by reason of FDE's sale of Asset A would be attributable to FDE and be treated as foreign branch category income.

(B) Analysis—(1) Disregarded basis determinations. If regarded, the $500x payment from FDE to P would result in FDE holding Asset A with a basis of $500x under section 1012. Accordingly, the tentative disregarded basis (within the meaning of paragraph (f)(3)(x) of this section) with respect to Asset A is $500x. Because there are no adjustments described in section 1016 with respect to Asset A (including any adjustments resulting from any disregarded payments made with respect to the transferred property), the adjusted disregarded basis (within the meaning of paragraph (f)(3)(i) of this section) with respect to Asset A is $500x.

(2) Adjusted disregarded gain. Under paragraph (f)(3)(ii) of this section, the adjusted disregarded gain with respect to Asset A is $300x, which is equal to the lesser of $300x (FDE's adjusted disregarded basis in Asset A ($500x) less the adjusted basis of Asset A at the time that Asset A was transferred to FDE ($200x)) and $400x (the gain (if any) attributable to the regarded sale or exchange of Asset A).

(3) Attribution of gross income. Under paragraph (f)(2)(vi)(A) of this section, the gross income attributable to FDE ($400x) is adjusted downward to the extent that the $500x disregarded payment from FDE to P is allocable to gross income of FDE that is reflected on FDE's separate set of books and records. Under paragraph (f)(2)(vi)(B)(2)(ii) of this section, the $500x payment from FDE to P is allocable to gross income attributable to FDE to the extent of FDE's adjusted disregarded gain ($300x) with respect to Asset A. The source and separate category of the gross income of FDE to which the payment is allocable is proportionate to the source and separate category of the gain recognized by FDE with respect to Asset A. Accordingly, $300x of the payment is allocable to foreign source income that would be foreign branch category income. Thus, under paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section, foreign source gross income attributable to P is adjusted upward by $300x (increasing foreign source general category income by $300x) and foreign source gross income attributable to FDE is adjusted downward by $300x (decreasing foreign source foreign branch category income by $300x) in Year 3.

(v) Example 5: Disregarded payment for depreciable non-inventory property—(A) Facts. The facts are the same as in paragraph (f)(4)(iv)(A) of this section (the facts in Example 4), except as set forth in this paragraph (f)(4)(v)(A). Asset A is depreciable property. In Year 2, P is entitled to a $20x depreciation deduction with respect to Asset A, $18x of which is allocated and apportioned to non-passive category gross income attributable to FDE under §§ 1.861-8 through 1.861-14T and $2x of which is allocated and apportioned to passive category gross income under §§ 1.861-8 through 1.861-14T. If the transfer of Asset A were regarded for Federal income tax purposes, FDE would be entitled to a $50x depreciation deduction, 90% of which would be allocated and apportioned to non-passive category gross income attributable to FDE under §§ 1.861-8 through 1.861-14T and 10% of which would be allocated and apportioned to passive category gross income under §§ 1.861-8 through 1.861-14T. In Year 2, FDE earns $315x of gross income that it reflects on its books and records that, in the absence of paragraph (f)(2)(vi) of this section, would be foreign branch category income. FDE also earns $35x of passive category income in Year 2 from the non-active rental of a portion of Asset A. In Year 3, FDE reflects $420x of gross income on its separate set of books and records by reason of the sale of Asset A (that is, $600x amount realized less Asset A's $180x adjusted basis), $42x of which is passive category income under paragraph (b) of this section.

(B) Analysis—(1) Attribution of gross income in Year 2. The disregarded payment from FDE to P in Year 1 is disregarded for Federal income tax purposes, and does not generate gross income. However, under paragraph (f)(2)(vi)(B)(1)(ii) of this section, the disregarded payment is allocable to gross income attributable to FDE to the extent of any disregarded cost recovery deduction relating to that payment in Year 2. Under paragraph (f)(3)(iii) of this section, the disregarded cost recovery deduction with respect to Asset A is $30x, which is $50x (the amount that would be allowed as a deduction, and that would give rise to an adjustment described in section 1016(a)(2), with respect to Asset A if the transfer of Asset A to FDE were regarded for Federal income tax purposes, to the extent that the deduction would be allocable to income attributable to a foreign branch), reduced by $20x (the amount allowed as a deduction, and that gives rise to an adjustment described in section 1016(a)(2), with respect to Asset A, to the extent allocable to income attributable to a foreign branch). If regarded, $27x (90% of $30x) of the disregarded cost recovery deduction would be allocated and apportioned to non-passive category gross income attributable to FDE under §§ 1.861-8 through 1.861-14T and $3x (10% of $30x) would be allocated and apportioned to passive category gross income under §§ 1.861-8 through 1.861-14T. Accordingly, under paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section, the $315x of non-passive category gross income that would otherwise be attributed to FDE is reduced to $288x ($315x less $27x), and the non-passive category gross income attributable to P is increased by $27x in Year 2. As a result, in Year 2, P's foreign branch category gross income is $288x, and its general category gross income is increased by $27x. P's passive category gross income is $35x. See paragraphs (f)(1)(ii) and (f)(2)(vi)(A) of this section.

(2) Attribution of gross income in Year 3—(i) Adjusted disregarded basis. If regarded, the $500x payment from FDE to P would result in FDE holding Asset A with a basis of $500x under section 1012. Accordingly, the tentative disregarded basis (within the meaning of paragraph (f)(3)(x) of this section) with respect to Asset A is $500x. To determine FDE's adjusted disregarded basis with respect to Asset A under paragraph (f)(3)(i) of this section, FDE's tentative disregarded basis is reduced by $30x (the disregarded cost recovery deduction with respect to Asset A), resulting in an adjusted disregarded basis of $470x.

(ii) Adjusted disregarded gain. Under paragraph (f)(3)(ii) of this section, the adjusted disregarded gain with respect to Asset A is $270x, which is equal to the lesser of $270x (FDE's adjusted disregarded basis in Asset A ($470x) less the adjusted basis of Asset A at the time that Asset A was transferred to FDE ($200x)), and $420x (the gain attributable to the regarded sale or exchange of Asset A).

(iii) Sale of Asset A. Under paragraph (f)(2)(vi)(A) of this section, the gross income attributable to FDE ($420x) by reason of the sale of Asset A is adjusted downward to the extent that the $500x disregarded payment from FDE to P is allocable to gross income that would be attributable to FDE under paragraphs (f)(2)(i) through (v) of this section. Under paragraph (f)(2)(vi)(B)(2)(ii) of this section, the $500x payment from FDE to P is allocable to gross income attributable to FDE to the extent of the adjusted disregarded gain with respect to Asset A, which is $270x. The source and separate category of the gross income of FDE to which that amount is allocable is proportionate to the source and separate category of the $420x of gain recognized on the regarded sale of Asset A ($378x of foreign source non-passive category income and $42x of foreign source passive category income). Consequently, under paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section, in Year 3, gross income attributable to P is adjusted upward by $270x (increasing P's foreign source general category gross income by $243x, which bears the same proportion to $270x as the foreign source non-passive gain ($378x) bears to P's overall gain with respect to Asset A ($420x)), and the foreign source gross income attributable to FDE is adjusted downward by $270x (with foreign source foreign branch category gross income reduced by $243x). P also has $42x of foreign source passive category income from the sale of Asset A. See paragraphs (f)(1)(ii) and (f)(2)(vi)(A) of this section.

(vi) Example 6: Disregarded payment for non-depreciable non-inventory property—regarded gain limitation—(A) Facts. The facts are the same as in paragraph (f)(4)(iv)(A) of this section (the facts in Example 4), except that in Year 3, FDE sells Asset A to a third party for $340x and reflects $140x of gross income on its separate set of books and records (that is, $340x amount realized less Asset A's $200x adjusted basis), none of which is passive category income.

(B) Analysis. The analysis is the same as the analysis in paragraph (f)(4)(iv)(B) of this section (the analysis in Example 4), except that in Year 3, the adjusted disregarded gain with respect to Asset A is $140x, which is equal to the lesser of $300x (FDE's adjusted disregarded basis in Asset A ($500x) less the adjusted basis of Asset A at the time that Asset A was transferred to FDE ($200x)), and $140x (the gain attributable to the regarded sale or exchange of Asset A). Accordingly, under paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section, gross income attributable to P is adjusted upward by $140x (increasing P's foreign source general category gross income by $140x) and gross income attributable to FDE is adjusted downward by $140x (decreasing P's foreign source foreign branch category gross income by $140x) in Year 3.

(vii) Example 7: Disregarded payment for non-depreciable non-inventory property—loss—(A) Facts. The facts are the same as in paragraph (f)(4)(iv)(A) of this section (the facts in Example 4), except that in Year 3, FDE sells Asset A to a third party for $175x and reflects a $25x loss on its separate set of books and records (that is, $175x amount realized less Asset A's $200x adjusted basis).

(B) Analysis. The analysis is the same as the analysis in paragraph (f)(4)(iv)(B) of this section (the analysis in Example 4), except that in Year 3, the adjusted disregarded gain with respect to Asset A is $0x, which is equal to the lesser of $300x (FDE's adjusted disregarded basis in Asset A ($500x) less the adjusted basis of Asset A at the time that Asset A was transferred to FDE ($200x)), and $0x (the gain attributable to the regarded sale or exchange of Asset A). Accordingly, gross income amounts attributable to P and FDE are not adjusted under paragraph (f)(2)(vi)(A) of this section by reason of the transfer of Asset A from P to FDE.

(viii) Example 8: Disregarded payment for non-depreciable non-inventory property—disregarded gain limitation—(A) Facts. The facts are the same as in paragraph (f)(4)(iv)(A) of this section (the facts in Example 4), except that in Year 1, P sells Asset A to FDE for $65x.

(B) Analysis. The analysis is the same as the analysis in paragraph (f)(4)(iv)(B) of this section (the analysis in Example 4), except that in Year 3, the tentative disregarded basis and the adjusted disregarded basis with respect to Asset A are $65x. Under paragraph (f)(3)(ii)(B) of this section, the adjusted disregarded gain with respect to Asset A is $0x. Accordingly, under paragraph (f)(2)(vi)(A) of this section, gross income amounts attributable to P and FDE are not adjusted under paragraph (f)(2)(vi)(A) of this section by reason of the transfer of Asset A from P to FDE.

(ix) Example 9: Application of the rules to the sale of inventory from a foreign branch owner to a foreign branch for distribution—(A) Facts. P, a domestic corporation, owns FDE, a disregarded entity that is a foreign branch within the meaning of paragraph (f)(3)(vii) of this section. FDE's functional currency is the U.S. dollar. P manufactures portable electronic devices, which it sells to FDE for $1,500x during a taxable year in a transaction that is disregarded for Federal income tax purposes. In the same taxable year, FDE sells the portable electronic devices to its customers for $1,750x. P uses an overall accrual method of accounting and has $1,300x of cost of goods sold for the taxable year, $1,200x of which were incurred prior to the disregarded sale to FDE and recorded on P's separate set of books and records and $100x of which were incurred after the disregarded sale and recorded on the books and records of FDE. P reports $450x of gross income for the taxable year: $1,750x of gross receipts less cost of goods sold of $1,300x. The $450x of gross income from the sale of portable electronic devices is U.S. source income under section 863(b).

(B) Analysis—(1) In general. The gross receipts from the sale of portable electronic devices ($1,750x), which results in U.S. source gross income of $450x, is recorded on FDE's separate books and records (as adjusted to conform to Federal income tax principles). Therefore, the gross income ($450x) generally would be foreign branch category income under paragraph (f)(2)(i) of this section. However, under paragraph (f)(2)(vi)(A) of this section, the amount of gross income attributable to FDE (and the gross income attributable to P) is adjusted to take the disregarded payment for the portable electronic devices from FDE to P into account. If both FDE and the disregarded payment from FDE to P were recognized for Federal income tax purposes, the amount of the payment ($1,500x) would reduce FDE's gross income. Therefore, under paragraph (f)(2)(vi)(B)(2)(iii) of this section, the principles of paragraph (f)(2)(vi)(B)(2)(ii) of this section apply for purposes of determining whether, and to what extent, the disregarded payment is allocable to non-passive category income attributable to FDE for purposes of determining the extent of any adjustment.

(2) Applying the principles of the tangible property rules to sales of inventory. The principles of paragraph (f)(2)(vi)(B)(2)(ii) of this section are applied by treating the cost of goods sold with respect to expenses recorded on P's separate set of books and records ($1,200x) similarly to the adjusted basis at the time of the disregarded sale; the gross income ($450x) similarly to gain from the disposition of non-inventory property; and the lesser of the recognized gross income ($450x) and the disregarded payment less the cost of goods sold attributable to expenses reflected on P's separate set of books and records ($1,500x less $1,200x) similarly to disregarded gain ($300x). Accordingly, under paragraph (f)(2)(vi)(A) of this section, general category U.S. source gross income attributable to P is adjusted upward by $300x and the non-passive category U.S. source gross income attributable to FDE is adjusted downward by $300x.

(x) Example 10: Gross income initially attributable to a foreign branch—(A) Facts—(1) Overview. P, a domestic corporation, owns FDE, which is a disregarded entity that is a foreign branch within the meaning of paragraph (f)(3)(vii) of this section that has the U.S. dollar as its functional currency. P, which is a foreign branch owner with respect to FDE, also conducts a trade or business in the United States. During a single taxable year, P and FDE engage in the transactions described in paragraphs (f)(4)(x)(A)(2) and (3) of this section.

(2) Unrelated party transactions. P, through its U.S. office, accrues and records on its books and records $5,000x of gross income from the performance of accounting services for Customer A, an unrelated party (the Customer A services). The gross income from the Customer A services performed by P is non-passive category income and, under section 861(a)(3), is U.S. source income. Absent the application of paragraph (f)(2)(vi) of this section, the gross income earned by P through its U.S. office would be general category income. FDE accrues and records on its books and records $3,400x of gross income from the performance of web design services for Customer B, an unrelated party (the Customer B services). The gross income from the Customer B services performed by FDE is non-passive category income and, under section 862(a)(3), is foreign source income. Absent the application of paragraph (f)(2)(vi) of this section, the $3,400x of gross income earned by FDE would be foreign branch category income.

(3) Disregarded payments. FDE provides web design services to P. As compensation for those services, P pays $300x to FDE. The deduction for P's payment to FDE (if regarded) would be allocable to the $5,000x of general category U.S. source gross income earned from P's performance of the Customer A services. P provides accounting services to FDE from P's U.S. office. As compensation for those services, FDE pays $300x to P. The deduction for FDE's payment to P (if regarded) would be allocable to the $3,400x of non-passive category foreign source gross income earned from FDE's performance of the Customer B services.

(B) Analysis—(1) Application of multiple disregarded payments rule. Under paragraph (f)(2)(vi)(F) of this section, paragraph (f)(2)(vi) of this section applies to determine the effects of the disregarded payments described in paragraph (f)(4)(x)(A)(3) of this section on gross income initially attributable to FDE before paragraph (f)(2)(vi) of this section is applied to gross income initially attributable to P.

(2) Disregarded payment from FDE to P. The disregarded payment from FDE to P is disregarded for Federal income tax purposes, and does not generate gross income. However, the disregarded payment is allocable to non-passive category gross income attributable to FDE because a deduction for the payment, if it were regarded, would be allocated to FDE's $3,400x of non-passive category foreign source gross services income under § 1.861-8. Under paragraph (f)(2)(vi)(A) of this section, the amount of non-passive category foreign source gross income attributable to FDE is adjusted downward, and the amount of general category foreign source gross income attributable to P (in its capacity as a foreign branch owner) is adjusted upward, to take the disregarded payment into account. Thus, $300x of FDE's foreign source gross income relating to the Customer B services is attributable to P for purposes of this section, and $3,100x of that income is attributable to FDE.

(3) Disregarded payment from P to FDE. The disregarded payment from P to FDE is not recorded on FDE's separate books and records (as adjusted to conform to Federal income tax principles) within the meaning of paragraph (f)(2)(i) of this section because it is disregarded for Federal income tax purposes. However, the disregarded payment is allocable to general category U.S. source gross income attributable to P because a deduction for the payment, if it were regarded, would be allocated to P's $5,000x of general category U.S. source gross services income under § 1.861-8. Accordingly, under paragraph (f)(2)(vi)(A) of this section, the amount of general category U.S. source gross income attributable to P is adjusted downward, and the amount of non-passive category U.S. source gross income attributable to FDE is adjusted upward, to take the disregarded payment into account. Thus, $300x of P's U.S. source gross income from the performance of Customer A services is attributable to FDE for purposes of this section, and $4,700x of that income is attributable to P.

(xi) Example 11: Ordering rule—(A) Facts—(1) Overview. P, a domestic corporation, owns FDE1 and FDE2, each of which is a disregarded entity that is a foreign branch within the meaning of paragraph (f)(3)(vii) of this section that has the U.S. dollar as its functional currency. P, which is a foreign branch owner with respect to FDE1 and FDE2, also conducts a trade or business in the United States. During a single taxable year, P, FDE1, and FDE2 engage in the transactions described in paragraphs (f)(4)(xi)(A)(2) and (3) of this section.

(2) Unrelated party transactions. FDE1 accrues and records on its books and records $1,000x of gross income from the performance of services for Customer A, an unrelated party (the Customer A services). The gross income from the Customer A services performed by FDE is non-passive category income and, under section 862(a)(3), is foreign source income. Absent the application of paragraph (f)(2)(vi) of this section, the $1,000x of non-passive foreign source gross income earned by FDE1 would be foreign branch category income. FDE2 accrues and records on its books and records $1,100x of gross income from royalties received from Customer B, an unrelated party (the Customer B royalties) on licensed intangible property developed by FDE2 and used by Customer B in the United States. The gross income from the Customer B royalties is non-passive category income and under section 861(a)(4) is U.S. source income. Absent the application of paragraph (f)(2)(vi) of this section, the $1,100x of non-passive category U.S. source gross income earned by FDE2 would be foreign branch category income.

(3) Disregarded payments. FDE2 provides services to FDE1. As compensation for those services, FDE1 pays $200x to FDE2. The deduction for FDE1's payment to FDE2 (if regarded) would be allocable to the $1,000x of non-passive category foreign source gross income earned from the Customer A services. P provides services to FDE2 from P's U.S. office. As compensation for those services, FDE2 pays $50x to P. The deduction for FDE2's payment to P (if regarded) would be allocable to the non-passive category foreign source gross income attributable to FDE2 (see paragraph (f)(4)(xi)(B)(1) of this section) relating to gross income from the Customer A services.

(B) Analysis—(1) Disregarded payment from FDE1 to FDE2. The $1,000x of gross income earned by FDE1 from the Customer A services would, but for paragraph (f)(2)(vi) of this section, be attributable to FDE1 (a foreign branch). Accordingly, under paragraph (f)(2)(vi)(F)(1) of this section, adjustments related to disregarded payments from FDE1 to FDE2 are computed before adjustments related to disregarded payments from FDE2 to P (in its capacity as a foreign branch owner). The disregarded payment from FDE1 to FDE2 is not recorded on FDE2's separate books and records (as adjusted to conform to Federal income tax principles) within the meaning of paragraph (f)(2)(i) of this section because it is disregarded for Federal income tax purposes. However, the disregarded payment is allocable to gross income attributable to FDE1 because a deduction for the payment, if it were regarded, would be allocated to FDE1's $1,000x of non-passive category foreign source gross services income under § 1.861-8. Accordingly, under paragraph (f)(2)(vi)(A) of this section, the amount of non-passive category foreign source gross income attributable to FDE1 is adjusted downward, and the amount of non-passive category foreign source gross income attributable to FDE2 is adjusted upward, to take the disregarded payment into account. Thus, $200x of FDE1's non-passive category foreign source gross income from the performance of Customer A services is attributable to FDE2 for purposes of this section, and $800x of that income is attributable to FDE1.

(2) Disregarded payment from FDE2 to P. The disregarded payment from FDE2 to P is disregarded for Federal income tax purposes, and does not generate gross income. However, the disregarded payment is allocable to gross income attributable to FDE2 because a deduction for the payment, if it were regarded, would be allocated to FDE2's $200x of non-passive category foreign source gross services income under § 1.861-8. Under paragraph (f)(2)(vi)(A) of this section, the amount of non-passive category foreign source gross income attributable to FDE2 is adjusted downward, and the amount of general category foreign source gross income attributable to P is adjusted upward, to take the $50x disregarded payment into account. Thus, $50x of non-passive category foreign source gross income relating to the Customer A services is attributable to P for purposes of this section, $150x of that income is attributable to FDE2, and $800x of that income remains attributable to FDE1. FDE2's $1,100x of U.S. source royalty income is not adjusted under paragraph (f)(2)(vi) of this section and remains foreign branch category income.

(xii) Example 12: Application of intangible property rules—(A) Facts. P, a domestic corporation that has a calendar taxable year, owns FDE, a disregarded entity that is a foreign branch within the meaning of paragraph (f)(3)(vii) of this section. FDE's functional currency is the U.S. dollar. Asset A, a patent with a useful life ending on December 31, Year 2, was obtained with respect to a discovery that was made by FDE in the course of its trade or business and was used in that trade or business until December 31, Year 1. On December 31, Year 1, FDE remits Asset A to P and receives no consideration. Asset A has an adjusted basis of $0. In Year 2, P uses Asset A to generate general category gross income. P earns $1,000x of general category U.S. source gross income in Year 2, including the income generated by its use of Asset A. If FDE were a domestic corporation, P were a foreign corporation, and Asset A had been transferred in exchange for stock in a transaction described in section 351, such that section 367(d) applied by its terms (but all other facts remained the same), the payment determined under section 367(d) for Year 2 would be $300x. A disregarded payment for the use of Asset A, if it were regarded, would be allocated to FDE's $1,000x of general category U.S. source gross income under § 1.861-8.

(B) Analysis. The remittance of Asset A by FDE to P is a transfer of intangible property described in section 367(d)(4) from a foreign branch to its foreign branch owner. The facts in paragraph (f)(4)(xii)(A) of this section do not implicate an exception in paragraph (f)(2)(vi)(D)(2) or (3) of this section. Therefore, this is a transaction to which paragraph (f)(2)(vi)(D)(1) of this section applies. The foreign branch is treated as having sold the transferred property to the foreign branch owner in exchange for annual payments contingent on the productivity or use of the property, the amount of which for Year 2 is determined under the principles of section 367(d) to be $300x. Thus, in Year 2, P is treated as making a $300x disregarded payment to FDE. The payment would be allocable to general category U.S. source income under paragraph (f)(2)(vi)(B)(1)(i) of this section. Therefore, $300x of P's non-passive category U.S. source gross income is attributable to FDE under paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section. P has $700x of general category U.S. source gross income and $300x of foreign branch category U.S. source gross income in Year 2.

(g) Section 951A category income—(1) In general. Except as provided in paragraph (g)(2) of this section, the term section 951A category income means amounts included (directly or indirectly through a pass-through entity) in gross income of a United States person under section 951A(a).

(2) Exceptions for passive category income. Section 951A category income does not include any amounts included under section 951A(a) that are allocable to passive category income under § 1.904-5(c)(6).

(h) * * *

(2) Treatment of export financing interest. Except as provided in paragraph (h)(3) of this section, if a taxpayer (including a financial services entity) receives or accrues export financing interest from an unrelated person, then that interest is not treated as passive category income. Instead, the interest income is treated as foreign branch category income, section 951A category income, general category income, or income in a specified separate category under the rules of this section.

(4) Examples. The following examples illustrate the application of paragraph (h)(3) of this section.

(i) Example 1. Controlled foreign corporation CFC is a wholly-owned subsidiary of domestic corporation USP. CFC is not a financial services entity and has accumulated cash reserves. USP has uncollected trade and service receivables of foreign obligors. USP sells the receivables at a discount (“factors”) to CFC. The income derived by CFC on the receivables is related person factoring income. The income is also export financing interest. Because the income is related person factoring income, the income is passive category income to CFC.

(ii) Example 2. Domestic corporation USS is a wholly-owned subsidiary of domestic corporation USP. USS is not a financial services entity, does not have any foreign qualified business entities, and has accumulated cash reserves. USP has uncollected trade and service receivables of foreign obligors. USP factors the receivables to USS. The income derived by USS on the receivables is related person factoring income. The income is also export financing interest. The income will be passive category income to USS.

(iii) Example 3. The facts are the same as in paragraph (h)(4)(ii) of this section (the facts in Example 2), except that instead of factoring USP's receivables, USS finances the sales of USP's goods by making loans to the purchasers of USP's goods. The interest derived by USS on these loans is export financing interest and is not related person factoring income. The income will be general category income to USS.

(5) Income eligible for section 864(d)(7) exception (same country exception) from related person factoring treatment—(i) Income other than interest. If any foreign person receives or accrues income that is described in section 864(d)(7) (income on a trade or service receivable acquired from a related person in the same foreign country as the recipient) and such income would also meet the definition of export financing interest if section 864(d)(1) applied to such income (income on a trade or service receivable acquired from a related person treated as interest), then the income is considered to be export financing interest and is not treated as passive category income. The income is treated as foreign branch category income, section 951A category income, general category income, or income in a specified separate category under the rules of this section.

(ii) Interest income. If export financing interest is received or accrued by any foreign person and that income would otherwise be treated as related person factoring income of a controlled foreign corporation under section 864(d)(6) if section 864(d)(7) did not apply, section 904(d)(2)(B)(iii)(I) applies and the interest is not treated as passive category income. The income is treated as general category income in the hands of the controlled foreign corporation.

(iii) Examples. The following examples illustrate the application of this paragraph (h)(5):

(A) Example 1. CFC1, a controlled foreign corporation, is a wholly-owned subsidiary of domestic corporation USP. CFC2, a controlled foreign corporation, is a wholly-owned subsidiary of CFC1. CFC1 and CFC2 are incorporated in Country M. In Year 1, USP sells tractors to CFC2, which CFC2 sells to X, an unrelated foreign corporation organized in Country M. The tractors are to be used in Country M. CFC2 uses a substantial part of its assets in its trade or business located in Country M. CFC2 has uncollected trade receivables from X that it factors to CFC1. The income is not related person factoring income because it is described in section 864(d)(7) (income eligible for the same country exception) and is tested income. If section 864(d)(1) applied, the income CFC1 derived from the receivables would meet the definition of export financing interest. The income, therefore, is considered to be export financing interest and is general category income to CFC1 and may be section 951A category income to USP.

(B) Example 2. CFC1, a controlled foreign corporation, is a wholly-owned subsidiary of domestic corporation, USP. CFC2, a controlled foreign corporation, is a wholly-owned subsidiary of CFC1. CFC1 and CFC2 are incorporated in Country M. In Year 1, USP sells tractors to CFC2, which CFC2 sells to X, a foreign partnership that is organized in Country M and is related to CFC1 and CFC2. CFC1 makes a loan to X to finance the tractor sales. The interest earned by CFC1 from financing the sales is described in section 864(d)(7) and is export financing interest and is tested income. Therefore, the income is general category income to CFC1 and may be section 951A category income to USP.

(k) Separate category under section 904(d)(6) or 865(h) for items resourced under treaties—(1) Section 904(d)(6)—(i) In general. Except as provided in paragraph (k)(1)(iv)(A) of this section, sections 904(a), (b), (c), (d), (f), and (g) and sections 907 and 960 are applied separately to any item of income that, without regard to a treaty obligation of the United States, would be treated as derived from sources within the United States, but under a treaty obligation of the United States such item of income would be treated as arising from sources outside the United States, and the taxpayer chooses the benefits of such treaty obligation.

(ii) Aggregation of items of income in each other separate category. For purposes of applying the general rule of paragraph (k)(1) of this section, items of income in each other separate category of income that are resourced under each applicable treaty are aggregated in a single separate category for income in that separate category that is resourced under that treaty. For example, all items of passive category income that would otherwise be treated as derived from sources within the United States but which the taxpayer chooses to treat as arising from sources outside the United States pursuant to a provision of a bilateral U.S. income tax treaty are treated as income in a separate category for passive category income resourced under the particular treaty, and the high-tax kickout grouping rules of paragraph (c) of this section are applied separately to the groups of passive income included in that separate category. Any items of resourced high-taxed passive income are assigned to a separate category for general (or other) category income resourced under a tax treaty. Items of income described in paragraph (k)(1) of this section are not combined with other income that is foreign source income under the Code, even if the other income arises from sources within the jurisdiction with which the United States has a bilateral income tax treaty (“treaty jurisdiction”) and is included in the same separate category to which the resourced income would be assigned without regard to section 904(d)(6). Items of income described in paragraph (k)(1) of this section are also not combined with other items of resourced income that are subject to a separate limitation by reason of a Code provision other than section 904(d)(6).

(iii) Related taxes. Foreign taxes, including foreign taxes paid to a foreign jurisdiction other than the treaty jurisdiction on an item of resourced income, are allocated to each separate category described in paragraph (k)(1)(ii) of this section in accordance with § 1.904-6.

(iv) Coordination with certain income tax treaty provisions—(A) Exception for special relief from double taxation for individual residents of treaty jurisdictions. Section 904(d)(6)(A) and paragraph (k)(1) of this section do not apply to any item of income deemed to be from foreign sources by reason of the relief from double taxation rules in any U.S. income tax treaty that is solely applicable to U.S. citizens who are residents of the other Contracting State.

(B) U.S. competent authority assistance. For purposes of applying paragraph (k)(1) of this section, if, under the mutual agreement procedure provisions of an applicable income tax treaty, the U.S. competent authority agrees to allow a taxpayer to treat an item of income as foreign source income, where such item of income would otherwise be treated as derived from sources within the United States, then the taxpayer is considered to have chosen the benefits of such treaty obligation to treat the item as foreign source income.

(v) Coordination with other Code provisions. Section 904(d)(6)(A) and paragraph (k)(1) of this section do not apply to any item of income to which any of section 245(a)(10), 865(h), or 904(h)(10) applies. See also paragraph (l) of this section.

(2) Section 865(h). If any gain, as defined in section 865(h)(2)(A)(i), would be treated as derived from sources within the United States under section 865, but pursuant to a treaty obligation of the United States such gain would be treated as arising from sources outside the United States, and the taxpayer chooses the benefits of such treaty obligation, then that gain will be treated as foreign source income. However, sections 904(a), (b), (c), (d), (f), and (g) and sections 907 and 960 are applied separately to amounts described in the preceding sentence with respect to each treaty under which the taxpayer has claimed benefits and, within each treaty, to each separate category of income. The principles of the rules in paragraphs (k)(1)(ii) through (iv) of this section apply to gains, and foreign taxes on gains, that are subject to a separate limitation under section 865(h).

(l) Priority rule. Income that meets the definitions of a specified separate category and another category of income described in section 904(d)(1) is subject to the separate limitation described in paragraph (m) of this section and is not treated as general category income, foreign branch category income, passive category income, or section 951A category income.

(m) Income treated as allocable to a specified separate category. If section 904(a), (b), and (c) are applied separately to any category of income under the Internal Revenue Code (for example, under section 245(a)(10), 865(h), 901(j), 904(d)(6), or 904(h)(10)), that category of income is treated for all purposes of the Internal Revenue Code as if it were a separate category listed in section 904(d)(1). For purposes of this section, a separate category that is treated as if it were listed in section 904(d)(1) by reason of the first sentence in this paragraph (m) is referred to as a specified separate category.

(n) Income from partnerships and other pass-through entities—(1) Distributive shares of partnership income—(i) In general. Except as provided in paragraph (n)(1)(ii) of this section, a partner's distributive share of partnership income is characterized as passive category income to the extent that the distributive share is a share of income earned or accrued by the partnership in the passive category. A partner's distributive share of partnership income that is not described in the first sentence of this paragraph (n) is treated as foreign branch category income, general category income, or income in a specified separate category under the rules of this section. The principles of the rules in this paragraph (n)(1)(i) also apply to characterize a person's share of income from any other pass-through entity.

(ii) Less than 10 percent partners partnership interests—(A) In general. Except as provided in paragraph (n)(1)(ii)(B) of this section, if any limited partner owns less than 10 percent of the value in a partnership, the partner's distributive share of partnership income from the partnership is passive income to the partner (subject to the exception for high-taxed income under section 904(d)(2)(B)(iii)(II) and paragraph (c) of this section), and the partner's distributive share of partnership deductions from the partnership is allocated and apportioned under the principles of § 1.861-8 only to the partner's passive income from that partnership. See also § 1.861-9(e)(4) for rules for apportioning partnership interest expense.

(B) Exception for partnership interest held in the ordinary course of business. If a partnership interest described in paragraph (n)(1)(ii)(A) of this section is held in the ordinary course of a partner's active trade or business, the rules of paragraph (n)(1)(i) of this section apply for purposes of characterizing the partner's distributive share of the partnership income. A partnership interest is considered to be held in the ordinary course of a partner's active trade or business if the partner (or a member of the partner's affiliated group of corporations (within the meaning of section 1504(a) and without regard to section 1504(b)(3))) engages (other than through a less than 10 percent interest in a partnership) in the same or a related trade or business as the partnership.

(2) Income from the sale of a partnership interest—(i) In general. To the extent a partner recognizes gain on the sale of a partnership interest, that income shall be treated as passive income to the partner, subject to the exception for high-taxed income under section 904(d)(2)(B)(iii)(II) and paragraph (c) of this section.

(ii) Exception for sale by 25-percent owner. Except as provided in paragraph (f)(2)(iv) of this section, in the case of a sale of an interest in a partnership by a partner that is a 25-percent owner of the partnership, determined by applying section 954(c)(4)(B) and substituting “partner” for “controlled foreign corporation” every place it appears, for purposes of determining the separate category to which the income recognized on the sale of the partnership interest is assigned such partner is treated as selling the proportionate share of the assets of the partnership attributable to such interest.

(3) Value of a partnership interest. For purposes of paragraphs (n)(1) and (2) of this section, a partner will be considered as owning 10 percent of the value of a partnership for a particular year if the partner, together with any person that bears a relationship to the partner described in section 267(b) or 707, owns 10 percent of the capital and profits interest of the partnership. For purposes of this paragraph (n)(3), value will be determined at the end of the partnership's taxable year.

(4) Example. The following example illustrates the application of this paragraph (n).

(i) Facts. PRS is a domestic partnership. PRS has two general partners, A and B. A and B each have a greater than 10% interest in PRS. PRS also has two limited partners, C and D. C has a 50% interest in the partnership and D has a 9% interest. D's partnership interest is not held in the ordinary course of business. A, B, C and D are all United States persons. In Year 1, PRS has $100x of general category non-subpart F income on which it pays no foreign tax.

(ii) Analysis. Under paragraph (n)(1)(i) of this section, A's, B's, and C's distributive shares of PRS's income are not passive category income. Under paragraph (n)(1)(ii)(A) of this section, because D is a limited partner with a less than 10% interest in PRS, D's distributive share of PRS's income is passive category income.

(o) Separate category of section 78 gross up. The amount included in income under section 78 by reason of taxes deemed paid under section 960 is assigned to the separate category to which the taxes are allocated under § 1.904-6(b).

(p) Separate category of foreign currency gain or loss. Foreign currency gain or loss recognized under section 986(c) with respect to a distribution of previously taxed earnings and profits (as described in section 959 or 1293(c)) is assigned to the separate category or categories of the previously taxed earnings and profits from which the distribution is made. See § 1.987-6(b) for rules on assigning section 987 gain or loss on a remittance from a section 987 QBU to a separate category or categories.

(q) Applicability dates. This section applies for taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(a) Scope and definitions—(1) Look-through rules under section 904(d)(3) to passive category income. Paragraph (c) of this section provides rules for determining the extent to which dividends, interest, rents, and royalties received or accrued by certain eligible persons, and inclusions under sections 951(a)(1) and 951A(a), are treated as passive category income. Paragraph (g) of this section provides rules applying the principles of paragraph (c) of this section to foreign source interest, rents, and royalties paid by a domestic corporation to a related corporation. Paragraph (h) of this section provides rules for assigning a partnership payment to a partner described in section 707 to the passive category. Paragraph (i) of this section provides rules applying the principles of this section to assign distributions and payments from certain related entities to the passive category or to treat the distributions and payments as not in the passive category.

(2) Other look-through rules under section 904(d). Under section 904(d)(4) and paragraph (c)(4)(iii) of this section, certain dividends from noncontrolled 10-percent owned foreign corporations are treated as income in a separate category. Under section 904(d)(3)(H) and paragraph (j) of this section, certain inclusions under section 1293 are treated as income in a separate category. Paragraph (i) of this section provides rules applying the principles of this section to assign distributions from certain related entities to separate categories.

(3) Other rules provided in this section. Paragraph (b) of this section provides operative rules for this section. Paragraph (d) of this section provides rules addressing exceptions to passive category income for certain purposes in the case of controlled foreign corporations that meet the requirements of section 954(b)(3)(A) (de minimis rule) or section 954(b)(4) (high-tax exception). Paragraph (e) of this section provides rules for characterizing a controlled foreign corporation's foreign base company income and gross insurance income when section 954(b)(3)(B) (full inclusion rule) applies. Paragraph (f) of this section modifies the look-through rules for certain types of income. Paragraph (k) of this section provides ordering rules for applying the look-through rules. Paragraph (l) of this section provides examples illustrating the application of certain rules in this section. Paragraphs (m) and (n) of this section provide rules related to the resourcing rules described in section 904(h).

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

(i) The term controlled foreign corporation has the meaning given such term by section 957 (taking into account the special rule for certain captive insurance companies contained in section 953(c)).

(ii) The term look-through rules means the rules described in this section that assign income to a separate category based on the separate category of the income to which it is allocable.

(iii) The term noncontrolled 10-percent owned foreign corporation has the meaning provided in section 904(d)(2)(E)(i).

(iv) The term pass-through entity means a partnership, S corporation, or any other person (whether domestic or foreign) other than a corporation to the extent that the income or deductions of the person are included in the income of one or more direct or indirect owners or beneficiaries of the person. For example, if a domestic trust is subject to Federal income tax on a portion of its income and its owners are subject to tax on the remaining portion, the domestic trust is treated as a domestic pass-through entity with respect to such remaining portion.

(v) The term separate category means, as the context requires, any category of income described in section 904(d)(1)(A), (B), (C), or (D), any specified separate category of income as defined in § 1.904-4(m), or any category of earnings and profits to which income described in such provisions is attributable.

(vi) The term United States shareholder has the meaning given such term by section 951(b) (taking into account the special rule for certain captive insurance companies contained in section 953(c)), except that for purposes of this section, a United States shareholder includes any member of the controlled group of the United States shareholder. For purposes of this paragraph (a)(4)(vi), the controlled group is any member of the affiliated group within the meaning of section 1504(a)(1) except that “more than 50 percent” is substituted for “at least 80 percent” wherever it appears in section 1504(a)(2). When used in reference to a noncontrolled 10-percent owned foreign corporation described in section 904(d)(2)(E)(i)(II), the term United States shareholder also means a taxpayer that meets the stock ownership requirements described in section 904(d)(2)(E)(i)(II).

(b) Operative rules—(1) Assignment of income not assigned under the look-through rules. Except as provided by the look-through rules, dividends, interest, rents, and royalties received or accrued by a taxpayer from a controlled foreign corporation in which the taxpayer is a United States shareholder are excluded from passive category income. Income excluded from the passive category under this paragraph (b)(1) is assigned to another separate category (other than the passive category) under the rules in § 1.904-4.

(2) Priority and ordering of look-through rules. Except as provided in this paragraph (b)(2), to the extent the look-through rules assign income to a separate category, the income is assigned to that separate category rather than the separate category to which the income would have been assigned under § 1.904-4 (not taking into account § 1.904-4(l)). See paragraph (k) of this section for ordering rules for applying the look-through rules. However, passive income that is financial services income is assigned to a separate category under the rules in § 1.904-4(e)(1), (f)(1), and (l), regardless of whether the look-through rules otherwise would have assigned such income to the passive category.

(c) * * * (1) Scope. Subject to the exceptions in paragraph (f) of this section, paragraphs (c)(2) through (6) (other than paragraph (c)(4)(iii) of this section) of this section provide look-through rules with respect to interest, rents, royalties, dividends, and inclusions under sections 951(a)(1) and 951A(a) that are received or accrued from a controlled foreign corporation in which the taxpayer is a United States shareholder. Paragraph (c)(4)(iii) of this section provides a look-through rule for dividends received from a noncontrolled 10-percent owned foreign corporation by a domestic corporation that is a United States shareholder in the foreign corporation.

(2) * * * (i) * * * Related person interest is treated as passive category income to the extent it is allocable to passive category income of the controlled foreign corporation. If related person interest is received or accrued from a controlled foreign corporation by two or more persons, the amount of interest received or accrued by each person that is allocable to passive category income is determined by multiplying the amount of related person interest allocable to passive category income by a fraction. * * * Solely for purposes of assigning interest income to a separate category under section 904(d)(3) and the look-through rule in this paragraph (c)(2), the rules in paragraph (c)(2)(ii) of this section for allocating and apportioning interest expense of a controlled foreign corporation apply for purposes of characterizing interest income in the hands of the recipient, even if a deduction for the interest expense is deferred or disallowed to the controlled foreign corporation.

(v) Examples. The following examples illustrate the application of this paragraph (c)(2).

(A) Example 1—(1) CFC, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns $200x of foreign personal holding company income that is passive category income. CFC also earns $100x of foreign base company sales income that is general category income. CFC has $2,000x of passive category assets and $2,000x of general category assets. In Year 1, CFC makes a $150x interest payment to USP with respect to a $1,500x loan from USP. CFC also pays $100x of interest to an unrelated person on a $1,000x loan from that person. CFC has no other expenses. CFC uses the asset method to apportion interest expense.

(2) Under paragraph (c)(2)(ii)(C) of this section, the $150x related person interest payment is allocable to CFC's passive category foreign personal holding company income. Therefore, the $150x interest payment is passive category income to USP. Because the entire related person interest payment is allocated to passive category income under paragraph (c)(2)(ii)(C) of this section, none of the related person interest payment is apportioned to general category income under paragraph (c)(2)(ii)(D) of this section. Under paragraph (c)(2)(iv)(B) of this section, the entire amount of the related person debt is allocable to passive category assets ($1,500x = $1,500x × $150x/$150x). Under paragraph (c)(2)(ii)(E) of this section, $20x of the interest expense paid to an unrelated person is apportioned to passive category income ($20x = $100x × ($2,000x − $1,500x)/($4,000x − $1,500x)), and $80x of the interest expense paid to an unrelated person is apportioned to general category income ($80x = $100x × $2,000x/($4,000x − $1,500x)).

(B) Example 2. The facts are the same as in paragraph (c)(2)(v)(A) of this section (the facts in Example 1), except that CFC uses the modified gross income method to apportion interest expense. Under paragraph (c)(2)(ii)(E) of this section, the unrelated person interest expense is apportioned based on gross income. Therefore, $33x of interest expense paid to an unrelated person is apportioned to CFC's passive category income ($33x = $100x × ($200x − $150x)/($300x − $150x)) and $67x of interest expense paid to an unrelated person is apportioned to CFC's general category income ($67x = $100x × $100x/($300x − $150x)).

(C) Example 3—(1) The facts are the same as in paragraph (c)(2)(v)(A) of this section (the facts in Example 1), except that CFC has an additional $50x of third person interest expense that is directly allocated to income from a specific property that produces only passive category income. The principal amount of indebtedness to which the interest relates is $500x. CFC also has $50x of additional non-interest expenses that are not definitely related expenses and that are apportioned on an asset basis.

(2) Under paragraph (c)(2)(ii)(B) of this section, the $50x of directly allocated third person interest is first allocated to reduce the passive category income of CFC. Under paragraph (c)(2)(ii)(C) of this section, the $150x of related person interest is allocated to the remaining $150x of passive category income. Under paragraph (c)(2)(iv)(B) of this section, all of the related person debt is allocated to passive category assets ($1,500x = $1,500x × $150x/$150x).

(3) Under paragraph (c)(2)(ii)(E) of this section, the non-interest expenses that are not definitely related are apportioned on the basis of the asset values reduced by the allocated related person debt. Therefore, $10x of these expenses are apportioned to the passive category ($50x × ($2,000x − $1,500x)/($4,000x − $1,500x)) and $40x are apportioned to the general category ($50x × $2,000x/($4,000x − $1,500x)).

(4) In order to apportion third person interest (that was not directly allocated third person interest) between the categories of assets, the value of assets in a separate category must also be reduced under the principles of § 1.861-8 by the indebtedness relating to the specifically allocated interest. Therefore, under paragraph (c)(2)(iv)(B) of this section, the value of assets in the passive category for purposes of apportioning the additional third person interest = 0 ($2,000x minus $500x (the principal amount of the debt, the interest payment on which is directly allocated to specific interest-producing properties) minus $1,500x (the related person debt allocated to passive category assets)). Under paragraph (c)(2)(ii)(E) of this section, all $100x of the non-definitely related third person interest expense is apportioned to the general category ($100x = $100x × $2,000x/($4,000x − $500x − $1,500x)).

(D) Example 4—(1) CFC, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns $100x of foreign personal holding company income that is passive category income. CFC also earns $100x of foreign base company sales income that is general category income. CFC has $1,000x of general category assets and $1,000x of passive category assets. In Year 1, CFC makes a $150x interest payment to USP on a $1,500x loan from USP and has $20x of general and administrative expenses (G & A) that under the principles of §§ 1.861-8 through 1.861-14T is treated as directly allocable to all of CFC's gross income. CFC also makes a $25x interest payment to an unrelated person on a $250x loan from the unrelated person. CFC has no other expenses. CFC uses the asset method to apportion interest expense. CFC uses the modified gross income method to apportion G & A.

(2) Under paragraph (c)(2)(iv)(B) of this section, related person debt allocated to passive category assets equals $1,000x ($1,000x = $1,500x × $100x/$150x).Under paragraph (c)(2)(ii)(C) of this section, $100x of the interest payment to USP is allocable to CFC's passive category foreign personal holding company income. Under paragraph (c)(2)(ii)(D) of this section, the additional $50x of related person interest expense is apportioned to CFC's general category income ($50x = $50x × $1,000x/$1,000x).

(3) Under paragraph (c)(2)(ii)(E) of this section, none of the $25x of interest expense paid to an unrelated person is apportioned to passive category income ($0 = $25x × ($1,000x − $1,000x)/($2,000x − $1,000x)). All $25x of the interest expense paid to an unrelated person is apportioned to general category income ($25x = $25x × $1,000x/($2,000x − $1,000x)). Under paragraph (c)(2)(ii)(E) of this section, none of the G & A is allocable to CFC's passive category foreign personal holding company income ($0 = $20x × ($100x − $100x)/($200x − $100x)). All $20x of the G & A is apportioned to CFC's general category income ($20x = $20x × $100x/($200x − $100x)).

(E) Example 5. The facts are the same as in paragraph (c)(2)(v)(D) of this section (the facts in Example 4), except that CFC uses the modified gross income method to apportion interest expense. As in paragraph (c)(2)(v)(D) of this section (Example 4), $100x of the interest payment to USP is allocated to passive category income under paragraph (c)(2)(ii)(C) of this section. Under paragraph (c)(2)(ii)(D) of this section, the additional $50x of related person interest expense is apportioned to general category income ($150x—100x × $100x/$100x). Under paragraph (c)(2)(ii)(E) of this section, none of the unrelated person interest expense and none of the G & A is apportioned to passive category income, because after the application of paragraph (c)(2)(ii)(C) of this section, no income remains in the passive category.

(F) Example 6. CFC2, a controlled foreign corporation, is a wholly-owned subsidiary of CFC1, a controlled foreign corporation. CFC1 is a wholly-owned subsidiary of USP, a domestic corporation. CFC1 and CFC2 are incorporated in the same country. In Year 1, USP sells tractors to CFC2, which CFC2 sells to X, a foreign corporation that is related to both CFC1 and CFC2 and is organized in the same country as CFC1 and CFC2. CFC1 makes a loan to × to finance the tractor sales. Assume that the interest earned by CFC1 from financing the sales is export financing interest that is neither related person factoring income nor foreign personal holding company income. Under § 1.904-4(h), the export financing interest earned by CFC1 is, therefore, general category income. CFC1 earns no other income. CFC1 makes a $100x interest payment to USP. The $100x of interest paid is not allocable under the look-through rules and paragraph (c)(2)(ii) of this section to passive category income of CFC1. The income is general category income to USP.

(3) Rents and royalties. Any rents or royalties received or accrued from a controlled foreign corporation in which the taxpayer is a United States shareholder are treated as passive category income to the extent they are allocable to passive category income of the controlled foreign corporation under the principles of §§ 1.861-8 through 1.861-14T.

(4) * * * (i) * * * Except as provided in paragraph (d)(2) of this section, any dividend paid or accrued out of the earnings and profits of any controlled foreign corporation is treated as passive category income in proportion to the ratio of the portion of earnings and profits attributable to passive category income to the total amount of earnings and profits of the controlled foreign corporation. * * *

(iii) Look-through rule for dividends from noncontrolled 10-percent owned foreign corporations—(A) In general. Except as provided in paragraph (c)(4)(iii)(B) of this section, any dividend that is distributed by a noncontrolled 10-percent owned foreign corporation and received or accrued by a domestic corporation that is a United States shareholder of such foreign corporation is treated as income in a separate category in proportion to the ratio of the portion of earnings and profits attributable to income in such category to the total amount of earnings and profits of the noncontrolled 10-percent owned foreign corporation.

(B) Inadequate substantiation. A dividend distributed by a noncontrolled 10-percent owned foreign corporation is treated as income in the separate category described in section 904(d)(4)(C)(ii) if the Commissioner determines that the look-through characterization of the dividend cannot reasonably be determined based on the available information.

(5) Inclusions under section 951(a)(1)(A). Any amount included in gross income under section 951(a)(1)(A) is treated as passive category income to the extent the amount included is attributable to income received or accrued by the controlled foreign corporation that is passive category income. All other amounts included in gross income under section 951(a)(1)(A) are treated as general category income or income in a specified separate category under the rules in § 1.904-4. For rules concerning a distributive share of partnership income, see § 1.904-4(n). For rules concerning the gross up under section 78, see § 1.904-4(o). For rules concerning inclusions under section 951(a)(1)(B), see paragraph (c)(4)(i) of this section.

(6) Inclusions under section 951A(a). Any amount included in gross income under section 951A(a) is treated as passive category income to the extent the amount included is attributable to income received or accrued by the controlled foreign corporation that is passive category income. All other amounts included in gross income under section 951A(a) are treated as section 951A category income or income in a specified separate category under the rules in § 1.904-4. For rules concerning a distributive share of partnership income, see § 1.904-4(n). For rules concerning the gross up under section 78, see § 1.904-4(o).

(7) Examples. The following examples illustrate the application of paragraph (c) of this section.

(i) Example 1—(A) Facts. CFC, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns $100x of net income, $85x of which is general category foreign base company sales income and $15x of which is passive category foreign personal holding company income. No foreign tax is imposed on the income. CFC's income of $100x is subpart F income taxed currently to USP under section 951(a)(1)(A).

(B) Analysis. Because $15x of the subpart F inclusion is attributable to passive category income of CFC, under section 904(d)(3)(B) and paragraph (c)(5) of this section $15x of the subpart F inclusion is passive category income to USP. The remaining $85x subpart F inclusion is general category income to USP.

(ii) Example 2—(A) Facts. CFC1, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. CFC2 is a controlled foreign corporation wholly owned by CFC1 and is incorporated and operates all of its business in the same country as CFC1. All of CFC2's earnings and profits are attributable to passive category foreign personal holding company income. USP elects to exclude CFC2's income from subpart F income under section 954(b)(4). In Year 1, CFC2 makes a distribution to CFC1 and CFC1 makes a distribution to USP, all of which is attributable to Year 1 earnings and profits. CFC1 has no earnings and profits in Year 1 other than those received from CFC2.

(B) Analysis—(1) With respect to the dividend from CFC2 to CFC1, such amount is not subpart F income. See section 954(c)(3). Under section 904(d)(3)(D) and (E) and paragraphs (c)(4) and (d)(2) of this section the dividend income is not passive category income and therefore under § 1.904-4 it is general category income to CFC1. Under section 951A(c)(2)(A)(i)(IV), such dividend income is not tested income.

(2) With respect to the dividend from CFC1 to USP, under section 904(d)(3)(D) and (E) and paragraphs (c)(4) and (d)(2) of this section, such dividend income is not passive category income and therefore under § 1.904-4 is general category income to USP.

(iii) Example 3—(A) Facts. The facts are the same as in paragraph (c)(7)(ii)(A) of this section (the facts in Example 2), except that CFC1 receives interest income from CFC2 instead of dividend income.

(B) Analysis. Under section 904(d)(3)(C) and paragraph (c)(2)(i) of this section, the interest income is passive category income to CFC1 because such interest is properly allocable to the passive category income of CFC2. The interest income from CFC2 is subpart F income of CFC1 taxable to USP because such income reduces the subpart F income of CFC2 or such interest is properly allocable to the subpart F income of CFC2. See section 954(c)(3) and (6). Under section 904(d)(3)(B) and paragraph (c)(5) of this section, the subpart F inclusion is passive category income to USP. Under section 959(a), the distribution from CFC1 to USP is excluded from USP's gross income.

(iv) Example 4—(A) Facts. The facts are the same as in paragraph (c)(7)(iii)(A) of this section (the facts in Example 3), except that USP elects to exclude CFC1's interest income from subpart F income under section 954(b)(4).

(B) Analysis. Under section 904(d)(3)(D) and (E) and paragraphs (c)(4) and (d)(2) of this section, the distribution from CFC1 to USP is not a passive category dividend and therefore under § 1.904-4 is general category income to USP.

(v) Example 5—(A) Facts. The facts are the same as in paragraph (c)(7)(iv)(A) of this section (the facts in Example 4), except that USP receives interest income from CFC1 instead of dividend income.

(B) Analysis. Under section 904(d)(3)(C) and paragraph (c)(2)(i) of this section, the interest income is passive category income to USP because such interest is properly allocable to passive category income of CFC1.

(d) * * * (1) De minimis amount of subpart F income. If the sum of a controlled foreign corporation's gross foreign base company income (determined under section 954(a) without regard to section 954(b)(5)) and gross insurance income (determined under section 953(a)) for the taxable year is less than the lesser of 5 percent of gross income or $1,000,000, then none of that income is treated as passive category income. In addition, if the test in the first sentence of this paragraph (d)(1) is satisfied, for purposes of paragraphs (c)(2)(ii)(D) and (E) of this section (apportionment of interest expense to passive income using the asset method), any passive assets are not treated as passive category assets but are treated as assets in the general category or a specified separate category. The determination in the first sentence of this paragraph (d)(1) is made before the application of the exception for certain income subject to a high rate of foreign tax described in paragraph (d)(2) of this section.

(2) Exception for certain income subject to high foreign tax. Except as provided in § 1.904-4(c)(7)(iii) (relating to reductions in tax upon distribution), for purposes of the dividend look-through rule of paragraph (c)(4)(i) of this section, an item of net income that would otherwise be passive category income (after application of the priority rules of § 1.904-4(l)) and that is received or accrued by a controlled foreign corporation is not treated as passive category income, and the earnings and profits attributable to such income is not treated as passive category earnings and profits, if the taxpayer establishes to the satisfaction of the Secretary under section 954(b)(4) that the income was subject to an effective rate of income tax imposed by a foreign country greater than 90 percent of the maximum rate of tax specified in section 11 (with reference to section 15, if applicable). Such income is treated as general category income or income in a specified separate category under the rules in § 1.904-4. The first sentence of this paragraph (d)(2) has no effect on amounts (other than dividends) paid or accrued by a controlled foreign corporation to a United States shareholder of such controlled foreign corporation to the extent those amounts are allocable to passive category income of the controlled foreign corporation.

(3) Example. The following example illustrates the application of this paragraph (d).

(i) Facts. CFC, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns $100x of gross income, $4x of which is interest that is foreign personal holding company income and $96x of which is gross manufacturing income that is not subpart F income. CFC has no other earnings for Year 1. CFC has no expenses and pays no foreign taxes.

(ii) Analysis. Under the de minimis rule of section 954(b)(3)(A) and § 1.954-1(b)(1)(i), none of CFC's income is treated as foreign base company income. All of CFC's income, therefore, is treated as general category income and tested income. In Year 1, USP has a GILTI inclusion amount with respect to CFC. Such amount is section 951A category income to USP.

(e) * * *

(2) Example. The following example illustrates the application of this paragraph (e).

(i) Facts. Controlled foreign corporation CFC is a wholly-owned subsidiary of USP, a domestic corporation. CFC earns $100x, $75x of which is foreign personal holding company income and $25x of which is non-subpart F services income. CFC's gross and net income are equal.

(ii) Analysis. Under the 70 percent full inclusion rule of section 954(b)(3)(B), the entire $100x is foreign base company income currently taxable to USP under section 951. Because $75x of the $100x section 951 inclusion is attributable to CFC's passive category income, $75x of the inclusion is passive category income to USP. The remaining $25x of the inclusion is treated as general category income to USP.

(h) Application of look-through rules to payments from a partnership or other pass-through entity. Payments to a partner described in section 707 (e.g., payments to a partner not acting in capacity as a partner) are characterized as passive category income to the extent that the payment is attributable under the principles of § 1.861-8 and this section to passive category income of the partnership, if the payments are interest, rents, or royalties that would be characterized under the controlled foreign corporation look-through rules of paragraph (c) of this section if the partnership were a foreign corporation, and the partner who receives the payment owns 10 percent or more of the value of the partnership (as determined under § 1.904-4(n)(3)). A payment by a partnership to a member of the controlled group (as defined in paragraph (a)(4)(vi) of this section) of the partner is characterized under the look-through rules of this paragraph (h) if the payment would be a section 707 payment entitled to look-through treatment if it were made to the partner. The rules in this paragraph (h) do not apply with respect to interest to the extent the interest income is assigned to a separate category under the downstream partnership loan rules described in § 1.861-9(e)(8). The principles of the rules in this paragraph (h) apply to characterize a payment from any other pass-through entity.

(i) * * * (1) * * * For purposes of this paragraph (i)(1), indirect ownership of stock is determined under section 318. In the case of a partnership or other pass-through entity, indirect ownership and value is determined under the rules in paragraph (i)(2) of this section.

(2) Indirect ownership and value of a partnership interest. A person is considered as owning, directly or indirectly, more than 50 percent of the value of a partnership if the person, together with any other person that bears a relationship to the first person that is described in section 267(b) or 707, owns more than 50 percent of the capital and profits interests of the partnership. For purposes of this paragraph (i)(2), value will be determined at the end of the partnership's taxable year. The principles of this paragraph (i)(2) apply with respect to a person that owns a pass-through entity other than a partnership.

(3) Special rule for dividends between certain foreign corporations. Solely for purposes of dividend payments between controlled foreign corporations, noncontrolled 10-percent owned foreign corporations, or a controlled foreign corporation and a noncontrolled 10-percent owned foreign corporation, the two foreign corporations are considered related look-through entities if the same person is a United States shareholder of both foreign corporations.

(5) Examples. The following examples illustrate the application of this paragraph (i):

(i) Example 1. USP, a domestic corporation, owns all of the stock of CFC1, a controlled foreign corporation. CFC1 owns 40% of the stock of CFC2, a Country X corporation that is a controlled foreign corporation. The remaining 60% of the stock of CFC2 is owned by V, a domestic corporation, unrelated to USP. The percentages of value and voting power of CFC2 owned by CFC1 and V correspond to their percentages of stock ownership. CFC2 owns 40% (by vote and value) of the stock of CFC3, a Country Z corporation that is a controlled foreign corporation. The remaining 60% of CFC3 is owned by unrelated United States persons. CFC3 earns exclusively general category income that is neither subpart F income nor tested income. In Year 1, CFC3 makes an interest payment of $100x to CFC2. Look-through principles do not apply because CFC2 and CFC3 are not related look-through entities under paragraph (i)(1) of this section (because CFC2 does not own more than 50% of the voting power or value of CFC3). The interest is passive category income to CFC2 and is subpart F income of CFC2 that is taxable to USP and V. Under paragraph (c)(5) of this section, USP and V's subpart F inclusion with respect to CFC2 is passive category income.

(ii) Example 2. The facts are the same as in paragraph (i)(5)(i) of this section (the facts in Example 1), except that instead of a $100x interest payment, CFC3 pays a $50x dividend to CFC2 in Year 1. USP and V each own, directly or indirectly, more than 10% of the voting power of all classes of stock of both CFC2 and CFC3, and, therefore, CFC2 and CFC3 have the same United States shareholders. Pursuant to paragraph (i)(3) of this section, because CFC2 and CFC3 have a common United States shareholder, for purposes of applying this section to the dividend from CFC2 to CFC3, CFC2 and CFC3 are treated as related look-through entities. Therefore, look-through principles apply. Because CFC3 has no passive category income or earnings and profits, the dividend income is characterized as general category income to CFC2. The dividend is subpart F income of CFC2 that is taxable to USP and V. Under paragraph (c)(5) of this section, the subpart F inclusions of USP and V are not passive category income to USP and V and therefore under § 1.904-4 the subpart F inclusions are general category income to USP and V.

(iii) Example 3. The facts are the same as in paragraph (i)(5)(i) of this section (the facts in Example 1), except that CFC3 pays both a $100x interest payment and a $50x dividend to CFC2, and CFC2 owns 80% (by vote and value) of CFC3. Under paragraph (i)(1) of this section, CFC2 and CFC3 are related look-through entities, because CFC2 owns more than 50% (by vote and value) of CFC3. Therefore, look-through principles apply to both the interest and dividend income paid or accrued by CFC3 to CFC2, and CFC2 treats both types of income as general category income because CFC3 does not have any passive category earnings. Under paragraph (c)(5) of this section and § 1.904-4, the resulting subpart F inclusions are general category income to USP and V.

(iv) Example 4. USP, a domestic corporation, owns 50% of the voting stock of CFC1, a controlled foreign corporation. CFC1 owns 10% of the voting stock of CFC2, a controlled foreign corporation. The remaining 50% of the stock of CFC1 is owned by X. The remaining 90% of the stock of CFC2 is owned by Y. X and Y are each United States shareholders of CFC2 but are not related to USP, CFC1, or each other. In Year 1, CFC2 pays a $100x dividend to CFC1. Under paragraph (i)(3) of this section because no person is a United States shareholder of both CFC1 and CFC2 (USP and X each own only 5% of CFC2), CFC1 and CFC2 are not related look-through entities. Because CFC2 is not a related person to CFC1 within the meaning of section 954(d)(3), section 954(c)(3) and (c)(6) are inapplicable, and the dividend is subpart F income of CFC1 that is taxable to USP and X. Therefore, under section 904(d)(2)(B)(i) and § 1.904-4(b)(2)(i)(A), because the dividend income is foreign personal holding company income, it is passive category income to CFC1.

(v) Example 5. The facts are the same as in paragraph (i)(5)(iv) of this section (the facts in Example 4), except that X owns 10% of the voting stock of CFC2 and Y owns only 80% of the voting stock of CFC2. Because CFC2 is not a related person to CFC1 within the meaning of section 954(d)(3), the dividend is subpart F income of CFC1 that is taxable to USP and X. In addition, because X is a United States shareholder of both CFC1 and CFC2, CFC2 and CFC1 are related look-through entities under paragraph (i)(3) of this section, the dividend income is general category income to CFC1 and the subpart F inclusion is general category income to USP and X.

(k) * * *

(2) * * *

(iii) Inclusions under sections 951(a)(1)(A) and 951A(a) and distributive shares of partnership income;

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

(1) Example 1—(i) Facts. CFC1 and CFC2, controlled foreign corporations, are wholly-owned subsidiaries of USP, a domestic corporation. CFC1 and CFC2 are incorporated in two different foreign countries and CFC2 is a financial services entity. In Year 1, CFC1 earns $100x of gross income that is passive category foreign personal holding company income. CFC1's only expense is a $50x interest payment to CFC2. CFC1's $50x of pre-tax income is subject to $20x of foreign income tax, and USP elects to exclude CFC1's $30x of net income from subpart F income under section 954(b)(4).

(ii) Analysis. The $50x of interest is foreign personal holding company income in CFC2's hands because section 954(c)(3)(A)(i) (same country exception for interest payments) and section 954(c)(6) do not apply, because the interest payment is allocable to and reduces CFC1's subpart F income. The $50x of interest income is also passive category income to CFC2 because CFC1 and CFC2 are related look-through entities within the meaning of paragraph (i)(1) of this section and, therefore the look-through rules of paragraph (c)(2)(i) of this section apply to characterize the interest payment. However, because CFC2 is a financial services entity, under § 1.904-4(e)(1) and paragraph (b)(2) of this section, the income is treated as financial services income and therefore as general category income in CFC2's hands. Thus, with respect to CFC2, under § 1.904-4(d) and paragraph (c)(5) of this section, USP includes in its gross income a $50x general category inclusion under section 951(a)(1)(A) attributable to the general category foreign personal holding company income.

(2) Example 2—(i) Facts. USP, a domestic corporation, owns 75% of USS, a domestic corporation. USP and USS are not financial services entities. In Year 1, USS's earnings consist of $100x of foreign source passive income. USS makes a $100x foreign source royalty payment to USP.

(ii) Analysis. Under paragraph (g) of this section, the royalty payment to USP is subject to the look-through rules of paragraph (c)(3) of this section and is characterized as passive category income the extent that it is allocable to such income in USS's hands.

(3) Example 3—(i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% of the stock of CFC2, a controlled foreign corporation. CFC1 has $100x of passive foreign personal holding company income from unrelated persons and $100x of general category income. CFC1 also has $50x of interest income from CFC2. CFC1 pays CFC2 $100x of interest.

(ii) Analysis. Under paragraph (k)(2) of this section, the $100x interest payment from CFC1 to CFC2 is reduced for limitation purposes to the extent of the $50x interest payment from CFC2 to CFC1 before application of the rules in paragraph (c)(2)(ii) of this section. Therefore, the interest payment from CFC2 to CFC1 is disregarded. CFC1 is treated as if it paid $50x of interest to CFC2, all of which is allocable to CFC1's passive category foreign personal holding company income under paragraph (c)(2)(ii)(C) of this section. Therefore, under paragraph (c)(2)(i) of this section, the $50x interest payment from CFC1 to CFC2 is passive category income.

(4) Example 4—(i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, a controlled foreign corporation. CFC1 owns 100% of the stock of CFC2, a controlled foreign corporation, and 100% of the stock of CFC3, a controlled foreign corporation. In Year 1, CFC2 pays CFC1 $5x of interest, CFC1 pays CFC3 $10x of interest, and CFC3 pays CFC2 $20x of interest.

(ii) Analysis. Under paragraph (k)(2) of this section, the interest payments from CFC1 to CFC3 must be offset by the amount of interest that CFC1 is considered as receiving indirectly from CFC3 and the interest payment from CFC3 to CFC2 is offset by the amount of the interest payment that CFC3 is considered as receiving indirectly from CFC2. The $10x payment by CFC1 to CFC3 is reduced by $5x, the amount of the interest payment from CFC2 to CFC1 that is treated as being paid indirectly by CFC3 to CFC1. Similarly, the $20x interest payment from CFC3 to CFC2 is reduced by $5x, the amount of the interest payment from CFC1 to CFC3 that is treated as being paid indirectly by CFC2 to CFC3. Therefore, under paragraph (k)(2) of this section, CFC2 is treated as having made no interest payment to CFC1, CFC1 is treated as having paid $5x of interest to CFC3, and CFC3 is treated as having paid $15x to CFC2.

(5) Example 5—(i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% of the stock of CFC2, a controlled foreign corporation. In Year 1, CFC1 earns $100x of passive category foreign personal holding company income and $100x of general category non-subpart F sales income from unrelated persons and $100x of general category non-subpart F interest income from a related person. CFC1 pays $150x of interest to CFC2. CFC2 earns $200x of general category sales income from unrelated persons and the $150x interest payment from CFC1. CFC2 pays CFC1 $100x of interest. USP does not have an inclusion under section 951A.

(ii) Analysis—(A) Under paragraph (k)(2) of this section, the $100x interest payment from CFC2 to CFC1 reduces the $150x interest payment from CFC1 to CFC2. CFC1 is treated as though it paid $50x of interest to CFC2. CFC2 is treated as though it made no interest payment to CFC1.

(B) Under paragraph (k)(2)(ii) of this section, the remaining $50x interest payment from CFC1 to CFC2 is then characterized. The interest payment is first allocable under the rules of paragraph (c)(2)(ii)(C) of this section to CFC1's passive category income. Therefore, under paragraph (c)(2)(i) of this section, the $50x interest payment to CFC2 is passive category income. The interest income is foreign personal holding company income in CFC2's hands. CFC2, therefore, has $50x of passive category subpart F income and $200x of general category non-subpart F income.

(C) Under paragraph (k)(2)(iii) of this section, inclusions under section 951(a)(1)(A) are characterized next. USP has an inclusion under section 951(a)(1)(A) with respect to CFC1 of $50x that is attributable to passive category income of CFC1 and is treated as passive category income to USP. USP has an inclusion under section 951(a)(1)(A) with respect to CFC2 of $50x that is attributable to passive category income of CFC2 and is treated as passive category income to USP.

(6) Example 6—(i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% of the stock of CFC2, a controlled foreign corporation. USP also owns 100% of the stock of CFC3, a controlled foreign corporation. CFC1, CFC2, and CFC3 are all incorporated in different foreign countries. In Year 1, CFC1 earns $100x of passive category foreign personal holding company income and $200x of general category non-subpart F income from unrelated persons. CFC1 also receives a $150x distribution from CFC2. CFC1 pays $100x of interest to CFC2 and $100x of interest to CFC3. CFC3 earns $300x of general category non-subpart F income and the $100x of interest received from CFC1. CFC3 pays a $100x royalty to CFC2. The royalty is directly allocable to CFC3's general category income and the royalty is not subpart F income to CFC2. CFC2 earns the $100x interest payment received from CFC1 and the $100x royalty received from CFC3. USP does not have an inclusion under section 951A.

(ii) Analysis—(A) Under paragraph (k)(2)(i) of this section, the royalty paid by CFC3 to CFC2 is characterized first. With respect to CFC2, the royalty is general category non-subpart F income.

(B) Under paragraph (k)(2)(ii) of this section, the interest payments from CFC1 to CFC2 and CFC3 are characterized next. Under paragraph (c)(2)(ii)(C) of this section, the interest payments are first allocable to CFC1's passive category income. Therefore, under paragraph (c)(2)(i) of this section, $50x of the interest payment to CFC2 is passive category income and $50x of the interest payment to CFC3 is passive category income. The remaining $50x paid to CFC2 is general category income and the remaining $50x paid to CFC3 is general category income. Because $100x of the interest income received or accrued from CFC1 is properly allocable to income of CFC1 which is not subpart F income, under section 954(c)(6) the general category interest income is not treated as foreign personal holding company income to CFC2 and CFC3. The remaining $100x of interest income received or accrued from CFC1 is passive category subpart F foreign personal holding company income to both recipients. Therefore, CFC3 and CFC2 each have $50x of passive category subpart F foreign personal holding company income related to the interest received from CFC1.

(C) Under paragraph (k)(2)(iii) of this section, USP's $50x inclusion under section 951(a)(1)(A) with respect to CFC2 is characterized next. Under paragraph (c)(5) of this section, USP's inclusion under section 951(a)(1)(A) is attributable to the passive category portion of the interest income received by CFC2 from CFC1 and is passive category income to USP. Under paragraph (k)(2)(iii) of this section, USP's $50x inclusion under section 951(a)(1)(A) with respect to CFC3 is also characterized next. Under paragraph (c)(5) of this section, USP's inclusion under section 951(a)(1)(A) is attributable to the passive category portion of the interest income received by CFC3 from CFC2 and is passive category income to USP.

(D) Under paragraph (k)(2)(iv) of this section, the $150x distribution from CFC2 to CFC1 is characterized next. The first $50x of the distribution is out of passive category earnings and profits described in section 959(c)(2). The remaining $100x of the distribution is a dividend that is not attributable to CFC2's passive category income, so under paragraph (c)(4)(i) of this section it is general category income to CFC1 in its entirety. Because $100x of the dividend received or accrued from CFC2 is attributable to income of CFC2 which is not subpart F income, under section 954(c)(6) such dividend income is not treated as foreign personal holding company income of CFC1.

(7) Example 7—(i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% of the stock of CFC2, a controlled foreign corporation. USP also owns 100% of the stock of CFC3, a controlled foreign corporation. CFC1, CFC2, and CFC3 are all incorporated in different foreign countries. In Year 1, CFC2 earns $100x of general category income that is not subpart F income and distributes the entire amount to CFC1 as a dividend. CFC1 earns $100x of passive category foreign personal holding company income and the $100x dividend from CFC2. CFC1 pays $100x of interest to CFC3. CFC3 earns $200x of general category income that is foreign base company income and the $100x of interest income from CFC1. USP does not have an inclusion under section 951A.

(ii) Analysis. This transaction does not involve circular payments and, therefore, the ordering rules of paragraph (k)(2) of this section do not apply. Instead, pursuant to paragraph (k)(1) of this section, income received is characterized first. CFC2's earnings and, thus, the dividend from CFC2 to CFC1 are characterized first. Under paragraph (c)(4)(i) of this section, CFC1 includes the $100x dividend from CFC2 in gross income as general category income because none of CFC2's earnings are passive category income. CFC1 thus has $100x of passive category foreign personal holding company income and $100x of general category income that is excluded from subpart F income under section 954(c)(6)(A). The interest payment from CFC1 to CFC3 is then characterized as $100x passive category income under paragraph (c)(2)(ii)(C) of this section because it is allocable to passive foreign personal holding company income of CFC1. For Year 1, CFC3 thus has $200x of general category income that is subpart F income, and $100x of passive category foreign personal holding company income. For Year 1, under § 1.904-4(d) and paragraph (c)(5) of this section, USP includes in its gross income an inclusion under section 951(a)(1)(A) with respect to CFC3, $200x of which is general category income and $100x of which is passive category income.

(m) * * *

(2) * * *

(ii) Interest payments from noncontrolled 10-percent owned foreign corporations. If interest is received or accrued by a shareholder from a noncontrolled 10-percent owned foreign corporation (where the shareholder is a domestic corporation that is a United States shareholder of such noncontrolled 10-percent owned foreign corporation), the rules of paragraph (m)(2)(i) of this section apply in determining the portion of the interest payment that is from sources within the United States, except that the related party interest rules of paragraph (c)(2)(ii)(C) of this section do not apply.

(3) Examples. The following examples illustrate the application of this paragraph (m).

(i) Example 1—(A) Facts. Controlled foreign corporation CFC is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC pays USP $300x of interest. CFC has no other expenses. In Year 1, CFC has $3,000x of assets that generate $650x of foreign source general category income and a $1,000x loan to an unrelated foreign person that generates $20x of foreign source passive category interest income. CFC also has a $4,000x loan to an unrelated United States person that generates $70x of U.S. source passive category interest income and $4,000x of assets that generate $100x of U.S. source general category income. CFC uses the asset method to allocate interest expense. The following chart summarizes CFC's assets and income:

(B) Analysis. Under paragraph (c)(2)(ii)(C) of this section, $90x of the related person interest payment is allocable to CFC's passive category income. Under paragraph (m)(2) of this section, $70x of USP's $90x of passive category interest income is from sources within the United States and $20x is from foreign sources. Under paragraph (c)(2)(ii)(D) of this section, the remaining $210x of the related person interest payment is allocated to general category income. Under paragraph (m)(2) of this section, $120x of the remaining $210x of USP's interest income is treated as general category income from sources within the United States ($120x = $210x × $4,000x/$7,000x) and $90x is treated as general category income from foreign sources ($90x = $210x × $3,000x/$7,000x).

(ii) Example 2. The facts are the same as in paragraph (m)(3)(i) of this section (the facts in Example 1), except that CFC uses the modified gross income method to allocate interest expense. The first $90x of related person interest expense is allocated to passive category income in the same manner as in paragraph (m)(3)(i) of this section (Example 1), $70x to U.S. sources and $20x to foreign sources. Under paragraph (c)(2)(ii)(D) of this section, the remaining $210x of the related person interest expense is allocated to CFC's general category income. Under paragraph (m)(2) of this section, $28x of the remaining $210x of USP's interest income is treated as general category income from U.S. sources ($28x = $210x × $100x/$750x) and $182x is treated as general category income from foreign sources ($182x = $210x × $650x/$750x).

(4) * * * (i) Rule. Any dividend or distribution treated as a dividend under this paragraph (m) (including an amount included in gross income under section 951(a)(1)(B)) that is received or accrued by a United States shareholder from a controlled foreign corporation, or any dividend that is received or accrued by a domestic corporation from a noncontrolled 10-percent owned foreign corporation with respect to which the shareholder is a United States shareholder, are treated as income in a separate category derived from sources within the United States in proportion to the ratio of the portion of the earnings and profits of the controlled foreign corporation or noncontrolled 10-percent owned foreign corporation in the corresponding separate category from U.S. sources to the total amount of earnings and profits of the controlled foreign corporation or noncontrolled 10-percent owned foreign corporation in that separate category.

(5) Treatment of inclusions under sections 951(a)(1)(A), 951A and 1293—(i) * * * Any amount included in the gross income of a United States shareholder of a controlled foreign corporation under section 951(a)(1)(A), 951A, or in the gross income of a domestic corporation that is a United States shareholder of a noncontrolled 10-percent owned foreign corporation described in section 904(d)(2)(E)(i)(II) that is a qualified electing fund under section 1293 is treated as income subject to a separate category that is derived from sources within the United States to the extent the amount is attributable to income of the controlled foreign corporation or qualified electing fund, respectively, in the corresponding category of income from sources within the United States. * * *

(ii) Example. The following example illustrates the application of this paragraph (m)(5).

(A) Facts. Controlled foreign corporation CFC is a wholly-owned subsidiary of domestic corporation, USP. In Year 1, CFC earns $100x of subpart F foreign personal holding company income that is passive category income. Of this amount, $40x is derived from sources within the United States. CFC also earns $50x of subpart F general category income. None of this income is from sources within the United States. Assume that CFC pays no foreign taxes and has no expenses.

(B) Analysis. USP must include $150x in gross income under section 951(a). Of this amount, $60x is foreign source passive category income to USP, $40x is U.S. source passive category income to USP, and $50x is foreign source general category income to USP.

(7) * * *

(ii) Example. The following example illustrates the application of this paragraph (m)(7).

(A) Facts. Controlled foreign corporation CFC is incorporated in Country A and is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns $80x of general category foreign base company sales income in Country A and $40x of passive category U.S. source interest income. CFC incurs $20x of expenses attributable to its sales business. CFC pays USP $40x of interest that is allocated to CFC's U.S. source passive category income under paragraph (c)(2)(ii)(C) of this section and so is U.S. source passive category income to USP under paragraphs (c)(2)(i) and (m)(2) of this section. Assume that earnings and profits equal net income. All of CFC's net income of $60x is subpart F income includible in USP's gross income under section 951(a)(1). For Year 1, USP also has $100x of foreign source passive category income derived from investments in Country B. Pursuant to section 904(h)(3) and paragraph (m)(2) of this section, the $40x interest payment from CFC is U.S. source income to USP because it is attributable to U.S. source interest income of CFC. The United States-Country A income tax treaty, however, treats all interest payments by residents of Country A as Country A sourced and USP elects to apply the treaty.

(B) Analysis. Pursuant to section 904(h)(10) and this paragraph (m)(7), the entire interest payment will be treated as foreign source income to USP. USP thus has $60x of foreign source general category income, $40x of foreign source Country A treaty category passive income from CFC, and $100x of foreign source passive category income.

(n) * * * Section 904(d)(3), (d)(4), and (h) and this section are then applied for purposes of characterizing and sourcing income received, accrued, or included by a United States shareholder of the foreign corporation that is attributable or allocable to income or earnings and profits of the foreign corporation.

(o) Applicability dates. This section is applicable for taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(a) * * * (1) * * * (i) * * * The amount of foreign taxes paid or accrued with respect to a separate category (as defined in § 1.904-5(a)(4)(v)) of income (including U.S. source income within the separate category) includes only those taxes that are related to income in that separate category. * * * Income included in the foreign tax base is calculated under foreign law, but characterized as income in a separate category under Federal income tax principles. For example, a foreign tax imposed on an amount realized on the disposition of controlled foreign corporation stock that is characterized as a capital gain under foreign law but as a dividend under section 1248 is generally assigned to the general category, not the passive category. * * *

(iv) Base and timing differences. If, under the law of a foreign country or possession of the United States, a tax is imposed on a type of item that does not constitute income under Federal income tax principles (a base difference), such as gifts or life insurance proceeds, that tax is treated as imposed with respect to income in the separate category described in section 904(d)(2)(H)(i). If, under the law of a foreign country or possession of the United States, a tax is imposed on an item of income that constitutes income under Federal income tax principles but is not recognized for Federal income tax purposes in the current year (a timing difference), that tax is allocated and apportioned to the appropriate separate category or categories to which the tax would be allocated and apportioned if the income were recognized under Federal income tax principles in the year in which the tax was imposed. If the amount of an item of income as computed for foreign tax purposes is positive but is greater than the amount of income that is currently recognized for Federal income tax purposes, for example, due to a difference in depreciation conventions or the timing of recognition of gross income, or because of a permanent difference between U.S. and foreign tax law in the amount of deductions that are allowed to reduce gross income, the tax is allocated or apportioned to the separate category to which the income is assigned, and no portion of the tax is attributable to a base difference. In addition, a tax imposed on a distribution that is excluded from gross income under section 959(a) or section 959(b) is treated as attributable to a timing difference (and not a base difference) and is treated as tax imposed on the earnings and profits from which the distribution was paid.

(2) Special rules for foreign branches—(i) In general. Except as provided in this paragraph (a)(2), any foreign tax reflected on the books and records of a foreign branch under the principles of § 1.987-2(b) is allocated and apportioned under the rules of paragraph (a)(1) of this section.

(ii) Disregarded reattribution transactions—(A) Foreign branch to foreign branch owner. In the case of a disregarded payment from a foreign branch to a foreign branch owner that is treated as a disregarded reattribution transaction that results in gross income being attributed to the foreign branch owner under § 1.904-4(f)(2)(vi), any foreign tax imposed solely by reason of that transaction, such as a withholding tax imposed on a disregarded payment, is allocated and apportioned to the reattributed gross income.

(B) Foreign branch owner to foreign branch. In the case of a disregarded payment from a foreign branch owner to a foreign branch that is treated as a disregarded reattribution transaction that results in gross income being attributed to the foreign branch under § 1.904-4(f)(2)(vi), any foreign tax imposed solely by reason of that transaction is allocated and apportioned to the reattributed gross income. In the case of a foreign branch owner that is a partnership, a foreign tax imposed solely by reason of a disregarded reattribution transaction that results in general category income being attributed to a foreign branch is allocated and apportioned to the partnership's general category income that is attributable to the foreign branch (as described in paragraph (b)(4)(ii) of this section).

(iii) Other disregarded payments—(A) Foreign branch to foreign branch owner. In the case of a disregarded payment from a foreign branch to a foreign branch owner that is not a disregarded reattribution transaction, foreign tax imposed solely by reason of that disregarded payment is allocated and apportioned to a separate category under paragraph (a)(1) of this section based on the nature of the item (determined under Federal income tax principles) that is included in the foreign tax base. For example, if a remittance of an appreciated asset results in gain recognition under foreign law, the tax imposed on that gain is treated as attributable to a timing difference with respect to recognition of the gain, and is allocated and apportioned to the separate category to which gain on a sale of that asset would have been assigned if it were recognized for Federal income tax purposes. However, a gross basis withholding tax on a remittance is attributable to a timing difference in taxation of the income out of which the remittance is made, and is allocated and apportioned to the separate category or categories to which a section 987 gain or loss would be assigned under § 1.987-6(b).

(B) Foreign branch owner to foreign branch. In the case of a disregarded payment from a foreign branch owner that is a United States person to a foreign branch that is neither a disregarded reattribution transaction nor described in § 1.904-4(f)(2)(vi)(C)(4), any foreign tax imposed solely by reason of the receipt of that disregarded payment is allocated and apportioned to the foreign branch category. In the case of a foreign branch owner that is a partnership, a foreign tax imposed solely by reason of the receipt of a disregarded payment by a foreign branch is allocated and apportioned to the partnership's general category income that is attributable to the foreign branch (as described in paragraph (b)(4)(ii) of this section).

(iv) Definitions. The following definitions apply for purposes of this paragraph (a)(2):

(A) Disregarded reattribution transaction. The term disregarded reattribution transaction means a disregarded payment or a transfer described in § 1.904-4(f)(2)(vi)(D) to the extent that it results in an adjustment to the gross income attributable to the foreign branch under § 1.904-4(f)(2)(vi)(A).

(B) The terms disregarded payment, foreign branch, foreign branch owner, and remittance have the same meaning given to those terms in § 1.904-4(f)(3).

(3) Taxes imposed on high-taxed income. For rules on the treatment of taxes imposed on high-taxed income, see § 1.904-4(c).

(b) Allocation and apportionment of deemed paid taxes and certain creditable foreign tax expenditures—(1) Taxes deemed paid under section 960(a) or (d). If a domestic corporation that is a United States shareholder includes any amount in gross income under section 951(a)(1)(A) or 951A(a), any foreign tax deemed paid with respect to such amount under section 960(a) or (d) is allocated to the separate category to which the inclusion is assigned.

(2) Taxes deemed paid under section 960(b)(1). If a domestic corporation that is a United States shareholder receives a distribution of previously taxed earnings and profits from a first-tier corporation that is excluded from the domestic corporation's income under section 959(a) and § 1.959-1, any foreign tax deemed paid under section 960(b)(1) with respect to such distribution is allocated to the same separate category as the annual PTEP account and PTEP group (as defined in § 1.960-3(c)) from which the distribution is made.

(3) Taxes deemed paid under section 960(b)(2). If a controlled foreign corporation receives a distribution of previously taxed earnings and profits from an immediately lower-tier corporation that is excluded from such controlled foreign corporation's gross income under section 959(b) and § 1.959-2, any foreign tax deemed paid under section 960(b)(2) with respect to such distribution is allocated to the same separate category as the annual PTEP account and PTEP group (as defined in § 1.960-3(c)) from which the distribution is made. See also § 1.960-3(c)(2).

(4) Creditable foreign tax expenditures—(i) In general. Except as provided in paragraph (b)(4)(ii) of this section, creditable foreign tax expenditures (CFTEs) allocated to a partner under § 1.704-1(b)(4)(viii)(a) are allocated for purposes of this section to the same separate category as the separate category to which the taxes were allocated in the hands of the partnership under the rules of paragraph (a) of this section.

(ii) Foreign branch category. CFTEs allocated to a partner in a partnership under § 1.704-1(b)(4)(viii)(a) are allocated and apportioned to the foreign branch category of the partner to the extent that:

(A) The CFTEs are allocated and apportioned by the partnership under the rules of paragraph (a) of this section to the general category;

(B) In the hands of the partnership, the CFTEs are related to general category income attributable to a foreign branch (as described in § 1.904-4(f)(2)) under the principles of paragraph (a) of this section; and

(C) The partner's distributive share of the income described in paragraph (b)(4)(ii)(B) of this section is foreign branch category income of the partner under § 1.904-4(f)(1)(i)(B).

(d) Applicability dates. This section is applicable for taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(a) Disregard of certain dividends and deductions—(1) In general. For purposes of section 904(a), in the case of a domestic corporation which is a United States shareholder with respect to a specified 10-percent owned foreign corporation (as defined in section 245A(b)), the domestic corporation's foreign source taxable income in a separate category and entire taxable income is determined without regard to the following items:

(i) Any dividend for which a deduction is allowed under section 245A;

(ii) Deductions properly allocable or apportioned to gross income in the section 245A subgroup as determined under paragraphs (b) and (c)(1) of this section; and

(iii) Deductions properly allocable or apportioned to stock of specified 10-percent owned foreign corporations in the section 245A subgroup as determined under paragraphs (b) and (c) of this section.

(2) Deductions properly allocable or apportioned to the residual grouping. Deductions that are properly allocable or apportioned to gross income or stock in the section 245A subgroup of the residual grouping (consisting of U.S. source income) are disregarded solely for purposes of determining entire taxable income under section 904(a).

(b) Determining properly allocable or apportioned deductions. The amount of deductions properly allocable or apportioned to gross income or stock described in paragraphs (a)(1)(ii) and (iii) of this section is determined by subdividing the United States shareholder's gross income and assets in each separate category described in § 1.904-5(a)(4)(v) into a section 245A subgroup and a non-section 245A subgroup. Gross income and assets in the residual grouping for U.S. source income are also subdivided into a section 245A subgroup and a non-section 245A subgroup. Each section 245A subgroup is treated as a statutory grouping under § 1.861-8(a)(4). Deductions properly allocable or apportioned to dividends or stock described in paragraphs (a)(1)(ii) and (iii) of this section only include those deductions that are allocated and apportioned under §§ 1.861-8 through 1.861-14T and 1.861-17 to the section 245A subgroups. The deduction allowed under section 245A(a) for dividends is allocated and apportioned solely among the section 245A subgroups on the basis of the relative amounts of gross income from such dividends in each section 245A subgroup.

(c) Income and assets in the 245A subgroups—(1) In general. For purposes of applying the allocation and apportionment rules under §§ 1.861-8 through 1.861-14T and 1.861-17 to the deductions of a United States shareholder, the only gross income included in a section 245A subgroup is dividend income for which a deduction is allowed under section 245A. The only asset included in a section 245A subgroup is the portion of the value of stock of each specified 10-percent owned foreign corporation that is assigned to the section 245A subgroup determined under paragraph (c)(2) of this section.

(2) Assigning stock to a subgroup. The value of stock of a specified 10-percent owned foreign corporation is characterized as an asset in a separate category described in § 1.904-5(a)(4)(v) or the residual grouping for U.S. source income under the rules of § 1.861-12(c). If the specified 10-percent owned foreign corporation is not a controlled foreign corporation, all of the value of its stock (other than the portion of stock assigned to the statutory groupings for gross section 245(a)(5) income under §§ 1.861-12(c)(4) and 1.861-13) in each separate category and in the residual grouping for U.S. source income is assigned to the section 245A subgroup in such separate category or residual grouping. If the specified 10-percent owned foreign corporation is a controlled foreign corporation, a portion of the value of stock in each separate category and in the residual grouping for U.S. source income is subdivided between a section 245A and non-section 245A subgroup under § 1.861-13(a)(5).

(d) Coordination with OFL and ODL rules—(1) In general. Section 904(b)(4) and this section apply before the operation of the overall foreign loss rules in section 904(f) and the overall domestic loss rules in section 904(g). See § 1.904(g)-3(c).

(2) [Reserved]

(e) Example. The following example illustrates the application of this section.

(1) Facts—(i) Income and assets of USP. USP is a domestic corporation. USP owns a factory in the United States with a tax book value of $27,000x. USP also directly owns all of the stock of each of the following three controlled foreign corporations: CFC1, CFC2, and CFC3. USP's tax book value in each of CFC1, CFC2, and CFC3 is $10,000x. USP incurs $1,500x of interest expense and earns $1,600x of U.S. source gross income. Under section 951A and the section 951A regulations (as defined in § 1.951A-1(a)(1)), USP's GILTI inclusion amount is $2,200x. USP's deduction under section 250 is $1,100x (“section 250 deduction”), all of which is by reason of section 250(a)(1)(B)(i). No portion of USP's section 250 deduction is reduced by reason of section 250(a)(2)(B). None of the CFCs makes any distributions.

(ii) Characterization of CFC stock. After application of § 1.861-13(a), USP determined that $8,000x of the stock of each of CFC1, CFC2, and CFC3 is assigned to the section 951A category (“section 951A category stock”) in the non-section 245A subgroup and the remaining $2,000x of the stock of each of CFC1, CFC2, and CFC3 is assigned to the general category (“general category stock”) in the section 245A subgroup. Additionally, under § 1.861-8(d)(2)(ii)(C)(2), $4,000x of the stock of each of CFC1, CFC2, and CFC3 that is section 951A category stock is an exempt asset. Accordingly, with respect to the stock of its controlled foreign corporations in the aggregate, USP has $12,000x of section 951A category stock in a non-section 245A subgroup; $6,000x of general category stock in a section 245A subgroup; and $12,000x of stock that is an exempt asset.

(iii) Apportioning of expenses. Taking into account USP's factory and its stock in CFC1, CFC2, and CFC3, the tax book value of USP's assets for purposes of apportioning expenses is $45,000x (excluding the $12,000x of exempt assets). Under § 1.861-9T(g), USP's $1,500 of interest expense is apportioned as follows: $400x ($1,500x × $12,000x/$45,000x) to section 951A category income, $200x ($1,500x × $6,000x/$45,000x) to general category income, and the remaining $900x ($1,500 × $27,000x/$45,000x) to the residual U.S. source grouping. Under § 1.861-8(e)(14), all of USP's section 250 deduction is allocated and apportioned to section 951A category income.

(2) Analysis—(i) USP's pre-credit U.S. tax. USP's worldwide taxable income is $1,200x, which equals its GILTI inclusion amount of $2,200x plus its U.S. source gross income of $1,600x, less its deduction under section 250 of $1,100 and its interest expense of $1,500x. For purposes of applying section 904(a), before taking into account any foreign tax credit under section 901, USP's Federal income tax liability is 21% of $1,200x, or $252x.

(ii) Application of section 904(b)(4). Under section 904(d)(1), USP applies section 904(a) separately to each separate category of income.

(A) General category income. Before application of section 904(b)(4) and the rules in this section, USP's foreign source taxable income in the general category is a loss of $200x, which equals $0 (USP's foreign source general category income) less $200x (interest expense apportioned to general category income), and USP's worldwide taxable income is $1,200. Under paragraph (d) of this section, the rules in section 904(f) and (g) apply after section 904(b)(4) and the rules in this section. Under paragraphs (b) and (c)(1) of this section, USP has no deductions properly allocable or apportioned to gross income in the section 245A subgroup because USP has no dividend income in the general category for which a deduction is allowed under section 245A. Under paragraphs (b) and (c) of this section, USP has $200x of deductions for interest expense that are properly allocable or apportioned to stock of specified 10-percent owned foreign corporations in the section 245A subgroup because USP's only general category assets are the general category stock of CFC1, CFC2, and CFC3, all of which are in the section 245A subgroup. Therefore, under paragraph (a) of this section, USP's foreign source taxable income in the general category and its worldwide taxable income are determined without regard to the $200x of deductions for interest expense. Accordingly, USP's foreign source taxable income in the general category is $0 and its worldwide taxable income is $1,400x, and therefore, there is no separate limitation loss for purposes of section 904(f). Under section 904(a) and (d)(1) USP's foreign tax credit limitation for the general category is $0.

(B) Section 951A category income. Before application of section 904(b)(4) and the rules in this section, USP's foreign source taxable income in the section 951A category is $700x, which equals $2,200x (USP's GILTI inclusion amount) less $1,100x (USP's section 250 deduction) less $400x (interest apportioned to section 951A category income). Under paragraphs (b) and (c)(1) of this section, USP has no deductions properly allocable and apportioned to gross income in a section 245A subgroup of the section 951A category. Under paragraphs (b) and (c) of this section, USP has no deductions properly allocable and apportioned to stock of specified 10-percent owned foreign corporations in a section 245A subgroup of section 951A category stock because no portion of section 951A category stock is assigned to a section 245A subgroup. See § 1.861-13(a)(5)(v). Therefore, under paragraph (a) of this section no adjustment is made to USP's foreign source taxable income in the section 951A category. However, the adjustments to USP's worldwide taxable income described in paragraph (e)(2)(ii)(A) of this section apply for purposes of calculating USP's foreign tax credit limitation for the section 951A category. Accordingly, USP's foreign source taxable income in the section 951A category is $700x and its worldwide taxable income is $1,400x. Under section 904(a) and (d)(1), USP's foreign tax credit limitation for the section 951A category is $126x ($252x × $700x/$1,400x).

(f) Applicability date. This section applies to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.

(j) Recapture in years beginning after December 31, 2017, of separate limitation losses, overall foreign losses, and overall domestic losses incurred in years beginning before January 1, 2018—(1) Definitions—(i) The term pre-2018 separate categories means the separate categories of income described in section 904(d) and any specified separate categories of income, as applicable to taxable years beginning before January 1, 2018.

(ii) The term post-2017 separate categories means the separate categories of income described in section 904(d) and any specified separate categories of income, as applicable to taxable years beginning after December 31, 2017.

(iii) The term specified separate category has the meaning set forth in § 1.904-4(m)).

(2) Allocation of separate limitation loss or overall foreign loss account incurred in a pre-2018 separate category—(i) Allocation to the same category. To the extent that a taxpayer has a balance in any separate limitation loss or overall foreign loss account in a pre-2018 separate category at the end of the taxpayer's last taxable year beginning before January 1, 2018, the amount of such balance is allocated on the first day of the taxpayer's next taxable year to the same post-2017 separate category as the pre-2018 separate category of the separate limitation loss or overall foreign loss account.

(ii) Exception for general category separate limitation loss or overall foreign loss account—(A) In general. To the extent a taxpayer has a balance in any separate limitation loss or overall foreign loss account in the pre-2018 separate category for general category income at the end of the taxpayer's last taxable year beginning before January 1, 2018, a taxpayer may choose to allocate any such balance to the taxpayer's post-2017 separate category for foreign branch category income to the extent the balance in the loss account would have been allocated to the taxpayer's post-2017 separate category for foreign branch category income if that separate category applied in the year or years the losses giving rise to the account were incurred. Any remaining portion of the balance in the separate limitation loss or overall foreign loss account is allocated to the taxpayer's post-2017 separate category for general category income.

(B) Safe harbor. In lieu of applying paragraph (j)(2)(ii)(A) of this section, the taxpayer may choose to recapture the balance in any loss account described in paragraph (j)(2)(ii)(A) of this section from the first available income in the taxpayer's post-2017 separate category for general category income or foreign branch category income. If the sum of taxpayer's general category income and foreign branch category income for a taxable year subject to recharacterization exceeds the amount of the loss account described in paragraph (j)(2)(ii)(A) of this section that is to be recaptured, then the amount of general category income and foreign branch category income that will be recharacterized under the relevant recapture provisions is determined on a proportionate basis. The recapture under this paragraph (j)(2)(ii)(B) of any loss account described in paragraph (j)(2)(ii)(A) of this section is made before the recapture of any amount by which the balance of the loss account is increased after the end of the taxpayer's last taxable year beginning before January 1, 2018.

(C) Rules regarding the exception. A taxpayer applying the exception described in paragraph (j)(2)(ii)(A) or (B) of this section must apply the exception to all balances in any separate limitation loss or overall foreign loss account in a pre-2018 separate category for general category income at the end of the taxpayer's last taxable year beginning before January 1, 2018. A taxpayer may apply the exception on a timely filed original return (including extensions) or an amended return. A taxpayer that applies the exception on an amended return must make appropriate adjustments to eliminate any double benefit arising from application of the exception to years that are not open for assessment.

(3) Recapture of separate limitation loss or overall domestic loss that reduced pre-2018 separate category income—(i) Recapture as income in the same separate category. To the extent that at the end of the taxpayer's last taxable year beginning before January 1, 2018, a taxpayer has a balance in any separate limitation loss or overall domestic loss account which offset pre-2018 separate category income, such loss is recaptured in subsequent taxable years as income in the same post-2017 separate category as the pre-2018 separate category of income that was offset by the loss.

(ii) Exception for separate limitation loss or overall domestic loss that reduced general category income—(A) In general. To the extent that a taxpayer's separate limitation loss or overall domestic loss account offset pre-2018 separate category income that was general category income, a taxpayer may choose to recapture the balance in the loss account at the end of the taxpayer's last taxable year beginning before January 1, 2018, in subsequent taxable years as income in the post-2017 separate category for foreign branch category income to the extent the balance in the loss account would have offset foreign branch category income had that separate category applied in the year or years the losses were incurred. Any remaining portion of the balance in the loss account is recaptured as income in the taxpayer's post-2017 separate category for general category income.

(B) Safe harbor. In lieu of applying paragraph (j)(3)(ii)(A) of this section, a taxpayer that had unused foreign income taxes in a pre-2018 taxable year that were allocated to the foreign branch category under § 1.904-2(j)(1)(iii)(A) or (B) may choose to recapture the balance in any loss account described in paragraph (j)(3)(ii)(A) of this section in subsequent taxable years ratably as income in the taxpayer's post-2017 separate categories for general category and foreign branch category income, based on the proportion in which any unused foreign taxes in the pre-2018 separate category for general category income are allocated under § 1.904-2(j)(1)(iii)(A) or (B).

(C) Rules regarding the exception. A taxpayer applying the exception described in paragraph (j)(2)(ii)(A) or (B) of this section must apply the exception to the recapture of all balances at the end of the taxpayer's last taxable year beginning before January 1, 2018 in any separate limitation loss or overall domestic loss account which offset pre-2018 separate category income that was general category income. A taxpayer may apply the exception on a timely filed original return (including extensions) or an amended return. A taxpayer that applies the exception on an amended return must make appropriate adjustments to eliminate any double benefit arising from application of the exception to years that are not open for assessment.

(4) Treatment of foreign losses that are part of net operating losses incurred in pre-2018 taxable years which are carried forward to post-2017 taxable years—(i) Treatment as a loss in the same separate category. A foreign loss that is part of a net operating loss incurred in a taxable year beginning before January 1, 2018, which is carried forward, pursuant to section 172, to a taxable year beginning after December 31, 2017, will be carried forward under the rules of § 1.904(g)-3(b)(2). For purposes of applying the rules of § 1.904(g)-3(b)(2), the portion of a net operating loss carryforward that is attributable to a foreign loss from a pre-2018 separate category will be treated as a loss attributable to the same post-2017 separate category as the pre-2018 separate category.

(ii) Exception for general category foreign losses that are part of net operating losses—(A) In general. A taxpayer may choose to treat the portion of a net operating loss carryforward that is attributable to a foreign loss from the pre-2018 separate category for general category income as attributable to the post-2017 separate category for foreign branch category income to the extent the net operating loss would have been attributable to the taxpayer's post-2017 separate category for foreign branch category income had that separate category applied in the year or years the net operating loss arose. Any remaining portion of the net operating loss carryforward is treated as attributable to the taxpayer's post-2017 separate category for general category income.

(B) Safe harbor. In lieu of applying paragraph (j)(4)(ii)(A) of this section, for the post-2017 taxable year in which a net operating loss carryforward described in paragraph (j)(4)(ii)(A) of this section is used, the taxpayer may choose to treat the net operating loss carryforward as attributable to the taxpayer's post-2017 separate categories for general category income and foreign branch category income to the extent of any general category income and foreign branch category income, respectively, that is available in the carryforward year to be offset by the net operating loss carryforward. To the extent the net operating loss carryforward offsets any other income in the carryforward year, it is treated as attributable to the taxpayer's post-2017 separate category for general category income. If the sum of taxpayer's general category income and foreign branch income in the carryforward year exceeds the amount of the net operating loss carryforward, then the amount of each type of separate income that is offset by the net operating loss carryforward, and therefore the separate category treatment of the net operating loss carryforward, is be determined on a proportionate basis. A general category net operating loss to which the exception is applied is absorbed before any general category net operating loss that is incurred after the end of the taxpayer's last taxable year beginning before January 1, 2018.

(C) Rules regarding the exception. A taxpayer applying the exception described in paragraph (j)(4)(ii)(A) or (B) of this section must apply the exception to all of its net operating losses that are attributable to a foreign loss from the pre-2018 separate category for general category income. A taxpayer may apply the exception on a timely filed original return (including extensions) or an amended return. A taxpayer that applies the exception on an amended return must make appropriate adjustments to eliminate any double benefit arising from application of the exception to years that are not open for assessment.

(5) Coordination rule with respect to exceptions. A taxpayer that applies any exception described in § 1.904-2(j)(1)(iii) or paragraph (j)(2)(ii), (j)(3)(ii), or (j)(4)(ii) of this section must apply all such exceptions and cannot apply any of the general rules described in § 1.904-2(j)(1)(ii) or paragraph (j)(2)(i), (j)(3)(i), or (j)(4)(i) of this section. However, in applying each such exception, the taxpayer may choose to apply the safe harbor provision regardless of whether the safe harbor is applied for purposes of any other exception.

(6) Applicability date. This paragraph (j) applies to taxable years beginning after December 31, 2017.

§ 1.904(g)-3 Ordering rules for the allocation of net operating losses, net capital losses, U.S. source losses, and separate limitation losses, and for the recapture of separate limitation losses, overall foreign losses, and overall domestic losses.

(i) Step Eight: Dispositions under section 904(f)(3) in which gain would not otherwise be recognized.

(j) [Reserved]

(k) Examples.

(l) Applicability date.

(c) * * * The taxpayer also takes into account any adjustments required under section 904(b)(4) and § 1.904(b)-3.

(f) Step Five: Recapture of overall foreign loss accounts. If the taxpayer's separate limitation income for the taxable year (reduced by any losses carried over under paragraph (b) of this section) exceeds the sum of the taxpayer's U.S. source loss and separate limitation losses for the year, so that the taxpayer has separate limitation income remaining after the application of paragraphs (d)(1) and (e) of this section, then the taxpayer recaptures prior year overall foreign losses, if any, in accordance with § 1.904(f)-2, and reduces overall foreign loss accounts in accordance with § 1.904(f)-2. The recapture in this paragraph (f) includes amounts determined under § 1.904(f)-2(c) and (d)(3) but not § 1.904(f)-2(d)(4), which is covered in paragraph (i) of this section.

(i) Step Eight: Dispositions under section 904(f)(3) in which gain would not otherwise be recognized. The taxpayer determines the amount of gain that would otherwise not be recognized but that must be recognized in accordance with § 1.904(f)-2(d)(4) (not exceeding the taxpayer's applicable overall foreign loss account) and then applies § 1.904(f)-2(a) and (b) to recapture and reduce its overall foreign loss accounts in an amount equal to the gain recognized. To the extent this recognition of gain in a taxable year reduces the amount of a current year net operating loss or increases the amount of a net operating loss carryover to that taxable year, paragraphs (b) through (e) of this section are applied to determine the allocation of any additional net operating loss deduction and other deductions or losses and the applicable increases in the taxpayer's overall foreign loss, separate limitation loss, and overall domestic loss accounts, but only after the applicable overall foreign loss account has been recaptured as provided in this paragraph (i).

(k) Examples. The following examples illustrate the rules of this section. Unless otherwise noted, all corporations use the calendar year as the U.S. taxable year.

(1) Example 1—(i) Facts—(A) USC is a domestic corporation with foreign branch operations in Country X. For Year 1, USC had the following taxable income and losses after application of section 904(f) and (g) to income and loss in Year 1:

(B) For Year 2, USC has a net operating loss of ($500x), determined as follows:

(ii) Analysis—(A) Net operating loss allocation. Because USC's taxable income for Year 1 exceeds its total net operating loss for Year 2, the full net operating loss is carried back. Under paragraph (b) of this section (Step 1), each component of the net operating loss is carried back and combined with its same category in Year 1. See paragraph (b)(2) of this section. After allocation of the net operating loss, USC has the following taxable income and losses for Year 1:

(B) Loss allocation. Under paragraph (e) of this section (Step 4), the ($90x) of U.S. loss is allocated proportionately to reduce the foreign branch category and passive category income. Accordingly, $30x ($90x × $100x/$300x) of the U.S. loss is allocated to foreign branch category income and $60x ($90x × $200x/$300x) of the U.S. loss is allocated to passive category income, with a corresponding creation or increase to USC's overall domestic loss accounts.

(2) Example 2—(i) Facts—(A) USC is a domestic corporation with foreign branch operations in Country X. As of January 1, Year 1, USC has no loss accounts subject to recapture. For Year 1, USC has a net operating loss of ($1,400x), determined as follows:

(B) For Year 2, USC has the following taxable income and losses:

(ii) Analysis—(A) Net operating loss allocation. Under paragraph (b) of this section (Step 1), because USC's total taxable income for Year 2 of $1600x ($1,200x + $500x − $100x) exceeds the total Year 1 net operating loss, the full $1,400x net operating loss is carried forward. Under paragraph (b)(2) of this section, each component of the net operating loss is carried forward and combined with its same category in Year 2. After allocation of the net operating loss, USC has the following taxable income and losses:

(B) Loss allocation. Under paragraph (d) of this section (Step 3), $100x of the passive category loss offsets the $100x of foreign branch category income, resulting in a passive category separate limitation loss account with respect to foreign branch category income, and the other $200x of passive category loss offsets $200x of the U.S. source taxable income, resulting in the creation of an overall foreign loss account in the passive category.

(3) Example 3—(i) Facts. Assume the same facts as in paragraph (k)(2)(i) of this section (the facts in Example 2), except that in Year 2, USC had the following taxable income and losses:

(ii) Analysis—(A) Net operating loss allocation. Under paragraph (b) of this section (Step 1), because the total net operating loss for Year 1 of ($1,400x) exceeds total taxable income for Year 2 of $1,300x ($1,200x + $200x − $100x), USC has a partial net operating loss carryover to Year 2 of $1,300x. Under paragraph (b)(3)(i) of this section, first, the $800x U.S. source component of the net operating loss is allocated to U.S. income for Year 2. The tentative foreign branch category carryover under paragraph (b)(3)(ii) of this section ($200x) does not exceed the remaining net operating loss carryover amount ($500x). Therefore, $200x of the foreign branch category component of the net operating loss is next allocated to the foreign branch category income for Year 2. Under paragraph (b)(3)(iii) of this section, the remaining $300x of net operating loss carryover ($1300x − $800x − $200x) is carried over proportionally from the remaining net operating loss components in the foreign branch category ($200x, or $400x total foreign branch category loss − $200x foreign branch category loss already allocated) and passive category ($200x). Therefore, $150x ($300x × $200x/$400x) of the remaining net operating loss carryover is carried over from the foreign branch category for Year 1 and combined with the foreign branch category income for Year 2, and $150x ($300x × $200x/$400x) of the remaining net operating loss carryover is carried over from the passive category for Year 1 and combined with the passive category loss for Year 2. After allocation of the net operating loss carryover from Year 1 to the appropriate categories for Year 2, USC has the following taxable income and losses:

(B) Loss allocation. Under paragraph (d) of this section (Step 3), the losses in the foreign branch and passive categories fully offset the U.S. source income, resulting in the creation of foreign branch category and passive category overall foreign loss accounts.

(4) Example 4—(i) Facts. Assume the same facts as in paragraph (k)(2)(i) of this section (the facts in Example 2), except that in Year 2, USC has the following taxable income and losses:

(ii) Analysis—(A) Net operating loss allocation. Under paragraph (b) of this section (Step 1), because the total net operating loss of ($1400x) exceeds total taxable income for Year 2 of $200x ($200x + $200x − $200x), USC has a partial net operating loss carryover to Year 2 of $200x. Because USC has no U.S. source income in Year 2, under paragraph (b)(3)(i) of this section no portion of the U.S. source component of the net operating loss is initially carried into Year 2. Because the total tentative carryover under paragraph (b)(3)(ii) of this section of $400x ($200x in each of the foreign branch and passive categories) exceeds the net operating loss carryover amount, the tentative carryover from each separate category is reduced proportionately by $100x ($200x × $200x/$400x). Accordingly, $100x ($200x − $100x) of the foreign branch category component of the net operating loss is carried forward and $100x ($200x − $100x) of the passive category component of the net operating loss is carried forward and combined with income in the same respective categories for Year 2. After allocation of the net operating loss carryover from Year 1, USC has the following taxable income and losses:

(B) Loss allocation. Under paragraph (e) of this section (Step 4), the $200x U.S. source loss offsets the remaining $100x of foreign branch category income and $100x of passive category income, resulting in the creation of overall domestic loss accounts with respect to the foreign branch and passive categories.

(5) Example 5—(i) Facts. Assume the same facts as in paragraph (k)(2)(i) of this section (the facts in Example 2), except that in Year 2, USC has the following taxable income and losses:

(ii) Analysis—(A) Net operating loss allocation. Under paragraph (b) of this section (Step 1), because USC's total net operating loss in Year 1 of ($1,400x) exceeds its total taxable income for Year 2 of $800x ($100x + $800x − $100x), USC has a partial net operating loss carryover to Year 2 of $800x. Under paragraph (b)(3)(i) of this section, $100x of the U.S. source component of the net operating loss is allocated to U.S. income for Year 2. The tentative foreign branch category carryover under paragraph (b)(3)(ii) of this section does not exceed the remaining net operating loss carryover amount. Therefore, $400x of the foreign branch category component of the net operating loss is allocated to reduce foreign branch category income in Year 2. Under paragraph (b)(3)(iii) of this section, of the remaining $300x of net operating loss carryover ($800x − $100x − $400x), $200x is carried forward from the passive category component of the net operating loss and combined with the passive category loss for Year 2. Under paragraph (b)(3)(iv) of this section, the remaining $100x ($300x − $200x) of net operating loss carryover is carried forward from the U.S. source component of the net operating loss and combined with the U.S. source income (and the previously allocated U.S. source component of the net operating loss) for Year 2. After allocation of the net operating loss carryover from Year 1, USC has the following taxable income and losses:

(B) Loss allocation—(1) Under paragraph (d) of this section (Step 3), the $300x passive category loss offsets the $300x of income in the foreign branch category, resulting in the creation of a passive category separate limitation loss account with respect to the foreign branch category.

(2) Under paragraph (e) of this section (Step 4), the $100x U.S. source loss offsets the remaining $100x of the foreign branch category income, resulting in the creation of an overall domestic loss account with respect to the foreign branch category.

(6) Example 6—(i) Facts—(A) USC is a domestic corporation with foreign branch operations in Country X. USC has no net operating losses and does not make an election to recapture more than the required amount of overall foreign losses. As of January 1, Year 1, USC has a ($200x) foreign branch category overall foreign loss (OFL) account and a ($200x) foreign branch category separate limitation loss (SLL) account with respect to the passive category. For Year 1, USC has $400x of passive category income that is fully offset by a ($400x) domestic loss in that taxable year, giving rise to the creation of an overall domestic loss (ODL) account with respect to the passive category. As of January 1, Year 2, USC has the following balances in its OFL, SLL, and ODL accounts:

(B) In Year 2, USC has the following taxable income and losses:

(ii) Analysis—(A) Loss allocation. Under paragraph (d) of this section (Step 3), the $100x of passive category loss offsets $100x of the foreign branch category income, creating a passive category SLL account of $100x with respect to the foreign branch category. Because there is an offsetting foreign branch category SLL account of $200x with respect to the passive category from a prior taxable year, the two accounts are netted against each other so that all that remains is a $100x foreign branch category SLL account with respect to the passive category.

(B) OFL account recapture. Under paragraph (f) of this section (Step 5), 50% of the remaining $300x, or $150x, of income in the foreign branch category is subject to recharacterization as U.S. source income as a recapture of part of the OFL account in the foreign branch category.

(C) SLL account recapture. Under paragraph (g) of this section (Step 6), $100x of the remaining $150x of income in the foreign branch category is recharacterized as passive category income as a recapture of the foreign branch category SLL account with respect to the passive category.

(D) ODL account recapture. Under paragraph (h) of this section (Step 7), 50% of the $600, or $300, of U.S. source income is subject to recharacterization as foreign source passive category income as a recapture of a part of the ODL account with respect to the passive category. None of the $150x of foreign branch category income that was recharacterized as U.S. source income under paragraph (f) of this section (Step 5) is included here as income subject to recharacterization in connection with recapture of the ODL account.

(E) Results—(1) After the allocation of loss and recapture of loss accounts, USC has the following taxable income and losses for Year 2:

(2) As of January 1, Year 3, USC has the following balances in its OFL, SLL and ODL accounts:

(l) Applicability date. This section applies to taxable years ending on or after December 16, 2019.

(a) * * *

(2) * * * If the receipt or the return is in a foreign language, a certified translation thereof must be furnished by the taxpayer. * * *

(a) Foreign tax redetermination. The term foreign tax redetermination means a change in the liability for a foreign income tax, as defined in § 1.960-1(b)(5), or certain other changes described in this paragraph (a) that may affect a taxpayer's foreign tax credit. In the case of a taxpayer that claims the credit in the year the taxes are paid, a foreign tax redetermination occurs if any portion of the tax paid is subsequently refunded. In the case of a taxpayer that claims the credit in the year the taxes accrue, a foreign tax redetermination occurs if taxes that when paid or later adjusted differ from amounts accrued by the taxpayer and claimed as a credit or added to PTEP group taxes (as defined in § 1.960-3(d)(1)). A foreign tax redetermination includes corrections and other adjustments to accrued amounts to reflect the final foreign tax liability, including additional payments of tax that accrue after the close of the taxable year to which the tax relates and, for foreign income taxes taken into account when accrued but translated into dollars on the date of payment, a payment of accrued tax if the value of the foreign currency relative to the dollar has changed between the date or taxable year of accrual and the date of payment. A foreign tax redetermination occurs if any tax claimed as a credit or added to PTEP group taxes is refunded in whole or in part, regardless of whether such tax was paid within the meaning of § 1.901-2(e) at the time the tax was claimed as a credit or added to PTEP group taxes. A foreign tax redetermination also includes accrued foreign income taxes that are not paid on or before the date that is 24 months after the close of the taxable year of the section 901 taxpayer (as defined in § 1.986(a)-1(a)(1)) to which such taxes relate, as well as a subsequent payment of any such accrued but unpaid taxes. If accrued foreign income taxes are not paid on or before the date that is 24 months after the close of the taxable year to which they relate, the resulting foreign tax redetermination is accounted for as if the unpaid portion of the foreign income taxes were refunded on such date. Foreign income taxes that first accrue after the date 24 months after the close of the taxable year to which such taxes relate may not be claimed as a credit or added to PTEP group taxes until paid. See section 905(b) and § 1.461-4(g)(6)(iii)(B), which require the taxpayer to establish the amount of tax that was properly accrued.

(b) Redetermination of U.S. tax liability—(1) Foreign income taxes other than taxes deemed paid under section 960—(i) In general. This paragraph (b)(1) applies to foreign income taxes claimed as a credit under section 901 other than foreign income taxes deemed paid under section 960. If a foreign tax redetermination occurs with respect to foreign income tax claimed as a credit under section 901 (other than a tax deemed paid under section 960), then a redetermination of U.S. tax liability is required for the taxable year in which the tax was claimed as a credit and any year to which unused foreign taxes from such year were carried under section 904(c). In the case of a taxpayer that claims the credit in the year the taxes are paid, the redetermination of U.S. tax liability is made by reducing the tax paid in such year by the amount refunded. In the case of a taxpayer that claims the credit in the year the taxes accrue, the redetermination of U.S. tax liability is made by treating the redetermined amount of foreign tax as the amount of tax that accrued in the year to which the redetermined tax relates. However, a redetermination of U.S. tax liability is not required (and a taxpayer need not notify the IRS) if the foreign income taxes are taken into account when accrued but translated into dollars on the date of payment, the difference between the dollar value of the accrued foreign income tax and the dollar value of the foreign income tax paid is solely attributable to fluctuations in the value of the foreign currency relative to the dollar between the date or taxable year of accrual and the date of payment, and the net dollar amount of the currency fluctuations attributable to the foreign tax redeterminations with respect to each and every foreign country is less than the lesser of $10,000 or two percent of the total dollar amount of the foreign income tax initially accrued with respect to that foreign country for the taxable year. In such case, if no redetermination of U.S. tax liability is made, an appropriate adjustment is made to the taxpayer's U.S. tax liability in the taxable year during which the foreign tax redeterminations occur.

(ii) Examples. The following examples illustrate the application of this paragraph (b)(1) and § 1.986(a)-1. In all examples, assume that USC is a domestic corporation that uses the calendar year as its taxable year both for Federal income tax purposes and for foreign tax purposes and that it is doing business through a foreign branch operating in Country X, which is a qualified business unit (within the meaning of section 989 and § 1.989(a)-1) (QBU) the functional currency of which is the “u.” Except as otherwise provided, the “u” is not an inflationary currency within the meaning of § 1.986(a)-1(a)(2)(iii). USC is an accrual basis taxpayer.

(A) Example 1: Contested tax—(1) Facts. In Year 1, USC earned 500u of foreign source foreign branch category income through its foreign branch in Country X and accrued and paid 50u of Country X foreign income tax on its earnings. The average exchange rate for Year 1 used to translate the foreign income taxes into dollars was $1x:1u. See § 1.986(a)-1(a)(1). On its Year 1 income tax return, USC claimed a foreign tax credit under section 901 of $50x (50u translated at the average exchange rate for Year 1, that is, $1x:1u). In Year 4, Country X assessed an additional 20u of tax with respect to USC's Year 1 earnings. USC did not pay or accrue the additional 20u of tax and contested the assessment. After exhausting all effective and practical remedies to reduce, over time, its liability for foreign tax, USC settled the contest with Country X in Year 6, paying 10u of additional tax on September 1, Year 6, when the spot rate was $1.10x:1u.

(2) Analysis. USC's payment in Year 6 of the 10u of additional tax accrued with respect to Year 1 is a foreign tax redetermination under paragraph (a) of this section. Under paragraph (b)(1)(i) of this section, the additional tax is taken into account in Year 1, the year to which the redetermined tax relates, irrespective of when the tax is paid. Under § 1.986(a)-1(a)(2)(i), because the tax was paid more than 24 months after the close of the year to which the redetermined tax relates, the 10u of tax is translated into dollars at the spot rate on the date of payment in Year 6 (10u at $1.10x:1u = $11x). If USC timely notifies the IRS, it may claim an increased foreign tax credit for Year 1. USC must also make corresponding adjustments in determining its taxable income and net unrecognized section 987 gain or loss in Year 1. See §§ 1.987-3(c)(2)(v) and 1.987-4(d)(7).

(B) Example 2: Refund of tax improperly claimed as a credit—(1) Facts. USC holds a note issued by FC, an unrelated foreign corporation in Country Y. In Year 1, FC owed USC 500u of interest on the loan. The statutory rate of withholding on interest paid to a nonresident of Country Y is 20%. On December 1, Year 1, when the spot rate was $1x:1u, FC withheld and remitted to Country Y 100u of tax and paid 400u to USC Effective for Year 1, USC elected under § 1.986(a)-1(a)(2)(iv) to translate its taxes denominated in nonfunctional currency into dollars at the spot rate on the date the taxes are paid. Under the United States—Country Y Income Tax Treaty (Treaty), USC was entitled to a reduced 15% rate of withholding that would result in a withholding tax of 75u. However, USC improperly claimed a foreign tax credit under section 901 for 100u = $100x on its Year 1 Federal income tax return. (See § 1.901-2(e)(2)(i) and (e)(5), providing that an amount is not tax paid to the extent it exceeds the taxpayer's liability for tax or is reasonably certain to be refunded.) In Year 4, USC filed a refund claim with Country Y for 25u, the difference between the amount actually withheld at the 20% statutory rate of tax and the amount owed by USC at the 15% Treaty rate. On March 15, Year 6, when the spot rate was $1.10x:1u, USC received a refund from Country Y of 25u. USC converted the 25u into dollars on the same day.

(2) Analysis. Notwithstanding that the 25u of refundable tax did not constitute an amount of tax paid within the meaning of § 1.901-2(e) at the time USC improperly claimed it as a credit, the 25u refund in Year 6 is a foreign tax redetermination under paragraph (a) of this section. Under paragraph (b)(1)(i) of this section, USC must redetermine its U.S. tax liability for Year 1, the taxable year to which the redetermined tax relates. Under § 1.986(a)-1(c), the refund is translated at the exchange rate that was used to translate such amount when originally claimed as a credit. Accordingly, if not previously adjusted by USC or the Internal Revenue Service, USC must file an amended return for Year 1, reducing the amount of foreign tax credit claimed for Year 1 by $25x (25u translated at the spot rate on December 1, Year 1; that is, $1x:1u). Under § 1.986(a)-1(e)(1), USC's basis in the 25u is the same dollar value of the refund as determined under § 1.986(a)-1(c), or $25x. When USC converted the 25u to $27.50x (translated at the spot rate on March 15, Year 6, that is, $1.10x:1u), it realized an exchange gain (within the meaning of § 1.988-1(e)) equal to $2.50x ($27.50x−$25x basis).

(C) Example 3: Change in functional currency—(1) Facts. In Year 1, USC earned 500u of foreign source foreign branch category income through its foreign branch in Country X and accrued 100u of Country X foreign income tax on its earnings. The average exchange rate for Year 1 used to translate the foreign income taxes into dollars was $1x:1u. See § 1.986(a)-1(a)(1). On its Federal income tax return for Year 1, USC claimed a foreign tax credit under section 901 of $100x (100u translated at the average exchange rate for Year 1, that is, $1x:1u). As of Year 2, the foreign branch changed its functional currency from the “u” to the dollar, and pursuant to § 1.985-5(d)(2), USC's foreign branch terminated and USC recognized section 987 gain or loss on December 31, Year 1 (the date of change). The rate of exchange, as determined under § 1.985-5(c), used to calculate the U.S. dollar basis in the foreign branch's property on the date of the change was $1.10x:1u, the spot rate on December 31, Year 1. On June 15, Year 3, when the spot rate was $1.30x:1u, USC's foreign branch received a refund from Country X of 10u. The foreign branch converted the 10u into $13x on the same day.

(2) Analysis. The 10u refund in Year 3 is a foreign tax redetermination under paragraph (a) of this section. Under paragraph (b)(1)(i) of this section, USC must redetermine its U.S. tax liability for Year 1, the taxable year to which the redetermined tax relates. Under § 1.986(a)-1(c), the refund is translated at the exchange rate that was used to translate such amount when originally claimed as a credit. Accordingly, USC must file an amended return, reducing the amount of foreign tax credit claimed for Year 1 by $10x (10u translated at the average exchange rate for Year 1, that is $1x:1u). USC must also make corresponding adjustments in determining its taxable income and net unrecognized section 987 gain or loss in Year 1. See §§ 1.987-3(c)(2)(v) and 1.987-4(d)(8). Because the foreign branch changed its functional currency to the dollar in Year 2, the 10u it receives is a refund of nonfunctional currency tax that is denominated in a currency that was the functional currency of the foreign branch at the time USC originally claimed a credit for that foreign income tax. Under §§ 1.985-5(d)(2) and 1.987-4(d), in Year 1 USC must recognize an additional $1x of section 987 gain (or $1x less of section 987 loss) by reason of the 10u being treated as an asset of the foreign branch at the time of the foreign branch's termination. Under § 1.986(a)-1(e)(2), USC's basis in the 10u refund is $11x, which is determined by using the exchange rate used under § 1.985-5(c) when the foreign branch changed its functional currency in Year 2 ($1.10x:1u). When the foreign branch converted the 10u to $13x (translated at the spot rate on June 15, Year 3, which is $1.30x:1u), it realized an exchange gain (within the meaning of § 1.988-1(e)) equal to $2x ($13x−$11x (10u translated at $1.10x:1u)).

(D) Example 4: Inflationary currency—(1) Facts. In Year 1, USC earned 500u of foreign source foreign branch category income through its foreign branch in Country X and accrued 100u of Country X foreign income tax on its earnings. The average exchange rate for Year 1 used to translate the foreign income taxes into dollars was $1x:1u. See § 1.986(a)-1(a)(1). On its Federal income tax return for Year 1, USC claimed a foreign tax credit under section 901 of $100x (100u translated at the average exchange rate for Year 1, that is, $1x:1u). USC paid the 100u of tax on April 15, Year 3, when the spot rate was $1x:2u. In Year 3, but not in Year 1, the u was an inflationary currency within the meaning of § 1.986(a)-1(a)(2)(iii).

(2) Analysis. Under § 1.986(a)-1(a)(2)(iii), because the u was an inflationary currency in the year the taxes were paid, USC must translate the 100u of Year 1 tax into dollars using the spot rate on the date of payment of the foreign taxes. Under paragraph (a) of this section, because the translated value of USC's Year 1 taxes when paid, that is, $50x (100u translated at the spot rate on April 15, Year 3, that is, $1x:2u), differs from the amount claimed as credits, that is, $100x (100u translated at the average exchange rate for Year 1, that is, $1x:1u), a foreign tax redetermination has occurred. Under paragraph (b)(1)(i) of this section, because the $50x foreign tax redetermination resulting from the currency fluctuation exceeds 2% of the $100x initially accrued, USC must redetermine its U.S. tax liability for Year 1, the taxable year to which the redetermined tax relates. Accordingly, USC must notify the IRS, reducing the amount of foreign tax credit claimed for Year 1 by $50x (the excess of the translated value of the Year 1 taxes when accrued, that is, $100x, over the translated value of the Year 1 taxes when paid, that is, $50x).

(E) Example 5: Two-year rule—(1) Facts. In Year 1, USC earned 500u of foreign source foreign branch category income through its foreign branch in Country X and accrued 100u of Country X foreign income tax on its earnings. The average exchange rate used to translate the foreign income taxes into dollars for Year 1 was $1x:1u. See § 1.986(a)-1(a)(1). On its Federal income tax return for Year 1, USC claimed a foreign tax credit under section 901 of $100x (100u translated at the average exchange rate for Year 1, that is, $1x:1u). USC did not pay the Year 1 foreign income taxes until March 15, Year 6, when the spot rate was $0.8x:1u.

(2) Analysis—(i) Result in Year 3. USC's failure to pay the tax by the end of Year 3 results in a foreign tax redetermination under paragraph (a) of this section. Because the taxes were not paid on or before the date 24 months after the close of the taxable year to which the tax relates, USC must account for the redetermination as if the unpaid 100u of accrued taxes were refunded on the last day of Year 3. Under paragraph (b)(1)(i) of this section, USC must redetermine its U.S. tax liability for Year 1, the taxable year to which the redetermined tax relates. Under § 1.986(a)-1(c), the deemed refund is translated at the exchange rate that was used to translate such amount when originally claimed as a credit. Accordingly, USC must notify the IRS, reducing the amount of foreign tax credit claimed for Year 1 by $100x (100u translated at the average exchange rate for Year 1, that is, $1x:1u). USC must also make corresponding adjustments in determining its taxable income and net unrecognized section 987 gain or loss in Year 1. See §§ 1.987-3(c)(2)(v) and 1.987-4(d)(8).

(ii) Result in Year 6. USC's payment of the Year 1 tax liability of 100u on March 15, Year 6, results in a second foreign tax redetermination under paragraph (a) of this section. Under paragraph (b)(1)(i) of this section, the additional tax is taken into account in Year 1, the year to which the redetermined tax relates, irrespective of when the tax is paid. Under § 1.986(a)-1(a)(2)(i), because the tax was paid more than 24 months after the close of the year to which the tax relates, USC must translate the 100u of tax at the spot rate on the date of payment of the foreign taxes in Year 6. If USC timely notifies the IRS, it may claim an increased foreign tax credit for Year 1. USC must also make corresponding adjustments in determining its taxable income and net unrecognized section 987 gain or loss in Year 1. See §§ 1.987-3(c)(2)(v) and 1.987-4(d)(7).

(F) Example 6: Cash basis taxpayer that pays additional foreign tax—(1) Facts. Individual A, a U.S. citizen resident in Country X, is a cash basis taxpayer who has not made an election under section 905(a) to claim the foreign tax credit in the year the taxes accrue. A uses the calendar year as the taxable year for both U.S. and Country X tax purposes. In Year 2, A pays 100u of foreign income taxes to Country X with respect to Year 1. The exchange rate used to translate the foreign income taxes into dollars was $1x:1u, the spot rate on the date A paid the taxes in Year 2. See section 986(a)(2)(A) and § 1.986(a)-1(b). On A's Year 2 Federal income tax return, A claims a foreign tax credit under section 901 of $100x. In Year 4, Country X assesses an additional 20u of tax with respect to A's Year 1 income. A does not pay the additional 20u of tax and contests the assessment. After exhausting all effective and practical remedies to reduce, over time, A's liability for foreign tax, A settles the contest with Country X in Year 6, paying 10u of additional tax on September 1, Year 6, when the spot rate is $1.10x:1u.

(2) Analysis. Because A is a cash basis taxpayer that claims the foreign tax credit in the year the taxes are paid, A's payment in Year 6 of 10u of additional tax owed with respect to Year 1 is not a foreign tax redetermination requiring a redetermination of U.S. tax liability under paragraph (b)(1) of this section. Rather, A is eligible to claim the additional tax as a credit in Year 6, the year in which the tax is paid. Under § 1.986(a)-1(b), the 10u of tax is translated into dollars at the spot rate on the date of payment in Year 6 (10u at $1.10x:1u = $11x).

(G) Example 7: Cash basis taxpayer that receives a refund of foreign tax—(1) Facts. The facts are the same as paragraph (b)(1)(ii)(F) of this section (the facts in Example 6) except that instead of being assessed additional tax in Year 4, A receives a refund in Year 4 of 10u with respect to A's Year 1 tax that was claimed as a credit in Year 2.

(2) Analysis. Under paragraphs (a) and (b)(1) of this section, A must redetermine its U.S. tax liability for Year 2 and any year to which unused foreign taxes were carried from Year 2. Under § 1.986(a)-1(c), the amount of A's foreign tax credit for Year 2 is reduced by $10x, the 10u refund translated at the exchange rate used to translate the tax when claimed as a credit. Under § 1.986(a)-1(e)(1), A's basis in the 10u is $10x.

(2) and (3) [Reserved]

(c) Foreign income tax imposed on foreign refund. If a redetermination of foreign income tax for a taxable year or years results from a refund to the section 901 taxpayer of foreign income taxes paid to a foreign country or possession of the United States and the foreign country or possession imposed foreign income tax on such refund, then, in accordance with section 905(c)(5), the amount of the refund is considered to be reduced by the amount of any foreign income tax described in section 901 imposed by the foreign country or possession of the United States with respect to such refund. In such case, no other credit under section 901, and no deduction under section 164, is allowed for any taxable year with respect to such tax imposed on such refund.

(d) Applicability dates. This section applies to foreign tax redeterminations occurring in taxable years ending on or after December 16, 2019.

(d) * * *

(3) * * *

(iii) Effect of potential and actual changes in taxes paid or accrued. Except as otherwise provided in this paragraph (d)(3)(iii), the amount of foreign income taxes paid or accrued with respect to a net item of income, determined in the manner provided in this paragraph (d), 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 by the foreign jurisdiction imposing such taxes to a shareholder, 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 (d)(3).

(h) Applicability dates—(1) Paragraph (d)(3) of this section. Paragraph (d)(3) of this section applies to taxable years of a controlled foreign corporation ending on or after December 4, 2018.

(2) Paragraph (g) of this section. Paragraph (g) of this section applies to taxable years of a controlled foreign corporation beginning on or after July 23, 2002.

(a) Overview—(1) Scope of §§ 1.960-1 through 1.960-3. This section and §§ 1.960-2 and 1.960-3 provide rules to associate foreign income taxes of a controlled foreign corporation with the income that a domestic corporation that is a United States shareholder of the controlled foreign corporation takes into account in determining a subpart F inclusion or GILTI inclusion amount of the domestic corporation, as well as to associate foreign income taxes of a controlled foreign corporation with distributions of previously taxed earnings and profits. This section and §§ 1.960-2 and 1.960-3 provide the exclusive rules for determining the foreign income taxes deemed paid by a domestic corporation under section 960. Therefore, only foreign income taxes of a controlled foreign corporation that are associated under these rules with a subpart F inclusion or GILTI inclusion amount of a domestic corporation that is a United States shareholder of the controlled foreign corporation, or with previously taxed earnings and profits, are eligible to be deemed paid. This section provides definitions and computational rules for determining foreign income taxes deemed paid under section 960(a), (b), and (d). Section 1.960-2 provides rules for computing the amount of foreign income taxes deemed paid by a domestic corporation that is a United States shareholder of a controlled foreign corporation under section 960(a) and (d). Section 1.960-3 provides rules for computing the amount of foreign income taxes deemed paid by a domestic corporation that is a United States shareholder of a controlled foreign corporation, or by a controlled foreign corporation, under section 960(b). This section and §§ 1.960-2 and 1.960-3 also apply for purposes of any provision that treats a taxpayer as a domestic corporation that is deemed to pay foreign income taxes or treats a foreign corporation as a controlled foreign corporation for purposes of section 960. See, for example, sections 962(a)(2) and 1293(f).

(2) Scope of this section. Paragraph (b) of this section provides definitions for purposes of this section and §§ 1.960-2 and 1.960-3. Paragraph (c) of this section provides computational rules to coordinate the various calculations under this section and §§ 1.960-2 and 1.960-3. Paragraph (d) of this section provides rules for computing the income in an income group within a section 904 category, and for associating foreign income taxes with an income group. Paragraph (e) of this section provides a rule for the treatment of taxes associated with the residual income group. Paragraph (f) of this section provides an example illustrating the application of this section.

(b) Definitions. The following definitions apply for purposes of this section and §§ 1.960-2 and 1.960-3.

(1) Annual PTEP account. The term annual PTEP account has the meaning set forth in § 1.960-3(c)(1).

(2) Controlled foreign corporation. The term controlled foreign corporation means a foreign corporation described in section 957(a).

(3) Current taxable year. The term current taxable year means the U.S. taxable year of a controlled foreign corporation that is an inclusion year, or during which the controlled foreign corporation receives a section 959(b) distribution or makes a section 959(a) distribution or a section 959(b) distribution.

(4) Current year tax. The term current year tax means a foreign income tax paid or accrued by a controlled foreign corporation in a current taxable year (taking into account any adjustments resulting from a foreign tax redetermination (as defined in § 1.905-3(a)). A foreign income tax accrues when all the events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy. See §§ 1.446-1(c)(1)(ii)(A) and 1.461-4(g)(6)(iii)(B) (economic performance exception for certain foreign taxes). Withholding taxes described in section 901(k)(1)(B) that are withheld from a payment accrue when the payment is made. A foreign income tax calculated on the basis of net income (or a base in lieu of net income) for a foreign taxable year accrues on the last day of the foreign taxable year. Accordingly, current year taxes include foreign withholding taxes that are withheld from payments made to the controlled foreign corporation during the current taxable year, and foreign income taxes that accrue in the controlled foreign corporation's current taxable year in which or with which its foreign taxable year ends. Additional payments of foreign income taxes resulting from a redetermination of foreign tax liability, including contested taxes that accrue when the contest is resolved, “relate back” and are considered to accrue as of the end of the foreign taxable year to which the taxes relate.

(5) Foreign income tax. The term foreign income tax means each separate levy (as defined in § 1.901-2(d)) that is an income, war profits, and excess profits tax as defined in § 1.901-2(a), and tax included in the term income, war profits, and excess profits tax by reason of section 903 and § 1.903-1(a), that is imposed by a foreign country or a possession of the United States, including any such tax that is deemed paid by a controlled foreign corporation under section 960(b)(2). Income, war profits, and excess profits taxes do not include amounts excluded from the definition of those taxes under section 901. See, for example, section 901(f), (g), and (i). Foreign income tax also does not include taxes paid by a controlled foreign corporation for which a credit is disallowed at the level of the controlled foreign corporation. See, for example, sections 245A(e)(3), 901(k)(1), (l), and (m), 909, and 6038(c)(1)(B). Foreign income tax, however, includes tax that may be deemed paid but for which a credit is reduced or disallowed at the level of the United States shareholder. See, for example, sections 901(e), 901(j), 901(k)(2), 908, 965(g), and 6038(c)(1)(A).

(6) Foreign taxable year. The term foreign taxable year has the meaning set forth in section 7701(a)(23), applied by substituting “under foreign law” for the phrase “under subtitle A.”

(7) Foreign taxable income. The term foreign taxable income means the base upon which a current year tax is imposed that comprises the items included in gross income under foreign law and the deductions allowed under foreign law. In the case of a current year tax that is imposed with respect to a taxable period, foreign taxable income includes all of the items taken into account under foreign law with respect to that period. See paragraph (d)(3)(ii)(A) of this section for rules for apportioning current year tax to section 904 categories or income groups on the basis of foreign taxable income.

(8) GILTI inclusion amount. The term GILTI inclusion amount has the meaning set forth in § 1.951A-1(c)(1) (or, in the case of a member of a consolidated group, § 1.1502-51(b)).

(9) Gross tested income. The term gross tested income has the meaning set forth in § 1.951A-2(c)(1).

(10) Inclusion percentage. The term inclusion percentage has the meaning set forth in § 1.960-2(c)(2).

(11) Inclusion year. The term inclusion year means the U.S. taxable year of a controlled foreign corporation which ends during or with the taxable year of a United States shareholder of the controlled foreign corporation in which the United States shareholder includes an amount in income under section 951(a)(1) or 951A(a) with respect to the controlled foreign corporation.

(12) Income group. The term income group means a group of income described in paragraph (d)(2)(ii) of this section.

(13) Partnership CFC. The term partnership CFC means, with respect to a U.S. shareholder partnership, a controlled foreign corporation stock of which is owned (within the meaning of section 958(a)) by the U.S. shareholder partnership.

(14) Passive category. The term passive category means the separate category of income described in section 904(d)(1)(C) and § 1.904-4(b).

(15) Previously taxed earnings and profits. The term previously taxed earnings and profits means earnings and profits described in section 959(c)(1) or (2), including earnings and profits described in section 959(c)(2) by reason of section 951A(f)(1) and § 1.951A-5(b)(1).

(16) PTEP group. The term PTEP group has the meaning set forth in § 1.960-3(c)(2).

(17) PTEP group taxes. The term PTEP group taxes has the meaning set forth in § 1.960-3(d)(1).

(18) Recipient controlled foreign corporation. The term recipient controlled foreign corporation has the meaning set forth in § 1.960-3(b)(2).

(19) Reclassified previously taxed earnings and profits. The term reclassified previously taxed earnings and profits has the meaning set forth in § 1.960-3(c)(4).

(20) Reclassified PTEP group. The term reclassified PTEP group has the meaning set forth in § 1.960-3(c)(4).

(21) Residual income group. The term residual income group has the meaning set forth in paragraph (d)(2)(ii)(D) of this section.

(22) Section 904 category. The term section 904 category means a separate category of income described in § 1.904-5(a)(4)(v).

(23) Section 951A category. The term section 951A category means the separate category of income described in section 904(d)(1)(A) and § 1.904-4(g).

(24) Section 959 distribution. The term section 959 distribution means a section 959(a) distribution or a section 959(b) distribution.

(25) Section 959(a) distribution. The term section 959(a) distribution means a distribution excluded from the gross income of a United States shareholder under section 959(a).

(26) Section 959(b) distribution. The term section 959(b) distribution means a distribution excluded from the gross income of a controlled foreign corporation for purposes of section 951(a) under section 959(b).

(27) Section 959(c)(2) PTEP group. The term section 959(c)(2) PTEP group has the meaning set forth in § 1.960-3(c)(4).

(28) Subpart F inclusion. The term subpart F inclusion has the meaning set forth in § 1.960-2(b)(1).

(29) Subpart F income. The term subpart F income has the meaning set forth in section 952 and § 1.952-1(a).

(30) Subpart F income group. The term subpart F income group has the meaning set forth in paragraph (d)(2)(ii)(B)(1) of this section.

(31) Tested foreign income taxes. The term tested foreign income taxes has the meaning set forth in § 1.960-2(c)(3).

(32) Tested income. The term tested income means the amount with respect to a controlled foreign corporation that is described in section 951A(c)(2)(A) and § 1.951A-2(b)(1).

(33) Tested income group. The term tested income group has the meaning set forth in paragraph (d)(2)(ii)(C) of this section.

(34) United States shareholder. The term United States shareholder has the meaning set forth in section 951(b).

(35) U.S. shareholder partner. The term U.S. shareholder partner means, with respect to a U.S. shareholder partnership and a partnership CFC of the U.S. shareholder partnership, a United States person that is a partner in the U.S. shareholder partnership and that is also a United States shareholder (as defined in section 951(b)) of the partnership CFC.

(36) U.S. shareholder partnership. The term U.S. shareholder partnership means a domestic partnership (within the meaning of section 7701(a)(4)) that is a United States shareholder of one or more controlled foreign corporations.

(37) U.S. taxable year. The term U.S. taxable year has the same meaning as that of the term taxable year set forth in section 7701(a)(23).

(c) Computational rules—(1) In general. For purposes of computing foreign income taxes deemed paid by either a domestic corporation that is a United States shareholder with respect to a controlled foreign corporation under § 1.960-2 or § 1.960-3 or by a controlled foreign corporation under § 1.960-3 for the current taxable year, the following rules apply in the following order, beginning with the lowest-tier controlled foreign corporation in a chain with respect to which the domestic corporation is a United States shareholder:

(i) First, items of gross income of the controlled foreign corporation for the current taxable year other than a section 959(b) distribution are assigned to section 904 categories and included in income groups within those section 904 categories under the rules in paragraph (d)(2) of this section. The receipt of a section 959(b) distribution by the controlled foreign corporation is accounted for under § 1.960-3(c)(3).

(ii) Second, deductions (other than for current year taxes) of the controlled foreign corporation for the current taxable year are allocated and apportioned to reduce gross income in the section 904 categories and the income groups within a section 904 category. See paragraph (d)(3)(i) of this section. Additionally, the functional currency amounts of current year taxes of the controlled foreign corporation for the current taxable year are allocated and apportioned to reduce gross income in the section 904 categories and the income groups within a section 904 category, and to reduce earnings and profits in any PTEP groups that were increased as provided in paragraph (c)(1)(i) of this section. See paragraph (d)(3)(ii) of this section. For purposes of computing foreign taxes deemed paid, current year taxes allocated and apportioned to income groups and PTEP groups in the section 904 categories are translated into U.S. dollars in accordance with section 986(a). See paragraph (c)(3) of this section.

(iii) Third, current year taxes deemed paid under section 960(a) and (d) by the domestic corporation with respect to income of the controlled foreign corporation are computed under the rules of § 1.960-2. In addition, foreign income taxes deemed paid under section 960(b)(2) with respect to the receipt of a section 959(b) distribution by the controlled foreign corporation are computed under the rules of § 1.960-3(b).

(iv) Fourth, any previously taxed earnings and profits of the controlled foreign corporation resulting from subpart F inclusions and GILTI inclusion amounts with respect to the controlled foreign corporation's current taxable year are separated from other earnings and profits of the controlled foreign corporation and added to an annual PTEP account, and a PTEP group within the PTEP account, under the rules of § 1.960-3(c).

(v) Fifth, paragraphs (c)(1)(i) through (iv) of this section are repeated for each next higher-tier controlled foreign corporation in the chain.

(vi) Sixth, with respect to the highest-tier controlled foreign corporation in a chain that is owned directly (or indirectly through a partnership) by the domestic corporation, foreign income taxes that are deemed paid under section 960(b)(1) in connection with the receipt of a section 959(a) distribution by the domestic corporation are computed under the rules of § 1.960-3(b).

(2) Inclusion of current year items. For a current taxable year, the items of income and deductions (including for taxes), and the U.S. dollar amounts of current year taxes, that are included in the computations described in this section and assigned to income groups and PTEP groups for the taxable year are the items that the controlled foreign corporation accrues and takes into account during the current taxable year.

(3) Functional currency and translation. The computations described in this paragraph (c) that relate to income and earnings and profits are made in the functional currency of the controlled foreign corporation (as determined under section 985), and references to taxes deemed paid are to U.S. dollar amounts (translated in accordance with section 986(a)).

(d) Computing income in a section 904 category and an income group within a section 904 category—(1) Scope. This paragraph (d) provides rules for assigning gross income (including gains) of a controlled foreign corporation for the current taxable year to a section 904 category and income group within a section 904 category, and for allocating and apportioning deductions (including losses and current year taxes) and the U.S. dollar amount of current year taxes of the controlled foreign corporation for the current taxable year among the section 904 categories, income groups within a section 904 category, and PTEP groups. For rules regarding maintenance of previously taxed earnings and profits in an annual PTEP account, and assignment of those previously taxed earnings and profits to PTEP groups, see § 1.960-3.

(2) Assignment of gross income to section 904 categories and income groups within a category—(i) Assigning items of gross income to section 904 categories. Items of gross income of the controlled foreign corporation for the current taxable year are first assigned to a section 904 category of the controlled foreign corporation under §§ 1.904-4 and 1.904-5, and under § 1.960-3(c)(1) in the case of gross income relating to a section 959(b) distribution received by the controlled foreign corporation. Income of a controlled foreign corporation, other than gross income relating to a section 959(b) distribution, cannot be assigned to the section 951A category. See § 1.904-4(g).

(ii) Grouping gross income within a section 904 category—(A) In general. Gross income within a section 904 category is assigned to an income group under the rules of this paragraph (d)(2)(ii), or to a PTEP group under the rules of § 1.960-3(c)(3). Gross income other than a section 959(b) distribution is assigned to a subpart F income group, tested income group, or residual income group.

(B) Subpart F income groups—(1) In general. The term subpart F income group means an income group within a section 904 category that consists of income that is described in paragraph (d)(2)(ii)(B)(2) of this section. Gross income that is treated as a single item of income under § 1.954-1(c)(1)(iii) is in a separate subpart F income group under paragraph (d)(2)(ii)(B)(2)(i) of this section. Items of gross income that give rise to income described in paragraph (d)(2)(ii)(B)(2)(ii) of this section are aggregated and treated as gross income in a separate subpart F income group. Similarly, items of gross income that give rise to income described in each one of paragraphs (d)(2)(ii)(B)(2)(iii) through (v) of this section are aggregated and treated as gross income in a separate subpart F income group.

(2) Income in subpart F income groups. The income included in subpart F income groups is:

(i) Items of foreign base company income treated as a single item of income under § 1.954-1(c)(1)(iii);

(ii) Insurance income described in section 952(a)(1);

(iii) Income subject to the international boycott factor described in section 952(a)(3);

(iv) Income from certain bribes, kickbacks and other payments described in section 952(a)(4); and

(v) Income subject to section 901(j) described in section 952(a)(5).

(C) Tested income groups. The term tested income group means an income group that consists of tested income within a section 904 category. Items of gross tested income in each section 904 category are aggregated and treated as gross income in a separate tested income group.

(D) Residual income group. The term residual income group means the income group within a section 904 category that consists of income that is not in a subpart F income group, tested income group, or PTEP group.

(E) Examples. The following examples illustrate the application of this paragraph (d)(2)(ii).

(1) Example 1: Subpart F income groups—(i) Facts. CFC, a controlled foreign corporation, is incorporated in Country X. CFC uses the “u” as its functional currency. At all relevant times, 1u = $1x. CFC earns from sources outside of Country X portfolio dividend income of 100,000u, portfolio interest income of 1,500,000u, and 70,000u of royalty income that is not derived from the active conduct of a trade or business. CFC also earns 50,000u from the sale of personal property to a related person for use outside of Country X that gives rise to foreign base company sales income under section 954(d). Finally, CFC earns 45,000u for performing consulting services outside of Country X for related persons that gives rise to foreign base company services income under section 954(e). None of the income is taxed by Country X. The dividend income is subject to a 15 percent third-country withholding tax after application of the applicable income tax treaty. The interest income and the royalty income are subject to no third-country withholding tax. CFC incurs no expenses.

(ii) Analysis. Under paragraph (d)(2)(i) of this section and § 1.904-4, the interest income, dividend income, and royalty income are passive category income and the sales and consulting income are general category income. Under paragraph (d)(2)(ii)(B) of this section, CFC has a separate subpart F income group within the passive category with respect to the 100,000u of dividend income, which is foreign personal holding company income described in § 1.954-1(c)(1)(iii)(A)(1)(i) (dividends, interest, rents, royalties and annuities) that falls within a single group of income under § 1.904-4(c)(3)(i) for passive income that is subject to withholding tax of fifteen percent or greater. CFC also has a separate subpart F income group within the passive category with respect to the 1,500,000u of interest income and the 70,000u of royalty income (in total 1,570,000u) which together are foreign personal holding company income described in § 1.954-1(c)(1)(iii)(A)(1)(i) (dividends, interest, rents, royalties and annuities) that falls within a single group of income under § 1.904-4(c)(3)(iii) for passive income that is subject to no withholding tax or other foreign tax. With respect to its 50,000u of sales income, CFC has a separate subpart F income group with respect to foreign base company sales income described in § 1.954-1(c)(1)(iii)(A)(2)(i) within the general category. With respect to its 45,000u of services income, CFC has a separate subpart F income group with respect to foreign base company services income described in § 1.954-1(c)(1)(iii)(A)(2)(ii) within the general category.

(2) Example 2: Tested income groups—(i) Facts. CFC, a controlled foreign corporation, is incorporated in Country X. CFC uses the “u” as its functional currency. At all relevant times, 1u = $1x. CFC earns 500u from the sale of goods to unrelated parties. CFC also earns 75u for performing consulting services for unrelated parties. All of its income is gross tested income. CFC incurs no deductions.

(ii) Analysis. Under paragraph (d)(2)(i) of this section and section 904 and § 1.904-4, the sales income and services income are both general category income. Under paragraph (d)(2)(ii)(C) of this section, with respect to the 500u of sales income and 75u services income (in total 575u), CFC has one tested income group within the general category.

(3) Allocation and apportionment of deductions among section 904 categories, income groups within a section 904 category, and certain PTEP groups—(i) In general. Gross income of the controlled foreign corporation in each income group within each section 904 category is reduced by deductions (including losses) of the controlled foreign corporation for the current taxable year under the rules in this paragraph (d)(3)(i). No deductions of the controlled foreign corporation for the current taxable year other than a deduction for current year taxes imposed solely by reason of the receipt of a section 959(b) distribution are allocated or apportioned to reduce earnings and profits in a PTEP group.

(A) First, 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), and section 951A(c)(2)(A)(ii) and § 1.951A-2(c)(3), as appropriate) apply to allocate and apportion to reduce gross income (or create a loss) in each section 904 category and income group within a section 904 category any deductions of the controlled foreign corporation that are definitely related to less than all of the controlled foreign corporation's gross income as a class. See paragraph (d)(3)(ii) of this section for special rules for allocating and apportioning current year taxes to section 904 categories, income groups, and PTEP groups.

(B) Second, related person interest expense is allocated to and apportioned among the subpart F income groups within the passive category under the principles of §§ 1.904-5(c)(2) and 1.954-1(c)(1)(i).

(C) Third, any remaining deductions are allocated and apportioned to reduce gross income (or create a loss) in the section 904 categories and income groups within each section 904 category under the rules referenced in paragraph (d)(3)(i)(A) of this section.

(ii) Allocation and apportionment of a current year tax—(A) In general. A current year tax is allocated and apportioned among the section 904 categories under the rules of § 1.904-6(a)(1) based on the portion of the foreign taxable income (as characterized under Federal income tax principles) that is assigned to a particular section 904 category. An amount of the current year tax that is allocated and apportioned to a section 904 category is then allocated and apportioned among the income groups within the section 904 category under the principles of § 1.904-6(a)(1) based on the portion of the foreign taxable income (as characterized under Federal income tax principles) that is assigned to a particular income group. Therefore, the portion of a current year tax that is attributable to a timing difference described in § 1.904-6(a)(1)(iv) is treated as related to the section 904 category and income group within a section 904 category to which the tax would be assigned if the foreign taxable income on which the tax is imposed was recognized under Federal income tax principles in the year in which the tax is paid or accrued. For purposes of determining foreign income taxes deemed paid under the rules in §§ 1.960-2 and 1.960-3, the U.S. dollar amount of a current year tax is assigned to the section 904 categories, income groups, and PTEP groups (to the extent provided in paragraph (d)(3)(ii)(C) of this section) to which the current year tax is allocated and apportioned.

(B) Foreign taxable income that includes a base difference. For purposes of allocating and apportioning a current year tax among the income groups within a section 904 category under the rules of this paragraph (d)(3)(ii), the portion of the foreign taxable income that constitutes a base difference described in § 1.904-6(a)(1)(iv) is assigned to a residual income group. An amount of current year tax that is imposed on such portion of the foreign taxable income is therefore allocated and apportioned to the residual income group within a section 904 category.

(C) Foreign taxable income that includes previously taxed earnings and profits. For purposes of allocating and apportioning a current year tax under this paragraph (d)(3)(ii), a PTEP group that is increased under § 1.960-3(c)(3) as a result of the receipt of a section 959(b) distribution in the current taxable year of the controlled foreign corporation is treated as an income group within the section 904 category. In such case, under the principles of § 1.904-6(a)(1), the portion of the foreign taxable income that is characterized under Federal income tax principles as a distribution of previously taxed earnings and profits that results in the increase in the PTEP group in the current taxable year is assigned to that PTEP group. If a PTEP group is not treated as an income group under the first sentence of this paragraph (d)(3)(ii)(C), and the principles of § 1.904-6(a)(1) would otherwise apply to assign foreign taxable income to a PTEP group, that foreign taxable income is instead assigned to the income group to which the income that gave rise to the previously taxed earnings and profits would be assigned if the income were recognized by the recipient controlled foreign corporation under Federal income tax principles in the current taxable year. For example, a net basis tax imposed on a controlled foreign corporation's receipt of a section 959(b) distribution by the corporation's country of residence is allocated or apportioned to a PTEP group. Similarly, a withholding tax imposed with respect to a controlled foreign corporation's receipt of a section 959(b) distribution is allocated and apportioned to a PTEP group. In contrast, a withholding tax imposed on a disregarded payment from a disregarded entity to its controlled foreign corporation owner is never treated as related to a PTEP group, even if all of the controlled foreign corporation's earnings are previously taxed earnings and profits, because the payment that gives rise to the foreign taxable income from which the tax was withheld does not constitute a section 959(b) distribution in the current taxable year. That foreign taxable income, however, may be assigned to a subpart F income group or tested income group under paragraph (d)(3)(ii)(A) of this section (applying the principles of § 1.904-6(a)(1)(iv)).

(e) No deemed paid credit for current year taxes related to residual income group. Current year taxes paid or accrued by a controlled foreign corporation that are allocated and apportioned under paragraph (d)(3)(ii) of this section to a residual income group cannot be deemed paid under section 960 for any taxable year.

(f) Example. The following example illustrates the application of this section and § 1.960-3.

(1) Facts—(i) Income of CFC1 and CFC2. CFC1, a controlled foreign corporation, conducts business in Country X. CFC1 uses the “u” as its functional currency. At all relevant times, 1u=$1x. CFC1 owns all of the stock of CFC2, a controlled foreign corporation. CFC1 and CFC2 both use the calendar year as their U.S. and foreign taxable years. In 2019, CFC1 earns 2,000,000u of gross income that is foreign oil and gas extraction income, within the meaning of section 907(c)(1), and 2,000,000u of interest income from unrelated persons, for both U.S. and Country X tax law purposes. Country X exempts interest income from tax. In 2019, CFC1 also receives a section 959(b) distribution from CFC2 of 4,000,000u of previously taxed earnings and profits attributable to an inclusion under section 965(a) for CFC2's 2017 U.S. taxable year. The inclusion under section 965(a) was income in the general category. There are no PTEP group taxes associated with the previously taxed earnings and profits distributed by CFC2 at the level of CFC2. The section 959(b) distribution is treated as a dividend taxable to CFC1 under Country X law. In 2019, CFC2 earns no gross income and receives no distributions.

(ii) Pre-tax deductions of CFC1 and CFC2. For both U.S. and Country X tax purposes, in 2019, CFC1 incurs 1,500,000u of deductible expenses other than current year taxes that are allocable to all gross income. For U.S. tax purposes, under §§ 1.861-8 through 1.861-14T, 750,000u of such deductions are apportioned to each of CFC1's foreign oil and gas extraction income and interest income. Under Country X law, 1,000,000u of deductions are allocated and apportioned to the 4,000,000u treated as a dividend, and 500,000u of deductions are allocated and apportioned to the 2,000,000u of foreign oil and gas extraction income. Under Country X law, no deductions are allocable to the interest income. Country X imposes tax of 900,000u on a base of 4,500,000u (6,000,000u gross income−1,500,000u deductions) consisting of 3,000,000u (4,000,000u−1,000,000u) attributable to CFC1's section 959(b) distribution and 1,500,000u (2,000,000u−500,000u) attributable to CFC1's foreign oil and gas extraction income. In 2019, CFC2 has no expenses (including current year taxes).

(iii) United States shareholders of CFC1. All of the stock of CFC1 is owned (within the meaning of section 958(a)) by corporate United States shareholders that use the calendar year as their U.S. taxable year. In 2019, the United States shareholders of CFC1 include in gross income subpart F inclusions in the passive category totaling $1,250,000x with respect to 1,250,000u of subpart F income of CFC1.

(2) Analysis—(i) CFC2. Under paragraph (c)(1) of this section, the computational rules of paragraph (c)(1) of this section are applied beginning with CFC2. However, CFC2 has no gross income or expenses in 2019 (the “current taxable year”). Accordingly, the computational rules described in paragraphs (c)(1)(i) through (iv) of this section are not relevant with respect to CFC2. Under paragraph (c)(1)(v) of this section, the rules in paragraph (c)(1)(i) through (iv) of this section are then applied to CFC1.

(ii) CFC1—(A) Step 1. Under paragraph (c)(1)(i) of this section, CFC1's items of gross income for the current taxable year are assigned to section 904 categories and included in income groups within those section 904 categories. In addition, CFC1's receipt of a section 959(b) distribution is assigned to a PTEP group. Under paragraph (d)(2)(i) of this section and § 1.904-4, the interest income is passive category income and the foreign oil and gas extraction income is general category income. Under paragraph (d)(2)(ii) of this section, the 2,000,000u of interest income is assigned to a subpart F income group (the “subpart F income group”) within the passive category because it is foreign personal holding company income described in § 1.954-1(c)(1)(iii)(A)(1)(i) that falls within a single group of income under § 1.904-4(c)(3)(iii) for passive income that is subject to no withholding tax or other foreign tax. The 2,000,000u of foreign oil and gas extraction income is assigned to the residual income group within the general category. Under § 1.960-3(c), the 4,000,000u section 959(b) distribution is assigned to the PTEP group described in § 1.960-3(c)(2)(vii) within the 2017 annual PTEP account (the “PTEP group”) within the general category.

(B) Step 2—(1) Allocation and apportionment of deductions for expenses other than taxes. Under paragraph (c)(1)(ii) of this section, CFC1's deductions for the current taxable year are allocated and apportioned among the section 904 categories, income groups within a section 904 category, and any PTEP groups that were increased as provided in paragraph (c)(1)(i) of this section. Under paragraph (d)(3)(i) of this section and §§ 1.861-8 through 1.861-14T, 750,000u of deductions are allocated and apportioned to the residual income group within the general category, and 750,000u of deductions are allocated and apportioned to the subpart F income group within the passive category. Therefore, CFC1 has 1,250,000u (2,000,000u−750,000u) of pre-tax income attributable to the residual income group within the general category and 1,250,000u (2,000,000u−750,000u) of pre-tax income attributable to the subpart F income group within the passive category. For U.S. tax purposes, no deductions other than current year taxes are allocated and apportioned to the 4,000,000u in CFC1's PTEP group.

(2) Allocation and apportionment of current year taxes. Under paragraph (c)(1)(ii) of this section, CFC1's current year taxes are allocated and apportioned among the section 904 categories, income groups within a section 904 category, and any PTEP groups that were increased as provided in paragraph (c)(1)(i) of this section. Under paragraphs (d)(3)(i) and (ii) of this section, for purposes of allocating and apportioning taxes to reduce the income in a section 904 category, an income group, or PTEP group, § 1.904-6(a)(1) and (ii) are applied to determine the amount of foreign taxable income, computed under Country X law but characterized under Federal income tax law, in each section 904 category, income group, and PTEP group that is included in the Country X tax base. For Country X purposes, 1,000,000u of deductions are apportioned to CFC1's PTEP group within the general category, 500,000u of deductions are apportioned to the residual income group within the general category, and no deductions are apportioned to the subpart F income group in the passive category. Therefore, for Country X purposes, CFC1 has 3,000,000u of foreign taxable income attributable to the PTEP group within the general category, 1,500,000u of foreign taxable income attributable to the residual income group within the general category, and no income attributable to the subpart F income group within the passive category. Under paragraph (d)(3)(ii) of this section, 600,000u (3,000,000u/4,500,000u × 900,000u) of the 900,000u current year taxes paid by CFC1 are related to the PTEP group within the general category, and 300,000u (1,500,000u/4,500,000u × 900,000u) are related to the residual income group within the general category. No current year taxes are allocated or apportioned to the subpart F income group within the passive category because the interest expense is exempt from Country X tax. Thus, for U.S. tax purposes, CFC1 has 3,400,000u of previously taxed earnings and profits (4,000,000u−600,000u) in the PTEP group within the general category, 1,250,000u of income in the subpart F income group within the passive category, and 950,000u of income (1,250,000u−300,000u) in the residual income group within the general category. For purposes of determining foreign taxes deemed paid under section 960, CFC1 has $600,000x of foreign income taxes in the PTEP group within the general category and $300,000x of current year taxes in the residual income group within the general category. Under paragraph (e) of this section, the United States shareholders of CFC1 cannot claim a credit with respect to the $300,000x of taxes on CFC1's income in the residual income group.

(C) Step 3. Under paragraph (c)(1)(iii) of this section, the United States shareholders of CFC1 compute current year taxes deemed paid under section 960(a) and (d) and the rules of § 1.960-2. None of the Country X tax is allocated to CFC1's subpart F income group. Therefore, there are no current year taxes deemed paid by CFC1's United States shareholders with respect to their passive category subpart F inclusions. See § 1.960-2(b)(5) and (c)(7) for examples of the application of section 960(a) and (d) and the rules in § 1.960-2. Additionally, under paragraph (c)(1)(iii) of this section, foreign income taxes deemed paid under section 960(b)(2) by CFC1 are determined with respect to the section 959(b) distribution from CFC2 under the rules of § 1.960-3. There are no PTEP group taxes associated with the previously taxed earnings and profits distributed by CFC2 in the hands of CFC2. Therefore, there are no foreign income taxes deemed paid by CFC1 under section 960(b)(2) with respect to the section 959(b) distribution from CFC2. See § 1.960-3(e) for examples of the application of section 960(b) and the rules in § 1.960-3.

(D) Step 4. Under paragraph (c)(1)(iv) of this section, previously taxed earnings and profits resulting from subpart F inclusions and GILTI inclusion amounts with respect to CFC1's current taxable year are separated from CFC1's other earnings and profits and added to an annual PTEP account and PTEP group within the PTEP account, under the rules of § 1.960-3(c). The United States shareholders of CFC1 include in gross income subpart F inclusions totaling $1,250,000x with respect to 1,250,000u of subpart F income of CFC1, and the subpart F inclusions are passive category income. Therefore, under § 1.960-3(c)(2), 1,250,000u of previously taxed earnings and profits resulting from the subpart F inclusions is added to CFC1's section 951(a)(1)(A) PTEP within the 2019 annual PTEP account within the passive category.

(E) Step 5. Paragraph (c)(1)(v) of this section does not apply because CFC1 is the highest-tier controlled foreign corporation in the chain.

(F) Step 6. Paragraph (c)(1)(vi) of this section does not apply because CFC1 did not make a section 959(a) distribution.

(a) Scope. Paragraph (b) of this section provides rules for computing the amount of foreign income taxes deemed paid by a domestic corporation that is a United States shareholder of a controlled foreign corporation under section 960(a). Paragraph (c) of this section provides rules for computing the amount of foreign income taxes deemed paid by a domestic corporation that is a United States shareholder of a controlled foreign corporation under section 960(d).

(b) Foreign income taxes deemed paid under section 960(a)—(1) In general. If a domestic corporation that is a United States shareholder of a controlled foreign corporation includes in gross income under section 951(a)(1)(A) its pro rata share of the subpart F income of the controlled foreign corporation (a subpart F inclusion), the domestic corporation is deemed to have paid the amount of the controlled foreign corporation's foreign income taxes that are properly attributable to the items of income in a subpart F income group of the controlled foreign corporation that give rise to the subpart F inclusion of the domestic corporation that is attributable to the subpart F income group. For each section 904 category, the domestic corporation is deemed to have paid foreign income taxes equal to the sum of the controlled foreign corporation's foreign income taxes that are properly attributable to the items of income in the subpart F income groups to which the subpart F inclusion is attributable. See § 1.904-6(b)(1) for rules on assigning the foreign income tax to a section 904 category. No foreign income taxes are deemed paid under section 960(a) with respect to an inclusion under section 951(a)(1)(B).

(2) Properly attributable. The amount of the controlled foreign corporation's foreign income taxes that are properly attributable to the items of income in the subpart F income group of the controlled foreign corporation to which a subpart F inclusion is attributable equals the domestic corporation's proportionate share of the current year taxes of the controlled foreign corporation that are allocated and apportioned under § 1.960-1(d)(3)(ii) to the subpart F income group. No other foreign income taxes are considered properly attributable to an item of income of the controlled foreign corporation.

(3) Proportionate share—(i) In general. A domestic corporation's proportionate share of the current year taxes of a controlled foreign corporation that are allocated and apportioned under § 1.960-1(d)(3)(ii) to a subpart F income group within a section 904 category of the controlled foreign corporation is equal to the total U.S. dollar amount of current year taxes that are allocated and apportioned under § 1.960-1(d)(3)(ii) to the subpart F income group multiplied by a fraction (not to exceed one), the numerator of which is the portion of the domestic corporation's subpart F inclusion that is attributable to the subpart F income group and the denominator of which is the total net income in the subpart F income group, both determined in the functional currency of the controlled foreign corporation. If the numerator or denominator of the fraction is zero or less than zero, then the proportionate share of the current year taxes that are allocated and apportioned under § 1.960-1(d)(3)(ii) to the subpart F income group is zero.

(ii) Effect of qualified deficits. Neither an accumulated deficit nor any prior year deficit in the earnings and profits of a controlled foreign corporation reduces its net income in a subpart F income group. Accordingly, any such deficit does not affect the denominator of the fraction described in paragraph (b)(3)(i) of this section. However, the first sentence of this paragraph (b)(3)(ii) does not affect the application of section 952(c)(1)(B) for purposes of determining the domestic corporation's subpart F inclusion. Any reduction to the domestic corporation's subpart F inclusion under section 952(c)(1)(B) is reflected in the numerator of the fraction described in paragraph (b)(3)(i) of this section.

(iii) Effect of current year E&P limitation or chain deficit. To the extent that an amount of income in a subpart F income group is excluded from the subpart F income of the controlled foreign corporation under section 952(c)(1)(A) or (C), the net income in the subpart F income group that is the denominator of the fraction described in paragraph (b)(3)(i) of this section is reduced (but not below zero) by the amount excluded. The domestic corporation's subpart F inclusion that is the numerator of the fraction described in paragraph (b)(3)(i) of this section is based on the controlled foreign corporation's subpart F income computed with the application of section 952(c)(1)(A) and (C).

(4) Domestic partnerships. For purposes of applying this paragraph (b), in the case of a domestic partnership that is a U.S. shareholder partnership with respect to a partnership CFC, the distributive share of a U.S. shareholder partner of the U.S. shareholder partnership's subpart F inclusion with respect to the partnership CFC is treated as a subpart F inclusion of the U.S. shareholder partner with respect to the partnership CFC.

(5) Example. The following example illustrates the application of this paragraph (b).

(i) Facts. USP, a domestic corporation, owns 80% of the stock of CFC, a controlled foreign corporation. The remaining portion of the stock of CFC is owned by an unrelated person. USP and CFC both use the calendar year as their U.S. taxable year, and CFC also uses the calendar year as its foreign taxable year. CFC uses the “u” as its functional currency. At all relevant times, 1u=$1x. For its U.S. taxable year ending December 31, 2018, after the application of the rules in § 1.960-1(d) the income of CFC after foreign taxes is assigned to the following income groups: 1,000,000u of dividend income in a subpart F income group within the passive category (“subpart F income group 1”); 2,400,000u of gain from commodities transactions in a subpart F income group within the passive category (“subpart F income group 2”); and 1,800,000u of foreign base company services income in a subpart F income group within the general category (“subpart F income group 3”). CFC has current year taxes, translated into U.S. dollars, of $740,000x that are allocated and apportioned as follows: $50,000x to subpart F income group 1; $240,000x to subpart F income group 2; and $450,000x to subpart F income group 3. USP has a subpart F inclusion with respect to CFC of 4,160,000u = $4,160,000x, of which 800,000u is attributable to subpart F income group 1, 1,920,000u to subpart F income group 2, and 1,440,000u to subpart F income group 3.

(ii) Analysis—(A) Passive category. Under paragraphs (b)(2) and (3) of this section, the amount of CFC's current year taxes that are properly attributable to items of income in subpart F income group 1 to which a subpart F inclusion is attributable equals USP's proportionate share of the current year taxes that are allocated and apportioned under § 1.960-1(d)(3)(ii) to subpart F income group 1, which is $40,000x ($50,000x × 800,000u/1,000,000u). Under paragraphs (b)(2) and (3) of this section, the amount of CFC's current year taxes that are properly attributable to items of income in subpart F income group 2 to which a subpart F inclusion is attributable equals USP's proportionate share of the current year taxes that are allocated and apportioned under § 1.960-1(d)(3)(ii) to subpart F income group 2, which is $192,000x ($240,000x × 1,920,000u/2,400,000u). Accordingly, under paragraph (b)(1) of this section, USP is deemed to have paid $232,000x ($40,000x + $192,000x) of passive category foreign income taxes of CFC with respect to its $2,720,000x subpart F inclusion in the passive category.

(B) General category. Under paragraphs (b)(2) and (3) of this section, the amount of CFC's current year taxes that are properly attributable items of income in subpart F income group 3 to which a subpart F inclusion is attributable equals USP's proportionate share of the foreign income taxes that are allocated and apportioned under § 1.960-1(d)(3)(ii) to subpart F income group 3, which is $360,000x ($450,000x × 1,440,000u/1,800,000u). CFC has no other subpart F income groups within the general category. Accordingly, under paragraph (b)(1) of this section, USP is deemed to have paid $360,000x of general category foreign income taxes of CFC with respect to its $1,440,000x subpart F inclusion in the general category.

(c) Foreign income taxes deemed paid under section 960(d)—(1) In general. If a domestic corporation that is a United States shareholder of one or more controlled foreign corporations includes an amount in gross income under section 951A(a) and § 1.951A-1(b), the domestic corporation is deemed to have paid an amount of foreign income taxes equal to 80 percent of the product of its inclusion percentage multiplied by the sum of all tested foreign income taxes in the tested income group within each section 904 category of the controlled foreign corporation or corporations.

(2) Inclusion percentage. The term inclusion percentage means, with respect to a domestic corporation that is a United States shareholder of one or more controlled foreign corporations, the domestic corporation's GILTI inclusion amount divided by the aggregate amount described in section 951A(c)(1)(A) and § 1.951A-1(c)(2)(i) with respect to the United States shareholder.

(3) Tested foreign income taxes. The term tested foreign income taxes means, with respect to a domestic corporation that is a United States shareholder of a controlled foreign corporation, the amount of the controlled foreign corporation's foreign income taxes that are properly attributable to tested income taken into account by the domestic corporation under section 951A and § 1.951A-1.

(4) Properly attributable. The amount of the controlled foreign corporation's foreign income taxes that are properly attributable to tested income taken into account by the domestic corporation under section 951A(a) and § 1.951A-1(b) equals the domestic corporation's proportionate share of the current year taxes of the controlled foreign corporation that are allocated and apportioned under § 1.960-1(d)(3)(ii) to the tested income group within each section 904 category of the controlled foreign corporation. No other foreign income taxes are considered properly attributable to tested income.

(5) Proportionate share. A domestic corporation's proportionate share of current year taxes of a controlled foreign corporation that are allocated and apportioned under § 1.960-1(d)(3)(ii) to a tested income group within a section 904 category of the controlled foreign corporation is the U.S. dollar amount of current year taxes that are allocated and apportioned under § 1.960-1(d)(3)(ii) to a tested income group within a section 904 category of the controlled foreign corporation multiplied by a fraction (not to exceed one), the numerator of which is the portion of the tested income of the controlled foreign corporation in the tested income group within the section 904 category that is included in computing the domestic corporation's aggregate amount described in section 951A(c)(1)(A) and § 1.951A-1(c)(2)(i), and the denominator of which is the income in the tested income group within the section 904 category, both determined in the functional currency of the controlled foreign corporation. If the numerator or denominator of the fraction is zero or less than zero, the domestic corporation's proportionate share of the current year taxes allocated and apportioned under § 1.960-1(d)(3)(ii) to the tested income group is zero.

(6) Domestic partnerships. See § 1.951A-1(e) for rules regarding the determination of the GILTI inclusion amount of a U.S. shareholder partner.

(7) Examples. The following examples illustrate the application of this paragraph (c).

(i) Example 1: Directly owned controlled foreign corporation—(A) Facts. USP, a domestic corporation, owns 100% of the stock of a number of controlled foreign corporations, including CFC1. USP and CFC1 each use the calendar year as their U.S. taxable year. CFC1 uses the “u” as its functional currency. At all relevant times, 1u=$1x. For its U.S. taxable year ending December 31, 2018, after application of the rules in § 1.960-1(d), the income of CFC1 is assigned to a single income group: 2,000u of income from the sale of goods in a tested income group within the general category (“tested income group”). CFC1 has current year taxes, translated into U.S. dollars, of $400x that are all allocated and apportioned to the tested income group. For its U.S. taxable year ending December 31, 2018, USP has a GILTI inclusion amount determined by reference to all of its controlled foreign corporations, including CFC1, of $6,000x, and an aggregate amount described in section 951A(c)(1)(A) and § 1.951A-1(c)(2)(i) of $10,000x. All of the income in CFC1's tested income group is included in computing USP's aggregate amount described in section 951A(c)(1)(A) and § 1.951A-1(c)(2)(i).

(B) Analysis. Under paragraph (c)(5) of this section, USP's proportionate share of the current year taxes that are allocated and apportioned under § 1.960-1(d)(3)(ii) to CFC1's tested income group is $400x ($400x × 2,000u/2,000u). Therefore, under paragraph (c)(4) of this section, the amount of current year taxes properly attributable to tested income taken into account by USP under section 951A(a) and § 1.951A-1(b) is $400x. Under paragraph (c)(3) of this section, USP's tested foreign income taxes with respect to CFC1 are $400x. Under paragraph (c)(2) of this section, USP's inclusion percentage is 60% ($6,000x/$10,000x). Accordingly, under paragraph (c)(1) of this section, USP is deemed to have paid $192 of the foreign income taxes of CFC1 (80% × 60% × $400x).

(ii) Example 2: Controlled foreign corporation owned through domestic partnership—(A) Facts—(1) US1, a domestic corporation, owns 95% of PRS, a domestic partnership. The remaining 5% of PRS is owned by US2, a domestic corporation that is unrelated to US1. PRS owns all of the stock of CFC1, a controlled foreign corporation. In addition, US1 owns all of the stock of CFC2, a controlled foreign corporation. US1, US2, PRS, CFC1, and CFC2 all use the calendar year as their taxable year. CFC1 and CFC2 both use the “u” as their functional currency. At all relevant times, 1u=$1x. For its U.S. taxable year ending December 31, 2018, after application of the rules in § 1.960-1(d), the income of CFC1 is assigned to a single income group: 300u of income from the sale of goods in a tested income group within the general category (“CFC1's tested income group”). CFC1 has current year taxes, translated into U.S. dollars, of $100x that are all allocated and apportioned to CFC1's tested income group. The income of CFC2 is also assigned to a single income group: 200u of income from the sale of goods in a tested income group within the general category (“CFC2's tested income group”). CFC2 has current year taxes, translated into U.S. dollars, of $20x that are allocated and apportioned to CFC2's tested income group.

(2) Under § 1.951A-1(e)(1), for purposes of determining the GILTI inclusion amount of US1 and US2, PRS is not treated as owning (within the meaning of section 958(a)) the stock of CFC1; instead, PRS is treated in the same manner as a foreign partnership for purposes of determining the stock of CFC1 owned by US1 and US2 under section 958(a)(2). Therefore, only US1 is a United States shareholder of CFC1. Taking into account both CFC1 and CFC2, US1 has a GILTI inclusion amount in the general category of $485x, and an aggregate amount described in section 951A(c)(1)(A) and § 1.951A-1(c)(2)(i) within the general category of $485x. 285u (95% × 300u) of the income in CFC1's tested income group and 200u of the income in CFC2's tested income group is included in computing US1's aggregate amount described in section 951A(c)(1)(A) and § 1.951A-1(c)(2)(i) within the general category. Because US2 is not a U.S. shareholder with respect to CFC1, US2 does not take into account CFC1's tested income in determining its GILTI inclusion amount.

(B) Analysis—(1) US1—(i) CFC1. Under paragraphs (c)(5) and (6) of this section, US1's proportionate share of the current year taxes that are allocated and apportioned under § 1.960-1(d)(3)(ii) to CFC1's tested income group is $95x ($100x × 285u/300u). Therefore, under paragraph (c)(4) of this section, the amount of the current year taxes properly attributable to tested income taken into account by US1 under section 951A(a) and § 1.951A-1(b) is $95x. Under paragraph (c)(3) of this section, US1's tested foreign income taxes with respect to CFC1 are $95x. Under paragraph (c)(2) of this section, US1's inclusion percentage is 100% ($485x/$485x). Accordingly, under paragraph (c)(1) of this section, US1 is deemed to have paid $76x of the foreign income taxes of CFC1 (80% × 100% × $95x).

(ii) CFC2. Under paragraph (c)(5) of this section, US1's proportionate share of the foreign income taxes that are allocated and apportioned under § 1.960-1(d)(3)(ii) to CFC2's tested income group is $20x ($20x × 200u/200u). Therefore, under paragraph (c)(4) of this section, the amount of foreign income taxes properly attributable to tested income taken into account by US1 under section 951A(a) and § 1.951A-1(b) is $20x. Under paragraph (c)(3) of this section, US1's tested foreign income taxes with respect to CFC2 are $20. Under paragraph (c)(2) of this section, US1's inclusion percentage is 100% ($485x/$485x). Accordingly, under paragraph (c)(1) of this section, US1 is deemed to have paid $16 of the foreign income taxes of CFC2 (80% × 100% × $20x).

(2) US2. US2 is not a United States shareholder of CFC1 or CFC2. Accordingly, under paragraph (c)(1) of this section, US2 is not deemed to have paid any of the foreign income taxes of CFC1 or CFC2.

(a) Scope. Paragraph (b) of this section provides rules for computing the amount of foreign income taxes deemed paid by a domestic corporation that is a United States shareholder of a controlled foreign corporation, or by a controlled foreign corporation, under section 960(b). Paragraph (c) of this section provides rules for the establishment and maintenance of PTEP groups within an annual PTEP account. Paragraph (d) of this section defines the term PTEP group taxes. Paragraph (e) of this section provides examples illustrating the application of this section.

(b) Foreign income taxes deemed paid under section 960(b)—(1) Foreign income taxes deemed paid by a domestic corporation with respect to a section 959(a) distribution. If a controlled foreign corporation makes a distribution to a domestic corporation that is a United States shareholder with respect to the controlled foreign corporation and that distribution is, in whole or in part, a section 959(a) distribution with respect to a PTEP group within a section 904 category, the domestic corporation is deemed to have paid the amount of the foreign corporation's foreign income taxes that are properly attributable to the section 959(a) distribution with respect to the PTEP group and that have not been deemed to have been paid by a domestic corporation under section 960 for the current taxable year or any prior taxable year. See § 1.965-5(c)(1)(iii) for rules disallowing credits in relation to a distribution of certain previously taxed earnings and profits resulting from the application of section 965. For each section 904 category, the domestic corporation is deemed to have paid foreign income taxes equal to the sum of the controlled foreign corporation's foreign income taxes that are properly attributable to section 959(a) distributions with respect to all PTEP groups within the section 904 category. See § 1.904-6(b)(2) for rules on assigning the foreign income tax to a section 904 category.

(2) Foreign income taxes deemed paid by a controlled foreign corporation with respect to a section 959(b) distribution. If a controlled foreign corporation (distributing controlled foreign corporation) makes a distribution to another controlled foreign corporation (recipient controlled foreign corporation) and the distribution is, in whole or in part, a section 959(b) distribution from a PTEP group within a section 904 category, the recipient controlled foreign corporation is deemed to have paid the amount of the distributing controlled foreign corporation's foreign income taxes that are properly attributable to the section 959(b) distribution from the PTEP group and that have not been deemed to have been paid by a domestic corporation under section 960 for the current taxable year or any prior taxable year. See § 1.904-6(b)(3) for rules on assigning the foreign income tax to a section 904 category.

(3) Properly attributable. The amount of foreign income taxes that are properly attributable to a section 959 distribution from a PTEP group within a section 904 category equals the domestic corporation's or recipient controlled foreign corporation's proportionate share of the PTEP group taxes with respect to the PTEP group within the section 904 category. No other foreign income taxes are considered properly attributable to a section 959 distribution.

(4) Proportionate share. A domestic corporation's or recipient controlled foreign corporation's proportionate share of the PTEP group taxes with respect to a PTEP group within a section 904 category is equal to the total amount of the PTEP group taxes with respect to the PTEP group multiplied by a fraction (not to exceed one), the numerator of which is the amount of the section 959 distribution from the PTEP group, and the denominator of which is the total amount of previously taxed earnings and profits in the PTEP group, both determined in the functional currency of the controlled foreign corporation. If the numerator or denominator of the fraction is zero or less than zero, then the proportionate share of the PTEP group taxes with respect to the PTEP group is zero.

(5) Domestic partnerships. For purposes of applying this paragraph (b), in the case of a domestic partnership that is a U.S. shareholder partnership with respect to a partnership CFC, the distributive share of a U.S. shareholder partner of a U.S. shareholder partnership's section 959(a) distribution from the partnership CFC is treated as a section 959(a) distribution received by the U.S. shareholder partner from the partnership CFC.

(c) Accounting for previously taxed earnings and profits—(1) Establishment of annual PTEP account. A separate, annual account (annual PTEP account) must be established for the previously taxed earnings and profits of the controlled foreign corporation to which inclusions under section 951(a) and GILTI inclusion amounts of United States shareholders of the CFC are attributable. Each account must correspond to the inclusion year of the previously taxed earnings and profits and to the section 904 category to which the inclusions under section 951(a) or GILTI inclusion amounts were assigned at the level of the United States shareholders. Accordingly, a controlled foreign corporation may have an annual PTEP account in the section 951A category or a treaty category (as defined in § 1.861-13(b)(6)), even though income of the controlled foreign corporation that gave rise to the previously taxed earnings and profits cannot initially be assigned to the section 951A category or a treaty category.

(2) PTEP groups within an annual PTEP account. The amount in an annual PTEP account is further assigned to one or more of the following groups of previously taxed earnings and profits (each, a PTEP group) within the account:

(i) Earnings and profits described in section 959(c)(1)(A) that were initially described in section 959(c)(2) by reason of section 965(a) (“reclassified section 965(a) PTEP”);

(ii) Earnings and profits described in section 959(c)(1)(A) that were initially described in section 959(c)(2) by reason of section 965(b)(4)(A) (“reclassified section 965(b) PTEP”);

(iii) Earnings and profits described in paragraphs (c)(2)(iii)(A) through (C) of this section (which are aggregated into a single PTEP group, “general section 959(c)(1) PTEP”):

(A) Earnings and profits described in section 959(c)(1)(A) by reason of section 951(a)(1)(B) and not by reason of section 959(a)(2);

(B) Earnings and profits described in section 959(c)(1)(A) that were initially described in section 959(c)(2) by reason of section 951(a)(1)(A) (other than earnings that were initially described in paragraphs (c)(2)(vi) through (ix) of this section); and

(C) Earnings and profits described in section 959(c)(1)(B), including by reason of section 959(a)(3) (before its repeal);

(iv) Earnings and profits described in section 959(c)(1)(A) that were initially described in section 959(c)(2) by reason of section 951A(f)(2) (“reclassified section 951A PTEP”);

(v) Earnings and profits described in paragraphs (c)(2)(v)(A) through (C) of this section (which are aggregated into a single PTEP group, “reclassified section 245A(d) PTEP”):

(A) Earnings and profits described in section 959(c)(1)(A) that were initially described in section 959(c)(2) by reason of section 245A(e)(2);

(B) Earnings and profits described in section 959(c)(1)(A) that were initially described in section 959(c)(2) by reason of section 959(e); and

(C) Earnings and profits described in section 959(c)(1)(A) that were initially described in section 959(c)(2) by reason of section 964(e)(4);

(vi) Earnings and profits described in section 959(c)(2) by reason of section 965(a) (“section 965(a) PTEP”);

(vii) Earnings and profits described in section 959(c)(2) by reason of section 965(b)(4)(A) (“section 965(b) PTEP”);

(viii) Earnings and profits described in section 959(c)(2) by reason of section 951A(f)(2) (“section 951A PTEP”);

(ix) Earnings and profits described in paragraphs (c)(2)(ix)(A) through (C) of this section (which are aggregated into a single PTEP group, “section 245A(d) PTEP”):

(A) Earnings and profits described in section 959(c)(2) by reason of section 245A(e)(2);

(B) Earnings and profits described in section 959(c)(2) by reason of section 959(e); and

(C) Earnings and profits described in section 959(c)(2) by reason of section 964(e)(4); and

(x) Earnings and profits described in section 959(c)(2) by reason of section 951(a)(1)(A) not otherwise described in paragraph (c)(2)(vi) through (ix) of this section (“section 951(a)(1)(A) PTEP”).

(3) Accounting for distributions of previously taxed earnings and profits. With respect to a recipient controlled foreign corporation that receives a section 959(b) distribution, such distribution amount is added to the annual PTEP account, and PTEP group within the annual PTEP account, that corresponds to the inclusion year and section 904 category of the annual PTEP account, and PTEP group within the annual PTEP account, from which the distributing controlled foreign corporation is treated as making the distribution under section 959. Similarly, with respect to a controlled foreign corporation that makes a section 959 distribution, such distribution amount reduces the annual PTEP account, and PTEP group within the annual PTEP account, that corresponds to the inclusion year and section 904 category of the annual PTEP account, and PTEP group within the annual PTEP account, from which the controlled foreign corporation is treated as making the distribution under section 959. Earnings and profits in a PTEP group are reduced by the amount of current year taxes that are allocated and apportioned to the PTEP group under § 1.960-1(d)(3)(ii), and the U.S. dollar amount of the taxes are added to an account of PTEP group taxes under the rules in paragraph (d)(1) of this section.

(4) Accounting for reclassifications of earnings and profits described in section 959(c)(2) to earnings and profits described in section 959(c)(1). If an amount of previously taxed earnings and profits that is in a PTEP group described in paragraphs (c)(2)(vi) through (x) of this section (each, a section 959(c)(2) PTEP group) is reclassified as previously taxed earnings and profits described in section 959(c)(1) (reclassified previously taxed earnings and profits), the section 959(c)(2) PTEP group is reduced by the functional currency amount of the reclassified previously taxed earnings and profits. This amount is added to the corresponding PTEP group described in paragraph (c)(2)(i), (ii), (iii) (by reason of paragraph (c)(2)(iii)(B) of this section), (iv) or (v) of this section (each, a reclassified PTEP group) in the same section 904 category and same annual PTEP account as the reduced section 959(c)(2) PTEP group.

(d) PTEP group taxes—(1) In general. The term PTEP group taxes means the U.S. dollar amount of foreign income taxes (translated in accordance with section 986(a)) that are paid, accrued, or deemed paid with respect to an amount in each PTEP group within an annual PTEP account. The foreign income taxes that are paid, accrued, or deemed paid with respect to a PTEP group within an annual PTEP account of a controlled foreign corporation are—

(i) The sum of—

(A) The current year taxes paid or accrued by the controlled foreign corporation that are allocated and apportioned to the PTEP group under § 1.960-1(d)(3)(ii);

(B) Foreign income taxes that are deemed paid under section 960(b)(2) and paragraph (b)(2) of this section by the controlled foreign corporation with respect to a section 959(b) distribution received by the controlled foreign corporation, the amount of which is added to the PTEP group under paragraph (c)(3) of this section; and

(C) In the case of a reclassified PTEP group of the controlled foreign corporation, reclassified PTEP group taxes that are attributable to the section 959(c)(2) PTEP group that corresponds to the reclassified PTEP group.

(ii) Reduced by—

(A) Foreign income taxes that were deemed paid under section 960(b)(2) and paragraph (b)(2) of this section by another controlled foreign corporation that received a section 959(b) distribution from the controlled foreign corporation, the amount of which is subtracted from the controlled foreign corporation's PTEP group under paragraph (c)(3) of this section;

(B) Foreign income taxes that were deemed paid under section 960(b)(1) and paragraph (b)(1) of this section by a domestic corporation that is a United States shareholder of the controlled foreign corporation that received a section 959(a) distribution from the controlled foreign corporation, the amount of which is subtracted from the controlled foreign corporation's PTEP group under paragraph (c)(3) of this section; and

(C) In the case of a section 959(c)(2) PTEP group of the controlled foreign corporation, reclassified PTEP group taxes.

(2) Reclassified PTEP group taxes. Reclassified PTEP group taxes are foreign income taxes that are initially included in PTEP group taxes with respect to a section 959(c)(2) PTEP group under paragraph (d)(1)(i)(A) or (B) of this section multiplied by a fraction, the numerator of which is the portion of the previously taxed earnings and profits in the section 959(c)(2) PTEP group that become reclassified previously taxed earnings and profits, and the denominator of which is the total previously taxed earnings and profits in the section 959(c)(2) PTEP group.

(3) Foreign income taxes deemed paid with respect to PTEP groups established for pre-2018 inclusion years. In the case of foreign income taxes paid or accrued in a taxable year of the controlled foreign corporation that began before January 1, 2018, with respect to an annual PTEP account, and a PTEP group within such account, that was established for an inclusion year that begins before January 1, 2018, the foreign income taxes are treated as PTEP group taxes of a controlled foreign corporation for purposes of this section only if those foreign income taxes were—

(i) Not included in a controlled foreign corporation's post-1986 foreign income taxes (as defined in section 902(c)(2) as in effect on December 21, 2017) used to compute foreign taxes deemed paid under section 902 (as in effect on December 21, 2017) in any taxable year that began before January 1, 2018; and

(ii) Not treated as deemed paid under section 960(a)(3) (as in effect on December 21, 2017) by a domestic corporation that was a United States shareholder of the controlled foreign corporation.

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

(1) Example 1: Establishment of PTEP groups and PTEP accounts—(i) Facts. USP, a domestic corporation, owns all of the stock of CFC1, a controlled foreign corporation. CFC1 owns all of the stock of CFC2, a controlled foreign corporation. USP, CFC1, and CFC2 each use the calendar year as their U.S. taxable year. CFC1 and CFC2 use the “u” as their functional currency. At all relevant times, 1u = $1x. With respect to CFC2, USP includes in gross income a subpart F inclusion of 1,000,000u = $1,000,000x for the taxable year ending December 31, 2018. The inclusion is with respect to passive category income. In its U.S. taxable year ending December 31, 2019, CFC2 distributes 1,000,000u to CFC1. CFC2 has no earnings and profits except for the 1,000,000u of previously taxed earnings and profits resulting from USP's 2018 taxable year subpart F inclusion. CFC2's country of organization, Country X, imposes a withholding tax on CFC1 of 300,000u on CFC2's distribution to CFC1. Under § 1.960-1(d)(3)(ii), CFC1's 300,000u of current year taxes are allocated and apportioned to the PTEP group within the annual PTEP account within the section 904 category to which the 1,000,000u of previously taxed earnings and profits are assigned.

(ii) Analysis—(A) Under paragraph (c)(1) of this section, a separate annual PTEP account in the passive category for the 2018 taxable year is established for CFC2 as a result of USP's subpart F inclusion. Under paragraph (c)(2) of this section, this account contains one PTEP group, section 951(a)(1)(A) PTEP.

(B) Under paragraph (c)(3) of this section, in the 2019 taxable year, the 1,000,000u related to the section 959(b) distribution from CFC2 is added to CFC1's annual PTEP account for the 2018 taxable year in the passive category and to the section 951(a)(1)(A) PTEP within such account. Similarly, CFC2's 2018 taxable year annual PTEP account within the passive category, and the section 951(a)(1)(A) PTEP within such account, is reduced by the amount of the 1,000,000u section 959(b) distribution to CFC1. Additionally, CFC1's annual PTEP account for the 2018 taxable year in the passive category, and the section 951(a)(1)(A) PTEP within such account, is reduced by the 300,000u of withholding tax imposed on CFC1 by Country X. Therefore, CFC1's annual PTEP account for the 2018 taxable year within the passive category and the section 951(a)(1)(A) PTEP within such account is 700,000u.

(C) Under paragraph (d)(1) of this section, the 300,000u of withholding tax is translated into U.S. dollars and $300,000x is added to the PTEP group taxes with respect to CFC1's section 951(a)(1)(A) PTEP within the annual PTEP account for the 2018 taxable year within the passive category.

(2) Example 2: Foreign income taxes deemed paid under section 960(b)—(i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, which in turn owns 60% of the stock of CFC2, which in turn owns 100% of the stock of CFC3. USP, CFC1, CFC2, and CFC3 all use the calendar year as their U.S. taxable year. CFC1, CFC2, and CFC3 all use the “u” as their functional currency. At all relevant times, 1u = $1x. On July 1, 2020, CFC2 distributes 600u to CFC1 and the entire distribution is a section 959(b) distribution (“distribution 1”). On October 1, 2020, CFC1 distributes 800u to USP and the entire distribution is a section 959(a) distribution (“distribution 2”). CFC1 and CFC2 make no other distributions in the year ending December 31, 2020, earn no other income, and incur no taxes on distribution 1 or distribution 2. Before taking into account distribution 1, CFC2 has 1,000u of section 951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable year within the general category. The previously taxed earnings and profits in CFC2's PTEP group relate to subpart F income of CFC3 that was included by USP in 2016. CFC3 distributed the earnings and profits to CFC2 before the 2020 taxable year and, solely as a result of the distribution of the previously taxed earnings and profits, CFC2 incurred withholding and net basis tax, resulting in $150 of PTEP group taxes with respect to section 951(a)(1)(A) PTEP. Before taking into account distribution 1 and distribution 2, CFC1 has 200u in section 951A PTEP within an annual PTEP account for the 2018 taxable year within the section 951A category. The previously taxed earnings and profits in CFC1's PTEP group relate to the portion of a GILTI inclusion amount that was included by USP in 2018 and allocated to CFC2 under section 951A(f)(2) and § 1.951A-6(b)(2). CFC2 distributed the earnings and profits to CFC1 before the 2020 taxable year and, solely as a result of the distribution of the previously taxed earnings and profits, CFC1 incurred withholding and net basis tax, resulting in $25x of PTEP group taxes with respect to section 951A PTEP.

(ii) Analysis—(A) Foreign income taxes deemed paid by CFC1. With respect to distribution 1 from CFC2 to CFC1, under paragraph (b)(4) of this section CFC1's proportionate share of PTEP group taxes with respect to CFC2's section 951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable year within the general category is $90x ($150x × 600u/1,000u). Under paragraph (b)(3) of this section, the amount of foreign income taxes that are properly attributable to distribution 1 is $90x. Accordingly, under paragraph (b)(2) of this section, CFC1 is deemed to have paid $90x of general category foreign income taxes of CFC2 with respect to its 600u section 959(b) distribution in the general category.

(B) Adjustments to PTEP accounts of CFC1 and CFC2. Under paragraph (c)(3) of this section, the 600u related to distribution 1 is added to CFC1's section 951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable year within the general category. Similarly, CFC2's section 951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable year within the general category is reduced by 600u, the amount of the section 959(b) distribution to CFC1. Additionally, under paragraph (d) of this section, CFC1's PTEP group taxes with respect to its section 951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable year within the general category are increased by $90 and CFC2's PTEP group taxes with respect to section 951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable year within the general category are reduced by $90x.

(C) Foreign income taxes deemed paid by USP. With respect to distribution 2 from CFC1 to USP, because CFC1 has PTEP groups in more than one section 904 category, this section is applied separately to each section 904 category (that is, distribution 2 of 800u is applied separately to the 200u of CFC1's section 951A PTEP and 600u of CFC1's section 951(a)(1)(A) PTEP).

(1) Section 951A category. Under paragraph (b)(4) of this section, USP's proportionate share of PTEP group taxes with respect to CFC1's section 951A PTEP within an annual PTEP account for the 2018 taxable year within the section 951A category is $25x ($25x × 200u/200u). Under paragraph (b)(3) of this section, the amount of foreign income taxes within the section 951A category that are properly attributable to distribution 2 is $25x. Accordingly, under paragraph (b)(1) of this section USP is deemed to have paid $25x of section 951A category foreign income taxes of CFC1 with respect to its 200u section 959(a) distribution in the section 951A category.

(2) General category. Under paragraph (b)(4) of this section, USP's proportionate share of PTEP group taxes with respect to CFC1's section 951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable year within the general category is $90x ($90x × 600u/600u). Under paragraph (b)(3) of this section, the amount of foreign income taxes that are properly attributable to distribution 2 is $90x. Accordingly, under paragraph (b)(1), USP is deemed to have paid $90x of general category foreign income taxes of CFC1 with respect to its 600u section 959(a) distribution in the general category.

(a) * * * (1) * * * 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).

(d) * * * 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.

(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).

(b) Example. The application of this section may be illustrated by the following example:

(1) Facts. USP, a domestic corporation, owns all the one class of stock of CFC, a controlled foreign corporation. Both corporations use the calendar year as the taxable year and the functional currency of CFC is the U.S. dollar. All of CFC's earnings and profits of $80x for Year 1 (after payment of foreign income taxes of $20x on its total income of $100x for such year) are attributable to amounts required under section 951(a) to be included in USP's gross income for Year 1 because such income is general category foreign base company services income of CFC. For Year 1, USP chooses to claim a foreign tax credit for the $20x of foreign income taxes which for such year are paid by CFC and deemed paid by USP under section 960(a) and § 1.960-2(b). In Year 2, CFC distributes the entire $80x of Year 1 previously taxed earnings and profits, from which a foreign income tax of $8x is withheld. Also in Year 2, CFC pays $40x of interest to USP, from which a foreign income tax of $4x is withheld. For Year 2, USP chooses to claim deductions for its creditable foreign income taxes under section 164 rather than a foreign tax credit under section 901.

(2) Analysis. Although USP does not choose to claim a foreign tax credit for Year 2, under section 960(c)(4) and paragraph (a) of this section it may not deduct the $8x of foreign income taxes under section 164. USP may, however, deduct under such section the foreign income tax of $4x which is withheld from the interest paid by CFC in Year 2.

(b) Example. The application of this section may be illustrated by the following example:

(1) Facts. USP, a domestic corporation, owns all of the one class of stock of CFC, a controlled foreign corporation. Both corporations use the calendar year as the taxable year, and the functional currency of CFC is the U.S. dollar. For Year 1, CFC has total income of $100,000x on which it pays foreign income taxes of $20,000x. All of CFC's earnings and profits for Year 1 of $80,000x are attributable to an amount which is required under section 951(a) to be included in USP's gross income for Year 1 because such income is general category foreign base company services income of CFC. By reason of such income inclusion USP is deemed for Year 1 to have paid under section 960(a), and is required under section 78 to include in gross income for such year, the $20,000x ($20,000x × $80,000x/$80,000x) of foreign income taxes paid by CFC for such year. USP also derives $100,000x of taxable income from sources within the United States for Year 1. For Year 2, USP has $4,000x of taxable income, all of which is derived from sources within the United States. No part of CFC's earnings and profits for Year 2 is attributable to an amount required under section 951(a) or section 951A(a) to be included in USP's gross income. During Year 2, CFC makes one distribution consisting of its $80,000x earnings and profits for Year 1, all of which is excluded under section 959(a)(1) from USP's gross income for Year 2, and from which distribution foreign income taxes of $1,000x are withheld. For Year 1 and Year 2, USP claims the foreign tax credit under section 901, subject to the limitation of section 904.

(2) Analysis. The U.S. tax liability of USP is determined as follows for such years, assuming a corporate tax rate of 21%:

Sections 1.960-1 through 1.960-6 apply to each taxable year of a foreign corporation that both begin after December 31, 2017, and ends on or after December 4, 2018, and to each taxable year of a domestic corporation that is a United States shareholder of the foreign corporation in which or with which such taxable year of such foreign corporation ends.

(c) * * *

(1) * * *

(iii) Foreign income taxes deemed paid under section 960(b) (as applicable to taxable years of controlled foreign corporations beginning after December 31, 2017, and to taxable years of United States persons in which or with which such taxable years of foreign corporations end). Paragraph (c)(1)(i) of this section applies to foreign income taxes deemed paid under section 960(b) (as in effect for a taxable year of a controlled foreign corporation beginning after December 31, 2017, and a taxable year of a United States person in which or with which such controlled foreign corporation's taxable year ends) only if such taxes are deemed paid under § 1.960-3(b)(1) with respect to distributions to a domestic corporation of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits. See also § 1.960-3(c)(2)(i), (ii), (vi), or (vii). Foreign income taxes that would have been deemed paid under section 960(a)(1) (as in effect on December 21, 2017) with respect to the portion of a section 965(a) earnings amount that was reduced under § 1.965-1(b)(2) or § 1.965-8(b) are not eligible to be deemed paid under section 960(b) and § 1.960-3(b) or any other section of the Code.

(c) Applicability date for certain portions of § 1.965-5. Paragraph (c)(1)(iii) of § 1.965-5 applies to taxable years of foreign corporations that both begin after December 31, 2017, and end on or after December 4, 2018, and with respect to a United States person, to the taxable years in which or with which such taxable years of the foreign corporations end.

(a) Translation of foreign income taxes taken into account when accrued—(1) In general. For purposes of this section, the term section 901 taxpayer means the “taxpayer” described in § 1.901-2(f)(1) and so includes a partnership or a specified 10-percent owned foreign corporation (as defined in section 245A(b)) that has legal liability under foreign law for foreign income tax. Except as provided in paragraph (a)(2) of this section, in the case of a section 901 taxpayer that takes foreign income taxes (as defined in section 986(a)(4) (including taxes described in section 903)) into account when accrued, the amount of any foreign income taxes denominated in foreign currency that has been paid or accrued, including additional tax liability denominated in foreign currency, foreign income taxes withheld in foreign currency, or estimated foreign income taxes paid in foreign currency, are translated into dollars using the weighted average exchange rate (as defined in § 1.989(b)-1) (the “average exchange rate”) for the section 901 taxpayer's U.S. taxable year (as defined in § 1.960-1(b)(37)) to which such foreign income taxes relate. See section 986(a)(1)(A). See section 988 and §§ 1.988-1(a)(2)(ii) and 1.988-2(c) for rules for determining whether and the extent to which there is a foreign currency gain or loss when an accrued functional currency amount of foreign income tax denominated in nonfunctional currency differs from the functional currency amount paid.

(2) Exceptions—(i) Foreign income taxes not paid within 24 months. Any foreign income taxes denominated in foreign currency that are paid more than 24 months after the close of the section 901 taxpayer's U.S. taxable year to which they relate are translated into dollars using the spot rate on the date of payment of the foreign income taxes. See section 986(a)(1)(B)(i) and (a)(2)(A). For purposes of this section and § 1.905-3, the term spot rate has the meaning provided in § 1.988-1(d). To the extent any accrued foreign income taxes denominated in foreign currency remain unpaid more than 24 months after the close of the taxable year to which they relate, see § 1.905-3 and paragraph (c) of this section for the required adjustments.

(ii) Foreign income taxes paid before taxable year begins. Any foreign income taxes denominated in foreign currency that are paid before the beginning of the section 901 taxpayer's U.S. taxable year to which such taxes relate are translated into dollars using the spot rate on the date of payment of the foreign income taxes. See section 986(a)(1)(B)(ii) and (a)(2)(A).

(iii) Inflationary currency. Any foreign income taxes denominated in a foreign currency that is an inflationary currency in the section 901 taxpayer's U.S. taxable year to which the foreign income taxes relate, or in any subsequent taxable year up to and including the taxable year in which the taxes are paid, are translated into dollars using the spot rate on the date of payment of such taxes. For purposes of section 986(a)(1)(C) and this paragraph (a)(2)(iii), the term inflationary currency means the currency of a country in which there is cumulative inflation during the base period of at least 30 percent, as determined under the principles of § 1.985-1(b)(2)(ii)(D), where the base period, with respect to any taxable year, is the 36 months ending on the last day of such taxable year (in lieu of the base period described in § 1.985-1(b)(2)(ii)(D), which ends on the last day of the preceding calendar year). Accrued but unpaid foreign income taxes denominated in a foreign currency that is an inflationary currency in the taxable year accrued are translated into dollars at the spot rate on the last day of the section 901 taxpayer's U.S. taxable year to which such taxes relate (provisional year-end rate). However, a U.S. taxpayer that claims a foreign tax credit under section 901 may choose to translate accrued but unpaid foreign income taxes (including foreign income taxes deemed paid under section 960) denominated in a foreign currency that is an inflationary currency into dollars at the spot rate on the date of payment, in lieu of the provisional year-end rate, if such taxes are paid prior to the due date (with extensions) of the original Federal income tax return for the taxable year for which the credit is claimed and such return is timely filed. In all other cases, see § 1.905-3 and paragraph (c) of this section for required adjustments upon payment of accrued foreign income taxes denominated in an inflationary currency.

(iv) Election to translate foreign income taxes using the spot rate as of date of payment—(A) Eligibility to make election. An individual or corporate taxpayer (including a specified 10-percent owned foreign corporation) that is otherwise required to translate foreign income taxes that are denominated in foreign currency using the average exchange rate may elect to translate foreign income taxes described in this paragraph (a)(2)(iv) into dollars using the spot rate on the date of payment of the foreign income taxes, provided that the liability for such taxes is denominated in nonfunctional currency. For purposes of section 986(a)(1)(D) and this paragraph (a)(2)(iv), whether the currency in which a tax liability attributable to a qualified business unit (within the meaning of section 989(a)) (QBU) is denominated is a nonfunctional currency is determined by reference to the functional currency of the individual or corporate taxpayer and not that of the QBU of the taxpayer. Accrued but unpaid foreign income taxes subject to the election under this paragraph (a)(2)(iv) are translated at the provisional year-end rate. However, a taxpayer that claims a foreign tax credit under section 901 may choose to translate accrued but unpaid foreign income taxes (including foreign taxes deemed paid under section 960 with respect to a specified 10-percent owned foreign corporation that has made an election under this paragraph (a)(2)(iv)) into dollars at the spot rate on the date of payment, in lieu of the provisional year-end rate, if such taxes are paid prior to the due date (with extensions) of the original return for the taxable year for which the credit is claimed and such return is timely filed. In all other cases, see § 1.905-3 and paragraph (c) of this section for required adjustments upon payment of accrued foreign income taxes that are translated into dollars at the spot rate on the date of payment.

(B) Scope of election. In general, an individual taxpayer may make an election under this paragraph (a)(2)(iv) for all foreign income taxes denominated in nonfunctional currency, or only for those foreign income taxes that are denominated in nonfunctional currency and that are attributable to the individual's non-QBU activities and all QBUs with dollar functional currencies. A corporate taxpayer may make an election under this paragraph (a)(2)(iv) for all foreign income taxes that are denominated in nonfunctional currency, or only for those foreign income taxes that are denominated in nonfunctional currency and that are attributable to all QBUs (including the corporate taxpayer) with dollar functional currencies. Therefore, an election under this paragraph (a)(2)(iv) may not be made for foreign income taxes that are denominated in a nonfunctional currency of the taxpayer and attributable to QBUs with non-dollar functional currencies, except as part of an election to translate all taxes denominated in nonfunctional currency at the spot rate on the date of payment. For purposes of this paragraph (a)(2)(iv)(B), foreign income tax is attributable to a QBU if the tax is properly recorded on the books and records of the QBU in accordance with sections 985 through 989. An election under this paragraph (a)(2)(iv) by a domestic corporation (or an individual that has made an election under section 962) does not apply to any taxes paid or accrued by foreign corporations with respect to which the individual or corporation is a United States shareholder. However, an election may be made on behalf of a foreign corporation to translate either all of the foreign corporation's foreign income taxes denominated in nonfunctional currency, or only the foreign income taxes denominated in nonfunctional currency that are attributable to the foreign corporation's QBUs with dollar functional currencies, using the spot rate on the date of payment. Such an election is made using the procedures under § 1.964-1(c)(3) that apply to permit controlling domestic shareholders to make or change a tax accounting election on behalf of a foreign corporation.

(C) Time and manner of election. The election under this paragraph (a)(2)(iv) must be made by attaching a statement to the taxpayer's timely filed Federal income tax or information return (including extensions) for the first taxable year to which the election applies. The statement must identify whether the election under this paragraph (a)(2)(iv) is made for all foreign income taxes denominated in nonfunctional currency or only for those foreign income taxes that are denominated in nonfunctional currency and that are either attributable to the taxpayer's QBUs with dollar functional currencies or, in the case of an individual, attributable to non-QBU activities. Once made, the election under this paragraph (a)(2)(iv) applies for the taxable year for which made and all subsequent taxable years unless revoked with the consent of the Commissioner.

(D) Example—(1) Facts. USP, a domestic corporation that uses the calendar year as its taxable year, owns a partnership interest in PS, a non-hybrid partnership organized in Country X. USP also owns an equity interest in HPS, a Country X corporation that has filed an entity classification election under § 301.7701-3 of this chapter to be treated as a partnership for Federal income tax purposes. USP also owns 100% of CFC, a Country Y controlled foreign corporation that uses the U.S. dollar as its functional currency. PS and HPS each use a fiscal year ending November 30 as its taxable year both for Federal income tax purposes and for Country X tax purposes, and their functional currency is the Euro. HPS is the section 901 taxpayer of foreign income taxes denominated in Euros that it pays to Country X and properly records on its books and records. USP takes its distributive share of the HPS taxes into account under sections 702(a)(6) and 901(b)(5) and §§ 1.702-1(a)(6) and 1.704-1(b)(4)(viii) in computing its foreign tax credit. USP is the section 901 taxpayer of Euro-denominated foreign income taxes it pays to Country X with respect to its distributive share of the income of PS, and also pays Country X taxes withheld in Euros from distributions from HPS to USP and properly records these taxes on its books and records. Pursuant to § 1.985-1(b)(1)(iii), USP's functional currency is the dollar. USP timely elects under § 1.986(a)-1(a)(2)(iv) to use the spot rate on the date of payment to translate into dollars its foreign income taxes denominated in nonfunctional currency that are attributable to all QBUs with dollar functional currencies.

(2) Result. The Euro taxes paid by USP with respect to its distributive share of income from PS and the Euro taxes withheld from distributions from HPS are nonfunctional currency taxes attributable to USP, a QBU with a dollar functional currency. Accordingly, these taxes are translated into dollars at the spot rate on the date the taxes are paid. USP's distributive share of the Euro taxes paid by HPS are attributable to HPS, a Euro functional currency QBU of USP. Because these taxes are not attributable to a dollar QBU of USP, they are not covered by USP's election and so are translated into dollars at the average exchange rate for HPS's U.S. taxable year ending on November 30. See § 1.986(a)-1(a)(1). Foreign income taxes paid by CFC are not covered by USP's election; however, if USP so chooses it may make a separate election on behalf of CFC to use the spot rate on the date of payment to translate either all of CFC's nonfunctional currency taxes, or only those taxes that are attributable to CFC's dollar QBUs (which includes CFC). If instead USP had elected to use the spot rate on the date of payment to translate all of its foreign income taxes denominated in nonfunctional currency, rather than only those taxes attributable to QBUs with dollar functional currencies, then the spot rate on the date of payment would apply to translate all of the Euro taxes paid or accrued by USP, including its distributive share of taxes paid by HPS. However, this election would still not apply to taxes paid or accrued by CFC. See § 1.986(a)-1(a)(2)(iv)(B).

(v) Regulated investment companies. In the case of a regulated investment company (as defined in section 851) which takes into account income on an accrual basis, foreign income taxes paid or accrued with respect to such income are translated into dollars using the spot rate on the date the income accrues. See section 986(a)(1)(E).

(b) Translation of foreign income taxes taken into account when paid. In the case of a section 901 taxpayer that takes foreign income taxes into account when paid, the amount of any foreign income tax liability denominated in foreign currency, including additional income tax liability denominated in foreign currency or estimated foreign income taxes paid in foreign currency, are translated into dollars using the spot rate on the date of payment of such taxes. See section 986(a)(2)(A). Foreign income taxes withheld in foreign currency are translated into dollars using the spot rate on the date on which such taxes were withheld.

(c) Refunds or other reductions of foreign income tax liability. In the case of a section 901 taxpayer that takes foreign income taxes into account when accrued, a reduction in the amount of previously-accrued foreign income taxes that is attributable to a refund of foreign income taxes, a credit allowed in lieu of a refund, or a reduction in or other downward adjustment to an accrued amount, including an adjustment on account of accrued foreign income taxes that were not paid by the date 24 months after the close of the U.S. taxable year to which such taxes relate, is translated into dollars using the exchange rate that was used to translate such amount when claimed as a credit or added to PTEP group taxes (as defined in § 1.960-3(d)(1)). In the case of foreign income taxes taken into account when accrued but translated into dollars on the date of payment, see § 1.905-3(b) for required adjustments to reflect a foreign tax redetermination (as defined in § 1.905-3(a)) attributable to a reduction in the amount of previously-accrued foreign income taxes that is attributable to a difference in exchange rates between the date or taxable year of accrual and the date of payment. In the case of a section 901 taxpayer that takes foreign income taxes into account when paid, a refund or other reduction in or downward adjustment to the amount of foreign income taxes is translated into dollars using the exchange rate that was used to translate such amount when claimed as a credit. If a refund or other reduction of foreign income taxes relates to foreign income taxes paid or accrued on more than one date, then the refund or other reduction is deemed to be derived from, and reduces, the payments of foreign income taxes in order, starting with the most recent payment of foreign income taxes first, to the extent thereof.

(d) Allocation of refunds of foreign income taxes. Refunds of foreign income taxes are allocated to the same separate category as the foreign income taxes to which the refunded taxes relate. Refunds are related to foreign income taxes in a separate category if the foreign income tax that was refunded was imposed with respect to that separate category. See § 1.904-6 concerning the allocation of foreign income taxes to separate categories of income.

(e) Basis of foreign currency refunded—(1) Nonfunctional currency tax liability and dollar functional currency. If the functional currency of the QBU that paid the tax and received the refund is the dollar or the person receiving the refund is not a QBU, then the recipient's basis in the foreign currency refunded is the dollar value of the refund determined under paragraph (c) of this section by using the exchange rate that was used to translate such amount into dollars when claimed as a credit or added to PTEP group taxes.

(2) Nonfunctional currency tax liability and non-dollar functional currency. If the functional currency of the QBU receiving the refund is not the dollar and is different from the currency in which the foreign income taxes were paid, then the recipient's basis in the refunded foreign currency is equal to the functional currency value of the nonfunctional currency refund, translated into functional currency at the appropriate exchange rate between the functional currency and the nonfunctional currency. Such exchange rate is determined under the principles of paragraph (c) of this section, substituting the words “functional currency” for the word “dollar” and using the exchange rate that was used to translate such amount into the QBU's functional currency when claimed as a credit or added to PTEP group taxes (as defined in § 1.960-3(d)(1)). If a QBU receives a refund of nonfunctional currency tax that is denominated in a currency that was the functional currency of the QBU when the refunded tax was claimed as a credit or added to PTEP group taxes, the QBU's basis in the nonfunctional currency received in the refund is determined by using the exchange rate used under § 1.985-5(c) when the QBU's functional currency changed. See § 1.905-3(b)(1)(ii)(C) (Example 3).

(3) Functional currency tax liabilities. If the functional currency of the QBU receiving the refund is the currency in which the refund was made, then the recipient's basis in the currency received is the amount of the functional currency received. If the QBU receives a refund of functional currency tax that was denominated in a nonfunctional currency of the QBU when the tax was claimed as a credit or added to PTEP group taxes, the QBU will recognize the section 988 gain or loss that would have been recognized under § 1.985-5(b) if the refund had been received immediately before the QBU's functional currency changed.

(4) Foreign currency gain or loss. For rules for determining subsequent foreign currency gain or loss on the disposition of nonfunctional currency, the basis of which is determined under this paragraph (e), see section 988(c)(1)(C).

(f) Applicability dates. This section applies to taxable years ending on or after December 16, 2019, and to taxable years of foreign corporations which end with or within a taxable year of a United States shareholder ending on or after December 16, 2019.

(a) * * *

(2) * * *

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(C) Basis in refunded foreign income tax. See § 1.986(a)-1(e) for rules relating to the determination of basis in refunded foreign income tax denominated in nonfunctional currency.