Title 26—Internal Revenue--Volume 1
PART 1—INCOME TAXES
§ 1.937-2   Income from sources within a possession.
(a) Scope. Section 937(b) and this section set forth the rules for determining whether income is considered to be from sources within a particular possession (the relevant possession) for purposes of the Internal Revenue Code, including section 957(c) and Subpart D, Part III, Subchapter N, Chapter 1 of the Internal Revenue Code, as well as section 7654(a) of the 1954 Internal Revenue Code (until the effective date of its repeal). Paragraphs (c)(1)(ii) and (c)(2) of this section do not apply, however, for purposes of sections 932(a) and (b) and 935(a)(3) (as in effect before the effective date of its repeal). In the case of a possession or territory that administers income tax laws that are identical (except for the substitution of the name of the possession or territory for the term “United States” where appropriate) to those in force in the United States, these rules do not apply for purposes of the application of such laws. These rules also do not affect the determination of whether income is considered to be from sources without the United States for purposes of the Internal Revenue Code.
(b) In general. Except as provided in paragraphs (c) through (i) of this section, the principles of sections 861 through 865 and the regulations under those provisions (relating to the determination of the gross and the taxable income from sources within and without the United States) generally will be applied in determining the gross and the taxable income from sources within and without the relevant possession. In the application of such principles, it generally will be sufficient to substitute, where appropriate, the name of the relevant possession for the term “United States,” and to substitute, where appropriate, the term “bona fide resident of” followed by the name of the relevant possession for the term “United States resident.” Furthermore, the term domestic will be construed to mean created or organized in the relevant possession. In applying these principles, additional substitutions may be necessary to accomplish the intent of section 937(b) and this section. For example, in applying the principles of sections 863(d) and (e) to individuals under this paragraph (b), the term “bona fide resident of a possession” will be used instead of the term “United States person.” In no case, however, will a bona fide resident or other person have, as a result of the application of these principles, more income from sources within the relevant possession than the amount of income from sources within the United States that a similarly situated U.S. person who is not a bona fide resident would have under sections 861 through 865.
(c) U.S. income —(1) In general. Except as provided in paragraph (d) of this section, income from sources within the relevant possession will not include any item of income determined under the rules of sections 861 through 865 and the regulations under those provisions to be—
(i) From sources within the United States; or
(ii) Effectively connected with the conduct of a trade or business within the United States.
(2) Conduit arrangements. Income will be considered to be from sources within the United States for purposes of paragraph (c)(1) of this section if, pursuant to a plan or arrangement—
(i) The income is received in exchange for consideration provided to another person; and
(ii) Such person (or another person) provides the same consideration (or consideration of a like kind) to a third person in exchange for one or more payments constituting income from sources within the United States.
(d) Income from certain sales of inventory property. For special rules that apply to determine the source of income from certain sales of inventory property, see § 1.863-3(e).
(e) Service in the Armed Forces. In the case of a member of the Armed Forces of the United States, the following rules will apply for determining the source of compensation for services performed in compliance with military orders:
(1) If the individual is a bona fide resident of a possession and such services are performed in the United States or in another possession, the compensation constitutes income from sources within the possession of which the individual is a bona fide resident (and not from sources within the United States or such other possession).
(2) If the individual is not a bona fide resident of a possession and such services are performed in a possession, the compensation constitutes income from sources within the United States (and not from sources within such possession).
(f) Gains from certain dispositions of property —(1) Property of former U.S. residents. (i) Except to the extent an election is made under paragraph (f)(1)(vi) of this section, income from sources within the relevant possession will not include gains from the disposition of property described in paragraph (f)(1)(ii) of this section by an individual described in paragraph (f)(1)(iii) of this section. See also section 1277(e) of the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085) (providing that gains from the disposition of certain property by individuals who acquired residency in certain possessions will be considered to be from sources within the United States).
(ii) Property is described in this paragraph (f)(1)(ii) when the following conditions are satisfied—
(A) The property is of a kind described in section 731(c)(3)(C)(i) or 954(c)(1)(B); and
(B) The property was owned by the individual before such individual became a bona fide resident of the relevant possession.
(iii) An individual is described in this paragraph (f)(1)(iii) when the following conditions are satisfied—
(A) For the taxable year for which the source of the gain must be determined, the individual is a bona fide resident of the relevant possession; and
(B) For any of the 10 years preceding such year, the individual was a citizen or resident of the United States (other than a bona fide resident of the relevant possession).
(iv) If an individual described in paragraph (f)(1)(iii) of this section exchanges property described in paragraph (f)(1)(ii) of this section for other property in a transaction in which gain or loss is not required to be recognized (in whole or in part) under U.S. income tax principles, such other property will also be considered property described in paragraph (f)(1)(ii) of this section.
(v) If an individual described in paragraph (f)(1)(iii) of this section owns, directly or indirectly, at least 10 percent (by value) of any entity to which property described in paragraph (f)(1)(ii) of this section is transferred in a transaction in which gain or loss is not required to be recognized (in whole or in part) under U.S. income tax principles, any gain recognized upon a disposition of the property by such entity will be treated as income from sources outside the relevant possession if any gain recognized upon a direct or indirect disposition of the individual's interest in such entity would have been so treated under paragraph (f)(1)(iv) of this section.
(vi) Notwithstanding the general rule of paragraph (f)(1)(i) of this section and section 1277(e) of the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085), an individual described in paragraph (f)(1)(iii) of this section may elect to treat as gain from sources within the relevant possession the portion of the gain attributable to the individual's possession holding period. The election under this paragraph (f)(1)(vi) will be considered made if the individual's income tax return for the year of disposition of the property reports the portion of gain attributable to the taxpayer's possession holding period as determined in accordance with paragraph (f)(1)(vi)(A) or paragraph (f)(1)(vi)(B) of this section, as the case may be.
(A) In the case of marketable securities, the portion of gain attributable to the possession holding period will be determined by reference to the fair market value of the marketable security at the close of the market on the first day of the individual's possession holding period. In the event that the individual is a bona fide resident of the relevant possession for more than a single continuous period, the portion of gain described in this paragraph (f)(1)(vi)(A) will be the aggregate of the portions of gain (or offsetting loss) attributable to each possession holding period.
(B) In the case of property other than marketable securities, the portion of gain attributable to the possession holding period in the relevant possession will be determined by multiplying the total gain on disposition of the property by a fraction, the numerator of which is the number of days in the possession holding period and the denominator of which is the total number of days in the individual's holding period for the property. For purposes of the preceding sentence, in the event that the individual is a bona fide resident of the relevant possession for more than a single continuous period, the number of days in the numerator will be the aggregate of the number of days in each possession holding period. For purposes of this paragraph (f)(1)(vi)(B), the denominator will include days that are required to be included in an individual's holding period under section 735(b), section 1223, and any other applicable holding period rule in the Internal Revenue Code.
(vii) For purposes of paragraph (f)(1)(vi) of this section—
(A) The term marketable securities means property described in paragraph (f)(1)(ii) of this section that is, throughout the individual's holding period, actively traded within the meaning of § 1.1092(d)-1(a); and
(B) The term possession holding period means the part of the individual's holding period for the property during which the individual is a bona fide resident of the relevant possession. However, for this purpose, the possession holding period will be considered to commence in all cases on the first day during such period that the individual does not have a tax home outside the relevant possession. In the event that the individual is a bona fide resident of the relevant possession for more than a single continuous period, each possession holding period prior to the one ending on the date of sale or other disposition will be considered to end on the first day that the individual has a tax home outside the relevant possession. With respect to the determination of tax home, see § 1.937-1(d).
(2) Special rules under section 865 for possessions —(i) Except as provided in paragraph (f)(1) of this section—
(A) Gain that is considered to be derived from sources outside of the United States under section 865(g)(3) will be considered income from sources within Puerto Rico; and
(B) Gain that is considered to be derived from sources outside of the United States under section 865(h)(2)(B) will be considered income from sources within the possession in which the liquidating corporation is created or organized.
(ii) In applying the principles of section 865 and the regulations under that section pursuant to paragraph (b) of this section, the rules of section 865(g) will not apply, but the special rule of section 865(h)(2)(B) will apply with respect to gain recognized upon the liquidation of corporations created or organized in the United States.
(g) Dividends —(1) Dividends from certain possessions corporations —(i) In general. Except as provided in paragraph (g)(1)(ii) of this section, with respect to any possessions shareholder, only the possessions source ratio of any dividend paid or accrued by a corporation created or organized in a possession (possessions corporation) will be treated as income from sources within such possession. For purposes of this paragraph (g)—
(A) The possessions source ratio will be a fraction, the numerator of which is the gross income of the possessions corporation from sources within the possession in which it is created or organized (applying the rules of this section) for the testing period and the denominator of which is the total gross income of the corporation for the testing period; and
(B) The term possessions shareholder means any individual who is a bona fide resident of the possession in which the corporation is created or organized and who owns, directly or indirectly, at least 10 percent of the total voting stock of the corporation.
(ii) Dividends from corporations engaged in the active conduct of a trade or business in the relevant possession. The entire amount of any dividend paid or accrued by a possessions corporation will be treated as income from sources within the possession in which it is created or organized when the following conditions are met—
(A) 80 percent or more of the gross income of the corporation for the testing period was derived from sources within such possession (applying the rules of this section) or was effectively connected with the conduct of a trade or business in such possession (applying the rules of § 1.937-3); and
(B) 50 percent or more of the gross income of the corporation for the testing period was derived from the active conduct of a trade or business within such possession.
(iii) Testing period. For purposes of this paragraph (g)(1), the term testing period means the 3-year period ending with the close of the taxable year of the payment of the dividend (or for such part of such period as the corporation has been in existence).
(iv) Subsidiary look-through rule. For purposes of this paragraph (g)(1), if a possessions corporation owns (directly or indirectly) at least 25 percent (by value) of the stock of another corporation, such possessions corporation will be treated as if it—
(A) Directly received its proportionate share of the income of such other corporation; and
(B) Actively conducted any trade or business actively conducted by such other corporation.
(2) Dividends from other corporations. In applying the principles of section 861 and the regulations under that section pursuant to paragraph (b) of this section, the special rules relating to dividends for which deductions are allowable under section 243 or 245 will not apply.
(h) Income inclusions. For purposes of determining whether an amount described in section 904(h)(1)(A) constitutes income from sources within the relevant possession—
(1) If the individual owns (directly or indirectly) at least 10 percent of the total voting stock of the corporation from which such amount is derived, the principles of section 904(h)(2) will apply. In the case of an individual who is not a possessions shareholder (as defined in paragraph (g)(1)(i)(B) of this section), the preceding sentence will apply only if the corporation qualifies as a “United States-owned foreign corporation” for purposes of section 904(h); and
(2) In all other cases, the amount will be considered income from sources in the jurisdiction in which the corporation is created or organized.
(i) Interest —(1) Interest from certain possessions corporations —(i) In general. Except as provided in paragraph (i)(1)(ii) of this section, with respect to any possessions shareholder (as defined in paragraph (g)(1)(i)(B) of this section), interest paid or accrued by a possessions corporation will be treated as income from sources within the possession in which it is created or organized to the extent that such interest is allocable to assets that generate, have generated, or could reasonably have been expected to generate income from sources within such possession (under the rules of this section) or income effectively connected with the conduct of a trade or business within such possession (under the rules of § 1.937-3). For purposes of the preceding sentence, the principles of §§ 1.861-9 through 1.861-12 will apply.
(ii) Interest from corporations engaged in the active conduct of a trade or business in the relevant possession. The entire amount of any interest paid or accrued by a possessions corporation will be treated as income from sources within the possession in which it is created or organized when the conditions of paragraphs (g)(1)(ii)(A) and (B) of this section are met (applying the rules of paragraphs (g)(1)(iii) and (iv) of this section).
(2) Interest from partnerships. Interest paid or accrued by a partnership will be treated as income from sources within a possession only to the extent that such interest is allocable to income effectively connected with the conduct of a trade or business in such possession. For purposes of the preceding sentence, the principles of § 1.882-5 will apply (as if the partnership were a foreign corporation and as if the trade or business in the possession were a trade or business in the United States).
(j) Indirect ownership. For purposes of this section, the rules of section 318(a)(2) will apply except that the language “5 percent” will be used instead of “50 percent” in section 318(a)(2)(C).
(k) Examples. The provisions of this section may be illustrated by the following examples:
(ii) Pursuant to section 1277(e) of the Tax Reform Act of 1986, and absent an election under paragraph (f)(1)(vi) of this section, all of X's gain ($60x) will be treated as income from sources within the United States for all purposes of the Internal Revenue Code (including section 7654, as in effect with respect to the NMI), and (under paragraph (f)(1)(i) of this section) not as income from sources in the NMI. However, pursuant to paragraph (f)(1)(vi) of this section, X may elect on his 2012 income tax return filed with NMI to treat the portion of this gain attributable to X's possession holding period with respect to NMI as gain from sources within NMI. X's possession holding period with respect to NMI begins on March 1, 2009, the date his tax home changes to the NMI. Under paragraph (f)(1)(vi)(A) of this section, the portion of X's gain attributable to this possession holding period is $50x, the excess of the sale price of the stock ($70x) over its closing value ($20x) on the first day of the possession holding period. By reporting $50x of gain on his 2012 NMI return, X will elect under paragraph (f)(1)(vi) of this section to treat that amount as NMI source income.
(ii) Pursuant to paragraph (f)(1) of this section, and absent an election under paragraph (f)(1)(vi) of this section, the gain will not be treated as income from sources within Puerto Rico for purposes of the Internal Revenue Code (including section 933(1)). However, pursuant to paragraph (f)(1)(vi) of this section, R may elect on her 2012 return filed with the IRS to treat the portion of this gain attributable to R's possession holding period with respect to Puerto Rico as gain from sources within Puerto Rico. R's possession holding period with respect to Puerto Rico is the 945-day period from June 1, 2010, the date her tax home changes to Puerto Rico, through December 31, 2012, the date of sale. Under paragraph (f)(1)(vi)(B) of this section, the portion of R's gain attributable to this possession holding period is $64.68x, computed as follows:
(ii) To the extent that Z performs personal services within the USVI, the compensation that Z receives for his services is sourced to the USVI under the principles of section 861(a)(3) and § 1.861-4 as applied pursuant to § 1.937-2(b). If all of Z's services are performed in the USVI, none of the writer's share is derived from sources within the United States under section 861(a)(3) and § 1.861-4, nor is it effectively connected with the conduct of a trade or business in the United States under section 864(c)(3). Accordingly, the U.S. income rule of section 937(b)(2) and paragraph (c)(1) of this section would not operate to prevent Z's services income from being USVI source or USVI effectively connected income within the meaning of section 937(b)(1). If Z also performs services in the United States, however, then the U.S. income rule would apply to the part of Z's compensation that is sourced to the United States under section 861(a)(3) and § 1.861-4. In the event that Y and Z are controlled taxpayers within the meaning of § 1.482-1(i)(5), section 482 and the regulations under that section, including § 1.482-9T(i), would apply to evaluate the arm's length amount charged for Z's controlled services.
(l) Effective/applicability dates. Except as otherwise provided in this paragraph (l), this section applies to income earned in taxable years ending after April 9, 2008. Taxpayers may choose to apply paragraph (b) of this section to income earned in open taxable years ending after October 22, 2004. Taxpayers may choose to apply paragraph (f)(1) of this section to dispositions made after April 11, 2005.
§ 1.937-3   Income effectively connected with the conduct of a trade or business in a possession.
(a) Scope. Section 937(b) and this section set forth the rules for determining whether income is effectively connected with the conduct of a trade or business within a particular possession (the relevant possession) for purposes of the Internal Revenue Code, including sections 881(b) and 957(c) and Subpart D, Part III, Subchapter N, Chapter 1 of the Internal Revenue Code. Paragraph (c) of this section does not apply, however, for purposes of section 881(b). In the case of a possession or territory that administers income tax laws that are identical (except for the substitution of the name of the possession or territory for the term “United States” where appropriate) to those in force in the United States, these rules do not apply for purposes of the application of such laws.
(b) In general. Except as provided in paragraphs (c) and (d) of this section, the principles of section 864(c) and the regulations under that section (relating to the determination of income, gain or loss that is effectively connected with the conduct of a trade or business within the United States) generally will be applied in determining whether income is effectively connected with the conduct of a trade or business within the relevant possession, without regard to whether the taxpayer qualifies as a nonresident alien individual or a foreign corporation with respect to such possession. Subject to the rules of this section, the principles of section 864(c)(4) will apply for purposes of determining whether income from sources without the relevant possession is effectively connected with the conduct of a trade or business in the relevant possession. For purposes of the preceding sentence, all income other than income from sources within the relevant possession (as determined under the rules of § 1.937-2) will be considered income from sources without the relevant possession in the application of the principles of section 864(c) under this paragraph (b), it generally will be sufficient to substitute the name of the relevant possession for the term “United States” where appropriate, but additional substitutions may be necessary to accomplish the intent of section 937(b) and this section. In no case, however, will a bona fide resident or other person have, as a result of the application of these principles, more income effectively connected with the conduct of a trade or business in the relevant possession than the amount of U.S. effectively connected income that a similarly situated U.S. person who is not a bona fide resident would have under section 864(c).
(c) U.S. income —(1) In general. Except as provided in paragraph (d) of this section, income considered to be effectively connected with the conduct of a trade or business within the relevant possession will not include any item of income determined under the rules of sections 861 through 865 and the regulations under those provisions to be—
(i) From sources within the United States; or
(ii) Effectively connected with the conduct of a trade or business within the United States.
(2) Conduit arrangements. Income will be considered to be from sources within the United States for purposes of paragraph (c)(1) of this section if, pursuant to a plan or arrangement—
(i) The income is received in exchange for consideration provided to another person; and
(ii) Such person (or another person) provides the same consideration (or consideration of a like kind) to a third person in exchange for one or more payments constituting income from sources within the United States.
(d) Income from certain sales of inventory property. Paragraph (c) of this section will not apply to income from sales of inventory property described in § 1.863-3(e).
(e) Examples. The provisions of this section may be illustrated by the following examples:
(ii) Under the principles of section 861(a)(1) as applied pursuant to § 1.937-2(b), interest payments received by F Bank from borrowers who reside in the United States or in Country FC constitute income from sources outside of the USVI. Under the principles of section 864(c)(4) as applied pursuant to paragraph (b) of this section, interest income from sources outside of the USVI generally may constitute income that is effectively connected with the conduct of a trade or business within the USVI for purposes of the Internal Revenue Code. However, interest payments received by F Bank from borrowers who reside in the United States constitute income from sources within the United States under section 861(a)(1). Accordingly, under paragraph (c)(1) of this section, such interest income will not be treated as effectively connected with the conduct of a trade or business in the USVI for purposes of the Internal Revenue Code (for example, for purposes of section 934(b)). Interest payments received by F Bank from borrowers who reside in Country FC, however, may be treated as effectively connected with the conduct of a trade or business in the USVI for purposes of the Internal Revenue Code (including section 934(b)).
(iii) To the extent that, as described in section 934(a), the USVI administers income tax laws that are identical (except for the substitution of the name of the USVI for the term “United States” where appropriate) to those in force in the United States, interest payments received by F Bank from borrowers who reside in the United States or in Country FC may be treated as income that is effectively connected with the conduct of a trade or business in the USVI for purposes of F Bank's income tax liability to the USVI under mirrored section 882.
(ii) The arrangement constitutes a conduit arrangement under paragraph (c)(2) of this section, and the interest payments received by G are treated as income from sources within the United States for purposes of paragraph (c)(1) of this section. Accordingly, the interest received by G will not be treated as effectively connected with the conduct of a trade or business in Possession I for purposes of the Internal Revenue Code (including sections 931(a)(2) and 934(b), if applicable with respect to D). Whether such interest constitutes income from sources within the United States for other purposes of the Internal Revenue Code under generally applicable conduit principles will depend on the facts and circumstances. See, for example, Aiken Indus., Inc. v. Commissioner , 56 T.C. 925 (1971).
(iii) If Possession I administers income tax laws that are identical (except for the substitution of the name of the possession for the term “United States” where appropriate) to those in force in the United States, the interest received by G may be treated as income effectively connected with the conduct of a trade or business in Possession I under mirrored section 864(c)(4) for purposes of determining the Possession I territorial income tax liability of N under mirrored section 871.
(f) Effective/applicability date. Except as otherwise provided in this paragraph (f), this section applies to income earned in taxable years ending after April 9, 2008. Taxpayers may choose to apply paragraph (b) of this section to income earned in open taxable years ending after October 22, 2004.
§ 1.951-1   Amounts included in gross income of United States shareholders.
(a) In general. If a foreign corporation is a controlled foreign corporation (within the meaning of section 957) at any time during any taxable year of such corporation, every person—
(1) Who is a United States shareholder (as defined in section 951(b) and paragraph (g) of this section) of such corporation at any time during such taxable year, and
(2) Who owns (within the meaning of section 958(a)) stock in such corporation on the last day, in such year, on which such corporation is a controlled foreign corporation shall include in his gross income for his taxable year in which or with which such taxable year of the corporation ends, the sum of—
(i) Such shareholder's pro rata share (determined under paragraph (b) of this section) of the corporation's subpart F income (as defined in section 952) for such taxable year of the corporation,
(ii) Such shareholder's pro rata share (determined under paragraph (c)(1) of this section) of the corporation's previously excluded subpart F income withdrawn from investment in less developed countries for such taxable year of the corporation,
(iii) Such shareholder's pro rata share (determined under paragraph (c)(2) of this section) of the corporation's previously excluded subpart F income withdrawn from investment in foreign base company shipping operations for such taxable year of the corporation, and
(iv) The amount determined under section 956 with respect to such shareholder for such taxable year of the corporation (but only to the extent not excluded from gross income under section 959(a)(2)).
(3) For purposes of determining whether a United States shareholder which is a domestic corporation is a personal holding company under section 542 and § 1.542-1, the character of the amount includible in gross income of such domestic corporation under this paragraph shall be determined as if such amount were realized directly by such corporation from the source from which it is realized by the controlled foreign corporation. See paragraph (a) of § 1.957-2 for special limitation on the amount of subpart F income in the case of a controlled foreign corporation described in section 957(b). See section 970(a) and § 1.970-1 which provides for the reduction of subpart F income of export trade corporations.
(4) See § 1.958-1(d) for rules regarding the ownership of stock of a foreign corporation through a domestic partnership for purposes of section 951 and for purposes of any provision that specifically applies by reference to section 951 or the regulations in this part under section 951.
(b) Limitation on a United States shareholder's pro rata share of subpart F income —(1) In general. For purposes of paragraph (a)(2)(i) of this section, a United States shareholder's pro rata share (determined in accordance with the rules of paragraph (e) of this section) of the foreign corporation's subpart F income for the taxable year of such corporation is—
(i) The amount which would have been distributed with respect to the stock which such shareholder owns (within the meaning of section 958(a)) in such corporation if on the last day, in such corporation's taxable year, on which such corporation is a controlled foreign corporation it had distributed pro rata to its shareholders an amount which bears the same ratio to its subpart F income for such taxable year as the part of such year during which such corporation is a controlled foreign corporation bears to the entire taxable year, reduced by—
(ii) The lesser of—
(A) The amount of distributions received by any other person during such taxable year as a dividend with respect to such stock multiplied by a fraction, the numerator of which is the subpart F income of such corporation for the taxable year and the denominator of which is the sum of the subpart F income and the tested income (as defined in section 951A(c)(2)(A) and § 1.951A-2(b)(1)) of such corporation for the taxable year, and
(B) The dividend which would have been received by such other person if the distributions by such corporation to all its shareholders had been the amount which bears the same ratio to the subpart F income of such corporation for the taxable year as the part of such year during which such shareholder did not own (within the meaning of section 958(a)) such stock bears to the entire taxable year.
(2) Examples. The following examples illustrate the application of this paragraph (b).
(i) Facts. The following facts are assumed for purposes of the examples.
(A) A is a United States shareholder.
(B) M is a foreign corporation that has only one class of stock outstanding.
(C) B is a nonresident alien individual, and stock owned by B is not considered owned by a domestic entity under section 958(b).
(D) P and R are foreign corporations.
(E) All persons use the calendar year as their taxable year.
(F) Year 1 ends on or after October 3, 2018, and has 365 days.
(ii) Example 1 —(A) Facts. A owns 100% of the stock of M throughout Year 1. For Year 1, M derives $100x of subpart F income, has $100x of earnings and profits, and makes no distributions.
(B) Analysis. Under section 951(a)(2) and paragraph (b)(1) of this section, A's pro rata share of the subpart F income of M for Year 1 is $100x.
(iii) Example 2 —(A) Facts. The facts are the same as in paragraph (b)(2)(ii)(A) of this section (the facts in Example 1 ), except that instead of holding 100% of the stock of M for the entire year, A sells 60% of such stock to B on May 26, Year 1. Thus, M is a controlled foreign corporation for the period January 1, Year 1, through May 26, Year 1.
(B) Analysis. Under section 951(a)(2)(A) and paragraph (b)(1)(i) of this section, A's pro rata share of the subpart F income of M is limited to the subpart F income of M which bears the same ratio to its subpart F income for such taxable year ($100x) as the part of such year during which M is a controlled foreign corporation bears to the entire taxable year (146/365). Accordingly, under section 951(a)(2) and paragraph (b)(1) of this section, A's pro rata share of the subpart F income of M for Year 1 is $40x ($100x × 146/365).
(iv) Example 3 —(A) Facts. The facts are the same as in paragraph (b)(2)(ii)(A) of this section (the facts in Example 1 ), except that instead of holding 100% of the stock of M for the entire year, A holds 60% of such stock on December 31, Year 1, having acquired such stock on May 26, Year 1, from B, who owned such stock from January 1, Year 1. Before A's acquisition of the stock, M had distributed a dividend of $15x to B in Year 1 with respect to the stock so acquired by A. M has no tested income for Year 1.
(B) Analysis. Under section 951(a)(2) and paragraph (b)(1) of this section, A's pro rata share of the subpart F income of M for Year 1 is $21x, such amount being determined as follows:
Table 1 to paragraph ( b )(2)( iv )(B)
(v) Example 4 —(A) Facts. A owns 100% of the only class of stock of P throughout Year 1, and P owns 100% of the only class of stock of R throughout Year 1. For Year 1, R derives $100x of subpart F income, has $100x of earnings and profits, and distributes a dividend of $20x to P. R has no gross tested income. P has no income for Year 1 other than the dividend received from R.
(B) Analysis. Under section 951(a)(2) and paragraph (b)(1) of this section, A's pro rata share of the subpart F income of R for Year 1 is $100x. A's pro rata share of the subpart F income of R is not reduced under section 951(a)(2)(B) and paragraph (b)(1)(ii) of this section for the dividend of $20x paid to P because there was no part of Year 1 during which A did not own (within the meaning of section 958(a)) the stock of R. Under section 959(b), the $20x distribution from R to P is not again includible in the gross income of A under section 951(a). The $20x distribution from R to P is not includible in the gross tested income of P.
(vi) Example 5 —(A) Facts. The facts are the same as in paragraph (b)(2)(v)(A) of this section (the facts in Example 4 ), except that instead of holding 100% of the stock of R for the entire year, P holds 60% of such stock on December 31, Year 1, having acquired such stock on March 14, Year 1, from B. Before P's acquisition of the stock, R had distributed a dividend of $100x to B in Year 1 with respect to the stock so acquired by P. The stock interest so acquired by P was owned by B from January 1, Year 1, until acquired by P. R also has $300x of tested income for Year 1.
(B) Analysis —( 1 ) Limitation of pro rata share of subpart F income. Under section 951(a)(2) and paragraph (b)(1) of this section, A's pro rata share of the subpart F income of M for Year 1 is $28x, such amount being determined as follows:
Table 1 to paragraph ( b )(2)( vi )(B)( 1 )
( 2 ) Limitation of pro rata share of tested income. Under section 951A(e)(1) and § 1.951A-1(d)(2), A's pro rata share of the tested income of M for Year 1 is $108x, such amount being determined as follows:
Table 1 to paragraph ( b )(2)( vi )(B)( 2 )
(c)-(d) [Reserved]
(e) Pro rata share of subpart F income defined —(1) In general —(i) Hypothetical distribution. For purposes of paragraph (b) of this section, a United States shareholder's pro rata share of a controlled foreign corporation's subpart F income for a taxable year is the amount that bears the same ratio to the corporation's subpart F income for the taxable year as the amount of the corporation's allocable earnings and profits that would be distributed with respect to the stock of the corporation which the United States shareholder owns (within the meaning of section 958(a)) for the taxable year bears to the total amount of the corporation's allocable earnings and profits that would be distributed with respect to the stock owned by all the shareholders of the corporation if all the allocable earnings and profits of the corporation for the taxable year (not reduced by actual distributions during the year) were distributed ( hypothetical distribution ) on the last day of the corporation's taxable year on which such corporation is a controlled foreign corporation ( hypothetical distribution date ).
(ii) Definition of allocable earnings and profits. For purposes of this paragraph (e), the term allocable earnings and profits means, with respect to a controlled foreign corporation for a taxable year, the amount that is the greater of—
(A) The earnings and profits of the corporation for the taxable year determined under section 964; and
(B) The sum of the subpart F income (as determined under section 952 after the application of section 951A(c)(2)(B)(ii) and § 1.951A-6(b)) of the corporation for the taxable year and the tested income (as defined in section 951A(c)(2)(A) and § 1.951A-2(b)(1)) of the corporation for the taxable year.
(2) One class of stock. If a controlled foreign corporation for a taxable year has only one class of stock outstanding on the hypothetical distribution date, the amount of the corporation's allocable earnings and profits distributed in the hypothetical distribution with respect to each share in the class of stock is determined as if the hypothetical distribution were made pro rata with respect to each share in the class of stock.
(3) More than one class of stock. If a controlled foreign corporation for a taxable year has more than one class of stock outstanding on the hypothetical distribution date, the amount of the corporation's allocable earnings and profits distributed in the hypothetical distribution with respect to each class of stock is determined based on the distribution rights of each class of stock on the hypothetical distribution date, which amount is then further distributed pro rata with respect to each share in the class of stock. Subject to paragraphs (e)(4) through (6) of this section, the distribution rights of a class of stock are determined taking into account all facts and circumstances related to the economic rights and interest in the allocable earnings and profits of the corporation of each class, including the terms of the class of stock, any agreement among the shareholders and, if and to the extent appropriate, the relative fair market value of shares of stock. For purposes of this paragraph (e)(3), facts and circumstances do not include actual distributions (including distributions by redemption) or any amount treated as a dividend under any other provision of subtitle A of the Internal Revenue Code (for example, under section 78, 356(a)(2), 367(b), or 1248) made during the taxable year that includes the hypothetical distribution date.
(4) Special rules —(i) Redemptions, liquidations, and returns of capital. No amount of allocable earnings and profits is distributed in the hypothetical distribution with respect to a particular class of stock based on the terms of the class of stock of the controlled foreign corporation or any agreement or arrangement with respect thereto that would result in a redemption (even if such redemption would be treated as a distribution of property to which section 301 applies pursuant to section 302(d)), a distribution in liquidation, or a return of capital.
(ii) Certain cumulative preferred stock. If a controlled foreign corporation has outstanding a class of redeemable preferred stock with cumulative dividend rights and dividend arrearages on such stock do not compound at least annually at a rate that equals or exceeds the applicable Federal rate (as defined in section 1274(d)(1)) that applies on the date the stock is issued for the term from such issue date to the mandatory redemption date based on a comparable compounding assumption (the relevant AFR ), the amount of the corporation's allocable earnings and profits distributed in the hypothetical distribution with respect to the class of stock may not exceed the amount of dividends actually paid during the taxable year with respect to the class of stock plus the present value at the end of the controlled foreign corporation's taxable year of the unpaid current dividends with respect to the class determined using the relevant AFR and assuming the dividends will be paid at the mandatory redemption date. For purposes of this paragraph (e)(4)(ii), if the class of preferred stock does not have a mandatory redemption date, the mandatory redemption date is the date that the class of preferred stock is expected to be redeemed based on all facts and circumstances.
(iii) Dividend arrearages. If there is an arrearage in dividends for prior taxable years with respect to a class of preferred stock of a controlled foreign corporation, an amount of the corporation's allocable earnings and profits is distributed in the hypothetical distribution to the class of preferred stock by reason of the arrearage only to the extent the arrearage exceeds the accumulated earnings and profits of the controlled foreign corporation remaining from prior taxable years beginning after December 31, 1962, as of the beginning of the taxable year, or the date on which such stock was issued, whichever is later (the applicable date ). If there is an arrearage in dividends for prior taxable years with respect to more than one class of preferred stock, the previous sentence is applied to each class in order of priority, except that the accumulated earnings and profits remaining after the applicable date are reduced by the allocable earnings and profits necessary to satisfy arrearages with respect to classes of stock with a higher priority. For purposes of this paragraph (e)(4)(iii), the amount of any arrearage with respect to stock described in paragraph (e)(4)(ii) of this section is determined in the same manner as the present value of unpaid current dividends on such stock under paragraph (e)(4)(ii) of this section.
(5) Restrictions or other limitations on distributions —(i) In general. A restriction or other limitation on distributions of an amount of earnings and profits by a controlled foreign corporation is not taken into account in determining the amount of the corporation's allocable earnings and profits distributed in a hypothetical distribution to a class of stock of the controlled foreign corporation.
(ii) Definition. For purposes of paragraph (e)(5)(i) of this section, a restriction or other limitation on distributions includes any limitation that has the effect of limiting the distribution of an amount of earnings and profits by a controlled foreign corporation with respect to a class of stock of the corporation, other than currency or other restrictions or limitations imposed under the laws of any foreign country as provided in section 964(b).
(iii) Exception for certain preferred distributions. For purposes of paragraph (e)(5)(i) of this section, the right to receive periodically a fixed amount (whether determined by a percentage of par value, a reference to a floating coupon rate, a stated return expressed in terms of a certain amount of U.S. dollars or foreign currency, or otherwise) with respect to a class of stock the distribution of which is a condition precedent to a further distribution of earnings and profits that year with respect to any class of stock (not including a distribution in partial or complete liquidation) is not a restriction or other limitation on the distribution of earnings and profits by a controlled foreign corporation.
(iv) Illustrative list of restrictions and limitations. Except as provided in paragraph (e)(5)(iii) of this section, restrictions or other limitations on distributions include, but are not limited to—
(A) An arrangement that restricts the ability of a controlled foreign corporation to pay dividends on a class of stock of the corporation until a condition or conditions are satisfied (for example, until another class of stock is redeemed);
(B) A loan agreement entered into by a controlled foreign corporation that restricts or otherwise affects the ability to make distributions on its stock until certain requirements are satisfied; or
(C) An arrangement that conditions the ability of a controlled foreign corporation to pay dividends to its shareholders on the financial condition of the corporation.
(6) Transactions and arrangements with a principal purpose of changing pro rata shares. Appropriate adjustments must be made to the allocation of allocable earnings and profits that would be distributed (without regard to this paragraph (e)(6)) in a hypothetical distribution with respect to any share of stock outstanding as of the hypothetical distribution date to disregard the effect on the hypothetical distribution of any transaction or arrangement that is undertaken as part of a plan a principal purpose of which is the avoidance of Federal income taxation by changing the amount of allocable earnings and profits distributed in any hypothetical distribution with respect to such share. This paragraph (e)(6) also applies for purposes of the pro rata share rules described in § 1.951A-1(d) that reference this paragraph (e), including the rules in § 1.951A-1(d)(3) that determine the pro rata share of qualified business asset investment based on the pro rata share of tested income.
(7) Examples. The following examples illustrate the application of this paragraph (e).
(i) Facts. Except as otherwise stated, the following facts are assumed for purposes of the examples:
(A) FC1 is a controlled foreign corporation.
(B) USP1 and USP2 are domestic corporations.
(C) Individual A is a foreign individual, and FC2 is a foreign corporation that is not a controlled foreign corporation.
(D) All persons use the calendar year as their taxable year.
(E) Any ownership of FC1 by any shareholder is for all of Year 1.
(F) The common shareholders of FC1 are entitled to dividends when declared by FC1's board of directors.
(G) There are no accrued but unpaid dividends with respect to preferred shares, the preferred stock is not described in paragraph (e)(4)(ii) of this section, and common shares have positive liquidation value.
(H) There are no other facts and circumstances related to the economic rights and interest of any class of stock in the allocable earnings and profits of a foreign corporation, and no transaction or arrangement was entered into as part of a plan a principal purpose of which is the avoidance of Federal income taxation.
(I) FC1 has neither tested income within the meaning of section 951A(c)(2)(A) and § 1.951A-2(b)(1) nor tested loss within the meaning of section 951A(c)(2)(B)(i) and § 1.951A-2(b)(2).
(ii) Example 1: Single class of stock —(A) Facts. FC1 has outstanding 100 shares of one class of stock. USP1 owns 60 shares of FC1. USP2 owns 40 shares of FC1. For Year 1, FC1 has $1,000x of earnings and profits and $100x of subpart F income within the meaning of section 952.
(B) Analysis. FC1 has one class of stock. Therefore, under paragraph (e)(2) of this section, FC1's allocable earnings and profits of $1,000x are distributed in the hypothetical distribution pro rata to each share of stock. Accordingly, under paragraph (e)(1) of this section, for Year 1, USP1's pro rata share of FC1's subpart F income is $60x ($100x × $600x/$1,000x) and USP2's pro rata share of FC1's subpart F income is $40x ($100x × $400x/$1,000x).
(iii) Example 2: Common and preferred stock —(A) Facts. FC1 has outstanding 70 shares of common stock and 30 shares of 4% nonparticipating, voting preferred stock with a par value of $10x per share. USP1 owns all of the common shares. Individual A owns all of the preferred shares. For Year 1, FC1 has $100x of earnings and profits and $50x of subpart F income within the meaning of section 952.
(B) Analysis. The distribution rights of the preferred shares are not a restriction or other limitation within the meaning of paragraph (e)(5) of this section. Under paragraph (e)(3) of this section, the amount of FC1's allocable earnings and profits distributed in the hypothetical distribution with respect to Individual A's preferred shares is $12x (0.04 × $10x × 30) and with respect to USP1's common shares is $88x ($100x−$12x). Accordingly, under paragraph (e)(1) of this section, USP1's pro rata share of FC1's subpart F income is $44x ($50x − $88x/$100x) for Year 1.
(iv) Example 3: Restriction based on cumulative income —(A) Facts. FC1 has outstanding 10 shares of common stock and 400 shares of 2% nonparticipating, voting preferred stock with a par value of $1x per share. USP1 owns all of the common shares. FC2 owns all of the preferred shares. USP1 and FC2 cause the governing documents of FC1 to provide that no dividends may be paid to the common shareholders until FC1 cumulatively earns $100,000x of income. For Year 1, FC1 has $50x of earnings and profits and $50x of subpart F income within the meaning of section 952.
(B) Analysis. The agreement restricting FC1's ability to pay dividends to common shareholders until FC1 cumulatively earns $100,000x of income is a restriction or other limitation within the meaning of paragraph (e)(5) of this section. Therefore, the restriction is disregarded for purposes of determining the amount of FC1's allocable earnings and profits distributed in the hypothetical distribution to a class of stock. The distribution rights of the preferred shares are not a restriction or other limitation within the meaning of paragraph (e)(5) of this section. Under paragraph (e)(3) of this section, the amount of FC1's allocable earnings and profits distributed in the hypothetical distribution with respect to FC2's preferred shares is $8x (0.02 × $1x × 400) and with respect to USP1's common shares is $42x ($50x − $8x). Accordingly, under paragraph (e)(1) of this section, USP1's pro rata share of FC1's subpart F income is $42x for Year 1.
(v) Example 4: Redemption rights —(A) Facts. FC1 has outstanding 40 shares of common stock and 10 shares of 4% nonparticipating, preferred stock with a par value of $50x per share. Pursuant to the terms of the preferred stock, FC1 has the right to redeem at any time, in whole or in part, the preferred stock. FC2 owns all of the preferred shares. USP1, wholly owned by FC2, owns all of the common shares. Pursuant to the governing documents of FC1, no dividends may be paid to the common shareholders while the preferred stock is outstanding. For Year 1, FC1 has $100x of earnings and profits and $100x of subpart F income within the meaning of section 952.
(B) Analysis. The agreement restricting FC1's ability to pay dividends to common shareholders while the preferred stock is outstanding is a restriction or other limitation within the meaning of paragraph (e)(5) of this section. Therefore, the restriction is disregarded for purposes of determining the amount of FC1's allocable earnings and profits distributed in the hypothetical distribution to a class of stock. Under paragraph (e)(4)(i) of this section, no amount of allocable earnings and profits is distributed in the hypothetical distribution to the preferred shareholders on the hypothetical distribution date as a result of FC1's right to redeem the preferred shares. This is the case regardless of the restriction on paying dividends to the common shareholders while the preferred stock is outstanding, and regardless of the fact that a redemption of FC2's preferred shares would be treated as a distribution to which section 301 applies under section 302(d) (due to FC2's constructive ownership of the common shares). Thus, neither the restriction on paying dividends to the common shareholders while the preferred stock is outstanding nor FC1's redemption rights with respect to the preferred shares affects the distribution of allocable earnings and profits in the hypothetical distribution to FC1's shareholders. However, the distribution rights of the preferred shares are not a restriction or other limitation within the meaning of paragraph (e)(5) of this section. As a result, the amount of FC1's allocable earnings and profits distributed in the hypothetical distribution with respect to FC2's preferred shares is $20x (0.04 × $50x × 10) and with respect to USP1's common shares is $80x ($100x−$20x). Accordingly, under paragraph (e)(1) of this section, USP1's pro rata share of FC1's subpart F income is $80x for Year 1.
(vi) Example 5: Shareholder owns common and preferred stock —(A) Facts. FC1 has outstanding 40 shares of common stock and 60 shares of 6% nonparticipating, nonvoting preferred stock with a par value of $100x per share. USP1 owns 30 shares of the common stock and 15 shares of the preferred stock during Year 1. The remaining 10 shares of common stock and 45 shares of preferred stock of FC1 are owned by Individual A. For Year 1, FC1 has $1,000x of earnings and profits and $500x of subpart F income within the meaning of section 952.
(B) Analysis. The right of the holder of the preferred stock to receive 6% of par value is not a restriction or other limitation within the meaning of paragraph (e)(5) of this section. The amount of FC1's allocable earnings and profits distributed in the hypothetical distribution with respect to FC1's preferred shares is $360x (0.06 × $100x × 60) and with respect to its common shares is $640x ($1,000x−$360x). As a result, the amount of FC1's allocable earnings and profits distributed in the hypothetical distribution to USP1 is $570x, the sum of $90x ($360x × 15/60) with respect to its preferred shares and $480x ($640x × 30/40) with respect to its common shares. Accordingly, under paragraph (e)(1) of this section, USP1's pro rata share of the subpart F income of FC1 is $285x ($500x × $570x/$1,000x).
(vii) Example 6: Subpart F income and tested income —(A) Facts. FC1 has outstanding 700 shares of common stock and 300 shares of 4% nonparticipating, voting preferred stock with a par value of $100x per share. USP1 owns all of the common shares. USP2 owns all of the preferred shares. For Year 1, FC1 has $10,000x of earnings and profits, $2,000x of subpart F income within the meaning of section 952, and $9,000x of tested income within the meaning of section 951A(c)(2)(A) and § 1.951A-2(b)(1).
(B) Analysis —( 1 ) Hypothetical distribution. The allocable earnings and profits of FC1 determined under paragraph (e)(1)(ii) of this section are $11,000x, the greater of FC1's earnings and profits as determined under section 964 ($10,000x) or the sum of FC1's subpart F income and tested income ($2,000x + $9,000x). The amount of FC1's allocable earnings and profits distributed in the hypothetical distribution with respect to USP2's preferred shares is $1,200x (0.04 × $100x × 300) and with respect to USP1's common shares is $9,800x ($11,000x−$1,200x).
( 2 ) Pro rata share of subpart F income. Accordingly, under paragraph (e)(1) of this section, USP1's pro rata share of FC1's subpart F income is $1,782x ($2,000x × $9,800x/$11,000x), and USP2's pro rata share of FC1's subpart F income is $218x ($2,000x × $1,200x/$11,000x).
( 3 ) Pro rata share of tested income. Accordingly, under § 1.951A-1(d)(2), USP1's pro rata share of FC1's tested income is $8,018x ($9,000x × $9,800x/$11,000x), and USP2's pro rata share of FC1's tested income is $982x ($9,000x × $1,200x/$11,000x) for Year 1.
(viii) Example 7: Subpart F income and tested loss —(A) Facts. The facts are the same as in paragraph (e)(7)(vii)(A) of this section (the facts in Example 6 ), except that for Year 1, FC1 has $8,000x of earnings and profits, $10,000x of subpart F income within the meaning of section 952 (but without regard to the limitation in section 952(c)(1)(A)), and $2,000x of tested loss within the meaning of section 951A(c)(2)(B)(i) and § 1.951A-2(b)(2). Under section 951A(c)(2)(B)(ii) and § 1.951A-6(b), the earnings and profits of FC1 are increased for purposes of section 952(c)(1)(A) by the amount of FC1's tested loss. Accordingly, after the application of section 951A(c)(2)(B)(ii) and § 1.951A-6(b), the subpart F income of FC1 is $10,000x.
(B) Analysis —( 1 ) Pro rata share of subpart F income. The allocable earnings and profits determined under paragraph (e)(1)(ii) of this section are $10,000x, the greater of the earnings and profits of FC1 determined under section 964 ($8,000x) or the sum of FC1's subpart F income and tested income ($10,000x + $0). The amount of FC1's allocable earnings and profits distributed in the hypothetical distribution with respect to USP2's preferred shares is $1,200x (.04 × $100x × 300) and with respect to USP1's common shares is $8,800x ($10,000x−$1,200x). Accordingly, under paragraph (e)(1) of this section, for Year 1, USP1's pro rata share of FC1's subpart F income is $8,800x and USP2's pro rata share of FC1's subpart F income is $1,200x.
( 2 ) Pro rata share of tested loss. The allocable earnings and profits determined under § 1.951A-1(d)(4)(i)(B) are $2,000x, the amount of FC1's tested loss. Under § 1.951A-1(d)(4)(i)(C), the entire $2,000x of tested loss is allocated in the hypothetical distribution to USP1's common shares. Accordingly, USP1's pro rata share of the tested loss is $2,000x.
(f) Determination of holding period. For purposes of sections 951 through 964, the holding period of an asset (including stock of a controlled foreign corporation) shall be determined by excluding the day on which such asset is acquired and including the day on which such asset is disposed of. The application of this paragraph may be illustrated by the following example:
(g) United States shareholder defined —(1) In general. For purposes of sections 951 through 964, the term United States shareholder means, with respect to a foreign corporation, a United States person (as defined in section 957(c)) who owns within the meaning of section 958(a), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation.
(2) Percentage of total combined voting power owned by United States person —(i) Meaning of combined voting power. In determining for purposes of subparagraph (1) of this paragraph whether a United States person owns the requisite percentage of voting power of all classes of stock entitled to vote, consideration will be given to all the facts and circumstances in each case. In any case where—
( a ) A foreign corporation has more than one class of stock outstanding, and
( b ) One or more United States persons own (within the meaning of section 958) shares of any one class of stock which possesses the power to elect, appoint, or replace a person, or persons, who with respect to such corporation, exercise the powers ordinarily exercised by a member of the board of directors of a domestic corporation, the percentage of the total combined voting power with respect to such corporation owned by any such United States person shall be his proportionate share of the percentage of the persons exercising the powers ordinarily exercised by members of the board of directors of a domestic corporation (described in ( b ) of this subdivision) which such class of stock (as a class) possesses the power to elect, appoint, or replace. In all cases, however, a United States person will be deemed to own 10 percent or more of the total combined voting power with respect to a foreign corporation if such person owns (within the meaning of section 958) 20 percent or more of the total number of shares of a class of stock of such corporation possessing one or more powers enumerated in paragraph (b)(1) of § 1.957-1. Whether a foreign corporation is a controlled foreign corporation for purposes of sections 951 through 964 shall be determined by applying the rules of section 957 and §§ 1.957-1 through 1.957-4.
(ii) Illustration. The application of this paragraph may be illustrated by the following examples:
(h) Applicability dates. Paragraphs (a), (b)(1)(ii), (b)(2), (e)(1)(ii)(B), and (g)(1) of this section apply to taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of United States shareholders in which or with which such taxable years of foreign corporations end. Except for paragraph (e)(1)(ii)(B) of this section, paragraph (e) of this section applies to taxable years of United States shareholders ending on or after October 3, 2018.
§ 1.951-2   [Reserved]
§ 1.951-3   Coordination of subpart F with foreign personal holding company provisions.
A United States shareholder (as defined in section 951(b)) who is required under section 551(b) to include in his gross income for his taxable year his share of the undistributed foreign personal holding company income for the taxable year of a foreign personal holding company (as defined in section 552) which for that taxable year is a controlled foreign corporation (as defined in section 957) shall not be required to include in his gross income for his taxable year under section 951(a) and paragraph (a) of § 1.951-1 any amount attributable to the earnings and profits of such corporation for that taxable year of such corporation. If a foreign corporation is both a foreign personal holding company and a controlled foreign corporation for the same period which is only a part of its taxable year, then, for purposes of applying the immediately preceding sentence, such corporation shall be deemed to be, for such part of such year, a foreign personal holding company and not a controlled foreign corporation and the earnings and profits of such corporation for the taxable year shall be deemed to be that amount which bears the same ratio to its earnings and profits for the taxable year as such part of the taxable year bears to the entire taxable year. The application of this section may be illustrated by the following examples:
(b) If P Corporation's earnings and profits accumulated for 1963, 1964, and 1965 were $15,000, instead of $40,000, the result would be the same as in paragraph (a) of this example, except that a withdrawal of only $15,000 of previously excluded subpart F income from investment in less developed countries would be includible in A's gross income for 1966 under section 951(a)(1)(A)(ii) and paragraph (a)(2) of § 1.951-1.
(c) The principles of this example also apply to withdrawals (determined under section 955(a), as in effect before the enactment of the Tax Reduction Act of 1975) of previously excluded subpart F income from investment in less developed countries effected after the effective date of such Act, and to withdrawals (determined under section 955(a), as amended by such Act) of previously excluded subpart F income from investment in foreign base company shipping operations.
(b) If P Corporation's earnings and profits accumulated for 1963, 1964, and 1965 were $9,000 instead of $22,000, the result would be the same as in paragraph (a) of this example, except that only $9,000 would be includible in A's gross income for 1966 under section 951(a)(1)(B) and paragraph (a)(2)(iv) of § 1.951-1 as an investment of earnings in United States property.
§ 1.951A-1   General provisions.
(a) Overview —(1) In general. This section and §§ 1.951A-2 through 1.951A-7 (collectively, the section 951A regulations ) provide rules to determine a United States shareholder's income inclusion under section 951A, describe certain consequences of an income inclusion under section 951A with respect to controlled foreign corporations and their United States shareholders, and define certain terms for purposes of section 951A and the section 951A regulations. This section provides general rules for determining a United States shareholder's inclusion of global intangible low-taxed income, including a rule relating to the application of section 951A and the section 951A regulations to domestic partnerships and their partners. Section 1.951A-2 provides rules for determining a controlled foreign corporation's tested income or tested loss. Section 1.951A-3 provides rules for determining a controlled foreign corporation's qualified business asset investment. Section 1.951A-4 provides rules for determining a controlled foreign corporation's tested interest expense and tested interest income. Section 1.951A-5 provides rules relating to the treatment of the inclusion of global intangible low-taxed income for certain purposes. Section 1.951A-6 provides certain adjustments to earnings and profits and basis of a controlled foreign corporation related to a tested loss. Section 1.951A-7 provides dates of applicability.
(2) Scope. Paragraph (b) of this section provides the general rule requiring a United States shareholder to include in gross income its global intangible low-taxed income for a U.S. shareholder inclusion year. Paragraph (c) of this section provides rules for determining the amount of a United States shareholder's global intangible low-taxed income for the U.S. shareholder inclusion year, including a rule for the application of section 951A and the section 951A regulations to consolidated groups. Paragraph (d) of this section provides rules for determining a United States shareholder's pro rata share of certain items for purposes of determining the United States shareholder's global intangible low-taxed income. Paragraph (e) of this section provides rules for the treatment of a domestic partnership and its partners for purposes of section 951A and the section 951A regulations. Paragraph (f) of this section provides additional definitions for purposes of this section and the section 951A regulations.
(b) Inclusion of global intangible low-taxed income. Each person who is a United States shareholder of any controlled foreign corporation and owns section 958(a) stock of any such controlled foreign corporation includes in gross income in the U.S. shareholder inclusion year the shareholder's GILTI inclusion amount, if any, for the U.S. shareholder inclusion year.
(c) Determination of GILTI inclusion amount —(1) In general. Except as provided in paragraph (c)(4) of this section, the term GILTI inclusion amount means, with respect to a United States shareholder and a U.S. shareholder inclusion year, the excess (if any) of—
(i) The shareholder's net CFC tested income (as defined in paragraph (c)(2) of this section) for the year, over
(ii) The shareholder's net deemed tangible income return (as defined in paragraph (c)(3) of this section) for the year.
(2) Definition of net CFC tested income. The term net CFC tested income means, with respect to a United States shareholder and a U.S. shareholder inclusion year, the excess (if any) of—
(i) The aggregate of the shareholder's pro rata share of the tested income of each tested income CFC (as defined in § 1.951A-2(b)(1)) for a CFC inclusion year that ends with or within the U.S. shareholder inclusion year, over
(ii) The aggregate of the shareholder's pro rata share of the tested loss of each tested loss CFC (as defined in § 1.951A-2(b)(2)) for a CFC inclusion year that ends with or within the U.S. shareholder inclusion year.
(3) Definition of net deemed tangible income return —(i) In general. The term net deemed tangible income return means, with respect to a United States shareholder and a U.S. shareholder inclusion year, the excess (if any) of—
(A) The shareholder's deemed tangible income return (as defined in paragraph (c)(3)(ii) of this section) for the U.S. shareholder inclusion year, over
(B) The shareholder's specified interest expense (as defined in paragraph (c)(3)(iii) of this section) for the U.S. shareholder inclusion year.
(ii) Definition of deemed tangible income return. The term deemed tangible income return means, with respect to a United States shareholder and a U.S. shareholder inclusion year, 10 percent of the aggregate of the shareholder's pro rata share of the qualified business asset investment (as defined in § 1.951A-3(b)) of each tested income CFC for a CFC inclusion year that ends with or within the U.S. shareholder inclusion year.
(iii) Definition of specified interest expense. The term specified interest expense means, with respect to a United States shareholder and a U.S. shareholder inclusion year, the excess (if any) of—
(A) The aggregate of the shareholder's pro rata share of the tested interest expense (as defined in § 1.951A-4(b)(1)) of each controlled foreign corporation for a CFC inclusion year that ends with or within the U.S. shareholder inclusion year, over
(B) The aggregate of the shareholder's pro rata share of the tested interest income (as defined in § 1.951A-4(b)(2)) of each controlled foreign corporation for a CFC inclusion year that ends with or within the U.S. shareholder inclusion year.
(4) Determination of GILTI inclusion amount for consolidated groups. For purposes of section 951A and the section 951A regulations, a member of a consolidated group (as defined in § 1.1502-1(h)) determines its GILTI inclusion amount taking into account the rules provided in § 1.1502-51.
(d) Determination of pro rata share —(1) In general. For purposes of paragraph (c) of this section, each United States shareholder that owns section 958(a) stock of a controlled foreign corporation as of a hypothetical distribution date determines its pro rata share (if any) of each tested item of the controlled foreign corporation for the CFC inclusion year that includes the hypothetical distribution date and ends with or within the U.S. shareholder inclusion year. Except as otherwise provided in this paragraph (d), a United States shareholder's pro rata share of each tested item is determined independently of its pro rata share of each other tested item. In no case may the sum of the pro rata share of any tested item of a controlled foreign corporation for a CFC inclusion year allocated to stock under this paragraph (d) exceed the amount of such tested item of the controlled foreign corporation for the CFC inclusion year. Except as modified in this paragraph (d), a United States shareholder's pro rata share of any tested item is determined under the rules of section 951(a)(2) and § 1.951-1(b) and (e) in the same manner as those provisions apply to subpart F income. Under section 951(a)(2) and § 1.951-1(b) and (e), as modified by this paragraph (d), a United States shareholder's pro rata share of any tested item for a U.S. shareholder inclusion year is determined with respect to the section 958(a) stock of the controlled foreign corporation owned by the United States shareholder on a hypothetical distribution date with respect to a CFC inclusion year that ends with or within the U.S. shareholder inclusion year. A United States shareholder's pro rata share of any tested item is translated into United States dollars using the average exchange rate for the CFC inclusion year of the controlled foreign corporation. Paragraphs (d)(2) through (5) of this section provide rules for determining a United States shareholder's pro rata share of each tested item of a controlled foreign corporation.
(2) Tested income —(i) In general. Except as provided in paragraph (d)(2)(ii) of this section, a United States shareholder's pro rata share of the tested income of each tested income CFC for a U.S. shareholder inclusion year is determined under section 951(a)(2) and § 1.951-1(b) and (e), substituting “tested income” for “subpart F income” each place it appears, other than in § 1.951-1(e)(1)(ii)(B) and the denominator of the fraction described in § 1.951-1(b)(1)(ii)(A).
(ii) Special rule for prior allocation of tested loss. In any case in which tested loss has been allocated to any class of stock in a prior CFC inclusion year under paragraph (d)(4)(iii) of this section, tested income is first allocated to each such class of stock in the order of its liquidation priority to the extent of the excess (if any) of the sum of the tested loss allocated to each such class of stock for each prior CFC inclusion year under paragraph (d)(4)(iii) of this section, over the sum of the tested income allocated to each such class of stock for each prior CFC inclusion year under this paragraph (d)(2)(ii). Paragraph (d)(2)(i) of this section applies for purposes of determining a United States shareholder's pro rata share of the remainder of the tested income, except that, for purposes of the hypothetical distribution of section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i), the amount of allocable earnings and profits of the tested income CFC is reduced by the amount of tested income allocated under the first sentence of this paragraph (d)(2)(ii). For an example of the application of this paragraph (d)(2), see paragraph (d)(4)(iv)(B) of this section ( Example 2 ).
(3) Qualified business asset investment —(i) In general. Except as provided in paragraphs (d)(3)(ii) of this section, a United States shareholder's pro rata share of the qualified business asset investment of a tested income CFC for a U.S. shareholder inclusion year bears the same ratio to the total qualified business asset investment of the tested income CFC for the CFC inclusion year as the United States shareholder's pro rata share of the tested income of the tested income CFC for the U.S. shareholder inclusion year bears to the total tested income of the tested income CFC for the CFC inclusion year.
(ii) Special rule for excess hypothetical tangible return —(A) In general. If the tested income of a tested income CFC for a CFC inclusion year is less than the hypothetical tangible return of the tested income CFC for the CFC inclusion year, a United States shareholder's pro rata share of the qualified business asset investment of the tested income CFC for a United States shareholder inclusion year bears the same ratio to the qualified business asset investment of the tested income CFC as the United States shareholder's pro rata share of the hypothetical tangible return of the CFC for the U.S. shareholder inclusion year bears to the total hypothetical tangible return of the CFC for the CFC inclusion year.
(B) Determination of pro rata share of hypothetical tangible return. For purposes of paragraph (d)(3)(ii)(A) of this section, a United States shareholder's pro rata share of the hypothetical tangible return of a CFC for a CFC inclusion year is determined in the same manner as the United States shareholder's pro rata share of the tested income of the CFC for the CFC inclusion year under paragraph (d)(2) of this section by treating the amount of the hypothetical tangible return as the amount of tested income.
(C) Definition of hypothetical tangible return. For purposes of this paragraph (d)(3)(ii), the term hypothetical tangible return means, with respect to a tested income CFC for a CFC inclusion year, 10 percent of the qualified business asset investment of the tested income CFC for the CFC inclusion year.
(iii) Examples. The following examples illustrate the application of paragraphs (d)(2) and (3) of this section. See also § 1.951-1(e)(7)(vii) ( Example 6 ) (illustrating a United States shareholder's pro rata share of tested income).
(A) Example 1 —( 1 ) Facts. FS, a controlled foreign corporation, has outstanding 70 shares of common stock and 30 shares of 4% nonparticipating, cumulative preferred stock with a par value of $10x per share. P Corp, a domestic corporation and a United States shareholder of FS, owns all of the common shares. Individual A, a United States citizen and a United States shareholder, owns all of the preferred shares. Individual A, FS, and P Corp use the calendar year as their taxable year. Individual A and P Corp are shareholders of FS for all of Year 4. At the beginning of Year 4, FS had no dividend arrearages with respect to its preferred stock. For Year 4, FS has $100x of earnings and profits, $120x of tested income, and no subpart F income within the meaning of section 952. FS also has $750x of qualified business asset investment for Year 4.
( 2 ) Analysis —( i ) Determination of pro rata share of tested income. For purposes of determining P Corp's pro rata share of FS's tested income under paragraph (d)(2) of this section, the amount of FS's allocable earnings and profits for purposes of the hypothetical distribution described in § 1.951-1(e)(1)(i) is $120x, the greater of its earnings and profits as determined under section 964 ($100x) and the sum of its subpart F income and tested income ($0 + $120x). Under paragraph (d)(2) of this section and § 1.951-1(e)(3), the amount of FS's allocable earnings and profits distributed in the hypothetical distribution with respect to Individual A's preferred shares is $12x (0.04 × $10x × 30) and the amount distributed with respect to P Corp's common shares is $108x ($120x − $12x). Accordingly, under paragraph (d)(2) of this section and § 1.951-1(e)(1), Individual A's pro rata share of FS's tested income is $12x, and P Corp's pro rata share of FS's tested income is $108x for Year 4.
( ii ) Determination of pro rata share of qualified business asset investment. The special rule of paragraph (d)(3)(ii)(A) of this section does not apply because FS's tested income of $120x is not less than FS's hypothetical tangible return of $75x, which is 10% of FS's qualified business asset investment of $750x. Accordingly, under the general rule of paragraph (d)(3)(i) of this section, Individual A's and P Corp's respective pro rata shares of FS's qualified business asset investment bears the same ratio to FS's total qualified business asset investment as their respective pro rata shares of FS's tested income bears to FS's total tested income. Thus, Individual A's pro rata share of FS's qualified business asset investment is $75x ($750x × $12x/$120x), and P Corp's pro rata share of FS's qualified business asset investment is $675x ($750x × $108x/$120x).
(B) Example 2 —( 1 ) Facts. The facts are the same as in paragraph (d)(3)(iv)(A)( 1 ) of this section (the facts in Example 1 of this section), except that FS has $1,500x of qualified business asset investment for Year 4.
( 2 ) Analysis —( i ) Determination of pro rata share of tested income. The analysis and the result are the same as in paragraph (d)(3)(iv)(A)( 2 )( i ) of this section (paragraph (i) of the analysis in Example 1 of this section).
( ii ) Determination of pro rata share of qualified business asset investment. The special rule of paragraph (d)(3)(ii)(A) of this section applies because FS's tested income of $120x is less than FS's hypothetical tangible return of $150x, which is 10% of FS's qualified business asset investment of $1,500x. Under paragraph (d)(3)(ii)(A) of this section, Individual A's and P Corp's respective pro rata shares of FS's qualified business asset investment bears the same ratio to FS's qualified business asset investment as their respective pro rata shares of the hypothetical tangible return of FS bears to the total hypothetical tangible return of FS. Under paragraph (d)(3)(ii)(B) of this section, P Corp's and Individual A's respective pro rata share of FS's hypothetical tangible return is determined under paragraph (d)(2) of this section in the same manner as their respective pro rata shares of the tested income of FS by treating the hypothetical tangible return as the amount of tested income. The amount of FS's allocable earnings and profits for purposes of the hypothetical distribution described in § 1.951-1(e)(1)(i) is $150x, the greater of its earnings and profits as determined under section 964 ($100x) and the sum of its subpart F income and hypothetical tangible return ($0 + $150x). The amount of FS's allocable earnings and profits distributed in the hypothetical distribution is $12x (.04 × $10x × 30) with respect to Individual A's preferred shares and $138x ($150x − $12x) with respect to P Corp's common shares. Accordingly, Individual A's pro rata share of FS's qualified business asset investment is $120x ($1,500x × $12x/$150x), and P Corp's pro rata share of FS's qualified business asset investment is $1,380x ($1,500x × $138x/$150x).
(C) Example 3 —( 1 ) Facts. P Corp, a domestic corporation and a United States shareholder, owns 100% of the only class of stock of FS, a controlled foreign corporation, from January 1 of Year 1, until May 26 of Year 1. On May 26 of Year 1, P Corp sells all of its FS stock to R Corp, a domestic corporation that is not related to P Corp, and recognizes no gain or loss on the sale. R Corp, a United States shareholder of FS, owns 100% of the stock of FS from May 26 through December 31 of Year 1. For Year 1, FS has $50x of earnings and profits, $50x of tested income, and no subpart F income within the meaning of section 952. FS also has $1,500x of qualified business asset investment for Year 1. On May 1 of Year 1, FS distributes a $20x dividend to P Corp. P Corp, R Corp, and FS all use the calendar year as their taxable year.
( 2 ) Analysis —( i ) Determination of pro rata share of tested income. For purposes of determining R Corp's pro rata share of FS's tested income under paragraph (d)(2) of this section, the amount of FS's allocable earnings and profits for purposes of the hypothetical distribution described in § 1.951-1(e)(1)(i) is $50x, the greater of its earnings and profits as determined under section 964 ($50x) or the sum of its subpart F income and tested income ($0 + $50x). Under paragraph (d)(2) of this section and § 1.951-1(e)(1), FS's allocable earnings and profits of $50x are distributed in the hypothetical distribution pro rata to each share of stock. R Corp's pro rata share of FS's tested income for Year 1 is its pro rata share under section 951(a)(2)(A) and § 1.951-1(b)(1)(i) ($50x), reduced under section 951(a)(2)(B) and § 1.951-1(b)(1)(ii) by $20x, which is the lesser of $20x, the dividend received by P Corp during Year 1 with respect to the FS stock acquired by R Corp ($20x), multiplied by a fraction, the numerator of which is the tested income ($50x) of FS for Year 1 and the denominator of which is the sum of the subpart F income ($0) and the tested income ($50x) of FS for Year 1 ($20x × $50x/$50x), and $20x, which is P Corp's pro rata share (100%) of the amount which bears the same ratio to FS's tested income for Year 1 ($50x) as the period during which R Corp did not own (within the meaning of section 958(a)) the FS stock (146 days) bears to the entire taxable year

(1 × $50x × 146/365). Accordingly, R Corp's pro rata share of tested income of FS for Year 1 is $30x ($50x − $20x).
( ii ) Determination of pro rata share of qualified business asset investment. The special rule of paragraph (d)(3)(ii) of this section applies because FS's tested income of $50x is less than FS's hypothetical tangible return of $150x, which is 10% of FS's qualified business asset investment of $1,500x. Under paragraph (d)(3)(ii) of this section, R Corp's pro rata share of FS's qualified business asset investment is the amount that bears the same ratio to FS's qualified business asset investment as R Corp's pro rata share of the hypothetical tangible return of FS bears to the total hypothetical tangible return of FS. R Corp's pro rata share of FS's hypothetical tangible return is its pro rata share under section 951(a)(2)(A) and § 1.951-1(b)(1)(i) ($150x), reduced under section 951(a)(2)(B) and § 1.951-1(b)(1)(ii) by $20x, which is the lesser of $20x, the dividend received by P Corp during Year 1 with respect to the FS stock acquired by R Corp ($20x) multiplied by a fraction, the numerator of which is the hypothetical tangible return ($150x) of FS for Year 1 and the denominator of which is the sum of the subpart F income ($0) and the hypothetical tangible return ($150x) of FS for Year 1 ($20x × $150x/$150x), and $60x, which is P Corp's pro rata share (100%) of the amount which bears the same ratio to FS's hypothetical tangible return for Year 1 ($150x) as the period during which R Corp did not own (within the meaning of section 958(a)) the FS stock (146 days) bears to the entire taxable year (1 × $150x × 146/365). Accordingly, R Corp's pro rata share of the hypothetical tangible return of FS for Year 1 is $130x ($150x − $20x), and R Corp's pro rata share of FS's qualified business asset investment is $1,300x ($1,500x × $130x/$150x).
(4) Tested loss —(i) In general. A United States shareholder's pro rata share of the tested loss of each tested loss CFC for a U.S. shareholder inclusion year is determined under section 951(a)(2) and § 1.951-1(b) and (e) with the following modifications—
(A) “Tested loss” is substituted for “subpart F income” each place it appears;
(B) For purposes of the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i), the amount of allocable earnings and profits of a controlled foreign corporation for a CFC inclusion year is treated as being equal to the tested loss of the tested loss CFC for the CFC inclusion year;
(C) Except as provided in paragraphs (d)(4)(ii) and (iii) of this section, the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i) is treated as made solely with respect to the common stock of the tested loss CFC; and
(D) In lieu of applying section 951(a)(2)(B) and § 1.951-1(b)(1)(ii), the United States shareholder's pro rata share of the tested loss allocated to section 958(a) stock of the tested loss CFC is reduced by an amount that bears the same ratio to the amount of the tested loss as the part of such year during which such shareholder did not own (within the meaning of section 958(a)) such stock bears to the entire taxable year.
(ii) Special rule in case of accrued but unpaid dividends. If a tested loss CFC's earnings and profits that have accumulated since the issuance of preferred shares are reduced below the amount necessary to satisfy any accrued but unpaid dividends with respect to such preferred shares, then the amount by which the tested loss reduces the earnings and profits below the amount necessary to satisfy the accrued but unpaid dividends is allocated in the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i) to the preferred stock of the tested loss CFC and the remainder of the tested loss is allocated in the hypothetical distribution to the common stock of the tested loss CFC.
(iii) Special rule for stock with no liquidation value. If a tested loss CFC's common stock has a liquidation value of zero and there is at least one other class of equity with a liquidation preference relative to the common stock, then the tested loss is allocated in the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i) to the most junior class of equity with a positive liquidation value to the extent of such liquidation value. Thereafter, tested loss is allocated to the next most junior class of equity to the extent of its liquidation value and so on. All determinations of liquidation value are to be made as of the beginning of the CFC inclusion year of the tested loss CFC.
(iv) Examples. The following examples illustrate the application of this paragraph (d)(4). See also § 1.951-1(e)(7)(viii) ( Example 7 ) (illustrating a United States shareholder's pro rata share of subpart F income and tested loss).
(A) Example 1 —( 1 ) Facts. FS, a controlled foreign corporation, has outstanding 70 shares of common stock and 30 shares of 4% nonparticipating, cumulative preferred stock with a par value of $10x per share. P Corp, a domestic corporation and a United States shareholder of FS, owns all of the common shares. Individual A, a United States citizen and a United States shareholder, owns all of the preferred shares. FS, Individual A, and P Corp all use the calendar year as their taxable year. Individual A and P Corp are shareholders of FS for all of Year 5. At the beginning of Year 5, FS had earnings and profits of $120x, which accumulated after the issuance of the preferred stock. At the end of Year 5, the accrued but unpaid dividends with respect to the preferred stock are $36x. For Year 5, FS has a $100x tested loss, and no other items of income, gain, deduction or loss. At the end of Year 5, FS has earnings and profits of $20x.
( 2 ) Analysis. FS is a tested loss CFC for Year 5. Before taking into account the tested loss in Year 5, FS had sufficient earnings and profits to satisfy the accrued but unpaid dividends of $36x. The amount of the reduction in earnings below the amount necessary to satisfy the accrued but unpaid dividends attributable to the tested loss is $16x ($36x − ($120x − $100x)). Accordingly, under paragraph (d)(4)(ii) of this section, $16x of the tested loss is allocated to Individual A's preferred stock in the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i), and $84x ($100x − $16x) of the tested loss is allocated to P Corp's common shares in the hypothetical distribution.
(B) Example 2 —( 1 ) Facts. FS, a controlled foreign corporation, has outstanding 100 shares of common stock and 50 shares of 4% nonparticipating, cumulative preferred stock with a par value of $100x per share. P Corp, a domestic corporation and a United States shareholder of FS, owns all of the common shares. Individual A, a United States citizen and a United States shareholder, owns all of the preferred shares. FS, Individual A, and P Corp all use the calendar year as their taxable year. Individual A and P Corp are shareholders of FS for all of Year 1 and Year 2. At the beginning of Year 1, the common stock has no liquidation value and the preferred stock has a liquidation value of $5,000x and no accrued but unpaid dividends. In Year 1, FS has a tested loss of $1,000x and no other items of income, gain, deduction, or loss. In Year 2, FS has tested income of $3,000x and no other items of income, gain, deduction, or loss. FS has earnings and profits of $3,000x for Year 2. At the end of Year 2, FS has accrued but unpaid dividends of $400x with respect to the preferred stock, the sum of $200x for Year 1 (0.04 × $100x × 50) and $200x for Year 2 (0.04 × $100x × 50).
( 2 ) Analysis —( i ) Year 1. FS is a tested loss CFC in Year 1. The common stock of FS has liquidation value of zero, and the preferred stock has a liquidation preference relative to the common stock. The tested loss ($1,000x) does not exceed the liquidation value of the preferred stock ($5,000x). Accordingly, under paragraph (d)(4)(iii) of this section, the tested loss is allocated to the preferred stock in the hypothetical distribution described in section 951(a)(2)(A) and § 1.951-1(b)(1)(i) and (e)(1)(i). Individual A's pro rata share of the tested loss is $1,000x, and P Corp's pro rata share of the tested loss is $0.
( ii ) Year 2. FS is a tested income CFC in Year 2. Because $1,000x of tested loss was allocated to the preferred stock in Year 1 under paragraph (d)(4)(iii) of this section, the first $1,000x of tested income in Year 2 is allocated to the preferred stock under paragraph (d)(2)(ii) of this section. P Corp's and Individual A's pro rata shares of the remaining $2,000x of tested income are determined under the general rule of paragraph (d)(2)(i) of this section, except that for purposes of the hypothetical distribution the amount of FS's allocable earnings and profits is reduced by the tested income allocated under paragraph (d)(2)(ii) of this section to $2,000x ($3,000x − $1,000x). Accordingly, under paragraph (d)(2)(i) of this section and § 1.951-1(e), the amount of FS's allocable earnings and profits distributed in the hypothetical distribution with respect to Individual A's preferred stock is $400x ($400x of accrued but unpaid dividends) and with respect to P Corp's common stock is $1,600x ($2,000x − $400x). Individual A's pro rata share of the tested income is $1,400x ($1,000x + $400x), and P Corp's pro rata share of the tested income is $1,600x.
(5) Tested interest expense. A United States shareholder's pro rata share of tested interest expense of a controlled foreign corporation for a U.S. shareholder inclusion year is equal to the amount by which the tested interest expense reduces the shareholder's pro rata share of tested income of the controlled foreign corporation for the U.S. shareholder inclusion year, increases the shareholder's pro rata share of tested loss of the controlled foreign corporation for the U.S. shareholder inclusion year, or both.
(6) Tested interest income. A United States shareholder's pro rata share of tested interest income of a controlled foreign corporation for a U.S. shareholder inclusion year is equal to the amount by which the tested interest income increases the shareholder's pro rata share of tested income of the controlled foreign corporation for the U.S. shareholder inclusion year, reduces the shareholder's pro rata share of tested loss of the controlled foreign corporation for the U.S. shareholder inclusion year, or both.
(e) Stock owned through domestic partnerships. See § 1.958-1(d) for rules regarding the ownership of stock of a foreign corporation through a domestic partnership for purposes of section 951A and for purposes of any provision that specifically applies by reference to section 951A or the section 951A regulations.
(f) Definitions. This paragraph (f) provides additional definitions that apply for purposes of this section and the section 951A regulations. Other definitions relevant to the section 951A regulations are included in §§ 1.951A-2 through 1.951A-4.
(1) CFC inclusion year. The term CFC inclusion year means any taxable year of a foreign corporation beginning after December 31, 2017, at any time during which the corporation is a controlled foreign corporation.
(2) Controlled foreign corporation. The term controlled foreign corporation has the meaning set forth in section 957(a).
(3) Hypothetical distribution date. The term hypothetical distribution date has the meaning set forth in § 1.951-1(e)(1)(i).
(4) Section 958(a) stock. The term section 958(a) stock means stock of a controlled foreign corporation owned (directly or indirectly) by a United States shareholder within the meaning of section 958(a), as modified by paragraph (e)(1) of this section.
(5) Tested item. The term tested item means tested income, tested loss, qualified business asset investment, tested interest expense, or tested interest income.
(6) United States shareholder. The term United States shareholder has the meaning set forth in section 951(b).
(7) U.S. shareholder inclusion year. The term U.S. shareholder inclusion year means any taxable year of a United States shareholder in which or with which a CFC inclusion year of a controlled foreign corporation ends.
§ 1.951A-2   Tested income and tested loss.
(a) Scope. This section provides rules for determining the tested income or tested loss of a controlled foreign corporation for purposes of determining a United States shareholder's net CFC tested income under § 1.951A-1(c)(2). Paragraph (b) of this section provides definitions related to tested income and tested loss. Paragraph (c) of this section provides rules for determining the gross tested income of a controlled foreign corporation and the deductions that are properly allocable to gross tested income.
(b) Definitions related to tested income and tested loss —(1) Tested income and tested income CFC. The term tested income means the excess (if any) of a controlled foreign corporation's gross tested income for a CFC inclusion year, over the allowable deductions (including taxes) properly allocable to the gross tested income for the CFC inclusion year (a controlled foreign corporation with tested income for a CFC inclusion year, a tested income CFC ).
(2) Tested loss and tested loss CFC. The term tested loss means the excess (if any) of a controlled foreign corporation's allowable deductions (including taxes) properly allocable to gross tested income (or that would be allocable to gross tested income if there were gross tested income) for a CFC inclusion year, over the gross tested income of the controlled foreign corporation for the CFC inclusion year (a controlled foreign corporation without tested income for a CFC inclusion year, a tested loss CFC ).
(c) Rules relating to the determination of tested income and tested loss —(1) Definition of gross tested income. The term gross tested income means the gross income of a controlled foreign corporation for a CFC inclusion year determined without regard to—
(i) Items of income described in section 952(b),
(ii) Gross income taken into account in determining the subpart F income of the corporation,
(iii) Gross income excluded from the foreign base company income (as defined in section 954) or the insurance income (as defined in section 953) of the corporation by reason of the exception described in section 954(b)(4) pursuant to an election under § 1.954-1(d)(5), or a tentative gross tested income item of the corporation that qualifies for the exception described in section 954(b)(4) pursuant to an election under paragraph (c)(7) of this section,
(iv) Dividends received by the corporation from related persons (as defined in section 954(d)(3)), and
(v) Foreign oil and gas extraction income (as defined in section 907(c)(1)) of the corporation.
(2) Determination of gross income and allowable deductions. For purposes of determining tested income and tested loss, the gross income and allowable deductions of a controlled foreign corporation for a CFC inclusion year are determined under the rules of § 1.952-2 for determining the subpart F income (as defined in section 952) of the controlled foreign corporation, except, for a controlled foreign corporation which is engaged in the business of reinsuring or issuing insurance or annuity contracts and which, if it were a domestic corporation engaged only in such business, would be taxable as an insurance company to which subchapter L of chapter 1 of the Code applies, the text “the principles of §§ 1.953-4 and 1.953-5” means “the rules of sections 953 and 954(i)” in § 1.952-2(b)(2).
(3) Allocation of deductions to gross tested income —(i) In general. Except as provided in paragraph (c)(5) of this section, any deductions of a controlled foreign corporation allowable under paragraph (c)(2) of this section are allocated and apportioned to gross tested income under the principles of section 954(b)(5) and § 1.954-1(c), by treating gross tested income that falls within a single separate category (as defined in § 1.904-5(a)(4)(v)) as a single item of gross income, separate and in addition to the items set forth in § 1.954-1(c)(1)(iii). Losses in other separate categories of income resulting from the application of § 1.954-1(c)(1)(i) cannot reduce any separate category of gross tested income, and losses in a separate category of gross tested income cannot reduce income in a category of subpart F income. In addition, deductions of a controlled foreign corporation that are allocated and apportioned to gross tested income under this paragraph (c)(3) are not taken into account for purposes of determining a qualified deficit as defined in section 952(c)(1)(B)(ii).
(ii) Coordination with the high-tax exclusion —(A) In general. In the case of a taxpayer that has made an election under paragraph (c)(7) of this section, in allocating and apportioning deductions under this paragraph (c)(3), the taxpayer must apply the rules of sections 861 through 865 and 904(d) (taking into account the rules of section 954(b)(5) and § 1.954-1(c)) in a manner that achieves results consistent with those under paragraph (c)(7) of this section.
(B) Application of consistency rule to deductions allocated and apportioned to the residual grouping in applying the high-tax exclusion. Deductions that are allocated and apportioned to the residual income group under paragraph (c)(7)(iii)(A) of this section for purposes of applying the high-tax exclusion to a controlled foreign corporation's tentative gross tested income items are allocated and apportioned for purposes of determining the controlled foreign corporation's net income in each relevant statutory grouping using a method that provides for a consistent allocation and apportionment of deductions to gross income in the relevant groupings. See §§ 1.954-1(c) and 1.960-1(d)(3) for rules relating to the allocation and apportionment of expenses for purposes of determining subpart F income, which is included in the residual grouping for purposes of applying the high-tax exclusion of sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(7) of this section. Therefore, for example, interest expense that is apportioned under the modified gross income method to a tentative gross tested income item of a lower-tier corporation under paragraph (c)(7)(iii)(A) of this section may be allocated and apportioned to the tested income of the upper-tier corporation or to the residual grouping, depending on whether the lower-tier corporation's tentative gross tested income item is an item of gross tested income or is excluded from gross tested income under the high-tax exclusion. See paragraph (c)(8)(iii)(C) (Example 3) of this section for an example illustrating the rules of this paragraph (c)(3).
(4) Gross income taken into account in determining subpart F income —(i) In general. Except as provided in paragraph (c)(4)(iii) of this section, gross income of a controlled foreign corporation for a CFC inclusion year described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section is gross income described in paragraphs (c)(4)(ii)(A) through (E) of this section.
(ii) Items of gross income included in subpart F income —(A) Insurance income. Gross income described in this paragraph (c)(4)(ii)(A) is any item of gross income included in the insurance income (adjusted net insurance income as defined in § 1.954-1(a)(6)) of the controlled foreign corporation for the CFC inclusion year.
(B) Foreign base company income. Gross income described in this paragraph (c)(4)(ii)(B) is any item of gross income included in the foreign base company income (adjusted net foreign base company income as defined in § 1.954-1(a)(5)) of the controlled foreign corporation for the CFC inclusion year.
(C) International boycott income. Gross income described in this paragraph (c)(4)(ii)(C) is the product of the gross income of the controlled foreign corporation for the CFC inclusion year that gives rise to the income described in section 952(a)(3)(A) multiplied by the international boycott factor described in section 952(a)(3)(B).
(D) Illegal bribes, kickbacks, or other payments. Gross income described in this paragraph (c)(4)(ii)(D) is the sum of the amounts of the controlled foreign corporation for the CFC inclusion year described in section 952(a)(4).
(E) Income earned in certain foreign countries. Gross income described in this paragraph (c)(4)(ii)(E) is income of the controlled foreign corporation for the CFC inclusion year described in section 952(a)(5).
(iii) Coordination rules —(A) Coordination with E&P limitation. Gross income of a controlled foreign corporation for a CFC inclusion year described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section includes any item of gross income that is excluded from subpart F income of the controlled foreign corporation for the CFC inclusion year, or that is otherwise excluded from the amount included under section 951(a)(1)(A) in the gross income of a United States shareholder of the controlled foreign corporation for the U.S. shareholder inclusion year in which or with which the CFC inclusion year ends, under section 952(c)(1) and § 1.952-1(c), (d), or (e).
(B) Coordination with E&P recapture. Gross income of a controlled foreign corporation for a CFC inclusion year described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section does not include any item of gross income that results in the recharacterization of earnings and profits as subpart F income of the controlled foreign corporation for the CFC inclusion year under section 952(c)(2) and § 1.952-1(f)(2).
(C) Coordination with full inclusion rule and high tax exception. Gross income of a controlled foreign corporation for a CFC inclusion year described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section does not include full inclusion foreign base company income that is excluded from subpart F income under § 1.954-1(d)(6). Full inclusion foreign base company income that is excluded from subpart F income under § 1.954-1(d)(6) is also not included in gross income of a controlled foreign corporation for a CFC inclusion year described in section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section.
(iv) Examples. The following examples illustrate the application of this paragraph (c)(4).
(A) Example 1 —( 1 ) Facts. A Corp, a domestic corporation, owns 100% of the single class of stock of FS, a controlled foreign corporation. Both A Corp and FS use the calendar year as their taxable year. In Year 1, FS has passive category foreign personal holding company income of $100x, a general category loss in foreign oil and gas extraction income of $100x, and earnings and profits of $0. FS has no other income. In Year 2, FS has general category gross income of $100x and earnings and profits of $100x. Without regard to section 952(c)(2), in Year 2 FS has no income described in any of the categories of income excluded from gross tested income in paragraphs (c)(1)(i) through (v) of this section. FS has no allowable deductions properly allocable to gross tested income for Year 2.
( 2 ) Analysis —( i ) Year 1. As a result of the earnings and profits limitation of section 952(c)(1)(A), FS has no subpart F income in Year 1, and A Corp has no inclusion with respect to FS under section 951(a)(1)(A). Under paragraph (c)(4)(iii)(A) of this section, gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section includes any item of gross income excluded from the subpart F income of FS for Year 1 under section 952(c)(1)(A) and § 1.952-1(c). Therefore, the $100x foreign personal holding company income of FS in Year 1 is excluded from gross tested income by reason of section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, and FS has no gross tested income in Year 1.
( ii ) Year 2. In Year 2, under section 952(c)(2) and § 1.952-1(f)(2), FS's general category earnings and profits ($100x) in excess of its subpart F income ($0) give rise to the recharacterization of its passive category recapture account as subpart F income. Therefore, FS has passive category subpart F income of $100x in Year 2, and A Corp has an inclusion of $100x with respect to FS under section 951(a)(1)(A). Under paragraph (c)(4)(iii)(B) of this section, gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section does not include any item of gross income that results in the recharacterization of earnings and profits as subpart F income in FS's taxable year under section 952(c)(2) and § 1.952-1(f)(2). Accordingly, the $100x of general category gross income of FS in Year 2 is not excluded from gross tested income by reason of section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, and FS has $100x of general category gross tested income in Year 2.
(B) Example 2 —( 1 ) Facts. A Corp, a domestic corporation, owns 100% of the single class of stock of FC1 and FC2, controlled foreign corporations. A Corp, FC1, and FC2 use the calendar year as their taxable year. In Year 1, FC1 has gross income of $290x from product sales to unrelated persons within its country of incorporation, gross interest income of $10x (an amount that is less than $1,000,000) that does not qualify for an exception to foreign personal holding company income, and earnings and profits of $300x. In Year 1, FC2 has gross income of $45x for performing consulting services within its country of incorporation for unrelated persons, gross interest income of $150x (an amount that is not less than $1,000,000) that does not qualify for an exception to foreign personal holding company income, and earnings and profits of $195x.
( 2 ) Analysis —( i ) FC1. In Year 1, by application of the de minimis rule of section 954(b)(3)(A) and § 1.954-1(b)(1)(i), the $10x of gross interest income earned by FC1 is not treated as foreign base company income ($10x of gross foreign base company income is less than $15x, the lesser of 5% of $300x, FC's total gross income for Year 1, or $1,000,000). Accordingly, FC1 has no subpart F income in Year 1, and A Corp has no inclusion with respect to FC1 under section 951(a)(1)(A). Under paragraph (c)(4)(i) of this section, gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section is any item of gross income included in foreign base company income, and thus gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section does not include any item of gross income excluded from foreign base company income under the de minimis rule in section 954(b)(3)(A) and § 1.954-1(b)(1)(i). Accordingly, FS's $10x of gross interest income in Year 1 is not excluded from gross tested income by reason of section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, and FC1 has $300x ($290x of gross sales income and $10x of gross interest income) of gross tested income in Year 1.
( ii ) FC2. In Year 1, by application of the full inclusion rule in section 954(b)(3)(B) and § 1.954-1(b)(1)(ii), the $45x of gross income earned by FC2 for performing consulting services within its country of incorporation for unrelated persons is treated as foreign base company income ($150x of gross foreign base company income exceeds $136.5x, which is 70% of $195x, FC2's total gross income for Year 1). Therefore, FC2 has $195x of foreign base company income in Year 1, including $45x of full inclusion foreign base company income as defined in § 1.954-1(b)(2), and A Corp has an inclusion of $195x with respect to FC2 under section 951(a)(1)(A). Under paragraph (c)(4)(i) of this section, gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section is any item of gross income included in foreign base company income, and thus gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section includes any item of gross income included as foreign base company income under the full inclusion rule in section 954(b)(3)(B) and § 1.954-1(b)(1)(ii). Accordingly, FC2's $45x of gross services income and its $150x of gross interest income in Year 1 are excluded from gross tested income by reason of section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, and FC2 has no gross tested income in Year 1.
(C) Example 3 —( 1 ) Facts. A Corp, a domestic corporation, owns 100% of the single class of stock of FS, a controlled foreign corporation. A Corp and FS use the calendar year as their taxable year. In Year 1, FS has gross income of $1,000x, of which $720x is general category foreign base company sales income and $280x is general category income from sales within its country of incorporation; FS has expenses of $650x (including creditable foreign income taxes), of which $500x are allocated and apportioned to foreign base company sales income and $150x are allocated and apportioned to sales income from sales within FS's country of incorporation; and FS has earnings and profits of $350x for Year 1. Foreign income tax of $55x is considered imposed on the $220x ($720x−$500x) of net foreign base company sales income, and $26x is considered imposed on the $130x ($280x−$150x) of net income from sales within FS's country of operation. The maximum rate of tax in section 11 for the taxable year is 21%, and FS elects the high tax exception of section 954(b)(4) under § 1.954-1(d)(1) for Year 1 for its foreign base company sales income. In a prior taxable year, FS had losses with respect to income other than foreign base company or insurance income that, by reason of the limitation in section 952(c)(1)(A), reduced the subpart F income of FS (consisting entirely of foreign source general category income) by $600x; as of the beginning of Year 1, such amount has not been recharacterized as subpart F income in a subsequent taxable year under section 952(c)(2).
( 2 ) Analysis —( i ) Foreign base company income. In Year 1, by application of the full inclusion rule in section 954(b)(3)(B) and § 1.954-1(b)(1)(ii), the $280x of gross income earned by FS for sales within its country of incorporation is treated as foreign base company income ($720x of gross foreign base company income exceeds $700x, which is 70% of $1,000x, FS's total gross income for the taxable year). However, the $220x of foreign base company sales income qualifies for the high tax exception of section 954(b)(4) and § 1.954-1(d)(1), because the effective rate of tax with respect to the net foreign base company sales income ($220x) is 20% ($55x/($220x + $55x)) which is greater than 18.9% (90% of 21%, the maximum rate of tax in section 11 for the taxable year). Because the $220x of net foreign base company sales income qualifies for the high tax exception of section 954(b)(4) and § 1.954-1(d)(1), the $130x of full inclusion foreign base company income is also excluded from subpart F income under § 1.954-1(d)(6).
( ii ) Recapture of subpart F income. Under section 952(c)(2) and § 1.952-1(f)(2), FS's general category earnings and profits ($350x) in excess of its subpart F income ($0) give rise to the recharacterization of its general category recapture account ($600x) as subpart F income to the extent of current year earnings and profits. Therefore, FS has general category subpart F income of $350x in Year 1, and A Corp has an inclusion of $350x with respect to FS under section 951(a)(1)(A).
( iii ) Gross tested income. The $720x of gross foreign base company income is excluded from gross tested income under section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section. However, the $280x of gross sales income earned from sales within FS's country of incorporation is not excluded from gross tested income under either section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section or section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section. Under paragraph (c)(4)(iii)(B) of this section, the $280x of gross sales income earned from sales within FS's country of incorporation is not excluded from gross tested income under section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, because gross income described in paragraph (c)(1)(ii) of this section does not include any item of gross income that results in the recharacterization of earnings and profits as subpart F income under section 952(c)(2) and § 1.952-1(f)(2). Further, under paragraph (c)(4)(iii)(C) of this section, the $280x of gross sales income earned from sales within FS's country of incorporation is not excluded from gross tested income under either section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section or section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section, because gross income described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section or section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section does not include full inclusion foreign base company income that is excluded from subpart F income under § 1.954-1(d)(6). Accordingly, FS has $280x of gross tested income for Year 1.
(5) Allocation of deduction or loss attributable to disqualified basis —(i) In general. A deduction or loss attributable to disqualified basis is allocated and apportioned solely to residual CFC gross income, and any depreciation, amortization, or cost recovery allowances attributable to disqualified basis is not properly allocable to property produced or acquired for resale under section 263, 263A, or 471.
(ii) Determination of deduction or loss attributable to disqualified basis. Except as otherwise provided in this paragraph (c)(5)(ii), in the case of a depreciation or amortization deduction with respect to property with disqualified basis and adjusted basis other than disqualified basis, the deduction or loss is treated as attributable to the disqualified basis in the same proportion that the disqualified basis bears to the total adjusted basis in the property. In the case of a loss from a taxable sale or exchange of property with disqualified basis and adjusted basis other than disqualified basis, the loss is treated as attributable to disqualified basis to the extent thereof.
(iii) Definitions. The following definitions apply for purposes of this paragraph (c)(5).
(A) Disqualified basis. The term disqualified basis has the meaning set forth in § 1.951A-3(h)(2)(ii).
(B) Residual CFC gross income. The term residual CFC gross income means gross income other than gross tested income, gross income taken into account in determining subpart F income, or gross income that is effectively connected, or treated as effectively connected, with the conduct of a trade or business in the United States (as described in § 1.882-4(a)(1)).
(iv) Reductions to disqualified basis pursuant to coordination rules. See § 1.245A-7(b) or § 1.245A-8(b), as applicable, for reductions to disqualified basis resulting from the application of § 1.245A-5.
(v) Examples. The following examples illustrate the application of this paragraph (c)(5).
(A) Example 1: Sale of intangible property during the disqualified period —( 1 ) Facts. USP, a domestic corporation, owns all of the stock in CFC1 and CFC2, each a controlled foreign corporation. Both USP and CFC2 use the calendar year as their taxable year. CFC1 uses a taxable year ending November 30. On November 1, 2018, before the start of its first CFC inclusion year, CFC1 sells Asset A to CFC2 in exchange for $100x of cash. Asset A is intangible property that is amortizable under section 197. Immediately before the sale, the adjusted basis in Asset A is $20x, and CFC1 recognizes $80x of gain as a result of the sale ($100x−$20x). CFC1's gain is not subject to U.S. tax or taken into account in determining an inclusion to USP under section 951(a)(1)(A).
( 2 ) Analysis. The sale by CFC1 is a disqualified transfer (within the meaning of § 1.951A-3(h)(2)(ii)(C)( 2 )) because it is a transfer of property in which gain was recognized by CFC1, CFC1 and CFC2 are related persons, and the transfer occurs during the disqualified period (within the meaning of § 1.951A-3(h)(2)(ii)(C)( 1 )). The disqualified basis in Asset A is $80x, the excess of CFC2's adjusted basis in Asset A immediately after the disqualified transfer ($100x), over the sum of CFC1's basis in Asset A immediately before the transfer ($20x) and the qualified gain amount (as defined in § 1.951A-3(h)(2)(ii)(C)( 3 )) ($0). Accordingly, under paragraph (c)(5)(i) of this section, any deduction or loss of CFC2 attributable to the disqualified basis is allocated and apportioned solely to residual CFC gross income of CFC2 and, therefore, is not taken into account in determining the tested income, tested loss, subpart F income, or effectively connected income of CFC2 for any CFC inclusion year.
(B) Example 2: Related party transfer after the disqualified period; gain recognition —( 1 ) Facts. The facts are the same as in paragraph (c)(5)(v)(A)( 1 ) of this section (the facts in Example 1 ), except that, on November 30, 2020, CFC2 sells Asset A to CFC3, a controlled foreign corporation wholly-owned by CFC2, in exchange for $120x of cash. Immediately before the sale, the adjusted basis in Asset A is $90x, $72x of which is disqualified basis. The gain recognized by CFC2 on the sale of Asset A is not described in paragraphs (c)(1)(i) through (v) of this section.
( 2 ) Analysis. Paragraph (c)(5)(i) of this section does not apply to the sale of Asset A from CFC2 to CFC3 because the sale does not give rise to a deduction or loss attributable to disqualified basis, but instead gives rise to gain. Therefore, CFC2 recognizes $30x ($120x−$90x) of gain that is included in gross tested income for its CFC inclusion year ending November 30, 2019. Under § 1.951A-3(h)(2)(ii)(B)( 1 )( ii ), because CFC2 sold Asset A to CFC3, a related person, and CFC2 did not recognize a deduction or loss on the sale, the disqualified basis in Asset A is not reduced or eliminated by reason of the sale. Accordingly, under paragraph (c)(5)(i) of this section, any deduction or loss of CFC3 attributable to the $72x of disqualified basis in Asset A is allocated and apportioned solely to residual CFC gross income of CFC3.
(C) Example 3: Related party transfer after the disqualified period; loss recognition —( 1 ) Facts. The facts are the same as in paragraph (c)(5)(v)(B)( 1 ) of this section (the facts in Example 2 ), except that CFC2 sells Asset A to CFC3 in exchange for $70x of cash.
( 2 ) Analysis. Under paragraph (c)(5)(ii) of this section, the $20x loss recognized by CFC2 on the sale is attributable to disqualified basis, to the extent thereof, notwithstanding that the loss may be deferred under section 267(f). Thus, under paragraph (c)(5)(i) of this section, the loss is allocated and apportioned solely to residual CFC gross income of CFC2 in the CFC inclusion year in which the loss is taken into account pursuant to section 267(f). Under § 1.951A-3(h)(2)(ii)(B)( 1 )( ii ), the disqualified basis in Asset A is reduced by $20x, the loss of CFC2 that is attributable to disqualified basis under paragraph (c)(5)(ii) of this section. Accordingly, under paragraph (c)(5)(i) of this section, any deduction or loss of CFC3 attributable to the remaining $52x of disqualified basis in Asset A is allocated and apportioned solely to residual CFC gross income of CFC3.
(6) Allocation of deductions attributable to disqualified payments —(i) In general. A deduction related directly or indirectly to a disqualified payment is allocated and apportioned solely to residual CFC gross income, and any deduction related to a disqualified payment is not properly allocable to property produced or acquired for resale under section 263, 263A, or 471.
(ii) Definitions. The following definitions apply for purposes of this paragraph (c)(6).
(A) Disqualified payment. The term disqualified payment means a payment made by a person to a related recipient CFC during the disqualified period with respect to the related recipient CFC, to the extent the payment would constitute income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to whether section 951A applies.
(B) Disqualified period. The term disqualified period has the meaning provided in § 1.951A-3(h)(2)(ii)(C)( 1 ), substituting “related recipient CFC” for “transferor CFC.”
(C) Related recipient CFC. The term related recipient CFC means, with respect to a payment by a person, a recipient of the payment that is a controlled foreign corporation that bears a relationship to the payor described in section 267(b) or 707(b) immediately before or after the payment.
(iii) Treatment of partnerships. For purposes of determining whether a payment is made by a person to a related recipient CFC for purposes of paragraph (c)(6)(ii)(A) of this section, a payment by or to a partnership is treated as made proportionately by or to its partners, as applicable.
(iv) Reductions to disqualified payments pursuant to coordination rules. See §§ 1.245A-5(j)(8) and 1.245A-7(b) or § 1.245A-8(b), as applicable, for reductions to disqualified payments resulting from the application of § 1.245A-5.
(v) Examples. The following examples illustrate the application of this paragraph (c)(6).
(A) Example 1: Deduction related directly to disqualified payment to related recipient CFC —( 1 ) Facts. USP, a domestic corporation, owns all of the stock in CFC1 and CFC2, each a controlled foreign corporation. Both USP and CFC2 use the calendar year as their taxable year. CFC1 uses a taxable year ending November 30. On October 15, 2018, before the start of its first CFC inclusion year, CFC1 receives and accrues a payment from CFC2 of $100x of prepaid royalties with respect to a license. The $100x payment is excluded from subpart F income pursuant to section 954(c)(6) and would constitute income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to whether section 951A applies.
( 2 ) Analysis. CFC1 is a related recipient CFC (within the meaning of paragraph (c)(6)(ii)(C) of this section) with respect to the royalty prepayment by CFC2 because it is related to CFC2 within the meaning of section 267(b). The royalty prepayment is received by CFC1 during its disqualified period (within the meaning of paragraph (c)(6)(ii)(B) of this section) because it is received during the period beginning January 1, 2018, and ending November 30, 2018. Because it would constitute income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to whether section 951A applies, the payment is a disqualified payment. Accordingly, CFC2's deductions related to such payment accrued during taxable years ending on or after April 7, 2020, are allocated and apportioned solely to residual CFC gross income under paragraph (c)(6)(i) of this section.
(B) Example 2: Deduction related indirectly to disqualified payment to partnership in which related recipient CFC is a partner —( 1 ) Facts. The facts are the same as in paragraph (c)(6)(v)(A)( 1 ) of this section (the facts in Example 1 ), except that CFC1 and USP own 99% and 1%, respectively of FPS, a foreign partnership, which has a taxable year ending November 30. USP receives a prepayment of $110x from CFC2 for the performance of future services. USP subcontracts the performance of these future services to FPS for which FPS receives and accrues a $100x prepayment from USP. The services will be performed in the same country under the laws of which CFC1 and FPS are created or organized, and the $100x prepayment is not foreign base company services income under section 954(e) and § 1.954-4(a). The $100x prepayment would constitute income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to whether section 951A applies.
( 2 ) Analysis. CFC1 is a related recipient CFC (within the meaning of paragraph (c)(6)(ii)(C) of this section) with respect to the services prepayment by USP because, under paragraph (c)(6)(iii) of this section, it is treated as receiving $99x (99% of $100x) of the services prepayment from USP, and it is related to USP within the meaning of section 267(b). The services prepayment is received by CFC1 during its disqualified period (within the meaning of paragraph (c)(6)(ii)(B) of this section) because it is received during the period beginning January 1, 2018, and ending November 30, 2018. Because it would constitute income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to whether section 951A applies, the prepayment is a disqualified payment. In addition, CFC2's deductions related to its prepayment to USP are indirectly related to the disqualified payment by USP. Accordingly, CFC2's deductions related to such payment accrued during taxable years ending on or after April 7, 2020 are allocated and apportioned solely to residual CFC gross income under paragraph (c)(6)(i) of this section.
(7) Election to apply high-tax exception of section 954(b)(4) —(i) In general. For purposes of section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section, a tentative gross tested income item of a controlled foreign corporation for a CFC inclusion year qualifies for the exception described in section 954(b)(4) only if—
(A) An election made under paragraph (c)(7)(viii) of this section is effective with respect to the controlled foreign corporation for the CFC inclusion year; and
(B) The tentative tested income item with respect to the tentative gross tested income item was subject to an effective rate of foreign tax, as determined under paragraph (c)(7)(vi) of this section, that is greater than 90 percent of the maximum rate of tax specified in section 11.
(ii) Calculation of tentative gross tested income item —(A) In general. A tentative gross tested income item with respect to a controlled foreign corporation for a CFC inclusion year is the aggregate of all items of gross income of the controlled foreign corporation attributable to a tested unit (as defined in paragraph (c)(7)(iv) of this section) of the controlled foreign corporation in the CFC inclusion year that would be gross tested income without regard to this paragraph (c)(7) and would be in a single tested income group (as defined in § 1.960-1(d)(2)(ii)(C)). A controlled foreign corporation may have multiple tentative gross tested income items. See paragraphs (c)(8)(iii)(A)( 2 )( i ) (Example 1) and (c)(8)(iii)(B)( 2 )( i ) (Example 2) of this section for illustrations of the application of the rule set forth in this paragraph (c)(7)(ii)(A).
(B) Gross income attributable to a tested unit —( 1 ) Items properly reflected on separate set of books and records. Items of gross income of a controlled foreign corporation are attributable to a tested unit of the controlled foreign corporation to the extent they are properly reflected on the separate set of books and records of the tested unit, as modified under paragraph (c)(7)(ii)(B)( 2 ) of this section. Each item of gross income of a controlled foreign corporation is attributable to a tested unit (and not to more than one tested unit) of the controlled foreign corporation. See paragraphs (c)(8)(iii)(D)( 2 ) and (c)(8)(iii)(D)( 5 ) (Example 4) of this section for illustrations of the application of the rule set forth in this paragraph (c)(7)(ii)(B).
( 2 ) Gross income determined under federal income tax principles, as adjusted for disregarded payments. For purposes of paragraph (c)(7)(ii)(B)( 1 ) of this section, gross income must be determined under federal income tax principles, except that the principles of § 1.904-4(f)(2)(vi) apply to adjust gross income of the tested unit, to the extent thereof, to reflect disregarded payments. For purposes of this paragraph (c)(7)(ii)(B)( 2 ), the principles of § 1.904-4(f)(2)(vi) are applied taking into account the rules in paragraphs (c)(7)(ii)(B)( 2 )( i ) through ( v ) of this section.
( i ) The controlled foreign corporation is treated as the foreign branch owner and any other tested units of the controlled foreign corporation are treated as foreign branches.
( ii ) The principles of the rules in § 1.904-4(f)(2)(vi)(A) apply in the case of disregarded payments between a foreign branch and another foreign branch without regard to whether either foreign branch makes a disregarded payment to, or receives a disregarded payment from, the foreign branch owner.
( iii ) The exclusion for interest and interest equivalents described in § 1.904-4(f)(2)(vi)(C)( 1 ) does not apply to the extent of the amount of a disregarded payment that is deductible in the country of tax residence (or location, in the case of a branch) of the tested unit that is the payor.
( iv ) In the case of an amount described in paragraph (c)(7)(ii)(B)( 2 )( iii ) of this section, the rules for determining how a disregarded payment is allocated to gross income of a foreign branch or foreign branch owner in § 1.904-4(f)(2)(vi)(B) are applied by treating the disregarded payment as allocated and apportioned ratably to all of the gross income attributable to the tested unit that is making the disregarded payment. If a tested unit is both a payor and payee of an amount described in paragraph (c)(7)(ii)(B)( 2 )( iii ) of this section, gross income to which the disregarded payments are allocable include gross income allocated to the payor tested unit as a result of the receipt of amounts described in paragraph (c)(7)(ii)(B)( 2 )( iii ) of this section, to the extent thereof. If a tested unit makes and receives payments described in paragraph (c)(7)(ii)(B)( 2 )( iii ) of this section to and from the same tested unit, the payments are netted so that paragraph (c)(7)(ii)(B)( 2 )( iii ) of this section and the principles of § 1.904-4(f)(2)(vi) apply only to the net amount of such payments between the two tested units.
( v ) In the case of multiple disregarded payments, in lieu of § 1.904-4(f)(2)(vi)(F), disregarded payments are taken into account under paragraph (c)(7)(ii)(B)( 2 ) of this section and the principles of § 1.904-4(f)(2)(vi) under the rules provided in this paragraph (c)(7)(ii)(B)( 2 )( v ). Adjustments are made with respect to a disregarded payment received by a tested unit before payments made by that tested unit. Except as provided in paragraph (c)(7)(ii)(B)( 2 )( iv ) of this section, if a tested unit both makes and receives disregarded payments, adjustments are first made with respect to disregarded payments that would be definitely related to a single class of gross income under the principles of § 1.861-8; second, adjustments are made with respect to disregarded payments that would be definitely related to multiple classes of gross income under the principles of § 1.861-8, but that are not definitely related to all gross income of the tested unit; third, adjustments are made with respect to disregarded payments (other than interest described in paragraph (c)(7)(ii)(B)( 2 )( iii ) of this section) that would be definitely related to all gross income under the principles of § 1.861-8; and fourth, adjustments are made with respect to interest described in paragraph (c)(7)(ii)(B)( 2 )( iii ) and disregarded payments that would not be definitely related to any gross income under the principles of § 1.861-8.
(iii) Calculation of tentative tested income item —(A) In general. A tentative tested income item with respect to the tentative gross tested income item described in paragraph (c)(7)(ii)(A) of this section is determined by allocating and apportioning deductions for the CFC inclusion year (including expense for current year taxes (as defined in § 1.960-1(b)(4)), and not including any items described in § 1.951A-2(c)(5) or (c)(6)) to the tentative gross tested income item under the principles of § 1.960-1(d)(3) and the rules of § 1.861-20. For purposes of this paragraph (c)(7)(iii), each tentative gross tested income item (if any) is treated as assigned to a separate tested income group, as that term is described in § 1.960-1(d)(2)(ii)(C), and all other income is treated as assigned to a residual income group. For purposes of applying §§ 1.861-9 and 1.861-9T under the principles of § 1.960-1(d)(3), the amount of interest deductions that are allocated and apportioned to the assets (or gross income, in the case of a taxpayer that has elected the modified gross income method) of a lower-tier corporation, such as a corporation the stock of which is owned by the controlled foreign corporation indirectly through the tested unit, are allocated and apportioned to the residual income category and not to any tentative gross tested income item of the controlled foreign corporation. See paragraphs (c)(8)(iii)(A)( 2 )( iii ) (Example 1), (c)(8)(iii)(B)( 2 )( iv ) (Example 2), and (c)(8)(iii)(C)( 2 )( iv ) (Example 3) of this section for illustrations of the application of the rules set forth in this paragraph (c)(7)(iii)(A).
(B) Effect of potential and actual changes in taxes paid or accrued. Except as otherwise provided in this paragraph (c)(7)(iii)(B), the amount of current year taxes paid or accrued by a controlled foreign corporation for purposes of this paragraph (c)(7) does not take into account any potential reduction in foreign income taxes that may occur by reason of a future distribution to shareholders of all or part of such income. However, to the extent the foreign income taxes paid or accrued by the controlled foreign corporation are reasonably certain to be returned to a shareholder by the foreign country imposing such taxes, directly or indirectly, through any means (including, but not limited to, a refund, credit, payment, discharge of an obligation, or any other method) on a subsequent distribution to such shareholder, the foreign income taxes are not treated as paid or accrued for purposes of this paragraph (c)(7). In addition, foreign income taxes that have not been paid or accrued because they are contingent on a future distribution of earnings (or other similar transaction, such as a loan to a shareholder) are not taken into account for purposes of this paragraph (c)(7). If, pursuant to section 905(c) and § 1.905-3, a redetermination of U.S. tax liability is required to account for the effect of a foreign tax redetermination (as defined in § 1.905-3(a)), this paragraph (c)(7) is applied in the adjusted year taking into account the adjusted amount of the redetermined foreign tax.
(iv) Tested unit rules —(A) In general. Subject to the combination rule in paragraph (c)(7)(iv)(C) of this section, the term tested unit means any corporation, interest, or branch described in paragraphs (c)(7)(iv)(A)( 1 ) through ( 3 ) of this section. See paragraph (c)(8)(iii)(D) (Example 4) of this section for an example that illustrates the application of the tested unit rules set forth in this paragraph (c)(7)(iv).
( 1 ) A controlled foreign corporation (as defined in section 957(a)).
( 2 ) An interest held directly or indirectly by a controlled foreign corporation in a pass-through entity that is—
( i ) A tax resident (as described in § 1.267A-5(a)(23)(i)) of any foreign country; or
( ii ) Not treated as fiscally transparent (as determined under the principles of § 1.267A-5(a)(8)) for purposes of the tax law of the foreign country of which the controlled foreign corporation is a tax resident or, in the case of an interest in a pass-through entity held by a controlled foreign corporation indirectly through one or more other tested units, for purposes of the tax law of the foreign country of which the tested unit that directly (or indirectly through the fewest number of transparent interests) owns the interest is a tax resident.
( 3 ) A branch (as described in § 1.267A-5(a)(2)) the activities of which are carried on directly or indirectly (through one or more pass-through entities) by a controlled foreign corporation. However, in the case of a branch that does not give rise to a taxable presence under the tax law of the foreign country where the branch is located, the branch is a tested unit only if, under the tax law of the foreign country of which the controlled foreign corporation is a tax resident (or, if applicable, under the tax law of a foreign country of which the tested unit that directly (or indirectly, through the fewest number of transparent interests) carries on the activities of the branch is a tax resident), an exclusion, exemption, or other similar relief (such as a preferential rate) applies with respect to income attributable to the branch. For purposes of this paragraph (c)(7)(iv)(A)( 3 ), similar relief does not include a credit (for example, a foreign tax credit) against the tax imposed under such tax law. If a controlled foreign corporation carries on directly or indirectly (through one or more pass-through entities) less than all of the activities of a branch (for example, if the activities are carried on indirectly through an interest in a partnership), then the rules in this paragraph apply separately with respect to the portion (or portions, if carried on indirectly through more than one chain of pass-through entities) of the activities carried on by the controlled foreign corporation. See paragraphs (c)(8)(iii)(D)( 3 ) and (c)(8)(iii)(D)( 4 ) (Example 4) of this section for illustrations of the application of the rules set forth in this paragraph (c)(7)(iv)(A)( 3 ).
(B) Items attributable to only one tested unit. For purposes of paragraph (c)(7) of this section, if an item is attributable to more than one tested unit in a tier of tested units, the item is considered attributable only to the lowest-tier tested unit. Thus, for example, if a controlled foreign corporation directly owns a branch tested unit described in paragraph (c)(7)(iv)(A)( 3 ) of this section, and an item of gross income is (under the rules of paragraph (c)(7)(ii)(B) of this section) attributable to both the branch tested unit and the controlled foreign corporation tested unit, then the item is considered attributable only to the branch tested unit.
(C) Combination rule —( 1 ) In general. Except as provided in paragraph (c)(7)(iv)(C)( 2 ) of this section, tested units of a controlled foreign corporation (including the controlled foreign corporation tested unit) are treated as a single tested unit if the tested units are tax residents of, or located in (in the case of a tested unit that is a branch, or a portion of the activities of a branch, that gives rise to a taxable presence under the tax law of a foreign country), the same foreign country. For purposes of this paragraph (c)(7)(iv)(C)( 1 ), in the case of a tested unit that is an interest in a pass-through entity or a portion of the activities of a branch, a reference to the tax residency or location of the tested unit means the tax residency of the entity the interest in which is the tested unit or the location of the branch, as applicable. See paragraphs (c)(8)(iii)(D)( 2 ) and (c)(8)(iii)(D)( 5 ) (Example 4) of this section for illustrations of the application of the rule set forth in this paragraph (c)(7)(iv)(C)( 1 ).
( 2 ) Exception for nontaxed branches. The rule in paragraph (c)(7)(iv)(C)( 1 ) of this section does not apply to a tested unit that is described in paragraph (c)(7)(iv)(A)( 3 ) of this section if the branch described in paragraph (c)(7)(iv)(A)( 3 ) of this section does not give rise to a taxable presence under the tax law of the foreign country where the branch is located. See paragraph (c)(8)(iii)(D)( 4 ) (Example 4) of this section for an illustration of the application of the rule set forth in this paragraph (c)(7)(v)(C)( 2 ).
( 3 ) Effect of combination rule. If, pursuant to paragraph (c)(7)(iv)(C)( 1 ) of this section, tested units are treated as a single tested unit, then, solely for purposes of paragraph (c)(7) of this section, items of gross income attributable to such tested units, and items of deduction and foreign taxes allocated and apportioned to such gross income, are aggregated for purposes of determining the combined tested unit's tentative gross tested income item, tentative tested income item, and foreign income taxes paid or accrued with respect to such tentative tested income item.
(v) Separate set of books and records —(A) In general. For purposes of this paragraph (c)(7), the term separate set of books and records has the meaning set forth in § 1.989(a)-1(d). In addition, for purposes of this paragraph (c)(7), in the case of a tested unit or a transparent interest that is an interest in a pass-through entity or a portion of the activities of a branch, a reference to the separate set of books and records of the tested unit or the transparent interest means the separate set of books and records of the entity or the branch, as applicable.
(B) Failure to maintain separate set of books and records. If a separate set of books and records is not maintained for a tested unit or transparent interest, the items of gross income, disregarded payments, and any other items required to apply paragraph (c)(7) of this section that would be reflected on a separate set of books and records of the tested unit or transparent interest must be determined. Such items are treated as properly reflected on the separate set of books and records of the tested unit or transparent interest for purposes of applying paragraph (c)(7) of this section.
(C) Transparent interests. If a tested unit of a controlled foreign corporation or an entity an interest in which is a tested unit of a controlled foreign corporation holds a transparent interest, either directly or indirectly through one or more other transparent interests, then, for purposes of paragraph (c)(7) of this section (and subject to the rule of paragraph (c)(7)(iv)(C) of this section), items of the controlled foreign corporation properly reflected on the separate set of books and records of the transparent interest are treated as being properly reflected on the separate set of books and records of the tested unit, as modified under paragraph (c)(7)(ii)(B)( 2 ) of this section. See paragraph (c)(8)(iii)(D)( 6 ) (Example 4) of this section for an illustration of the application of the rule set forth in this paragraph (c)(7)(v)(C).
(D) Items not taken into account for financial accounting purposes. For purposes of this paragraph (c)(7), an item of gross income in a CFC inclusion year that is not taken into account in such year for financial accounting purposes, and therefore not properly reflected on a separate set of books and records of a tested unit or a transparent interest, or an entity an interest in which is a tested unit or a transparent interest, is treated as properly reflected on a separate set of books and records to the extent it would have been so reflected if the item were taken into account for financial accounting purposes in such CFC inclusion year.
(vi) Effective rate at which foreign taxes are imposed. For a CFC inclusion year of a controlled foreign corporation, the effective rate of foreign tax with respect to the tentative tested income items of the controlled foreign corporation is determined separately for each such item. See paragraphs (c)(8)(iii)(A)( 2 )( v ) (Example 1), (c)(8)(iii)(B)( 2 )( vi ) (Example 2), and (c)(8)(iii)(C)( 2 )( vi ) (Example 3) of this section for illustrations of the application of the rules set forth in this paragraph (c)(7)(vi). The effective rate at which foreign income taxes are imposed on a tentative tested income item is—
(A) The U.S. dollar amount of foreign income taxes paid or accrued with respect to the tentative tested income item, determined by applying paragraph (c)(7)(vii) of this section; divided by
(B) The U.S. dollar amount of the tentative tested income item, increased by the amount of foreign income taxes referred to in paragraph (c)(7)(vi)(A) of this section.
(vii) Foreign income taxes paid or accrued with respect to a tentative tested income item. For a CFC inclusion year, the amount of foreign income taxes paid or accrued by a controlled foreign corporation with respect to a tentative tested income item of the controlled foreign corporation for purposes of this paragraph (c)(7) is the U.S. dollar amount of the controlled foreign corporation's eligible current year taxes (as defined in § 1.960-1(b)(5)) that are allocated and apportioned to the related tentative gross tested income item under the rules of paragraph (c)(7)(iii) of this section. See paragraphs (c)(8)(iii)(A)( 2 )( iv ) (Example 1), (c)(8)(iii)(B)( 2 )( v ) (Example 2), and (c)(8)(iii)(C)( 2 )( v ) (Example 3) of this section for illustrations of the application of the rule set forth in this paragraph (c)(7)(vii).
(viii) Rules regarding the high-tax election —(A) Manner —( 1 ) An election is made under this paragraph (c)(7)(viii) by the controlling domestic shareholders (as defined in § 1.964-1(c)(5)) with respect to a controlled foreign corporation for a CFC inclusion year (a high-tax election ) in accordance with the rules provided in forms or instructions and by—
( i ) Filing the statement required under § 1.964-1(c)(3)(ii) with a timely filed original federal income tax return, or with an amended federal income tax return in accordance with paragraph (c)(7)(viii)(A)( 2 ) of this section, for the U.S. shareholder inclusion year of each controlling domestic shareholder in which or with which such CFC inclusion year ends;
( ii ) Providing any notices required under § 1.964-1(c)(3)(iii); and
( iii ) Providing any additional information required by applicable administrative pronouncements.
( 2 ) In the case of an election (or revocation) made with an amended federal income tax return—
( i ) The election (or revocation) must be made on an amended federal income tax return duly filed within 24 months of the unextended due date of the original federal income tax return for the U.S. shareholder inclusion year with or within which the CFC inclusion year ends;
( ii ) Each United States shareholder that owns within the meaning of section 958(a) (including both domestic partnerships that are United States shareholders that own stock within the meaning of section 958(a) without regard to § 1.951A-1(e)(1) and partners of a domestic partnership that are United States shareholders that are treated as owning stock withing the meaning of section 958(a) by reason of § 1.951A-1(e)(1)) stock of the controlled foreign corporation as of the end of the CFC's taxable year to which the election relates must file amended Federal income tax returns (or timely original federal income tax returns if a return has not yet been filed) reflecting the effect of such election (or revocation) for the U.S. shareholder inclusion year with or within which the CFC inclusion year ends as well as for any other taxable year in which the U.S. tax liability of the United States shareholder would be increased by reason of the election (or revocation) (or in the case of a partnership if any item reported by the partnership or any partnership-related item would change as a result of the election (or revocation)) within a single period no greater than six months within the 24-month period described in paragraph (c)(7)(viii)(A)( 2 )( i ) of this section; and
( iii ) Each United States shareholder in the controlled foreign corporation as of the end of the controlled foreign corporation's taxable year to which the election relates must pay any tax due as a result of such adjustments within a single period no greater than six months within the 24-month period described in paragraph (c)(7)(viii)(A)( 2 )( i ) of this section.
( 3 ) In the case of a United States shareholder that is a partnership, paragraphs (c)(7)(viii)(A)( 1 ) and ( 2 ) and (c)(7)(viii)(C) of this section are applied by substituting “Form 1065 (or successor form)” for “federal income tax return” and by substituting “amended Form 1065 (or successor form) or administrative adjustment request (as described in § 301.6227-1), as applicable,” for “amended federal income tax return”, each place that it appears.
( 4 ) A United States shareholder that is a partner in a partnership that is also a United States shareholder in the controlled foreign corporation must generally file an amended return, as required under paragraph (c)(7)(viii)(A)( 2 )( ii ) of this section, and must generally pay any additional tax owed as required under paragraph (c)(7)(viii)(A)( 2 )( iii ) of this section. However, in the case of a United States shareholder that is a partner in a partnership that duly files an administrative adjustment request under paragraph (c)(7)(viii)(A)( 2 ) of this section, the partner is treated as having satisfied the requirements of paragraphs (c)(7)(viii)(A)( 2 )( ii ) and ( iii ) of this section with respect to the interest held through that partnership if:
( i ) The partnership timely files an administrative adjustment request described in paragraph (c)(7)(viii)(A)( 2 )( i ) or ( ii ) of this section, as applicable; and,
( ii ) Both the partnership and its partners timely comply with the requirements of section 6227 with respect to the administrative adjustment request. See §§ 301.6227-1 through -3 for rules relating to administrative adjustment requests.
(B) Scope. A high-tax election applies with respect to each tentative gross tested income item of the controlled foreign corporation for the CFC inclusion year and is binding on all United States shareholders of the controlled foreign corporation.
(C) Revocation. A high-tax election may be revoked by the controlling domestic shareholders of the controlled foreign corporation in the same manner as prescribed for an election made on an amended return as described in paragraph (c)(7)(viii)(A) of this section.
(D) Failure to satisfy election requirements. A high-tax election (or revocation) is valid only if all of the requirements in paragraph (c)(7)(viii)(A) of this section, including the requirement to provide notice under paragraph (c)(7)(viii)(A)( 1 )( ii ) of this section, are satisfied.
(E) Rules applicable to CFC groups —( 1 ) In general. In the case of a controlled foreign corporation that is a member of a CFC group, a high-tax election is made under paragraph (c)(7)(viii)(A) of this section, or revoked under paragraph (c)(7)(viii)(C) of this section, with respect to all controlled foreign corporations that are members of the CFC group and the rules in paragraphs (c)(7)(viii)(A) through (D) of this section apply by reference to the CFC group.
( 2 ) Determination of the CFC group —( i ) Definition. Subject to the rules in paragraphs (c)(7)(viii)(E)( 2 )( ii ) and ( iii ) of this section, the term CFC group means an affiliated group as defined in section 1504(a) without regard to section 1504(b)(1) through (6), except that section 1504(a) is applied by substituting “more than 50 percent” for “at least 80 percent” each place it appears, and section 1504(a)(2)(A) is applied by substituting “or” for “and.” For purposes of this paragraph (c)(7)(viii)(E)( 2 )( i ), stock ownership is determined by applying the constructive ownership rules of section 318(a), other than section 318(a)(3)(A) and (B), by applying section 318(a)(4) only to options (as defined in § 1.1504-4(d)) that are reasonably certain to be exercised as described in § 1.1504-4(g), and by substituting in section 318(a)(2)(C) “5 percent” for “50 percent.
( ii ) Member of a CFC group. The determination of whether a controlled foreign corporation is included in a CFC group is made as of the close of the CFC inclusion year of the controlled foreign corporation that ends with or within the taxable years of the controlling domestic shareholders. One or more controlled foreign corporations are members of a CFC group if the requirements of paragraph (c)(7)(viii)(E)( 2 ) of this section are satisfied as of the end of the CFC inclusion year of at least one of the controlled foreign corporations, even if the requirements are not satisfied as of the end of the CFC inclusion year of all controlled foreign corporations. If the controlling domestic shareholders do not have the same taxable year, the determination of whether a controlled foreign corporation is a member of a CFC group is made with respect to the CFC inclusion year that ends with or within the taxable year of the majority of the controlling domestic shareholders (determined based on voting power) or, if no such majority taxable year exists, the calendar year. See paragraph (c)(8)(iii)(E) (Example 5) of this section for an example that illustrates the application of the rule set forth in this paragraph (c)(7)(viii)(E)( 2 )( ii ). Notwithstanding the rule set forth in this paragraph (c)(7)(viii)(E)( 2 )( ii ), a controlled foreign corporation is not a member of a CFC group if, as of the close of its CFC inclusion year, the controlled foreign corporation does not have a controlling domestic shareholder.
( iii ) Controlled foreign corporations included in only one CFC group. A controlled foreign corporation cannot be a member of more than one CFC group. If a controlled foreign corporation would be a member of more than one CFC group under paragraph (c)(7)(viii)(E)( 2 ) of this section, then ownership of stock of the controlled foreign corporation is determined by applying paragraph (c)(7)(viii)(E)( 2 ) of this section without regard to section 1504(a)(2)(B) or, if applicable, by reference to the ownership existing as of the end of the first CFC inclusion year of a controlled foreign corporations that would cause a CFC group to exist.
(ix) Definitions. The following definitions apply for purposes of this paragraph (c)(7).
(A) Indirectly. The term indirectly, when used in reference to ownership, means ownership through one or more pass-through entities.
(B) Pass-through entity. The term pass-through entity means a partnership, a disregarded entity, or any other person (whether domestic or foreign) other than a corporation to the extent that income, gain, deduction or loss of the person is taken into account in determining the income or loss of a controlled foreign corporation that owns, directly or indirectly, interests in the person.
(C) Transparent interest. The term transparent interest means an interest in a pass-through entity (or the activities of a branch) that is not a tested unit.
(8) Examples —(i) Scope. This paragraph (c)(8) provides examples illustrating the application of the rules in paragraph (c)(7) of this section.
(ii) Presumed facts. For purposes of the examples in paragraph (c)(8)(iii) of this section, except as otherwise stated, the following facts are presumed:
(A) USP is a domestic corporation.
(B) CFC1X and CFC2X are controlled foreign corporations organized in, and tax residents of, Country X.
(C) CFC3Z is a controlled foreign corporation organized in, and tax resident of, Country Z.
(D) FDEX is a disregarded entity that is a tax resident of Country X.
(E) FDE1Y and FDE2Y are disregarded entities that are tax residents of Country Y.
(F) FPSY is an entity that is organized in, and a tax resident of, Country Y but is classified as a partnership for federal income tax purposes.
(G) CFC1X, CFC2X, CFC3Z, and the interests in FDEX, FDE1Y, FDE2Y, and FPSY are tested units (the CFC1X tested unit, CFC2X tested unit, CFC3Z tested unit, FDEX tested unit, FDE1Y tested unit, FDE2Y tested unit, and FPSY tested unit, respectively).
(H) CFC1X, CFC2X, CFC3Z, FDEX, FDE1Y, and FDE2Y conduct activities in the foreign country in which they are tax resident, and properly reflect items of income, gain, deduction, and loss on separate sets of books and records.
(I) All entities have calendar taxable years (for both federal income tax purposes and for purposes of the relevant foreign country) and use the Euro (€) as their functional currency. At all relevant times €1 = $1.
(J) The maximum rate of tax specified in section 11 for the CFC inclusion year is 21 percent.
(K) Neither CFC1X, CFC2X, nor CFC3Z directly or indirectly earns income described in section 952(b), has any items of income, gain, deduction, or loss, or makes or receives disregarded payments. In addition, no tested unit of CFC1X, CFC2X, or CFC3Z makes or receives disregarded payments.
(L) An election made under section 954(b)(4) and paragraph (c)(7)(viii) of this section is effective with respect to CFC1X and CFC2X, as applicable, for the CFC inclusion year.
(M) The same amounts of regarded items of income and deduction that are accrued under federal income tax law are also accrued under foreign law.
(iii) Examples —(A) Example 1: Effect of disregarded interest —( 1 ) Facts —( i ) Ownership. USP owns all of the stock of CFC1X, and CFC1X owns all of the interests of FDE1Y.
( ii ) Gross income and deductions (other than for foreign income taxes). In Year 1, CFC1X generates €100x of gross income from services to unrelated parties that would be gross tested income without regard to paragraph (c)(7) of this section and that is properly reflected on the books and records of FDE1Y. The €100x of services income is general category income under § 1.904-4(d). In Year 1, FDE1Y accrues and pays €20x of interest to CFC1X that is deductible for Country Y tax purposes but is disregarded for federal income tax purposes. The €20x of disregarded interest income received by CFC1X from FDE1Y is properly reflected on CFC1X's books and records, and the €20x of disregarded interest expense paid from FDE1Y to CFC1X is properly reflected on FDE1Y's books and records.
( iii ) Foreign income taxes. Country X imposes no tax on net income, and Country Y imposes a 25% tax on net income. For Country Y tax purposes, FDE1Y (which is not disregarded under Country Y tax law) has €80x of taxable income (€100x of services income from the unrelated parties, less a €20x deduction for the interest paid to CFC1X). Accordingly, FDE1Y incurs a Country Y income tax liability with respect to Year 1 of €20x (€80x x 25%), the U.S. dollar amount of which is $20x.
( 2 ) Analysis —( i ) Tentative gross tested income items. Under paragraph (c)(7)(ii)(A) of this section, the tentative gross tested income item with respect to each of the CFC1X tested unit and the FDE1Y tested unit is the aggregate of the gross income of CFC1X that is attributable to the tested unit, that would be gross tested income (without regard to this paragraph (c)(7)), and that would be in a single tested income group. Under paragraphs (c)(7)(ii)(B)( 1 ) and ( 2 ) of this section, items of gross income of CFC1X are attributable to the CFC1X tested unit, or the FDE1Y tested unit, to the extent properly reflected on its separate set of books and records, as determined under federal income tax principles and adjusted to take into account disregarded payments. Without regard to the €20x disregarded interest payment from FDE1Y to CFC1X, gross income attributable to the CFC1X tested unit would be €0 (that is, the €20x of interest income reflected on the books and records of CFC1X would be reduced by €20x, the amount attributable to the payment that is disregarded for federal income tax purposes). Similarly, without regard to the €20x disregarded interest payment from FDE1Y to CFC1X, gross income attributable to the FDE1Y tested unit would be €100x (that is, €100x of services income reflected on the books and records of FDE1Y, unreduced by the €20x disregarded interest payment from FDE1Y to CFC1X). However, under paragraph (c)(7)(ii)(B)( 2 ) of this section, the gross income attributable to each of the CFC1X tested unit and the FDE1Y tested unit is adjusted by €20x, the amount of the disregarded interest payment from FDE1Y to CFC1X that is deductible for Country Y tax purposes. Accordingly, the tentative gross tested income item attributable to the CFC1X tested unit (the “CFC1X tentative gross tested income item”) is €20x (€0 + €20x), and the tentative gross tested income item attributable to the FDE1Y tested unit (the “FDE1Y tentative gross tested income item”) is €80x (€100x − €20x).
( ii ) Foreign income tax deduction. Under paragraph (c)(7)(iii)(A) of this section, CFC1X's tentative tested income items are computed by treating the CFC1X tentative gross tested income item and the FDE1Y tentative gross tested income item each as income in a separate tested income group (the “CFC1X income group” and the “FDE1Y income group”) and by allocating and apportioning CFC1X's deductions for current year taxes under § 1.861-20 (CFC1X has no other deductions to allocate and apportion). Under paragraph (c)(7)(iii)(A) of this section and § 1.861-20(d)(3)(v), the €20x deduction for Country Y income taxes is allocated and apportioned solely to the FDE1Y income group (the “FDE1Y group tax”) and none of the Country Y taxes are allocated and apportioned to the CFC1X income group.
( iii ) Tentative tested income items. Under paragraph (c)(7)(iii) of this section, the tentative tested income item with respect to the CFC1X income group (the “CFC1X tentative tested item”), is €20x. The tentative tested income item with respect to the FDE1Y income group (the “CFC1X tentative tested item”) is €60x (the FDE1Y tentative gross tested income item of €80x, less the €20x deduction for the FDE1Y group tax).
( iv ) Foreign income tax paid or accrued with respect to a tentative tested income item. Under paragraph (c)(7)(vii) of this section, the foreign income taxes paid or accrued with respect to a tentative tested income item is the U.S. dollar amount of the eligible current year taxes that are allocated and apportioned to the related tentative gross tested income item under the rules of paragraph (c)(7)(iii) of this section. Therefore, the foreign income taxes paid or accrued with respect to the FDE1Y tentative tested income item is $20x, the U.S. dollar amount of the FDE1Y group tax. The foreign income tax paid or accrued with respect to the CFC1X tentative tested income item is $0, the U.S. dollar amount of the foreign tax allocated and apportioned to the CFC1X tentative gross tested income item under paragraph (c)(7)(iii) of this section.
( v ) Effective foreign tax rate. The effective foreign tax rate is determined under paragraph (c)(7)(vi) of this section by dividing the U.S. dollar amount of foreign income taxes paid or accrued with respect to each respective tentative tested income item by the U.S. dollar amount of the tentative tested income item increased by the U.S. dollar amount of the relevant foreign income taxes. Therefore, the effective foreign tax rate with respect to the FDE1Y tentative tested income item is 25%, computed by dividing $20x (the U.S. dollar amount of the foreign income taxes paid or accrued with respect to the FDE1Y tentative tested income item under paragraph (c)(7)(vii) of this section) by $80x (the sum of $60x, the U.S. dollar amount of the FDE1Y tentative tested income item, and $20x, the U.S. dollar amount of the foreign income taxes paid or accrued with respect to the FDE1Y tentative tested income item). The CFC1X tentative tested income item is not subject to any foreign income tax, so is subject to an effective foreign tax rate of 0%, calculated as $0 (the U.S. dollar amount of the foreign income taxes paid or accrued with respect to the CFC1X tentative tested income item) divided by $20x (the U.S. dollar amount of the CFC1X tentative tested income item).
( vi ) Gross income items excluded under sections 954(b)(4) and 951A(c)(2)(A)(i)(III). The FDE1Y tentative tested income item is subject to an effective foreign tax rate (25%) that is greater than 18.9% (90% of the maximum rate of tax specified in section 11). Therefore, the requirement of paragraph (c)(7)(i)(B) of this section is satisfied, and the FDE1Y tentative gross tested income item qualifies under paragraph (c)(7)(i) of this section for the high-tax exception of section 954(b)(4) and is excluded from tested income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(iii) of this section. The CFC1X tentative tested income item is subject to an effective foreign tax rate of 0%. Therefore, the CFC1X tentative tested income item does not satisfy the requirement of paragraph (c)(7)(i)(B) of this section, and the CFC1X tentative gross tested income item does not qualify under paragraph (c)(7)(i) of this section for the high-tax exception of section 954(b)(4) and is not excluded from tested income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(iii) of this section.
(B) [Reserved]
(C) Example 3: Interest expense allocated and apportioned with respect to the income of a lower-tier CFC —( 1 ) Facts —( i ) Ownership. USP owns all of the stock of CFC1X. CFC1X directly owns all the interests of FDE1Y. FDE1Y owns all of the stock of CFC3Z. Pursuant to § 1.861-9(j) and § 1.861-9T(j), CFC1X uses the modified gross income method to allocate and apportion its interest expense.
( ii ) Gross income and deductions (including for foreign income taxes). During Year 1, CFC1X generates €4,000x of gross income from services that would be gross tested income without regard to paragraph (c)(7) of this section, €3,000x of which is properly reflected on the books and records of the CFC1X tested unit and €1,000x of which is properly reflected on the books and records of the FDE1Y tested unit. CFC1X also accrues €1,000x of interest expense to an unrelated person. Country X imposes €200x of income taxes with respect to the €3,000x of gross income properly reflected on the books and records of the CFC1X tested unit, and Country Y imposes €200x of income taxes with respect to the €1,000x of gross income properly reflected on the books and records of the FDE1Y tested unit. CFC3Z generates €1,000x of gross income from services that would be gross tested income without regard to paragraph (c)(7) of this section, and such gross income is properly reflected on the books and records of the CFC3Z tested unit. CFC3Z accrues no expenses, and Country Z imposes €100x of income taxes with respect to the €1,000x of gross income generated by CFC3Z.
( 2 ) Analysis —( i ) Tentative gross tested income items. Under paragraph (c)(7)(ii) of this section, the €3,000x of gross income that is reflected on the books and records of the CFC1X tested unit, and the €1,000x of gross income that is reflected on the books and records of the FDE1Y tested unit, are attributable to the CFC1X tested unit and the FDE1Y tested unit, respectively. Under paragraph (c)(7)(ii) of this section, each of these amounts is a separate tentative gross tested income item of CFC1X (the “CFC1X tentative gross tested income item” and the “FDE1Y tentative gross tested income item,” respectively). Under paragraph (c)(7)(ii) of this section, the €1,000x item of tentative gross tested income that is properly reflected on the books and records of the CFC3Z tested unit is attributable to the CFC3Z tested unit. Under paragraph (c)(7)(ii) of this section, the amount attributable to the CFC3Z tested unit is a tentative gross tested income item of CFC3Z (the “CFC3Z tentative gross tested income item”).
( ii ) Allocation and apportionment of interest expense. To compute CFC1X's tentative tested income items, the principles of § 1.960-1(d)(3) apply by treating each of CFC1X's tentative gross tested income items as income in a separate tested income group (the “CFC1X income group” and the “FDE1Y income group”) and allocate and apportion its deductions among those income groups under federal income tax principles. Because CFC1X uses the modified gross income method under § 1.861-9(j) and § 1.861-9T(j) to allocate and apportion interest expense, it must allocate and apportion its interest expense between the CFC1X income group and the FDE1Y income group based on a combined gross income amount that includes both the gross income of CFC1X (including the gross income attributable to both the CFC1X tested unit and the FDE1Y tested unit) and the gross income of CFC3Z, adjusted as provided under § 1.861-9(j) and § 1.861-9T(j). Under § 1.861-9(j) and § 1.861-9T(j), the adjusted combined gross income of CFC1X comprises the CFC1X tentative gross tested income item (€3,000x), or 60% of the combined adjusted gross income amount, the FDE1Y tentative gross tested income item (€1,000x), or 20% of the combined adjusted gross income amount, and the CFC3Z gross tentative tested income item (€1,000x), or 20% of the combined adjusted gross income amount. Under paragraph (c)(7)(iii) of this section, interest expense of CFC1X that is allocated and apportioned to the gross income of CFC3Z under § 1.861-9(j) and § 1.861-9T(j) is not allocated and apportioned to either the CFC1X income group or the FDE1Y income group. Therefore, €600x of interest expense (60% of the €1,000x of interest expense) is allocated and apportioned to the CFC1X income group, and €200x of interest expense (20% of the €1,000x of interest expense) is allocated and apportioned to the FDE1Y income group. The €200x of interest expense that is allocated and apportioned to the €1,000x of gross tentative tested income of CFC3Z is allocated and apportioned to the residual income group for purposes of paragraph (c)(7) of this section, but can still be allocated and apportioned to a statutory grouping of tested income of CFC1X for purposes of paragraph (c)(3) of this section. See paragraph (c)(7)(iii) of this section.
( iii ) Foreign income tax deduction. Under paragraph (c)(7)(iii) of this section, deductions for foreign income taxes paid or accrued by CFC1X are allocated and apportioned under § 1.861-20 to the CFC1X income group and the FDE1Y income group. Similarly, foreign income taxes paid or accrued by CFC3Z are allocated and apportioned under § 1.861-20 to the tentative gross tested income item of CFC3Z (the “CFC3Z income group”). Under § 1.861-20, €200x of Country X income taxes are allocated and apportioned to the CFC1X income group (the “CFC1X group tax”), the €200x of Country Y income taxes are allocated and apportioned to the FDE1Y income group (the “FDE1Y group tax”), and the €100x of Country Z income taxes are allocated and apportioned to the CFC3Z income group (the “CFC3Z group tax”).
( iv ) Tentative tested income items. After the allocation and apportionment of deductions to reduce the tentative gross tested income in each income group, under paragraph (c)(7)(iii) of this section, CFC1X has a tentative tested income item with respect to the CFC1X tested unit of €2,200x (€3,000x, less €600x of interest expense and €200x of foreign income tax expense, the “CFC1X tentative tested income item”) and a tentative tested income item with respect to the FDE1Y tested unit of €600x (€1,000x, less €200x of interest expense and €200x of foreign income tax expense, the “FDE1Y tentative tested income item”). CFC3Z has a tentative tested income item of €900x (€1,000x, less €100x of foreign income tax expense, the “CFC3Z tentative tested income item”).
( v ) Foreign income taxes paid or accrued with respect to a tentative tested income item. Under paragraph (c)(7)(vii) of this section, the foreign income taxes paid or accrued with respect to a tentative tested income item is the U.S. dollar amount of the eligible current year taxes that are allocated and apportioned to the related tentative gross tested income item under the rules of paragraph (c)(7)(iii) of this section. Therefore, the foreign income tax paid or accrued with respect to the CFC1X tentative tested income item is $200x, the U.S. dollar amount of the CFC1X group tax. Similarly, the foreign income tax paid or accrued with respect to the FDE1Y tentative tested income item is $200x, the U.S. dollar amount of the FDE1Y group tax, and the foreign income tax paid or accrued with respect to the CFC3Z tentative tested income item is $100x, the U.S. dollar amount of the CFC3Z group tax.
( vi ) Effective foreign tax rate. The effective foreign tax rate is determined under paragraph (c)(7)(vi) of this section by dividing the U.S. dollar amount of foreign income taxes paid or accrued with respect to each respective tentative tested income item by the U.S. dollar amount of the tentative tested income item increased by the U.S. dollar amount of the relevant foreign income taxes. Therefore, the effective foreign tax rate for the CFC1X tentative tested income item is 8.3%, computed by dividing $200x (the U.S. dollar amount of the foreign income taxes paid or accrued with respect to the CFC1X tentative tested income item), by $2,400x (the sum of $2,200x, the U.S. dollar amount of the CFC1X tentative tested income item and $200x, the U.S. dollar amount of the foreign taxes paid or accrued with respect to the CFC1X tentative tested income item). The effective foreign tax rate for the FDE1Y tentative tested income item is 25%, computed by dividing $200x (the U.S. dollar amount of the foreign taxes paid or accrued with respect to the FDE1Y tentative tested income item) by $800x (the sum of $600x, the U.S. dollar amount of the FDE1Y tentative tested income item, and $200x, the U.S. dollar amount of the foreign taxes paid or accrued with respect to the FDE1Y tentative tested income item). The effective foreign tax rate for the CFC3Z tentative tested income item is 10%, computed by dividing $100x (the U.S. dollar amount of the foreign taxes paid or accrued with respect to the CFC3Z tentative tested income item) by $1,000x (the sum of $900x, the U.S. dollar amount of the CFC3Z tentative tested income item, and $100x, the U.S. dollar amount of the foreign taxes paid or accrued with respect to the CFC3Z tentative tested income item).
( vii ) Gross income items excluded under sections 954(b)(4) and 951A(c)(2)(A)(i)(III). The FDE1Y tentative tested income item is subject to tax at an effective foreign tax rate (25%) that is greater than 18.9% (90% of the maximum rate of tax specified in section 11). Therefore, the requirement of paragraph (c)(7)(i)(B) of this section is satisfied, and the FDE1Y tentative gross tested income item qualifies under paragraph (c)(7)(i) of this section for the high-tax exception of section 954(b)(4) and is excluded from tested income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(iii) of this section. In computing the tested income of CFC1X under paragraph (c)(3) of this section, the deductions of CFC1X that were allocated and apportioned to the FDE1Y tentative gross tested income item (that is, the €200x of interest expense and the €200x of FDE1Y group taxes) are allocated and apportioned to this item of tentative gross tested income. As a result, the €1,000x of tentative gross tested income excluded from tested income under section 954(b)(4), as well as the €200x of interest expense and €200x of foreign tax expense allocable to that gross income, are allocated and apportioned to the residual category under paragraph (c)(3) of this section for purposes of determining the tested income of CFC1X. Under § 1.960-1(d)(3), the $200x of foreign income taxes allocated and apportioned to the excluded gross income would also be assigned to the residual income group for purposes of determining CFC1X's tested taxes for purposes of section 960(d). The CFC1X tentative tested income item and CFC3Z tentative tested income item each have effective foreign tax rates (8.3% and 10%, respectively) that are not greater than 90% of the maximum rate of tax specified in section 11. Therefore, the CFC1X tentative gross tested income item and the CFC3Z tentative gross tested income item do not qualify under paragraph (c)(7)(i) of this section for the high-tax exception of section 954(b)(4), and are not excluded from tested income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(i) of this section. Under paragraph (c)(3) of this section, the corresponding deductions are allocated and apportioned to that gross tested income in a manner that achieves a result that is consistent the result of the allocation and apportionment of those deductions under paragraph (c)(7) of this section. Accordingly, because CFC3Z's tentative gross tested income is not excluded from gross tested income under sections 951A(c)(2)(A)(i)(IIII) and 954(b)(4) and paragraph (c)(1)(i) of this section, under paragraph (c)(3) of this section the €200x of CFC1X's interest expense that was apportioned to tentative gross tested income of CFC3Z under the modified gross income method in § 1.861-9 is allocated and apportioned to gross tested income of CFC1X and therefore reduces CFC1X's tested income. In contrast, if the CFC3Z tentative gross tested item had been excluded from gross tested income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(i) of this section, then the €200x of CFC1X's interest expense that was allocated and apportioned to that income would be assigned to the residual category.
(D) Example 4: Application of tested unit rules —( 1 ) Facts —( i ) Ownership. USP owns all of the stock of CFC1X. CFC1X directly owns all the interests of FDEX and FDE1Y. In addition, CFC1X directly carries on activities in Country Y that constitute a branch (as described in § 1.267A-5(a)(2)) and that give rise to a taxable presence under Country Y tax law and Country X tax law (such branch, “FBY”).
( ii ) Items reflected on books and records. For the CFC inclusion year, CFC1X had a €20x item of gross income (Item A), which is properly reflected on the books and records of FBY, and a €30x item of gross income (Item B), which is properly reflected on the books and records of FDEX.
( 2 ) Analysis —( i ) Identifying the tested units of CFC1X. Without regard to the combination rule of paragraph (c)(7)(iv)(C) of this section, CFC1X, CFC1X's interest in FDEX, CFC1X's interest in FDE1Y, and FBY would each be a tested unit of CFC1X. See paragraph (c)(7)(iv)(A) of this section. Pursuant to the combination rule, however, the FDE1Y tested unit is combined with the FBY tested unit and treated as a single tested unit because FDE1Y is a tax resident of Country Y, the same country in which FBY is located (the “Country Y tested unit”). See paragraph (c)(7)(iv)(C)( 1 ) of this section. The CFC1X tested unit (without regard to any items attributable to the FDEX, FDE1Y, or FBY tested units) is also combined with the FDEX tested unit and treated as a single tested unit because CFC1X and FDEX are both tax residents of County X (the “Country X tested unit”). See paragraph (c)(7)(iv)(C)( 1 ) of this section.
( ii ) Computing the items of CFC1X. Under paragraph (c)(7)(ii)(A) of this section, a tentative gross tested income item is determined with respect to each of the Country Y tested unit and the Country X tested unit. To determine the tentative gross tested income item of each tested unit, the item of gross income that is attributable to the tested unit is determined under paragraph (c)(7)(ii)(B) of this section. Under paragraph (c)(7)(ii)(B) of this section, only Item A is attributable to the Country Y tested unit. Item A is not attributable to the Country X tested unit because it is not reflected on the separate set of books and records of the CFC1X tested unit or the FDEX tested unit, and an item of gross income is only attributable to one tested unit. See paragraph (c)(7)(ii)(B)( 1 ) of this section. Under paragraph (c)(7)(ii)(B) of this section, only Item B is attributable to the Country X tested unit.
( 3 ) Alternative facts—branch does not give rise to a taxable presence in country where located —( i ) Facts. The facts are the same as in paragraph (c)(8)(iii)(D)( 1 ) of this section (the original facts in this Example 4 ), except that FBY does not give rise to a taxable presence under Country Y tax law; moreover, Country X tax law does not provide an exclusion, exemption, or other similar relief with respect to income attributable to FBY.
( ii ) Analysis. FBY is not a tested unit but is a transparent interest. See paragraphs (c)(7)(iv)(A)( 3 ) and (c)(7)(ix)(C) of this section. CFC1X has a tested unit in Country X that includes the CFC1X tested unit (without regard to any items related to the interest in FDEX or FDE1Y, but that includes FBY since it is a transparent interest and not a tested unit) and the interest in FDEX. See paragraph (c)(7)(iv)(C) of this section. CFC1X has another tested unit in Country Y, the interest in FDE1Y.
( 4 ) Alternative facts—branch is a tested unit but is not combined —( i ) Facts. The facts are the same as in paragraph (c)(8)(iii)(D)( 1 ) of this section (the original facts in this Example 4 ), except that FBY does not give rise to a taxable presence under Country Y tax law but Country X tax law provides an exclusion, exemption, or other similar relief (such as a preferential rate) with respect to income attributable to FBY.
( ii ) Analysis. FBY is a tested unit. See paragraph (c)(7)(iv)(A)( 3 ) of this section. CFC1X has two tested units in Country Y, the interest in FDE1Y and FBY. The interest in FDE1Y and FBY tested units are not combined because FBY does not give rise to a taxable presence under the tax law of Country Y. See paragraph (c)(7)(iv)(C)( 2 ) of this section. CFC1X also has a tested unit in Country X that includes the activities of CFC1X (without regard to any items related to the interest in FDEX, the interest in FDE1Y, or FBY) and the interest in FDEX.
( 5 ) Alternative facts—split ownership of tested unit —( i ) Facts. The facts are the same as in paragraph (c)(8)(iii)(D)( 1 ) of this section (the original facts in this Example 4 ), except that USP also owns CFC2X, CFC1X does not own FDE1Y, and CFC1X and CFC2X own 60% and 40%, respectively, of the interests of FPSY.
( ii ) Analysis for CFC1X. Under paragraph (c)(7)(iv)(C)( 1 ) of this section, FBY and CFC1X's 60% interest in FPSY are combined and treated as a single tested unit of CFC1X (“CFC1X's Country Y tested unit”), and CFC1X's interest in FDEX and CFC1X's other activities are combined and treated as a single tested unit of CFC1X (“CFC1X's Country X tested unit”). CFC1X's Country Y tested unit is attributed any item of CFC1X that is derived through its interest in FPSY to the extent the item is properly reflected on the books and records of FPSY. See paragraph (c)(7)(ii)(B)( 1 ) of this section.
( iii ) Analysis for CFC2X. Under paragraphs (c)(7)(iv)(A)( 1 ) and (c)(7)(iv)(A)( 2 )( i ) of this section, CFC2X and CFC2X's 40% interest in FPSY are tested units of CFC2X. CFC2X's interest in FPSY is attributed any item of CFC2X that is derived through FPSY to the extent that it is properly reflected on the books and records of FPSY. See paragraph (c)(7)(ii)(B)( 1 ) of this section.
( iv ) Analysis for not combining CFC1X and CFC2X tested units. None of the tested units of CFC1X are combined with the tested units of CFC2X under paragraph (c)(7)(iv)(C)( 1 ) of this section because they are tested units of different controlled foreign corporations, and the combination rule only combines tested units of the same controlled foreign corporation.
( 6 ) Alternative facts—split ownership of transparent interest —( i ) Facts. The facts are the same as in paragraph (c)(8)(iii)(D)( 1 ) of this section (the original facts in this Example 4 ), except that USP also owns CFC2X, CFC1X does not own FDE1Y, and CFC1X and CFC2X own 60% and 40%, respectively, of the interests in FPSY, but FPSY is not a tax resident of any foreign country and is fiscally transparent for Country X tax law purposes.
( ii ) Analysis for CFC1X. CFC1X's interest in FPSY is not a tested unit but is a transparent interest. See paragraphs (c)(7)(iv)(A)( 2 ) and (c)(7)(ix)(C) of this section. Under paragraph (c)(7)(v)(C) of this section, any item of CFC1X that is derived through its interest in FPSY and is properly reflected on the books and records of FPSY is treated as properly reflected on the books and records of CFC1X.
( iii ) Analysis for CFC2X. CFC2X's interest in FPSY is not a tested unit but is a transparent interest. See paragraphs (c)(7)(iv)(A)( 2 ) and (c)(7)(ix)(C) of this section. Under paragraph (c)(7)(v)(C) of this section, any item of CFC2X that is derived through its interest in FPSY and is properly reflected on the books and records of FPSY is treated as properly reflected on the books and records of CFC2X.
(E) Example 5: CFC group—Controlled foreign corporations with different taxable years —( 1 ) Facts. USP owns all the stock of CFC1X and CFC2X. CFC2X has a taxable year ending November 30. On December 15, Year 1, USP sells all the stock of CFC2X to an unrelated party for cash.
( 2 ) Analysis. The determination of whether CFC1X and CFC2X are in a CFC group is made as of the close of their CFC inclusion years that end with or within the taxable year ending December 31, Year 1, the taxable year of USP, the controlling domestic shareholder. See paragraph (c)(7)(viii)(E)( 2 )( ii ) of this section. Under paragraph (c)(7)(viii)(E)( 2 )( i ) of this section, USP directly owns more than 50% of the stock of CFC1X as of December 31, Year 1, the end of CFC1X's CFC inclusion year. USP also directly owns more than 50% of the stock of CFC2X as of November 30, Year 1, the end of CFC2X's CFC inclusion year. Therefore, CFC1X and CFC2X are members of a CFC group, and USP must consistently make high-tax elections, or revocations, under paragraph (c)(7)(viii) of this section with respect to CFC1X's taxable year ending December 31, Year 1, and CFC2X's taxable year ending November 30, Year 1. This is the case notwithstanding that USP does not directly own more than 50% of the stock of CFC2X as of December 31, Year 1, the end of CFC1X's CFC inclusion year. See paragraph (c)(7)(viii)(E)( 2 )( ii ) of this section.