[Federal Register Volume 77, Number 30 (Tuesday, February 14, 2012)]
[Rules and Regulations]
[Pages 8120-8127]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-3352]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9576]
RIN 1545-BF73


Definition of a Taxpayer

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final Income Tax Regulations which 
provide guidance relating to the determination of who is considered to 
pay a foreign income tax for purposes of the foreign tax credit. These 
regulations provide rules for identifying the person with legal 
liability to pay the foreign income

[[Page 8121]]

tax in certain circumstances. These regulations affect taxpayers 
claiming foreign tax credits.

DATES: Effective Date: These regulations are effective on February 14, 
2012.
    Applicability Dates: For dates of applicability, see Sec.  1.901-
2(h)(4).

FOR FURTHER INFORMATION CONTACT: Suzanne M. Walsh, (202) 622-3850 (not 
a toll-free call).

SUPPLEMENTARY INFORMATION: 

Background

I. Section 901 Regulations

    On August 4, 2006, the Federal Register published proposed 
regulations (71 FR 44240) under section 901 of the Internal Revenue 
Code concerning the determination of the person who paid a foreign 
income tax for foreign tax credit purposes (2006 proposed regulations). 
The 2006 proposed regulations would address the inappropriate 
separation of foreign income taxes from the income on which the tax was 
imposed in certain circumstances. In particular, the 2006 proposed 
regulations would provide guidance under Sec.  1.901-2(f) relating to 
the person on whom foreign law imposes legal liability for tax, 
including in the case of taxes imposed on the income of foreign 
consolidated groups and entities that have different classifications 
for U.S. and foreign tax law purposes.
    The Treasury Department and the IRS received written comments on 
the 2006 proposed regulations and held a public hearing on October 13, 
2006. All comments are available at www.regulations.gov or upon 
request. In Notice 2007-95 (2007-2 CB 1091 (December 3, 2007)), the 
Treasury Department and the IRS announced that when issued, the final 
regulations will be effective for taxable years beginning after the 
final regulations are published in the Federal Register. This Treasury 
decision adopts, in part, the 2006 proposed regulations with the 
changes discussed in this preamble.

II. Section 909 and Notice 2010-92

    Section 909 was enacted as part of legislation commonly referred to 
as the Education Jobs and Medicaid Assistance Act (EJMAA) on August 10, 
2010 (Pub. L. 111-226, 124 Stat. 2389 (2010)). Section 909 was enacted 
to address concerns about the inappropriate separation of foreign 
income taxes and related income.
    Section 909 provides that there is a foreign tax credit splitting 
event if a foreign income tax is paid or accrued by a taxpayer or 
section 902 corporation and the related income is, or will be, taken 
into account by a covered person with respect to such taxpayer or 
section 902 corporation. In such a case, the tax is suspended until the 
taxable year in which the related income is taken into account by the 
payor of the tax or, if the payor is a section 902 corporation, by a 
section 902 shareholder of the section 902 corporation.
    On December 6, 2010, the Treasury Department and the IRS issued 
Notice 2010-92 (2010-2 CB 916 (December 6, 2010)), which primarily 
addresses the application of section 909 to foreign income taxes paid 
or accrued by a section 902 corporation in taxable years beginning on 
or before December 31, 2010 (pre-2011 taxable years). The notice 
provides rules for determining whether foreign income taxes paid or 
accrued by a section 902 corporation in pre-2011 taxable years (pre-
2011 taxes) are suspended under section 909 in taxable years beginning 
after December 31, 2010 (post-2010 taxable years) of a section 902 
corporation. It also identifies an exclusive list of arrangements that 
will be treated as giving rise to foreign tax credit splitting events 
in pre-2011 taxable years (pre-2011 splitter arrangements) and provides 
guidance on determining the amount of related income and pre-2011 taxes 
paid or accrued with respect to pre-2011 splitter arrangements. The 
pre-2011 splitter arrangements are reverse hybrid structures, certain 
foreign consolidated groups, disregarded debt structures in the context 
of group relief and other loss-sharing regimes, and two classes of 
hybrid instruments. The notice states that future guidance will provide 
that foreign tax credit splitting events in post-2010 taxable years 
will at least include all of the pre-2011 splitter arrangements. The 
notice also states that the Treasury Department and the IRS do not 
intend to finalize the portion of the 2006 proposed regulations 
relating to the determination of the person who paid a foreign income 
tax with respect to the income of a reverse hybrid. See Prop. Sec.  
1.901-2(f)(2)(iii). Temporary regulations under section 909 are 
published elsewhere in this issue of the Federal Register.

Summary of Comments and Explanation of Revisions

I. In General

    In response to written comments on the 2006 proposed regulations 
and in light of the enactment of section 909, the Treasury Department 
and the IRS have determined that it is appropriate to finalize certain 
portions of the 2006 proposed regulations. These final regulations 
revise several of the proposed rules to take into account comments 
received. Other portions of those regulations are adopted without 
amendment. The Treasury Department and the IRS have also determined 
that the remaining portions of the 2006 proposed regulations should be 
withdrawn. The Treasury Department and the IRS, however, are continuing 
to consider whether and to what extent to revise or clarify the general 
rule that tax is considered paid by the person who has legal liability 
under foreign law for the tax. For example, the Treasury Department and 
the IRS are continuing to study whether it is appropriate to provide a 
special rule for determining who has legal liability in the case of a 
withholding tax imposed on an amount of income that is considered 
received by different persons for U.S. and foreign tax purposes, as in 
the case of certain sale-repurchase transactions.

II. Taxes Imposed on Combined Income

    Section 1.901-2(f)(2) of the 2006 proposed regulations addresses 
the application of the legal liability rule to foreign consolidated 
groups and other combined income regimes, including those in which the 
regime imposes joint and several liability in the U.S. sense, those in 
which the regime treats subsidiaries as branches of the parent 
corporation (or otherwise attributes income of subsidiaries to the 
parent corporation), and those in which some of the group members have 
limited obligations, or even no obligation, to pay the consolidated 
tax. Section 1.901-2(f)(2)(i) of the 2006 proposed regulations provides 
that the foreign tax must be apportioned among the persons whose income 
is included in the combined base pro rata based on each person's 
portion of the combined income, as computed under foreign law. Because 
failure to allocate appropriately the consolidated tax among the 
members of the group may result in the separation of foreign income tax 
from the related income as described in section 909, comments 
recommended that the proposed rules be finalized in lieu of treating 
these arrangements as foreign tax credit splitting events under section 
909, which would require suspension of split tax until the related 
income is taken into account. The Treasury Department and the IRS agree 
with the comments, and accordingly, Sec.  1.901-2(f)(3)(i) of the final 
regulations adopts with minor modifications Prop. Sec.  1.901-
2(f)(2)(i). As these regulations are generally effective for foreign 
taxes paid or accrued during taxable years beginning after February 14, 
2012, a foreign tax credit splitting event will not occur with respect 
to foreign taxes paid or accrued on combined income in such

[[Page 8122]]

years. However, with respect to foreign income taxes paid or accrued on 
combined income during taxable years beginning after December 31, 2010, 
and on or before February 14, 2012, temporary regulations under section 
909 provide that a foreign tax credit splitting event occurs to the 
extent that a taxpayer does not allocate the foreign consolidated tax 
liability among the members of the foreign consolidated group based on 
each member's share of the consolidated taxable income included in the 
foreign tax base under the principles of Sec.  1.901-2(f)(3) prior to 
its amendment by this Treasury decision.
    One comment recommended that combined income subject to 
preferential tax rates should be allocated only to group members with 
that type of income, in order to more closely match the tax with the 
related income. The Treasury Department and the IRS agree with this 
comment, and Sec.  1.901-2(f)(3)(i) of the final regulations provides 
that combined income with respect to each foreign tax that is imposed 
on a combined basis, and combined income subject to tax exemption or 
preferential tax rates, is computed separately, and the tax on that 
combined income base is allocated separately.
    Section 1.901-2(f)(2)(ii) of the 2006 proposed regulations provides 
that for purposes of Sec.  1.901-2(f)(2) of the 2006 proposed 
regulations, foreign tax is imposed on the combined income of two or 
more persons if such persons compute their taxable income on a combined 
basis under foreign law. Foreign tax is considered to be imposed on the 
combined income of two or more persons even if the combined income is 
computed under foreign law by attributing to one such person (for 
example, the foreign parent of a foreign consolidated group) the income 
of other such persons. However, foreign tax is not considered to be 
imposed on the combined income of two or more persons solely because 
foreign law: (1) Permits one person to surrender a net loss to another 
person pursuant to a group relief or similar regime; (2) requires a 
shareholder of a corporation to include in income amounts attributable 
to taxes imposed on the corporation with respect to distributed 
earnings, pursuant to an integrated tax system that allows the 
shareholder a credit for such taxes; or (3) requires a shareholder to 
include, pursuant to an anti-deferral regime (similar to subpart F of 
the Internal Revenue Code (sections 951 through 965)), income 
attributable to the shareholder's interest in the corporation.
    The final regulations adopt Sec.  1.901-2(f)(2)(ii) of the 2006 
proposed regulations with several modifications in response to 
comments. Section 1.901-2(f)(3)(ii) of the final regulations provides 
that tax is considered to be computed on a combined basis if two or 
more persons that would otherwise be subject to foreign tax on their 
separate taxable incomes add their items of income, gain, deduction, 
and loss to compute a single consolidated taxable income amount for 
foreign tax purposes. In addition, foreign tax is not considered to be 
imposed on the combined income of two or more persons if, because one 
or more of such persons is a fiscally transparent entity under foreign 
law, only one of such persons is subject to tax under foreign law (even 
if two or more of such persons are corporations for U.S. tax purposes). 
The regulations include additional illustrations clarifying that 
foreign tax is not considered to be imposed on combined income solely 
because foreign law: (1) Reallocates income from one person to a 
related person under foreign transfer pricing provisions; (2) requires 
a person to take into account a distributive share of taxable income of 
an entity that is a partnership or other fiscally transparent entity 
for foreign tax law purposes; or (3) requires a person to take all or 
part of the income of an entity that is a corporation for U.S. tax 
purposes into account because foreign law treats the entity as a branch 
or fiscally transparent entity (a reverse hybrid). A reverse hybrid 
does not include an entity that is treated under foreign law as a 
branch or fiscally transparent entity solely for purposes of 
calculating combined income of a foreign consolidated group.
    One comment requested clarification that the exclusions from the 
definition of a combined income base (for example, foreign integration 
and anti-deferral regimes) apply solely for purposes of determining 
whether a foreign income tax is imposed on combined income, and do not 
apply for purposes of determining each person's ratable share of the 
combined income base. The Treasury Department and the IRS agree that 
these exclusions from the definition of a combined income base do not 
exclude any amount of income otherwise subject to tax on a combined 
basis from the operation of the combined income rule. However, since 
nothing in the list of exclusions affects the amount of income in the 
combined income base, which is computed under foreign law, the Treasury 
Department and the IRS believe a change is unnecessary.
    Section 1.901-2(f)(2)(iii) of the 2006 proposed regulations 
provides that a reverse hybrid is considered to have legal liability 
under foreign law for foreign taxes imposed on the owners of the 
reverse hybrid in respect of each owner's share of the reverse hybrid's 
income. As stated in Notice 2010-92, the Treasury Department and the 
IRS will not finalize the portion of the 2006 proposed regulations 
relating to the determination of the person who paid a foreign income 
tax with respect to the income of a reverse hybrid. Notice 2010-92 
identifies reverse hybrids as pre-2011 splitter arrangements, and the 
temporary regulations under section 909 also identify reverse hybrids 
as splitter arrangements.
    Section 1.901-2(f)(2)(iv) of the 2006 proposed regulations provides 
rules for determining each person's share of the combined income tax 
base, generally relying on foreign tax reporting of separate taxable 
income or books maintained for that purpose. The 2006 proposed 
regulations provide that payments between group members that result in 
a deduction under both U.S. and foreign tax law will be given effect in 
determining each person's share of the combined income. The 2006 
proposed regulations, however, explicitly reserve with respect to the 
effect of hybrid instruments and disregarded payments between related 
parties, which the preamble to the proposed regulations describes as a 
matter to be addressed in subsequent published guidance. Section 1.901-
2(f)(2)(iv) of the 2006 proposed regulations also provides special 
rules addressing the effect of dividends (and deemed dividends) and net 
losses of group members on the determination of separate taxable 
income.
    Section 1.901-2(f)(3)(iii) of the final regulations adopts Prop. 
Sec.  1.901-2(f)(2)(iv) with modifications reflecting that certain 
hybrid instruments and certain disregarded payments are treated as 
splitter arrangements subject to section 909. In particular, the final 
regulations provide that in determining separate taxable income of 
members of a combined income group, effect will be given to 
intercompany payments that are deductible under foreign law, even if 
such payments are not deductible (or are disregarded) for purposes of 
U.S. tax law. Thus, for example, interest accrued by one group member 
with respect to an instrument held by another member that is treated as 
debt for foreign tax purposes but as equity for U.S. tax purposes would 
be considered income of the holder and would reduce the taxable income 
of the issuer. The final regulations, however, include a cross-

[[Page 8123]]

reference to Sec.  1.909-2T(b)(3)(i) for rules requiring suspension of 
foreign income taxes paid or accrued by the owner of a U.S. equity 
hybrid instrument.
    Section 1.901-2(f)(2)(v) of the 2006 proposed regulations provides 
that U.S. tax principles apply to determine the tax consequences if one 
person remits a tax that is the legal liability of another person. For 
example, a payment of tax for which a corporation has legal liability 
by a shareholder of that corporation (including an owner of a reverse 
hybrid), will ordinarily result in a deemed capital contribution and 
deemed payment of tax by the corporation. Prop. Sec.  1.901-2(f)(2)(v) 
also provides that if the corporation reimburses the shareholder for 
the tax payment, such reimbursement would ordinarily be treated as a 
distribution for U.S. tax purposes. The Treasury Department and the IRS 
received several comments regarding Prop. Sec.  1.901-2(f)(2)(v) noting 
that a shareholder's payment of a corporation's tax and a corporation's 
reimbursement of a shareholder for paying its tax liability will not 
result in deemed capital contribution and deemed dividend treatment if 
arrangements are in place that treat the shareholder's payment of the 
tax as pursuant to a lending or agency arrangement. In response to 
these comments, the second and third sentences of Sec.  1.901-
2(f)(2)(v) of the 2006 proposed regulations are not included in Sec.  
1.901-2(f)(3)(iv) of the final regulations, and the final regulations 
simply provide that U.S. tax principles apply to determine the tax 
consequences if one person remits a tax that is the legal liability of 
another person.

III. Taxes Imposed on Partnerships and Disregarded Entities

    Section 1.901-2(f)(3) of the 2006 proposed regulations provides 
rules regarding the treatment of two types of hybrid entities. First, 
in the case of an entity that is treated as a partnership for U.S. 
income tax purposes but is taxable at the entity level under foreign 
law (which the 2006 proposed regulations define as a hybrid 
partnership), such entity is considered to have legal liability under 
foreign law for foreign income tax imposed on the income of the entity. 
The 2006 proposed regulations also provide rules for allocating foreign 
tax paid or accrued by a hybrid partnership if the partnership's U.S. 
taxable year closes with respect to one or more (or all) partners or if 
there is a change in ownership of the hybrid partnership. See Prop. 
Sec.  1.901-2(f)(3)(i).
    Second, in the case of an entity that is disregarded as separate 
from its owner for U.S. federal income tax purposes, the person that is 
treated as owning the assets of such entity for U.S. tax purposes is 
considered to have legal liability under foreign law for tax imposed on 
the income of the entity. The 2006 proposed regulations provide rules 
for allocating foreign tax between the old owner and the new owner of a 
disregarded entity if there is a change in the ownership of the 
disregarded entity during the entity's foreign taxable year and such 
change does not result in a closing of the entity's foreign taxable 
year. See Prop. Sec.  1.901-2(f)(3)(ii). The 2006 proposed regulations 
generally provide that for hybrid partnerships and disregarded 
entities, allocations of tax will be made under the principles of Sec.  
1.1502-76(b) based on the respective portions of the taxable income of 
the hybrid entity (as determined under foreign law) for the foreign 
taxable year that are attributable to the period ending on the date of 
the ownership change (or the last day of the terminating partnership's 
U.S. taxable year) and the period ending after such date. This approach 
is consistent with the rule provided in Sec.  1.338-9(d) for 
apportioning foreign tax paid by a target corporation that is acquired 
in a transaction that is treated as an asset acquisition pursuant to an 
election under section 338, if the foreign taxable year of the target 
does not close at the end of the acquisition date.
    A change in the ownership of a hybrid partnership or disregarded 
entity during the entity's foreign taxable year that does not result in 
the closing of the hybrid entity's foreign taxable year may result in 
the separation of income from the associated foreign income taxes. A 
change in the ownership occurs if there is a disposition of all or a 
portion of the owner's interest. A separation of income from the 
associated foreign income taxes could occur if the foreign tax paid or 
accrued with respect to such foreign taxable year has not been 
allocated appropriately between the old owner and the new owner. 
Certain changes of ownership involving related parties could be treated 
as a foreign tax credit splitting event under section 909. Comments 
recommended that the proposed legal liability rules addressing the 
treatment of hybrid entities be finalized in lieu of treating the 
above-described case of a change in the ownership of a hybrid entity as 
a foreign tax credit splitting event under section 909. The Treasury 
Department and the IRS agree, and accordingly, the final regulations 
adopt the proposed rules with modifications in response to comments.
    One comment recommended that, if a termination under section 
708(b)(1)(B) requires a closing of the books to allocate U.S. taxable 
income between the old partnership and new partnership but the foreign 
taxable year does not close, or if a change in a partner's interest 
results in a closing of the partnership's taxable year with respect to 
the partner and an allocation of partnership items based on a closing 
of the books under section 706, foreign tax for the year of change 
should similarly be allocated under the principles of sections 706 and 
708 and the regulations under those sections based on a closing of the 
books, rather than under the principles of Sec.  1.1502-76(b), which 
permits ratable allocation of the foreign tax with an exception for 
extraordinary items. The comment noted that apportioning the foreign 
tax using the same methodology as is used to apportion U.S. taxable 
income between the terminating partnership and the new partnership, or 
between the partner whose interest changes and the other partners, 
would lead to better matching of foreign tax and the associated income. 
The Treasury Department and the IRS are concerned about the increased 
administrative and compliance burdens associated with requiring a 
closing of the foreign tax books in order to apportion foreign tax for 
the year of change. Accordingly, this comment was not adopted.
    In response to a comment, the final regulations apply the same 
foreign tax allocation rules to section 708 terminations that arise 
under section 708(b)(1)(A) in the case of a partnership that has ceased 
its operations, including a change in ownership in which a partnership 
becomes a disregarded entity. The final regulations also apply the same 
allocation rules if there are multiple ownership changes within a 
single foreign taxable year.
    Finally, Sec.  1.901-2(f)(3)(i) of the 2006 proposed regulations 
defines a hybrid partnership as an entity that is treated as a 
partnership for U.S. income tax purposes but is taxable at the entity 
level under foreign law. Because the Treasury Department and the IRS 
believe that a special definition of the term hybrid partnership is 
unnecessary and could cause confusion, references to the term hybrid 
partnership are replaced in the final regulations with references to 
the term partnership. No substantive change is intended by this 
revision.

IV. Effective/Applicability Date

    The 2006 proposed regulations would generally apply to foreign 
taxes paid or accrued during taxable years beginning on or after 
January 1, 2007. However,

[[Page 8124]]

consistent with Notice 2007-95, Sec.  1.901-2(h)(4) provides that these 
final regulations are generally effective for foreign taxes paid or 
accrued in taxable years beginning after February 14, 2012.
    A comment raised several transition-related questions arising in 
situations where applying the final regulations changes the person who 
is considered the taxpayer with respect to a particular foreign income 
tax. First, the comment stated it is unclear what happens to the 
carryover under section 904(c) of foreign taxes paid or accrued in a 
taxable year beginning before the effective date of the final 
regulations (pre-effective date year) to a taxable year beginning on or 
after the effective date of the final regulations (post-effective date 
year). The comment recommended that the regulations clarify the 
treatment of foreign tax credit carryovers from pre-effective date 
years and foreign tax credit carrybacks from post-effective date years, 
and that the regulations provide that taxes paid or accrued in a pre-
effective date year that are carried forward to a post-effective date 
year be assigned to the taxpayer that paid or accrued the foreign taxes 
in the pre-effective date year. Similarly, the comment recommended that 
taxes paid or accrued in a post-effective date year that are carried 
back to the last pre-effective date year should be treated in the 
carryback year as paid or accrued by the taxpayer that paid or accrued 
the taxes in the post-effective date year.
    The Treasury Department and the IRS believe it is clear under 
current law that the person who paid or accrued foreign income taxes in 
a pre-effective date year is the person who is eligible under section 
904(c) to carry forward such taxes to a post-effective date year, 
notwithstanding that such person may not be considered the taxpayer 
under these final regulations had the taxes been paid or accrued in the 
post-effective date carryover year. Similarly, the Treasury Department 
and the IRS believe it is clear that the person who paid or accrued 
foreign income taxes in a post-effective date year is the person who is 
eligible under section 904(c) to carry back such taxes to the last pre-
effective date year. Therefore, the Treasury Department and the IRS 
believe that revision of the final regulations to reflect this comment 
is unnecessary.
    The comment also recommended that taxpayers be permitted to apply 
the final regulations retroactively, but that taxpayers should not be 
permitted to take inconsistent positions with respect to the incidence 
of the foreign tax. The comment recommended that a duty of consistency 
be imposed on related parties, or parties that were related at the time 
the foreign tax was imposed. If parties that were related but are now 
unrelated do not agree on an election to apply the regulations 
retroactively, the comment stated no election should be permitted.
    In response to the comment, the final regulations permit taxpayers 
to apply the combined income rules of Sec.  1.901-2(f)(3) of the final 
regulations to taxable years beginning after December 31, 2010, and on 
or before February 14, 2012. This provision will permit taxpayers to 
avoid uncertainty regarding the application of section 909 to foreign 
taxes paid or accrued by foreign consolidated groups in pre-effective 
date taxable years beginning in 2011 and 2012. No inference is intended 
as to the determination of the person who paid the foreign tax under 
the rules in effect prior to the amendment of the regulations by this 
Treasury decision. To the extent that a taxpayer did not allocate 
foreign consolidated tax liability among the members of a foreign 
consolidated group based on each member's share of the consolidated 
taxable income included in the foreign tax base under the principles of 
Sec.  1.901-2(f)(3), the foreign consolidated group is a foreign tax 
credit splitting event under section 909. See Section 4.03 of Notice 
2010-92 and Sec.  1.909-5T.
    The Treasury Department and the IRS have concerns about the 
administrative complexity and burden on taxpayers associated with 
requirements to elect to apply Sec.  1.901-2(f)(4) retroactively that 
would be necessary to prevent potential whipsaws from two unrelated 
persons claiming a foreign tax credit for a single payment of foreign 
income tax, in cases where different persons are considered to pay the 
tax under the final regulations and under prior law. Although taxpayers 
may not elect to apply Sec.  1.901-2(f)(4) retroactively, certain 
portions of that provision, specifically with respect to the person 
that has legal liability for a foreign tax paid by a disregarded entity 
or a partnership in the absence of a change in ownership, were 
consistent with the rules in effect under the final regulations prior 
to amendment by this Treasury decision. In addition, to prevent 
treating more than one person as paying a single amount of tax, Sec.  
1.901-2(f)(4) of the final regulations will not apply to any amount of 
tax paid or accrued in a post-effective date year of any person, if 
such tax would be treated as paid or accrued by a different person in a 
pre-effective date year under the prior regulations.

Availability of IRS Documents

    IRS notices cited in this preamble are made available by the 
Superintendent of Documents, U.S. Government Printing Office, 
Washington, DC 20402.

Effect on Other Documents

    The following publication is obsolete in part as of February 14, 
2012.
    Notice 2007-95 (2007-2 CB 1091).

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to this regulation and because the 
regulation does not impose a collection of information requirement on 
small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
does not apply. Pursuant to section 7805(f) of the Internal Revenue 
Code, the notice of proposed rulemaking preceding this regulation was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Drafting Information

    The principal author of these regulations is Suzanne M. Walsh of 
the Office of Associate Chief Counsel (International). However, other 
personnel from the IRS and Treasury Department participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 * * *

PART 1--[Corrected]

0
Par. 2. Section 1.706-1 is amended by adding paragraph (c)(6) to read 
as follows:


Sec.  1.706-1  Taxable years of partner and partnership.

* * * * *
    (c) * * *
    (6) Foreign taxes. For rules relating to the treatment of foreign 
taxes paid or

[[Page 8125]]

accrued by a partnership, see Sec.  1.901-2(f)(4)(i) and (f)(4)(ii).
* * * * *

0
Par. 3. Section 1.901-2 is amended by revising paragraph (f)(3) and 
adding paragraphs (f)(4), (f)(5), and (h)(4) to read as follows:


Sec.  1.901-2  Income, war profits, or excess profits tax paid or 
accrued.

* * * * *
    (f) * * *
    (3) Taxes imposed on combined income of two or more persons--(i) In 
general. If foreign tax is imposed on the combined income of two or 
more persons (for example, a husband and wife or a corporation and one 
or more of its subsidiaries), foreign law is considered to impose legal 
liability on each such person for the amount of the tax that is 
attributable to such person's portion of the base of the tax. 
Therefore, if foreign tax is imposed on the combined income of two or 
more persons, such tax is allocated among, and considered paid by, such 
persons on a pro rata basis in proportion to each person's portion of 
the combined income, as determined under foreign law and paragraph 
(f)(3)(iii) of this section. Combined income with respect to each 
foreign tax that is imposed on a combined basis is computed separately, 
and the tax on that combined income is allocated separately under this 
paragraph (f)(3)(i). If foreign law exempts from tax, or provides for 
specific rates of tax with respect to, certain types of income, or if 
certain expenses, deductions or credits are taken into account only 
with respect to a particular type of income, combined income with 
respect to such portions of the combined income is also computed 
separately, and the tax on that combined income is allocated separately 
under this paragraph (f)(3)(i). The rules of this paragraph (f)(3) 
apply regardless of which person is obligated to remit the tax, which 
person actually remits the tax, or which person the foreign country 
could proceed against to collect the tax in the event all or a portion 
of the tax is not paid. For purposes of this paragraph (f)(3), the term 
person means an individual or an entity (including a disregarded entity 
described in Sec.  301.7701-2(c)(2)(i) of this chapter) that is subject 
to tax in a foreign country as a corporation (or otherwise at the 
entity level). In determining the amount of tax paid by an owner of a 
partnership or a disregarded entity, this paragraph (f)(3) first 
applies to determine the amount of tax paid by the partnership or 
disregarded entity, and then paragraph (f)(4) of this section applies 
to allocate the amount of such tax to the owner.
    (ii) Combined income. For purposes of this paragraph (f)(3), 
foreign tax is imposed on the combined income of two or more persons if 
such persons compute their taxable income on a combined basis under 
foreign law and foreign tax would otherwise be imposed on each such 
person on its separate taxable income. For example, income is computed 
on a combined basis if two or more persons add their items of income, 
gain, deduction, and loss to compute a single consolidated taxable 
income amount for foreign tax purposes. Foreign tax is considered to be 
imposed on the combined income of two or more persons even if the 
combined income is computed under foreign law by attributing to one 
such person (for example, the foreign parent of a foreign consolidated 
group) the income of other such persons or by treating persons that 
would otherwise be subject to tax as separate entities as 
unincorporated branches of a single corporation for purposes of 
computing the foreign tax on the combined income of the group. However, 
foreign tax is not considered to be imposed on the combined income of 
two or more persons if, because one or more persons is a fiscally 
transparent entity (under the principles of Sec.  1.894-1(d)(3)) under 
foreign law, only one of such persons is subject to tax under foreign 
law (even if two or more of such persons are corporations for U.S. 
Federal income tax purposes). Therefore, foreign tax is not considered 
to be imposed on the combined income of two or more persons solely 
because foreign law:
    (A) Permits one person to surrender a loss to another person 
pursuant to a group relief or other loss-sharing regime described in 
Sec.  1.909-2T(b)(2)(vi);
    (B) Requires a shareholder of a corporation to include in income 
amounts attributable to taxes imposed on the corporation with respect 
to distributed earnings, pursuant to an integrated tax system that 
allows the shareholder a credit for such taxes;
    (C) Requires a shareholder to include, pursuant to an anti-deferral 
regime (similar to subpart F of the Internal Revenue Code (sections 951 
through 965)), income attributable to the shareholder's interest in the 
corporation;
    (D) Reallocates income from one person to a related person under 
foreign transfer pricing rules;
    (E) Requires a person to take into account a distributive share of 
income of an entity that is a partnership or other fiscally transparent 
entity for foreign tax law purposes; or
    (F) Requires a person to take all or part of the income of an 
entity that is a corporation for U.S. Federal income tax purposes into 
account because foreign law treats the entity as a branch or fiscally 
transparent entity (a reverse hybrid). A reverse hybrid does not 
include an entity that is treated under foreign law as a branch or 
fiscally transparent entity solely for purposes of calculating combined 
income of a foreign consolidated group.
    (iii) Portion of combined income--(A) In general. Each person's 
portion of the combined income is determined by reference to any 
return, schedule or other document that must be filed or maintained 
with respect to a person showing such person's income for foreign tax 
purposes, as properly amended or adjusted for foreign tax purposes. If 
no such return, schedule or other document must be filed or maintained 
with respect to a person for foreign tax purposes, then, for purposes 
of this paragraph (f)(3), such person's income is determined from the 
books of account regularly maintained by or on behalf of the person for 
purposes of computing its income for foreign tax purposes. Each 
person's portion of the combined income is determined by adjusting such 
person's income determined under this paragraph (f)(3)(iii)(A) as 
provided in paragraph (f)(3)(iii)(B) and (f)(3)(iii)(C) of this 
section.
    (B) Effect of certain payments--(1) Each person's portion of the 
combined income is determined by giving effect to payments and accrued 
amounts of interest, rents, royalties, and other amounts between 
persons whose income is included in the combined base to the extent 
such amounts would be taken into account in computing the separate 
taxable incomes of such persons under foreign law if they did not 
compute their income on a combined basis. Each person's portion of the 
combined income is determined without taking into account any payments 
from other persons whose income is included in the combined base that 
are treated as dividends or other non-deductible distributions with 
respect to equity under foreign law, and without taking into account 
deemed dividends or any similar attribution of income made for purposes 
of computing the combined income under foreign law, regardless of 
whether any such deemed dividend or attribution of income results in a 
deduction or inclusion under foreign law.
    (2) For purposes of determining each person's portion of the 
combined income, the treatment of a payment is determined under foreign 
law. Thus, for example, interest accrued by one group member with 
respect to an instrument

[[Page 8126]]

held by another member that is treated as debt for foreign tax purposes 
but as equity for U.S. Federal income tax purposes would be considered 
income of the holder and would reduce the income of the issuer. See 
also Sec.  1.909-2T(b)(3)(i) for rules requiring suspension of foreign 
income taxes paid or accrued by the owner of a U.S. equity hybrid 
instrument.
    (C) Net losses. If tax is considered to be imposed on the combined 
income of three or more persons and one or more of such persons has a 
net loss for the taxable year for foreign tax purposes, the following 
rules apply. If foreign law provides mandatory rules for allocating the 
net loss among the other persons, then the rules that apply for foreign 
tax purposes apply for purposes of this paragraph (f)(3). If foreign 
law does not provide mandatory rules for allocating the net loss, the 
net loss is allocated among all other such persons on a pro rata basis 
in proportion to the amount of each person's income, as determined 
under paragraphs (f)(3)(iii)(A) and (f)(3)(iii)(B) of this section. For 
purposes of this paragraph (f)(3)(iii)(C), foreign law is not 
considered to provide mandatory rules for allocating a net loss solely 
because such loss is attributed from one person to a second person for 
purposes of computing combined income, as described in paragraph 
(f)(3)(ii) of this section.
    (iv) Collateral consequences. U.S. tax principles apply to 
determine the tax consequences if one person remits a tax that is the 
legal liability of, and thus is considered paid by, another person.
    (4) Taxes imposed on partnerships and disregarded entities--(i) 
Partnerships. If foreign law imposes tax at the entity level on the 
income of a partnership, the partnership is considered to be legally 
liable for such tax under foreign law and therefore is considered to 
pay the tax for U.S. Federal income tax purposes. The rules of this 
paragraph (f)(4)(i) apply regardless of which person is obligated to 
remit the tax, which person actually remits the tax, or which person 
the foreign country could proceed against to collect the tax in the 
event all or a portion of the tax is not paid. See Sec. Sec.  1.702-
1(a)(6) and 1.704-1(b)(4)(viii) for rules relating to the determination 
of a partner's distributive share of such tax. If the U.S. taxable year 
of a partnership closes for all partners due to a termination of the 
partnership under section 708(b)(1)(A) and the regulations under that 
section and the foreign taxable year of the partnership does not close, 
then foreign tax paid or accrued with respect to the foreign taxable 
year in which the termination occurs is allocated between the 
terminating partnership and its successors or assigns. For example, if, 
as a result of a change in ownership during a partnership's foreign 
taxable year, the partnership becomes a disregarded entity and the 
entity's foreign taxable year does not close, foreign tax paid or 
accrued by the owner of the disregarded entity with respect to the 
foreign taxable year is allocated between the partnership and the owner 
of the disregarded entity. If the U.S. taxable year of a partnership 
closes for all partners due to a termination of the partnership under 
section 708(b)(1)(B) and the regulations under that section and the 
foreign taxable year of the partnership does not close, then foreign 
tax paid or accrued by the new partnership with respect to the foreign 
taxable year in which the termination occurs is allocated between the 
terminating partnership and the new partnership. If multiple 
terminations under section 708(b)(1)(B) occur within the foreign 
taxable year, foreign tax paid or accrued with respect to that foreign 
taxable year by a new partnership is allocated among all terminating 
and new partnerships. In the case of any termination under section 
708(b)(1), the allocation of foreign tax is made based on the 
respective portions of the taxable income (as determined under foreign 
law) for the foreign taxable year that are attributable under the 
principles of Sec.  1.1502-76(b) to the period of existence of each 
terminating and new partnership, or successor or assign of a 
terminating partnership, during the foreign taxable year. Foreign tax 
allocated to a terminating partnership under this paragraph (f)(4)(i) 
is treated as paid or accrued by such partnership as of the close of 
the last day of its final U.S. taxable year. In the case of a change in 
any partner's interest in the partnership (a variance), except as 
otherwise provided in section 706(d)(2) (relating to certain cash basis 
items) or 706(d)(3) (relating to tiered partnerships), foreign tax paid 
or accrued by the partnership during its U.S. taxable year in which the 
variance occurs is allocated between the portion of the U.S. taxable 
year ending on, and the portion of the U.S. taxable year beginning on 
the day after, the day of the variance. The allocation is made under 
the principles of this paragraph (f)(4)(i) as if the variance were a 
termination under section 708(b)(1).
    (ii) Disregarded entities. If foreign law imposes tax at the entity 
level on the income of an entity described in Sec.  301.7701-2(c)(2)(i) 
of this chapter (a disregarded entity), the person (as defined in 
section 7701(a)(1)) who is treated as owning the assets of the 
disregarded entity for U.S. Federal income tax purposes is considered 
to be legally liable for such tax under foreign law. Such person is 
considered to pay the tax for U.S. Federal income tax purposes. The 
rules of this paragraph (f)(4)(ii) apply regardless of which person is 
obligated to remit the tax, which person actually remits the tax, or 
which person the foreign country could proceed against to collect the 
tax in the event all or a portion of the tax is not paid. If there is a 
change in the ownership of such disregarded entity during the entity's 
foreign taxable year and such change does not result in a closing of 
the disregarded entity's foreign taxable year, foreign tax paid or 
accrued with respect to such foreign taxable year is allocated between 
the transferor and the transferee. If there is more than one change in 
the ownership of a disregarded entity during the entity's foreign 
taxable year, foreign tax paid or accrued with respect to that foreign 
taxable year is allocated among all transferors and transferees. The 
allocation is made based on the respective portions of the taxable 
income of the disregarded entity (as determined under foreign law) for 
the foreign taxable year that are attributable under the principles of 
Sec.  1.1502-76(b) to the period of ownership of each transferor and 
transferee during the foreign taxable year. If, as a result of a change 
in ownership, the disregarded entity becomes a partnership and the 
entity's foreign taxable year does not close, foreign tax paid or 
accrued by the partnership with respect to the foreign taxable year is 
allocated between the owner of the disregarded entity and the 
partnership under the principles of this paragraph (f)(4)(ii). If the 
person who owns a disregarded entity is a partnership for U.S. Federal 
income tax purposes, see Sec.  1.704-1(b)(4)(viii) for rules relating 
to the allocation of such tax among the partners of the partnership.
    (5) Examples. The following examples illustrate the rules of 
paragraphs (f)(3) and (f)(4) of this section:

    Example 1. (i) Facts. A, a United States person, owns 100 
percent of B, an entity organized in country X. B owns 100 percent 
of C, also an entity organized in country X. B and C are 
corporations for U.S. and foreign tax purposes that use the ``u'' as 
their functional currency. Pursuant to a consolidation regime, 
country X imposes an income tax described in (a)(1) of this section 
on the combined income of B and C within the meaning of paragraph 
(f)(3)(ii) of this section. In year 1, C pays 25u of interest to B. 
If B and C did not report their income on a combined basis for 
country X tax purposes,

[[Page 8127]]

the interest paid from C to B would result in 25u of interest income 
to B and 25u of deductible interest expense to C. For purposes of 
reporting the combined income of B and C, country X first requires B 
and C to determine their own income (or loss) on a separate 
schedule. For this purpose, however, neither B nor C takes into 
account the 25u of interest paid from C to B because the income of B 
and C is included in the same combined base. The separate income of 
B and C reported on their country X schedules for year 1, which do 
not reflect the 25u intercompany payment, is 100u and 200u, 
respectively. The combined income reported for country X purposes is 
300u (the sum of the 100u separate income of B and 200u separate 
income of C).
    (ii) Result. On the separate schedules described in paragraph 
(f)(3)(iii)(A) of this section, B's separate income is 100u and C's 
separate income is 200u. Under paragraph (f)(3)(iii)(B)(1) of this 
section, the 25u interest payment from C to B is taken into account 
for purposes of determining B's and C's portions of the combined 
income under paragraph (f)(3)(iii) of this section, because B and C 
would have taken the items into account if they did not compute 
their income on a combined basis. Thus, B's portion of the combined 
income is 125u (100u plus 25u) and C's portion of the combined 
income is 175u (200u less 25u). The result is the same regardless of 
whether the 25u interest payment from C to B is deductible for U.S. 
Federal income tax purposes. See paragraph (f)(3)(iii)(B)(2) of this 
section.
    Example 2. (i) Facts. A, a United States person, owns 100 
percent of B, an entity organized in country X. B is a corporation 
for country X tax purposes, and a disregarded entity for U.S. income 
tax purposes. B owns 100 percent of C and D, entities organized in 
country X that are corporations for both U.S. and country X tax 
purposes. B, C, and D use the ``u'' as their functional currency and 
file on a combined basis for country X income tax purposes. Country 
X imposes an income tax described in paragraph (a)(1) of this 
section at the rate of 30 percent on the taxable income of 
corporations organized in country X. Under the country X combined 
reporting regime, income (or loss) of C and D is attributed to, and 
treated as income (or loss) of, B. B has the sole obligation to pay 
country X income tax imposed with respect to income of B and income 
of C and D that is attributed to, and treated as income of, B. Under 
the law of country X, country X may proceed against B, but not C or 
D, if B fails to pay over to country X all or any portion of the 
country X income tax imposed with respect to such income. In year 1, 
B has income of 100u, C has income of 200u, and D has a net loss of 
(60u). Under the law of country X, B is considered to have 240u of 
taxable income with respect to which 72u of country X income tax is 
imposed. Country X does not provide mandatory rules for allocating 
D's loss.
    (ii) Result. Under paragraph (f)(3)(ii) of this section, the 72u 
of country X tax is considered to be imposed on the combined income 
of B, C, and D. Because country X law does not provide mandatory 
rules for allocating D's loss between B and C, under paragraph 
(f)(3)(iii)(C) of this section D's (60u) loss is allocated pro rata: 
20u to B ((100u/300u) x 60u) and 40u to C ((200u/300u) x 60u). Under 
paragraph (f)(3)(i) of this section, the 72u of country X tax must 
be allocated pro rata among B, C, and D. Because D has no income for 
country X tax purposes, no country X tax is allocated to D. 
Accordingly, 24u (72u x (80u/240u)) of the country X tax is 
allocated to B, and 48u (72u x (160u/240u)) of such tax is allocated 
to C. Under paragraph (f)(4)(ii) of this section, A is considered to 
have legal liability for the 24u of country X tax allocated to B 
under paragraph (f)(3) of this section.
    Example 3. (i) Facts. A, B, and C are U.S. persons that each use 
the calendar year as their taxable year. A and B each own 50 percent 
of the capital and profits of D, an entity organized in country M. D 
is a partnership for U.S. tax purposes, but is a corporation for 
country M tax purposes. D uses the ``u'' as its functional currency 
and the calendar year as its taxable year for both U.S. tax purposes 
and country M tax purposes. Country M imposes an income tax 
described in paragraph (a)(1) of this section at a rate of 30 
percent at the entity level on the taxable income of D. On September 
30 of Year 1, A sells its 50 percent interest in D to C. A's sale of 
its partnership interest results in a termination of the partnership 
under section 708(b)(1)(B) for U.S. tax purposes. As a result of the 
termination, ``old'' D's taxable year closes on September 30 of Year 
1 for U.S. tax purposes. New D also has a short U.S. taxable year, 
beginning on October 1 and ending on December 31 of Year 1. The sale 
of A's interest does not close D's taxable year for country M tax 
purposes. D has 400u of taxable income for its foreign taxable year 
ending December 31, Year 1 with respect to which country M imposes 
120u of income tax, equal to $120 as translated in accordance with 
section 986(a).
    (ii) Result. Under paragraph (f)(4)(i) of this section, 
partnership D is legally liable for the $120 of country M income tax 
imposed on its foreign taxable income. Because D's taxable year 
closes on September 30, Year 1, for U.S. tax purposes, but does not 
close for country M tax purposes, under paragraph (f)(4)(i) of this 
section the $120 of country M tax must be allocated under the 
principles of Sec.  1.1502-76(b) between terminating D and new D. 
See Sec.  1.704-1(b)(4)(viii) for rules relating to the allocation 
of terminating D's country M taxes between A and B and the 
allocation of new D's country M taxes between B and C.
* * * * *
    (h) * * *
    (4) Paragraphs (f)(3), (f)(4), and (f)(5) of this section apply to 
foreign taxes paid or accrued in taxable years beginning after February 
14, 2012. However, if an amount of tax is paid or accrued in a taxable 
year of any person beginning on or before February 14, 2012, and the 
tax is treated as paid or accrued by such person under 26 CFR 1.901-
2(f) (revised as of April 1, 2011), then paragraph (f)(4) of this 
section will not apply, and 26 CFR 1.901-2(f) (revised as of April 1, 
2011) will apply, to determine the person with legal liability for that 
tax. No other person will be treated as legally liable for such tax, 
even if the tax is paid or accrued on a date that falls within a 
taxable year of such other person beginning after February 14, 2012. 
Taxpayers may choose to apply paragraph (f)(3) of this section to 
foreign taxes paid or accrued in taxable years beginning after December 
31, 2010, and on or before February 14, 2012.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
    Approved: February 8, 2012.
Emily S. McMahon,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2012-3352 Filed 2-9-12; 4:15 pm]
BILLING CODE 4830-01-P