[Federal Register Volume 65, Number 221 (Wednesday, November 15, 2000)]
[Proposed Rules]
[Pages 69138-69182]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-28950]



[[Page 69137]]

-----------------------------------------------------------------------

Part III





Department of the Treasury





-----------------------------------------------------------------------



Internal Revenue Service



-----------------------------------------------------------------------



26 CFR Part 1



Stock Transfer Rules: Carryover of Earnings and Taxes; Proposed Rule

Federal Register / Vol. 65, No. 221 / Wednesday, November 15, 2000 / 
Proposed Rules

[[Page 69138]]


-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-116050-99]
RIN 1545-AX65


Stock Transfer Rules: Carryover of Earnings and Taxes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations addressing 
transactions described in section 367(b) of the Internal Revenue Code 
(section 367(b) transactions). A section 367(b) transaction includes a 
corporate reorganization, liquidation, or division involving one or 
more foreign corporations. The proposed regulations address the 
carryover of certain tax attributes, such as earnings and profits and 
foreign income tax accounts, when two corporations combine in a section 
367(b) transaction. The proposed regulations also address the 
allocation of certain tax attributes when a corporation distributes 
stock of another corporation in a section 367(b) transaction. This 
document also provides notice of a public hearing on the proposed 
regulations.

DATES: Written or electronic comments and requests to speak (with 
outlines of oral comments) at a public hearing scheduled for March 13, 
2001 must be received by February 20, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-116050-99), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG-116050-99), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option on 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at http://www.irs.gov/tax_regs/regslist.html. The public 
hearing will be held in room 7218, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Anne O'Connell Devereaux, at (202) 622-3850; concerning submissions of 
comments, the hearing, and/or to be placed on the building access list 
to attend the hearing, Guy Traynor, at (202) 622-7180 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S:O, 
Washington, DC 20224. Comments on the collection of information should 
be received by January 16, 2001. Comments are specifically requested 
concerning:
    <bullet> Whether the proposed collection of information is 
necessary for the proper performance of the functions of the IRS, 
including whether the information will have practical utility;
    <bullet> The accuracy of the estimated burden associated with the 
proposed collection of information (see below);
    <bullet> How the quality, utility, and clarity of the information 
to be collected may be enhanced;
    <bullet> How the burden of complying with the proposed collection 
of information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    <bullet> Estimates of capital or start-up costs and costs of 
operation, maintenance, and purchase of services to provide 
information.
    The collection of information in this proposed regulation is in 
Sec. 1.367(b)-1. This collection of information is required by the IRS 
to verify compliance with the regulations under section 367(b) relating 
to exchanges described therein. The likely respondents are corporations 
that are affected by such exchanges.
    Estimated total annual reporting burden: 1,800 hours.
    The estimated annual burden per respondent: 3 hours.
    Estimated number of respondents: 600.
    Estimated annual frequency of responses: One.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On December 27, 1977, the IRS and Treasury issued proposed and 
temporary regulations under section 367(b) of the Code. Subsequent 
guidance updated and amended the 1977 temporary regulations several 
times over the next 14 years. On August 26, 1991, the IRS and Treasury 
issued proposed regulations Secs. 1.367(b)-1 through 1.367(b)-6 (the 
1991 proposed regulations). Final regulations under section 367(b) of 
the Internal Revenue Code (Code) were issued in June 1998 and January 
2000 and the 1977 temporary regulations and the 1991 proposed 
regulations were generally removed. The preamble to the January 2000 
final regulations refers to proposed regulations that would be issued 
at a later date to address the carryover of certain corporate tax 
attributes in transactions involving one or more foreign corporations. 
Those proposed regulations are set forth in this document.

Overview

A. General Policies of Section 367(b)

    In general, section 367 governs corporate restructurings under 
sections 332, 351, 354, 355, 356, and 361 (Subchapter C nonrecognition 
transactions) in which the status of a foreign corporation as a 
``corporation'' is necessary for the application of the relevant 
nonrecognition provisions. Other provisions in Subchapter C (Subchapter 
C carryover provisions) apply to such transactions in conjunction with 
the enumerated provisions and detail additional consequences that occur 
in connection with the transactions. For example, sections 362 and 381 
govern the carryover of basis and earnings and profits from the 
transferor corporation to the transferee corporation in applicable 
transactions and section 312 governs the allocation of earnings and 
profits from a distributing corporation in a transaction described in 
section 355.
    The Subchapter C carryover provisions generally have been drafted 
to apply to domestic corporations and U.S. shareholders, and thus do 
not fully take into account the cross-border

[[Page 69139]]

aspects of U.S. taxation. For example, sections 381 and 312 do not take 
into account source and foreign tax credit issues that arise when 
earnings and profits move from one corporation to another.
    Congress enacted section 367(b) to ensure that international tax 
considerations in the Code are adequately addressed when the Subchapter 
C provisions apply to an exchange involving a foreign corporation in 
order to prevent the avoidance of U.S. taxation. Because determining 
the proper interaction of the Code's international and Subchapter C 
provisions is ``necessarily highly technical,'' Congress granted the 
Secretary broad regulatory authority to provide the ``necessary or 
appropriate'' rules rather than enacting a complex statutory regime. 
H.R. Rep. No. 658, 94th Cong., 1st Sess. 241 (1975). Thus, section 
367(b)(2) provides in part that the regulations ``shall include (but 
shall not be limited to) regulations * * * providing * * * the extent 
to which adjustments shall be made to earnings and profits, basis of 
stock or securities, and basis of assets.''
    The proposed regulations provide rules regarding the movement of 
certain corporate tax attributes between corporations in a Subchapter C 
nonrecognition transaction involving one or more foreign corporations. 
Generally, the regulations continue to apply the principles of the 
Subchapter C carryover provisions with modifications as necessary or 
appropriate to preserve international tax policies of the Code and to 
prevent material distortions of income.
    The remainder of this Overview section is divided by specific 
categories of section 367(b) transactions and describes the relevant 
Subchapter C and international policies and provisions. The ``Details 
of Provisions'' portion of this preamble describes the proposed 
regulations' principal operative rules that implement the policies and 
reconcile the provisions described in the Overview portion of this 
preamble. The IRS and Treasury welcome comments regarding both the 
general approach and the specific provisions of the proposed 
regulations.

B. Specific Policies Related to Inbound Nonrecognition Transactions 
(Prop. Reg. Sec. 1.367(b)-3)

    Proposed Sec. 1.367(b)-3 addresses acquisitions by a domestic 
corporation (domestic acquiring corporation) of the assets of a foreign 
corporation (foreign acquired corporation) in a section 332 liquidation 
or an asset acquisition described in section 368(a)(1), such as a C, D, 
or F reorganization (inbound nonrecognition transaction).
    The preamble to the January 2000 final regulations generally 
describes international policy issues that can arise in an inbound 
nonrecognition transaction. The preamble states that the ``principal 
policy consideration of section 367(b) with respect to inbound 
nonrecognition transactions is the appropriate carryover of attributes 
from foreign to domestic corporations. This consideration has 
interrelated shareholder-level and corporate-level components.'' The 
final regulations address the carryover of certain attributes, such as 
the carryover of foreign taxes, earnings and profits, and basis. 
However, the carryover of earnings and profits and basis are addressed 
only to the extent attributable to earnings and profits accumulated 
during a U.S. shareholder's holding period, i.e., ``the all earnings 
and profits amount,'' as defined in Sec. 1.367(b)-2(d).
    The preamble to the final regulations also notes that it would be 
consistent with the policy considerations of section 367(b) for future 
regulations to provide further rules with respect to the extent to 
which attributes carry over from a foreign corporation to a U.S. 
corporation. The proposed regulations do not comprehensively address 
this issue. Compare Modify Treatment of Built-In Losses and Other 
Attribute Trafficking, General Explanations of the Administration's 
Fiscal Year 2001 Revenue Proposals at 205. However, the proposed 
regulations do provide additional rules concerning several attributes, 
specifically net operating loss and capital loss carryovers, and 
earnings and profits that are not included in income as an all earnings 
and profits amount (or a deficit in earnings and profits). The proposed 
regulations generally provide that these tax attributes carry over from 
a foreign acquired corporation to a domestic acquiring corporation only 
to the extent that they are effectively connected to a U.S. trade or 
business (or attributable to a permanent establishment, in the case of 
an applicable U.S. income tax treaty).

C. Specific Policies Related to Foreign 381 Transactions (Prop. Reg. 
Sec. 1.367(b)-7)

    Proposed regulation Sec. 1.367(b)-7 applies to an acquisition by a 
foreign corporation (foreign acquiring corporation) of the assets of 
another foreign corporation (foreign target corporation) in a 
transaction described in section 381 (foreign 381 transaction) and 
addresses the manner in which earnings and profits and foreign income 
taxes of the foreign acquiring corporation and foreign target 
corporation carry over to the surviving foreign corporation (foreign 
surviving corporation). This would include, for example, a C, D, or F 
reorganization or a section 332 liquidation between two foreign 
corporations.
    The international provisions of the Code distinguish between 
categories of foreign corporations. A foreign acquiring, target, or 
surviving corporation can be a controlled foreign corporation as 
defined in section 957 (CFC), a noncontrolled section 902 corporation 
as defined in section 904(d)(2)(E) after 2003, the effective date of 
section 1105(b) of Public Law 105-34 (111 Stat. 788) (the 1997 Act) 
(look-through 10/50 corporation and, together with CFCs, look-through 
corporations), a noncontrolled section 902 corporation before 2003 
(non-look-through 10/50 corporation and, together with look-through 10/
50 corporations, 10/50 corporations), or a foreign corporation that is 
neither a CFC nor a 10/50 corporation (less-than-10%-U.S.-owned foreign 
corporation).
    The principal Code sections implicated by the carryover of earnings 
and profits and foreign income taxes in a foreign 381 transaction are 
sections 381, 902, 904, and 959. Section 381 generally permits earnings 
and profits (or deficit in earnings and profits) to carry over to a 
surviving corporation, thus enabling ``the successor corporation to 
step into the 'tax shoes' of its predecessor. * * * [and] represents 
the economic integration of two or more separate businesses into a 
unified business enterprise.'' H. Rep. No. 1337, 83rd Cong., 2nd Sess. 
41 (1954). However, a deficit in earnings and profits of either the 
transferee or transferor corporation can only be used to offset 
earnings and profits accumulated after the date of transfer (hovering 
deficit rule). Section 381(c)(2)(B). The hovering deficit rule is a 
legislative mechanism designed to deter the trafficking in favorable 
tax attributes that the IRS and courts had repeatedly encountered. See, 
e.g., Commissioner v. Phipps, 336 U.S. 410 (1949). The proposed 
regulations adopt the principles of section 381 but adapt its operation 
in consideration of the international provisions that address foreign 
corporations' earnings and profits and their related foreign income 
taxes, such as sections 902, 904, and 959.
    Section 902 generally provides that a deemed paid foreign tax 
credit is available to a domestic corporation that receives a dividend 
from a foreign corporation in which it owns 10 percent or more of the 
voting stock (i.e., a look-

[[Page 69140]]

through corporation or non-look-through 10/50 corporation). The Code 
modifies the general last-in, first-out (LIFO) rule of section 316 and 
provides that look-through corporations and non-look-through 10/50 
corporations pay dividends out of multi-year pools of earnings and 
profits and foreign income taxes for earnings and profits accumulated 
(and related foreign income taxes paid or deemed paid) in taxable years 
beginning after December 31, 1986, or the first day after which a 
domestic corporation owns 10 percent or more of the voting stock of a 
foreign corporation, whichever is later. Section 902(c). (The Code and 
regulations refer to pooled earnings and profits and foreign income 
taxes as post-1986 undistributed earnings and post-1986 foreign income 
taxes even though a particular corporation may begin to pool after 
1986. Sections 902(c)(1) and (2), Sec. 1.902-1(a)(8) and (9).)
    Congress enacted the pooling rules because it believed that 
averaging of foreign income taxes was fairer than distributions out of 
annual layers. Joint Committee on Taxation, General Explanation of the 
Tax Reform Act of 1986 (Public Law 99-514) (1986 Bluebook) at 870. 
Averaging prevents taxpayers from inflating their foreign income tax 
rate for a particular year in order to obtain artificially enhanced 
foreign tax credits. Id. Averaging also prevents the trapping of 
foreign income taxes in years in which a taxpayer may have no earnings 
and profits. Id. 
    However, Congress enacted pooling on a limited basis. Earnings and 
profits accumulated (and related foreign income taxes paid or deemed 
paid) while a foreign corporation is a less-than-10%-U.S.-owned foreign 
corporation and pre-1987 earnings and profits accumulated (and related 
foreign income taxes paid or deemed paid) by a look-through corporation 
or non-look-through 10/50 corporation are not pooled. Rather, such 
earnings and profits (and related foreign income taxes) are maintained 
in separate annual layers. Section 902(c)(6). (The Code and regulations 
refer to earnings and profits and foreign income taxes in annual layers 
as pre-1987 accumulated profits and pre-1987 foreign income taxes even 
though a particular corporation may have annual layers for years after 
1986. Section 902(c)(6); Sec. 1.902-1(a)(10).)
    A distribution of earnings and profits is first out of pooled 
earnings and profits and then, only after all pooled earnings and 
profits have been distributed, out of annual layers of earnings and 
profits on a LIFO basis. Section 902(a) and (c). The retention of 
annual layers beneath pooled earnings and profits limits the need to 
recreate tax histories, an administrative burden that is more 
significant for periods during which a corporation had limited nexus to 
the U.S. taxing jurisdiction and for pre-1987 earnings and profits when 
pooling was not required.
    The section 904 foreign tax credit limitation ensures that 
taxpayers can use foreign tax credits only to offset U.S. tax on 
foreign source income. The limitation is computed separately with 
respect to different categories of income (baskets). The purpose of the 
baskets is to limit taxpayers' ability to cross-credit taxes from 
different categories of foreign source income. Congress was concerned 
that, without separate limitations, cross-crediting opportunities would 
distort economic incentives to invest in the United States versus 
abroad. 1986 Bluebook at 862.
    A dividend received by a U.S. shareholder that owns less than 10 
percent of the stock of a foreign corporation is categorized as passive 
income because such a dividend is in the nature of a portfolio 
investment. 1986 Bluebook at 866.
    A dividend received by a U.S. shareholder that owns 10 percent or 
more of a foreign corporation is subject to other limitations. 
Dividends paid by a non-look-through 10/50 corporation to a 10 percent 
or greater U.S. corporate shareholder are currently subject to a 
separate basket limitation on a corporation-by-corporation basis. 
Congress initially separately basketed dividends from each 10/50 
corporation because it believed a minority investment in a foreign 
corporation did not create sufficient identity of interest to justify 
look-through treatment and that cross-crediting of taxes among 
investments in 10/50 corporations was inappropriate because the foreign 
companies were not parts of a single economic unit. 1986 Bluebook at 
868. In addition, Congress was concerned about the administrability of 
applying the look-through rules to 10/50 corporations. 1986 Bluebook at 
868.
    In 1997, Congress amended the Code's treatment of dividends from 
10/50 corporations to provide that dividends paid after taxable years 
beginning after December 31, 2002 by a look-through 10/50 corporation 
out of earnings and profits accumulated before 2003 are subject to a 
single separate basket limitation for all 10/50 corporations, while 
dividends paid out of earnings and profits accumulated after 2003 are 
treated as income in a basket based on the ratio of the earnings and 
profits attributable to income in such basket to the foreign 
corporation's total earnings and profits (the so-called ``look-
through'' approach). Earnings and profits accumulated after 2003 by a 
look-through 10/50 corporation are distributed before earnings and 
profits accumulated by that same foreign corporation before 2003. Joint 
Committee on Taxation, General Explanation of Tax Legislation Enacted 
in 1997 (1997 Bluebook) at 303.
    The legislative history indicates that Congress changed its view 
with respect to 10/50 corporations because the separate basket 
limitation for dividends from each 10/50 corporation imposed a 
substantial recordkeeping burden and discouraged minority investments 
in foreign joint ventures. 1997 Bluebook at 302. However, as described 
above, the 1997 Act enacted look-through treatment for 10/50 
corporation dividends only on a limited basis. Furthermore, Congress 
provided regulatory authority regarding the treatment of distributions 
out of earnings and profits for periods prior to a taxpayer's 
acquisition of stock in a look-through 10/50 corporation because of 
concerns that look-through treatment could provide inappropriate 
opportunities to traffic in foreign tax credits.
    Dividends paid by a CFC out of earnings and profits accumulated 
while the corporation was not a CFC are treated as a distribution from 
a 10/50 corporation while dividends paid out of earnings and profits 
accumulated while the corporation was a CFC are eligible for look-
through treatment. Section 904(d)(2)(E)(i) and (d)(3). As in the case 
of a look-through 10/50 corporation, pooled earnings and profits of a 
CFC that are eligible for look-through treatment are distributed before 
other pooled earnings and profits. Prop. Reg. Sec. 1.904-4(g)(3)(iii). 
Congress provided look-through treatment for dividends paid by CFCs in 
order to provide greater parity between the treatment of income earned 
through a branch and a subsidiary. 1986 Bluebook at 866.
    Before 1997, except as otherwise provided in regulations, dividend 
distributions to a 10 percent U.S. shareholder of a CFC did not obtain 
look-through treatment unless the distributed earnings and profits 
accrued while the shareholder was a 10 percent U.S. shareholder and the 
corporation was a CFC. Section 904(d)(2)(E)(i), as in effect before the 
1997 Act. This rule was intended to prevent trafficking in foreign 
income taxes related to preacquisition earnings and profits. However, 
because of the administrative issues presented by maintaining 
shareholder-level earnings and profits accounts, Congress modified the 
rule in 1997 to provide that look-through

[[Page 69141]]

treatment applies with respect to CFC earnings and profits without 
regard to whether a 10 percent U.S. shareholder was a shareholder at 
the time accumulated. However, pre-CFC earnings and profits continue to 
be treated as earnings and profits of a 10/50 corporation because of 
foreign tax credit trafficking concerns.
    The section 904 basketing rules reflect Congress' concern with 
respect to cross-crediting opportunities and its intent to limit the 
benefit of look-through treatment to appropriate circumstances. Where 
Congress determined that look-through is inappropriate, a dividend is 
treated as passive income or is subject to a separate limitation for 
10/50 corporations (whether separately or collectively). Regulations 
have not yet been issued with respect to preacquisition earnings and 
profits of a look-through 10/50 corporation and the effect, if any, on 
the treatment of pre-CFC earnings and profits described in section 
904(d)(2)(E)(i). The IRS and Treasury solicit comments as to the 
appropriate treatment of such earnings and profits after 2003 in light 
of Congress' anti-trafficking concerns, as well as the impact that such 
rules should have on the section 367(b) regulations.
    Another international provision implicated by the movement of 
earnings and profits in foreign 381 transactions is section 959. 
Section 959 governs the distribution of earnings and profits that have 
been previously taxed to U.S. shareholders under section 951(a) (PTI). 
After studying the interaction of section 367(b) and the PTI rules, the 
IRS and Treasury determined that more guidance under section 959 would 
be useful before issuing regulations to address PTI issues that arise 
under section 367(b). Accordingly, the IRS and Treasury have opened a 
separate regulations project under section 959 and expect to issue 
regulations that address PTI issues under section 959 as well as 
section 367(b) in the future. The fundamental issue under consideration 
in that project is whether earnings and profits that are treated as PTI 
should be distributable to another shareholder, as well as the various 
implications that result from that determination. The IRS and Treasury 
invite comments with respect to these issues. Accordingly, the proposed 
regulations reserve on section 367(b) issues related to PTI.
    Other sections may have also applied to characterize pre-
transaction earnings of a foreign acquiring corporation or a foreign 
target corporation for certain purposes of the Code. For example, 
certain earnings may have been subject to characterization as U.S. 
source earnings under section 904(g), effectively connected earnings 
and profits under section 884, or post-1986 undistributed U.S. earnings 
under section 245. The characterization of such earnings carry over to 
the foreign surviving corporation for purposes of applying the relevant 
Code sections. See Georday Enterprises v. Commissioner, 126 F.2d 384 
(4th Cir. 1942).

D. Specific Policies Related to Foreign Divisive Transactions (Prop. 
Reg. Sec. 1.367(b)-8)

    Proposed regulation Sec. 1.367(b)-8 addresses the allocation of 
earnings and profits and foreign income taxes in a transaction 
described in section 312(h) (that is, a section 355 distribution 
whether or not in connection with a section 368(a)(1)(D) 
reorganization) in which either or both the distributing or the 
controlled corporation is a foreign corporation (foreign divisive 
transaction). The scope of proposed Sec. 1.367(b)-8 thus encompasses 
three situations: a domestic distributing corporation that distributes 
stock of a foreign controlled corporation, a foreign distributing 
corporation that distributes stock of a domestic controlled 
corporation, and a foreign distributing corporation that distributes 
stock of a foreign controlled corporation. The proposed regulations 
generally adopt the principles embodied in the regulations under 
section 312(h) but modify their application in consideration of the 
international provisions such as the source and foreign tax credit 
rules.
    Regulations under section 312(h) reflect the principle that a pro 
rata portion of a distributing corporation's earnings and profits 
should be reduced to account for the distribution of a portion of its 
assets. Sec. 1.312-10. Furthermore, the earnings and profits of a 
controlled corporation should include the portion of the distributing 
corporation's earnings and profits allocable to any assets transferred 
to the controlled corporation in connection with a section 368(a)(1)(D) 
reorganization (D reorganization) that immediately precedes the section 
355 distribution (together with a D reorganization, a D/355 
distribution). Sec. 1.312-10(a). If a section 355 distribution is not 
preceded by a D reorganization, the earnings and profits of the 
controlled corporation are at least equal to the amount of the 
reduction in the distributing corporation's earnings and profits. 
Sec. 1.312-10(b). It is likely that this rule was included to prevent 
taxpayers from using a section 355 distribution as a device to 
facilitate a bailout of earnings and profits through the controlled 
corporation. (The Sec. 1.312-10 rules are derived from the Senate's 
directions to the IRS and Treasury in implementing the regulatory 
authority in section 312(h); the Senate Report does not, however, 
explain its reasons for these rules. Senate Finance Committee, Report 
on H.R. 8300 (1954), at 249.)
    The application of the Sec. 1.312-10 rules to foreign divisive 
transactions implicates the Code's international provisions because 
earnings and profits are moving in the cross-border context and because 
the earnings and profits of controlled foreign corporations are being 
adjusted. In transactions involving a domestic distributing corporation 
and a foreign controlled corporation, the foreign controlled 
corporation may succeed to earnings and profits of the domestic 
distributing corporation. A post-transaction distribution by the 
foreign controlled corporation out of earnings and profits it receives 
from the domestic distributing corporation is generally eligible for 
the dividends received deduction and treated as U.S. source income 
under sections 243(e) and 861(a)(2)(C). This treatment is appropriate 
because the earnings and profits have already been subject to U.S. 
corporate taxation and should not be subject to a second level of U.S. 
corporate tax upon repatriation if the earnings and profits would have 
qualified for the dividends received deduction if distributed before 
the section 355 distribution. H.R. Rep. No. 2101, at 3 (1960). In 
addition, such earnings and profits should not increase a domestic 
distributee's foreign tax credit limitation under section 904.
    In circumstances where the foreign controlled corporation makes a 
post-transaction distribution to foreign shareholders, the foreign 
divisive transaction should not alter the character of earnings and 
profits allocated from the domestic distributing corporation. 
Otherwise, the section 355 distribution may serve as a vehicle to avoid 
U.S. tax, including U.S. withholding tax. Accordingly, the proposed 
regulations provide that a post-transaction distribution out of 
earnings and profits of a distributing corporation that carry over to a 
foreign controlled corporation is generally treated as a U.S. source 
dividend for purposes of Chapter 3 of subtitle A of the Code. See 
Georday Enterprises v. Commissioner, 126 F.2d 384 (4th Cir. 1942).
    Foreign divisive transactions involving a foreign distributing 
corporation and a domestic controlled corporation are similar to 
inbound nonrecognition transactions to the

[[Page 69142]]

extent the domestic controlled corporation receives assets of a foreign 
corporation. Current regulations under Sec. 1.367(b)-3 require direct 
and indirect U.S. shareholders in an inbound asset reorganization to 
include an all earnings and profits amount in income in order to 
ensure, in part, that the bases of assets repatriated to the United 
States reflect an after-tax amount. Section 1.367(b)-3(d) and proposed 
Sec. 1.367(b)-3(f) provide further rules regarding the carryover of 
earnings and profits and foreign income taxes from a foreign 
corporation to a domestic corporation. Those rules should also apply to 
a section 355 distribution involving a foreign distributing corporation 
and a domestic controlled corporation. These transactions also 
implicate the current rules under Sec. 1.367(b)-5, because a reduction 
in a foreign distributing corporation's earnings and profits can 
directly affect the post-transaction application of section 1248 with 
respect to U.S. shareholders of the distributing corporation.
    Foreign divisive transactions involving a foreign distributing 
corporation and a foreign controlled corporation raise issues similar 
to those raised in the context of a foreign 381 transaction described 
in Sec. 1.367(b)-7, to the extent the controlled corporation succeeds 
to earnings and profits (and related foreign income taxes) of the 
distributing corporation. Accordingly, the proposed regulations adopt 
the principles of Sec. 1.367(b)-7 to determine the manner in which the 
foreign controlled corporation succeeds to the earnings and profits 
(and related foreign income taxes) of a foreign distributing 
corporation. These transactions also implicate the Sec. 1.367(b)-5 
rules concerning diminutions in U.S. shareholders' section 1248 
amounts.
    The proposed regulations under Sec. 1.367(b)-8 balance the 
Sec. 1.312-10 rules and policies with the interests and concerns of the 
relevant international provisions of the Code. However, the IRS and 
Treasury recognize that the mechanics of Sec. 1.312-10 as applied in 
the international context can be cumbersome and complex. The IRS and 
Treasury solicit comments as to whether the mechanical difficulties of 
applying the section 312 rules in the cross-border context outweigh the 
benefits and, if so, whether there are simpler alternative regimes that 
would address the international policy concerns without compromising 
the Subchapter C policies embodied in Sec. 1.312-10.

Details of Provisions

A. Prop. Reg. Sec. 1.367(b)-1

    The proposed regulations supplement the current Sec. 1.367(b)-1 
notice requirements in consideration of the transactions addressed by 
proposed Secs. 1.367(b)-7 and 1.367(b)-8. Accordingly, foreign 
surviving corporations described in proposed Sec. 1.367(b)-7 and 
distributing and controlled corporations involved in transactions 
described in proposed Sec. 1.367(b)-8 are included within the scope of 
the Sec. 1.367(b)-1 notice requirement.

B. Prop. Reg. Sec. 1.367(b)-3

    The proposed regulations address the carryover of net operating 
loss and capital loss carryovers, and earnings and profits that are not 
included in income as an all earnings and profits amount (or a deficit 
in earnings and profits). The proposed regulations generally provide 
that these tax attributes do not carry over from a foreign acquired 
corporation to a domestic acquiring corporation unless they are 
effectively connected to a U.S. trade or business (or attributable to a 
permanent establishment, in the context of a relevant U.S. income tax 
treaty).
    The limitations on the carryover of these attributes prevent 
inappropriate or anomalous results. For example, net operating loss and 
capital loss carryovers are eligible to carry over from a foreign 
acquired corporation to a domestic acquiring corporation only to the 
extent the underlying deductions or losses were allowable under Chapter 
1 of subtitle A of the Code. Thus, only a net operating loss or capital 
loss carryover that is effectively connected to a U.S. trade or 
business (or attributable to a permanent establishment) may carry over. 
Inappropriate or anomalous results are thus avoided because losses 
incurred by a foreign acquired corporation outside the U.S. taxing 
jurisdiction should not be available to offset the future U.S. tax 
liability of a domestic acquiring corporation. Otherwise, a taxpayer 
would have an incentive to import losses into the United States in 
order to shelter future income from U.S. tax.
    The carryover of earnings and profits (or a deficit in earnings and 
profits) of the foreign acquired corporation can create similarly 
inappropriate results. For example, the policies underlying the section 
243(a) dividends received deduction are not present with respect to a 
subsequent distribution by the domestic acquiring corporation out of 
earnings and profits accumulated by the foreign acquired corporation 
because those earnings and profits are not generally subject to a U.S. 
corporate level of tax. On the other hand, if the foreign acquired 
corporation has PTI, those earnings should not be taxed again when 
distributed to U.S. shareholders to whom the PTI is attributable 
regardless of whether or not the U.S. shareholder is eligible for the 
dividends received deduction. A deficit in earnings and profits can 
also be used to avoid tax, such as in the case of a foreign shareholder 
of a domestic acquiring corporation that imports a deficit and 
therefore is not subject to U.S. withholding tax on subsequent 
corporate distributions.
    As a result of the issues raised by a carryover of earnings and 
profits and given that Sec. 1.367(b)-3 already requires U.S. 
shareholders to include in income as a deemed dividend the all earnings 
and profits amount, the proposed regulations provide that earnings and 
profits (or deficit in earnings and profits) of the foreign acquired 
corporation do not carry over to the domestic acquiring corporation 
except to the extent effectively connected to a U.S. trade or business 
(or attributable to a permanent establishment, in the context of a 
relevant U.S. income tax treaty).

C. Prop. Reg. Sec. 1.367(b)-7

    Proposed Sec. 1.367(b)-7 provides the manner in which a foreign 
surviving corporation succeeds to and takes into account the earnings 
and profits and foreign income taxes of a foreign acquiring corporation 
and a foreign target corporation. The proposed regulation attempts to 
preserve the character of earnings and profits and foreign income taxes 
to the extent possible in light of the applicable statutory 
limitations, as well as the relevant policy and administrative 
concerns. Compare Sec. 1.381(c)(2)-1(a)(3) (ensuring that earnings and 
profits accumulated before March 1, 1913 retain their character as pre-
1913 earnings and profits after a section 381 transaction). 
Accordingly, the proposed rules provide that, to the extent possible, 
pooled earnings and profits (and foreign income taxes) remain pooled, 
earnings and profits (and foreign income taxes) in annual layers remain 
in annual layers, foreign income taxes trapped before the transaction 
remain trapped after the transaction, and earnings and profits (and 
foreign income taxes) remain in the same basket before and after the 
transaction.
    The proposed regulation also respects the section 902 preference 
for distributing pooled earnings and profits before earnings and 
profits in annual

[[Page 69143]]

layers. Accordingly, proposed Sec. 1.367(b)-7 provides that a foreign 
surviving corporation's pooled earnings and profits are distributed 
first (even though earnings and profits in the annual layers may have 
been accumulated after earnings and profits in the pool) and annual 
layers are distributed on a LIFO basis. Similarly, the proposed 
regulation also incorporates the section 904 preference for 
distributing pooled earnings and profits eligible for look-through 
before other pooled earnings and profits.
    However, in certain cases, an overriding statutory policy requires 
that the proposed regulation modify the character of earnings and 
profits (and related foreign income taxes). For example, if a CFC 
combines with a non-look-through 10/50 corporation in a foreign 381 
transaction and the foreign surviving corporation is a non-look-through 
10/50 corporation, dividends paid by the surviving non-look-through 10/
50 corporation are required to be separately basketed and do not obtain 
the benefit of look-through. Thus, earnings and profits of a CFC that 
would have obtained the benefit of look-through if distributed before 
the foreign 381 transaction are not eligible for look-through after the 
transaction. (The loss of look-through in connection with this type of 
foreign 381 transaction is somewhat ameliorated by a U.S. shareholder's 
section 1248 amount inclusion under Sec. 1.367(b)-4 with respect to 
earnings and profits that accrued during its holding period.)
    Proposed regulation Sec. 1.367(b)-7 also provides rules regarding 
the carryover of deficits in earnings and profits from one foreign 
corporation to another. The purpose of the hovering deficit rule in the 
domestic context is to prevent the trafficking of deficits in earnings 
and profits. Otherwise, a corporation with positive earnings and 
profits may acquire or be acquired by another corporation with a 
deficit in earnings and profits and make distributions out of capital 
rather than earnings and profits.
    In transactions involving foreign corporations, similar concerns 
exist regarding the trafficking of deficits in earnings and profits. 
The ability to benefit from combining positive and deficit earnings and 
profits among foreign corporations is different than in the domestic 
context, however, because of the nature of the foreign tax credit 
rules. In a reorganization involving two domestic corporations, the 
hovering deficit rule applies to a corporation with a net accumulated 
deficit in earnings and profits because the relevant statutory rules do 
not distinguish among classes of earnings and profits. In contrast, the 
foreign tax credit rules require further subcategorization of earnings 
and profits according to the pooling and basketing rules. Because of 
these distinctions, taxpayers may inappropriately benefit by 
trafficking in an earnings and profits deficit in a basket, pool, or 
particular annual layer, even though a corporation may have net 
positive earnings and profits. Accordingly, the proposed regulations 
apply the hovering deficit principle to the relevant subcategories of 
earnings and profits and provide that foreign income taxes related to 
the deficit are not added to the foreign surviving corporation's 
foreign income tax accounts until all of the deficit has been offset 
with post-transaction earnings. (Under proposed Sec. 1.367(b)-9 (which 
is described below), these hovering deficit rules do not apply to F 
reorganizations and foreign 381 transactions in which either the 
foreign target corporation or the foreign acquiring corporation is 
newly created.)
    Because the treatment of distributions by a foreign surviving 
corporation depends on whether it is a look-through corporation, a non-
look-through 10/50 corporation, or a less-than-10%-U.S.-owned foreign 
corporation, proposed Sec. 1.367(b)-7 is divided according to these 
categories. The proposed regulation uses the term surviving corporation 
in order to prevent confusion between the acquiring corporation and the 
foreign surviving entity. In addition, the term highlights the proposed 
regulation's general approach that provides the same results regardless 
of whether a corporation is the ostensible acquiring or target 
corporation.
1. Look-Through Surviving Corporation
    Where the foreign surviving corporation is a look-through 
corporation, the proposed regulation generally preserves the character 
of earnings and profits and foreign income taxes. For example, if a CFC 
(CFC1) acquires the assets of another CFC (CFC2) in a foreign 381 
transaction and the surviving corporation is a CFC, then the 
corporations' positive amounts of earnings and profits and foreign 
income taxes would carry over in a manner that combines the look-
through earnings and profits pools (and related foreign income taxes) 
of each corporation on a basket-by-basket basis. Thus, for example, 
CFC1's passive basket would be combined with CFC2's passive basket, 
CFC1's general basket would be combined with CFC2's general basket, and 
so forth.
    If CFC1 or CFC2 has pooled earnings and profits or foreign income 
taxes that do not qualify for look-through treatment (non-look-through 
pool) (for example, earnings and profits accumulated during a period 
when the corporation was not a CFC and that are subject to a separate 
10/50 limitation), such earnings and profits and foreign income taxes 
would be distributed only after all of the look-through earnings and 
profits pool has been distributed. This rule is consistent with the 
ordering rule in Prop. Reg. Sec. 1.904-4(g)(3)(iii), which provides 
that when a 10/50 corporation becomes a CFC, pooled earnings and 
profits accumulated and foreign income taxes paid or accrued while the 
corporation is a CFC are distributed before pooled earnings and profits 
accumulated and foreign income taxes paid or accrued while the 
corporation was a 10/50 corporation. (If the foreign surviving 
corporation is instead a look-through 10/50 corporation, this rule is 
also consistent with the earnings and profits in the look-through pool 
being distributed before earnings and profits in the non-look-through 
pool.)
    When earnings and profits from the non-look-through pool are 
distributed, the earnings and profits will be distributed pro rata out 
of the non-look-through pools of CFC1 and CFC2 (if any) and placed in 
two separate baskets under section 904(d)(1)(E). This preserves the 
character of the earnings and profits and related foreign income taxes 
and is consistent with the policy of section 904(d)(1)(E) to maintain 
separate baskets for each 10/50 corporation. After 2003, these earnings 
and profits will continue to be distributed pro rata from separate non-
look-through pools but will be combined into a single 10/50 basket in 
the hands of the distributee. Maintaining separate pools prevents the 
refreshing of foreign income taxes that would have been trapped had the 
foreign 381 transaction not occurred. (The same rules apply in the case 
of a foreign surviving corporation that is a look-through 10/50 
corporation.)
    If CFC1 or CFC2 has pre-1987 accumulated profits (i.e., annual 
layers of earnings and profits) or foreign income taxes, then those 
earnings and profits are distributed only after the distribution of all 
pooled earnings and profits and taxes, regardless of whether those 
earnings and profits may have been accumulated after the pooled 
earnings and profits of the other corporation. Such earnings and 
profits are distributed on a LIFO basis and pro rata out of the 
respective corporation's annual layers if both companies have

[[Page 69144]]

earnings and profits in the same year that are treated as pre-1987 
accumulated profits and foreign income taxes. This rule respects two 
international policies. First, pooled earnings and profits are 
distributed before earnings and profits in annual layers. Second, 
earnings and profits in annual layers should not be pooled unless they 
are distributed to an upper-tier entity. Compare Sec. 1.902-1(a)(8)(ii) 
(providing that distributions out of pre-1987 earnings and profits by a 
lower-tier corporation are included in the post-1986 earnings and 
profits of an upper-tier corporation). This rule is also consistent 
with the section 902 rule that traps foreign income taxes in annual 
layers in which there are no earnings and profits.
    These results preserve the character of earnings and profits and 
taxes because pooled earnings and profits and taxes remain pooled, 
earnings and profits and taxes retain the same character under the 
look-through provisions, and foreign income taxes that were trapped 
before the foreign 381 transaction remain trapped. The rules are also 
consistent with concerns about limiting the administrative burden of 
requiring taxpayers to recreate tax histories.
    Because of the foreign tax credit considerations presented by 
foreign 381 transactions, Sec. 1.367(b)-7 applies the hovering deficit 
rule to subcategories of earnings and profits. Thus, deficits in the 
look-through pool, non-look-through pool, and net deficits in annual 
layers can offset only future earnings and profits of the foreign 
surviving corporation. In addition, a hovering deficit cannot be used 
to reduce current earnings and profits of the foreign surviving 
corporation and, as a result, does not reduce subpart F income. Foreign 
income taxes related to a hovering deficit do not enter the foreign 
income tax accounts of the surviving corporation until the entire 
hovering deficit offsets post-transaction earnings and profits. 
However, foreign income taxes related to the post-transaction earnings 
that are offset by the hovering deficit immediately enter the foreign 
income tax accounts of the foreign surviving corporation.
2. Non-Look-Through 10/50 Surviving Corporation
    The proposed regulation's rules with respect to a non-look-through 
10/50 corporation apply if the foreign surviving corporation is a 10/50 
corporation before 2003. The principal statutory limitation of a non-
look-through 10/50 corporation is that a dividend distribution is not 
eligible for look-through treatment and is instead separately basketed 
for each 10/50 corporation. As a result, earnings and profits of an 
acquiring or target corporation that would have been eligible for look-
through (assuming the corporation qualified under the look-through 
rule) if distributed before the foreign 381 transaction lose their 
look-through character after the transaction.
    For example, suppose a CFC combines with a non-look-through 10/50 
corporation in a foreign 381 transaction in 2001 and the surviving 
entity is a non-look-through 10/50 corporation. Prior to the 
transaction, the CFC maintained earnings and profits and foreign income 
tax accounts expecting that the look-through rules would apply on a 
distribution of earnings and profits to U.S. shareholders. However, 
after the foreign 381 transaction, section 904(d)(1)(E) requires that a 
distribution from the surviving 10/50 corporation will be deemed to be 
paid out of a single pool of earnings and profits that will be 
separately basketed. In order to address the carryover of attributes to 
a non-look-through 10/50 corporation in a manner consistent with 
section 904(d)(1)(E), the proposed regulations combine the net positive 
earnings and profits and foreign income taxes in the respective pools 
of the acquiring and target corporations. (Thus, the separate baskets 
of pooled earnings and profits and foreign income taxes of the CFC 
would be netted into a single pool along with the non-look-through 10/
50 corporation's pooled earnings and profits and foreign income taxes.)
    Annual layers of the acquiring and target corporations are carried 
over to the foreign surviving corporation under the same rules as 
described above with respect to look-through corporations. Hovering 
deficit rules similar to those described with respect to a look-through 
corporation's non-look-through pool and annual layers also apply to 
surviving non-look-through 10/50 corporations.
    Look-through treatment of earnings and profits and foreign income 
taxes does not re-emerge if the corporation later becomes a look-
through corporation. For example, if the surviving non-look-through 10/
50 corporation becomes a CFC, all of the earnings and profits and 
foreign income taxes of the surviving non-look-through 10/50 
corporation remain as earnings and profits to which the look-through 
rules do not apply. Look-through only applies to earnings and profits 
accumulated after the corporation becomes a CFC. The IRS and Treasury 
believe that this rule is appropriate because of the administrative 
difficulties posed by recreating tax histories. In addition, earnings 
and profits and foreign income taxes of a CFC accumulated during a U.S. 
shareholder's holding period are generally deemed distributed (and the 
look-through rules apply) if a U.S. shareholder includes a section 1248 
amount in income under Sec. 1.367(b)-4 in connection with the foreign 
381 transaction.
3. Less-than-10%-U.S.-owned Foreign Surviving Corporation
    Proposed Sec. 1.367(b)-7 also determines the manner in which 
earnings and profits and foreign income taxes of the acquiring and 
target corporation are combined if the foreign surviving corporation is 
a less-than-10%-U.S.-owned foreign corporation. Generally, rules 
similar to the rules provided for annual layers of look-through 
corporations and non-look-through 10/50 corporations apply with respect 
to the annual layers of the acquiring and target corporation, but the 
rules take into account the possibility that one of the corporations 
may have been a CFC or 10/50 corporation immediately prior to the 
foreign 381 transaction.
    If either the acquiring or target corporation is a CFC or a 10/50 
corporation, its pooled earnings and profits and foreign income taxes 
are treated as earnings and profits and foreign income taxes 
accumulated in the annual layer of the applicable corporation 
immediately before the foreign 381 transaction. For example, suppose a 
less-than-10%-U.S.-owned foreign corporation combines with a 10/50 
corporation and the foreign surviving corporation is a less-than-10%-
U.S.-owned foreign corporation. The foreign surviving corporation is an 
entity that has never been required to pool earnings and profits and 
foreign income taxes under section 902(c)(3). Accordingly, 
distributions from the foreign surviving corporation are out of annual 
layers on a LIFO basis. Rather than recreating the tax history of the 
acquired 10/50 corporation for each year, the proposed regulation 
places all pooled earnings and profits and foreign income taxes of the 
10/50 corporation into a single annual layer that closes immediately 
before the foreign 381 transaction. This rule is intended to ameliorate 
administrative burdens while respecting the policy that earnings and 
profits and foreign income taxes are distributed from annual layers for 
a less-than-10%-U.S.-owned foreign corporation. Because of concerns 
about neutrality, the same result applies regardless of whether the 10/
50 corporation is the ostensible acquiring or target corporation.

[[Page 69145]]

    If the surviving less-than-10%-U.S.-owned foreign corporation later 
becomes a non-look-through 10/50 corporation or a look-through 
corporation, earnings and profits and foreign income taxes that were 
pooled or obtained the benefit of look-through prior to the foreign 381 
transaction are not recreated. Instead, those earnings and profits and 
foreign income taxes remain as earnings and profits accumulated and 
foreign income taxes paid or deemed paid while the corporation was a 
less-than-10%-U.S.-owned foreign corporation. As in the case of a 
surviving non-look-through 10/50 corporation that later becomes a look-
through corporation, this rule is provided because of administrative 
issues associated with recreating tax histories. In addition, earnings 
and profits and foreign income taxes of a CFC accumulated during a 
shareholder's holding period generally would have been deemed 
distributed (and the look-through rules would have applied) if the 
shareholder was required to include a section 1248 amount in income 
under Sec. 1.367(b)-4 in connection with the foreign 381 transaction.

D. Prop. Reg. Sec. 1.367(b)-8

    Section 1.367(b)-8 provides rules applicable to foreign divisive 
transactions. The regulation is divided into four sections. Section 
1.367(b)-8(b) provides rules that are generally applicable to foreign 
divisive transactions. The other three sections describe the 
application of the general rules to specific situations. Section 
1.367(b)-8(c) applies to a distribution by a domestic distributing 
corporation of the stock of a foreign controlled corporation, 
Sec. 1.367(b)-8(d) applies to a distribution by a foreign distributing 
corporation of the stock of a domestic controlled corporation, and 
Sec. 1.367(b)-8(e) applies to a distribution by a foreign distributing 
corporation of the stock of a foreign controlled corporation.
1. General Rules Applicable to Foreign Divisive Transactions
    Section 1.367(b)-8(b) provides that the rules of Sec. 1.312-10 
generally apply to determine the allocation of earnings and profits 
between a distributing and a controlled corporation, as well as to 
determine the reduction in the earnings and profits of a distributing 
corporation. The rules of Sec. 1.312-10 are, however, subject to 
certain modifications.
    In a D/355 distribution involving a controlled corporation that is 
newly created as part of the transaction, Sec. 1.312-10(a) allocates 
the pre-transaction earnings and profits of the distributing 
corporation between the distributing and controlled corporations based 
upon a comparison of the fair market values of the assets received by 
the controlled corporation and the assets retained by the distributing 
corporation after the D reorganization. Section 1.312-10(a) provides 
that, ``in a proper case,'' this allocation should be based on the 
relative net bases of the assets transferred and retained by the 
distributing corporation, or based on another ``appropriate'' method.
    The proposed regulations generally adopt the rule of Sec. 1.312-
10(a), except that the allocation is based upon relative net adjusted 
bases of assets transferred and retained in all cases. This rule 
reflects the view that net basis is the most accurate measure of the 
appropriate amount of earnings and profits that should be allocated to 
the assets transferred by a distributing corporation in the D 
reorganization. For example, in cases where the controlled corporation 
recognizes gain on a later sale or distribution of appreciated property 
that it receives from the distributing corporation an allocation based 
upon relative bases prevents a misallocation of earnings and profits to 
the controlled corporation.
    In a section 355 distribution that is not preceded by a D 
reorganization, Sec. 1.312-10(b) provides that the earnings and profits 
of the distributing corporation are decreased by an amount equal to the 
lesser of (i) the amount by which the earnings and profits of the 
distributing corporation would have been decreased if it had 
transferred the stock of the controlled corporation to a new 
corporation in a D/355 distribution, and (ii) the net worth of the 
controlled corporation. For this purpose, net worth is defined as ``the 
sum of the bases of all of the properties plus cash minus all 
liabilities.'' If ``the earnings and profits of the controlled 
corporation immediately before the transaction are less than the amount 
of the decrease in earnings and profits of the distributing corporation 
. . . the earnings and profits of the controlled corporation, 
immediately after the transaction, shall be equal to the amount of such 
decrease. If the earnings and profits of the controlled corporation 
immediately before the transaction are more than the amount of the 
decrease in the earnings and profits of the distributing corporation, 
they shall remain the same.''
    Section 1.312-10(b) reflects the principle that a pro rata portion 
of a distributing corporation's earnings and profits should be reduced 
to account for the distribution of the controlled corporation. In 
addition, the requirement that the earnings and profits of the 
controlled corporation at least equal the reduction in the distributing 
corporation's earnings and profits appears intended to prevent a 
bailout of earnings and profits through the controlled corporation, 
while preventing the potential double counting of earnings and profits 
in situations where the distributing corporation did not organize the 
controlled corporation.
    In consideration of the complexities raised by the cross-border 
application of the Sec. 1.312-10(b) adjustment to the controlled 
corporation's earnings and profits, taken together with the current 
rules that prevent the potential bailout of earnings and profits in the 
international context (such as the Sec. 1.367(b)-5 requirement that a 
shareholder include in income a reduction in its section 1248 amount), 
the IRS and Treasury have concluded that the Sec. 1.312-10(b) rules 
should be modified when applied to section 367(b) transactions. 
Accordingly, the proposed regulations provide that the earnings and 
profits of the distributing corporation are decreased in an amount 
equal to the amount by which the earnings and profits of the 
distributing corporation would have been decreased if it had 
transferred the stock of the controlled corporation to a new 
corporation in a D/355 distribution. However, the earnings and profits 
of the controlled corporation are not increased or replaced. The 
reduction in earnings and profits (and related foreign income taxes) of 
the distributing corporation disappears unless otherwise included in 
income, such as under Sec. 1.367(b)-5.
    Section 1.312-10 does not specifically address the allocation and 
reduction of earnings and profits in connection with a D/355 
distribution that involves a preexisting controlled corporation. The 
proposed regulations provide that, in such a case, the distributing 
corporation's earnings and profits are reduced in a manner that 
incorporates both the rules applicable to a D/355 distribution with a 
newly created controlled corporation and a section 355 distribution 
that is not preceded by a D reorganization. The rule thus accounts for 
a decrease in earnings and profits attributable to assets transferred 
to the controlled corporation as part of the D reorganization as well 
as a decrease in earnings and profits attributable to the distribution 
of stock of a preexisting controlled corporation (without regard to the 
D reorganization). The controlled corporation succeeds only to those 
earnings and profits allocable to the property it receives in the D 
reorganization.

[[Page 69146]]

    In consideration of the international provisions' distinctions 
among classes and categories of earnings and profits, proposed 
Sec. 1.367(b)-8(b) specifically addresses the determination of which 
earnings and profits of the distributing corporation are affected by a 
foreign divisive transaction. The proposed regulation provides that an 
allocation or reduction in earnings and profits shall generally be pro 
rata out of a cross-section of the distributing corporation's tax 
history (except to the extent it is included in income as a deemed 
dividend such as under Sec. 1.367(b)-3 or Sec. 1.367(b)-5). This rule 
determines the earnings and profits (and related foreign income taxes, 
where applicable) that remain in the distributing corporation after the 
transaction as well as any earnings and profits (and related foreign 
income taxes, where applicable) to which the controlled corporation 
succeeds in a D reorganization.
    The proposed Sec. 1.367(b)-8(b) cross-section rule decreases the 
earnings and profits of a distributing corporation without regard to 
the type of income generated by the assets of the controlled 
corporation. This is consistent with the general assumption in 
Sec. 1.312-10 and the proposed regulations that the earnings and 
profits of the distributing corporation should be decreased 
proportionately to reflect the transfer or distribution of assets, 
rather than by some other measure, such as by determining the earnings 
and profits attributable to the income generated by assets transferred 
or distributed (a tracing model) or by decreasing most recently 
accumulated earnings and profits to the extent of assets transferred or 
distributed (a dividend model).
2. Branch Profits Tax Considerations
    Notwithstanding the above-described rules, the proposed regulations 
provide that an allocation or reduction in a distributing corporation's 
earnings and profits shall not reduce the distributing corporation's 
effectively connected earnings and profits or non-previously taxed 
accumulated effectively connected earnings and profits, as defined in 
the branch profits rule in section 884 (branch earnings). Both a 
domestic or foreign distributing corporation can potentially have 
branch earnings that are subject to the branch profits tax.
    In the case of a foreign divisive transaction that does not include 
a D reorganization, a U.S. branch of a foreign distributing corporation 
would be retained by the foreign distributing corporation. Accordingly, 
Sec. 1.367(b)-8 should not reduce the foreign distributing 
corporation's branch earnings because such a reduction would improperly 
decrease the earnings subject to the branch profits tax upon the 
section 355 distribution (which would trigger the branch profits tax 
under section 884). The same issues arise in the case of a D/355 
distribution in which a foreign distributing corporation transfers the 
assets that are not part of a U.S. branch to a controlled corporation. 
The IRS and Treasury do not believe that it is appropriate to reduce 
the earnings that could give rise to a subsequent branch profits tax 
under these circumstances.
    Different issues arise in a foreign divisive transaction in which a 
foreign distributing corporation transfers the assets of a U.S. branch 
to a controlled corporation as part of a D/355 distribution. While the 
branch profits rules permit a deferral of the branch profits tax in 
certain instances (by allowing branch earnings to be allocated to the 
domestic transferee in proportion to the assets transferred when a 
branch is incorporated in a section 351 exchange in a domestic 
corporation (see Sec. 1.884-2T(d)(1)), the branch profits tax is 
triggered in any event if stock of the incorporated branch is later 
distributed to its shareholders. See Sec. 1.884-2T(d)(5). Accordingly, 
because foreign divisive transactions include a section 355 
distribution immediately following the D reorganization, it would be 
unnecessary and inappropriate to attribute branch earnings to a 
domestic controlled corporation under proposed Sec. 1.367(b)-8.
    Similar branch profits issues can arise with respect to a domestic 
distributing corporation. While branch earnings are accumulated by a 
foreign corporation, such earnings may have been carried over to a 
domestic corporation in a prior section 351 or 381 transaction. See 
Sec. 1.884-2T(c)(4). Accordingly, the proposed regulations treat 
domestic distributing corporations in the same manner as foreign 
distributing corporations with respect to branch earnings.
3. Domestic Corporation Distributes Stock of a Foreign Corporation
    In foreign divisive transactions involving a domestic distributing 
corporation and a foreign controlled corporation, the foreign 
controlled corporation may succeed to earnings and profits of the 
domestic distributing corporation. The regulations provide that 
sections 243(e) and 861(a)(2)(C) apply to earnings and profits 
allocated to the foreign controlled corporation that were accumulated 
by a domestic corporation. In addition, a post-transaction distribution 
out of earnings and profits allocated to the foreign controlled 
corporation is generally treated as a U.S. source dividend under 
section 904(g) and for purposes of Chapter 3 of subtitle A of the Code. 
See Georday Enterprises v. Commissioner, 126 F.2d 384 (4th Cir. 1942).
4. Foreign Corporation Distributes Stock of a Domestic Corporation
    In foreign divisive transactions involving a foreign distributing 
corporation and a domestic controlled corporation, two issues arise in 
determining the appropriate reduction in the foreign distributing 
corporation's earnings and profits and its effects on the earnings and 
profits of the domestic controlled corporation. First, it should be 
determined whether it is appropriate to reduce PTI of the foreign 
distributing corporation and, if so, in what manner (e.g., if the 
foreign distributing corporation has earnings and profits that are PTI 
and not PTI, should the reduction in earnings and profits be out of PTI 
first, last, pro rata, or depending on the identity of the controlled 
corporation's shareholders). As in the case of Sec. 1.367(b)-7, 
Sec. 1.367(b)-8 reserves on PTI issues, and the IRS and Treasury 
solicit comments with respect to the appropriate treatment of these 
amounts.
    Second, a domestic corporation succeeds to the earnings and profits 
of a foreign corporation if the section 355 distribution is preceded by 
a D reorganization. Because earnings and profits are allocable from 
foreign corporate solution to U.S. corporate solution, U.S. 
shareholders are required to include in income the all earnings and 
profits amount attributable to earnings and profits that carry over to 
the controlled corporation. The proposed regulations provide rules that 
coordinate the proposed Sec. 1.367(b)-8 and the current Sec. 1.367(b)-3 
regimes. The regulations, however, reserve with respect to the 
treatment of U.S. persons that own foreign distributing corporation 
stock after a non pro rata distribution. The IRS and Treasury invite 
comments as to whether U.S. shareholders should have an all earnings 
and profits amount inclusion in connection with a non pro rata foreign 
divisive transaction in which they do not receive stock of the domestic 
controlled corporation.
5. Foreign Corporation Distributes Stock of a Foreign Corporation
    In foreign divisive transactions involving a foreign distributing 
corporation and a foreign controlled corporation, the foreign 
controlled corporation may succeed to earnings

[[Page 69147]]

and profits of the foreign distributing corporation. Because such 
earnings and profits are allocated from one foreign corporation to 
another foreign corporation, the transaction raises issues similar to 
those in a foreign 381 transaction. Accordingly, the proposed 
regulations adopt and apply the principles in proposed regulation 
Sec. 1.367(b)-7 to these transactions.

E. Prop. Reg. Sec. 1.367(b)-9

    Proposed Sec. 1.367(b)-9 provides special rules applicable to 
foreign-to-foreign F reorganizations and foreign 381 transactions in 
which either the foreign target corporation or the foreign acquiring 
corporation is newly created. Proposed Sec. 1.367(b)-9 also applies to 
foreign divisive transactions that involve a foreign distributing and a 
foreign controlled corporation, either of which is newly created.
    Under proposed Sec. 1.367(b)-9, a foreign surviving corporation 
succeeds to earnings and profits, deficits in earnings and profits, and 
foreign income taxes without regard to the proposed Sec. 1.367(b)-7 
hovering deficit rules. See section 1.381(b)-1(a)(2) (providing an 
analogous rule with respect to domestic F reorganizations).
    This rule prevents inappropriate tax consequences. For example, 
under the generally applicable hovering deficit rules, a foreign 
corporation with significant deficits in earnings and profits could 
combine with a newly created foreign corporation and thereafter 
distribute dividends (along with deemed paid foreign income taxes under 
section 902), despite the presence of a significant deficit that would 
have precluded a dividend distribution before the transaction. Proposed 
Sec. 1.367(b)-7 provides the Commissioner discretion to apply the 
principles of proposed Sec. 1.367(b)-9 to circumstances where a 
principal purpose of the foreign 381 transaction is to affirmatively 
use the hovering deficit rule in order to gain a tax benefit.

Proposed Effective Dates

    These regulations are proposed to apply to section 367(b) exchanges 
that occur on or after 30 days after these regulations are published as 
final regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic or written comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed rules and how they can be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for March 13, 2001, beginning 
at 10 a.m., in room 7218 of the Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the 10th Street entrance, located 
between Constitution and Pennsylvania Avenues, NW. In addition, all 
visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 15 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (signed original and eight (8) copies) 
by February 20, 2001. A period of 10 minutes will be allotted to each 
person for making comments. An agenda showing the scheduling of the 
speakers will be prepared after the deadline for receiving outlines has 
passed. Copies of the agenda will be available free of charge at the 
hearing.

Drafting Information

    The principal author of these regulations is Anne O'Connell 
Devereaux, 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.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
revising the entries for sections 1.367(b)-7, 1.367(b)-8, and 1.367(b)-
9 to read in part as follows:

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

    Section 1.367(b)-7 also issued under 26 U.S.C. 367(a) and (b), 
26 U.S.C. 902, and 26 U.S.C. 904.
    Section 1.367(b)-8 also issued under 26 U.S.C. 367(a) and (b), 
26 U.S.C. 902, and 26 U.S.C. 904.
    Section 1.367(b)-9 also issued under 26 U.S.C. 367(a) and (b), 
26 U.S.C. 902, and 26 U.S.C. 904. * * *

    Par. 2. Section 1.312-10 is amended by adding paragraph (d) to read 
as follows:


Sec. 1.312-10  Allocation of earnings in certain corporate separations.

* * * * *
    (d) For additional rules involving foreign corporations, see 
Sec. 1.367(b)-8.
    Par. 3. Section 1.367(b)-0 is amended by:
    1. Revising the introductory text.
    2. Revising the entry for Sec. 1.367(b)-2(j)(3) and adding entries 
for Sec. 1.367(b)-2(j)(4), (j)(5), and (l).
    3. Adding entries for Sec. 1.367(b)-3(e) and (f).
    4. Adding entries for Sec. 1.367(b)-5(c)(2)(i), (c)(2)(ii), and 
(e)(3).
    5. Adding entries for Secs. 1.367(b)-7 through 1.367(b)-9.
    The revisions and additions read as follows:


Sec. 1.367(b)-0  Table of contents.

    This section lists the paragraphs contained in Secs. 1.367(b)-1 
through 1.367(b)-9.
* * * * *

Sec. 1.367(b)-2  Definitions and special rules.

* * * * *
    (j) * * *
    (3) Dividend described in section 243(e).
    (4) Coordination with Sec. 1.367(b)-8(c)(2).
    (5) Other rules.
* * * * *
    (l) Additional definitions.
    (1) Foreign income taxes.
    (2) Post-1986 undistributed earnings.
    (3) Post-1986 foreign income taxes.
    (4) Pre-1987 accumulated profits.
    (5) Pre-1987 foreign income taxes.
    (6) Pre-1987 section 960 earnings and profits.
    (7) Pre-1987 section 960 foreign income taxes.
    (8) Earnings and profits.
    (9) Look-through corporation.

[[Page 69148]]

    (10) Non-look-through 10/50 corporation.
    (11) Less-than-10%-U.S.-owned foreign corporation.
    (12) Separate category.
    (13) Statutory grouping of earnings and profits.

Sec. 1.367(b)-  Repatriation of foreign corporate assets in certain 
nonrecognition transactions.

* * * * *
    (e) Net operating loss and capital loss carryovers.
    (f) Carryover of earnings and profits.
* * * * *

Sec. 1.367(b)-5  Distributions of stock described in section 355.

* * * * *
    (c) * * *
    (2) * * *
    (i) In general.
    (ii) Exception.
* * * * *
    (e) * * *
    (3) Divisive D reorganization with a preexisting controlled 
corporation.
* * * * *

Sec. 1.367(b)-7  Carryover of earnings and profits and foreign income 
taxes in certain foreign-to-foreign nonrecognition transactions.

    (a) Scope.
    (b) General rules.
    (1) Non-previously taxed earnings and profits and related taxes.
    (2) Previously taxed earnings and profits. [Reserved]
    (c) Ordering rule for post-transaction distributions.
    (1) If foreign surviving corporation is a look-through 
corporation.
    (2) If foreign surviving corporation is a non-look-through 10/50 
corporation.
    (3) If foreign surviving corporation is a less-than-10%-U.S.-
owned foreign corporation.
    (d) Look-through pool.
    (1) In general.
    (i) Qualifying earnings and taxes.
    (ii) Carryover rule.
    (2) Hovering deficit.
    (i) Offset Rule.
    (ii) Related taxes.
    (3) Examples.
    (e) Non-look-through pool.
    (1) If foreign surviving corporation is a look-through 
corporation.
    (i) Qualifying earnings and taxes.
    (iii) Hovering deficit.
    (A) Offset rule.
    (B) Related taxes.
    (iv) Examples.
    (2) If foreign surviving corporation is a non-look-through 10/50 
corporation.
    (i) Qualifying earnings and taxes.
    (ii) Carryover rule.
    (iii) Hovering deficit.
    (A) Offset rule.
    (B) Related taxes.
    (iv Examples.
    (f) Pre-pooling annual layers.
    (1) If foreign surviving corporation is a look-through 
corporation or a non-look-through 10/50 corporation.
    (i) Qualifying earnings and taxes.
    (ii) Carryover rule.
    (iii) Deficits.
    (A) Aggregate positive earnings and profits.
    (B) Aggregate deficit in earnings and profits.
    (iv) Pre-1987 section 960 earnings and profits and foreign 
income taxes.
    (v) Examples.
    (2) If foreign surviving corporation is a less-than-10%-U.S.-
owned foreign corporation.
    (i) Qualifying earnings and taxes.
    (ii) Carryover rule.
    (iii) Deficits.
    (A) Aggregate positive earnings and profits.
    (B) Aggregate deficit in earnings and profits.
    (iv) Pre-1987 section 960 earnings and profits and foreign 
income taxes.
    (v) Examples.
    (g) Special rules.
    (1) Treatment of deficit.
    (2) Reconciling taxable years.
    (3) Post-transaction change of status.
    (4) Ordering rule for offsetting multiple hovering deficits.
    (i) Rule.
    (ii) Example.
    (5) Pro rata rule for earnings during transaction year.
    (6) Nonapplicability of hovering deficit rules to certain 
transactions.
    (i) Rule.
    (ii) Example.
    (h) Effective date.

Sec. 1.367(b)-8  Allocation of earnings and profits and foreign income 
taxes in certain foreign corporate separations.

    (a) Scope.
    (b) General rules.
    (1) Application of Sec. 1.312-10.
    (i) In general.
    (ii) Special rules for application of Sec. 1.312-10(b).
    (A) Distributing corporation.
    (B) Controlled corporation.
    (iii) Net deficit in pre-transaction earnings.
    (iv) Use of net bases.
    (v) Gain recognized by distributing corporation.
    (vi) Coordination with branch profits tax.
    (2) Cross-section of earnings and profits.
    (3) Foreign income taxes.
    (4) Divisive D reorganization with a preexisting controlled 
corporation.
    (i) Calculation of earnings and profits of distributing 
corporation.
    (ii) Calculation of earnings and profits of controlled 
corporation.
    (c) Foreign divisive transactions involving a domestic 
distributing corporation and a foreign controlled corporation.
    (1) Scope.
    (2) Earnings and profits allocated to a foreign controlled 
corporation.
    (3) Examples.
    (d) Foreign divisive transactions involving a foreign 
distributing corporation and a domestic controlled corporation.
    (1) Scope.
    (2) Coordination with Sec. 1.367(b)-3.
    (i) In general.
    (ii) Determination of all earnings and profits amount.
    (iii) Interaction with section 358 and Sec. 1.367(b)-
2(e)(3)(ii).
    (iv) Coordination with Sec. 1.367(b)-3(c).
    (v) Special rule for U.S. persons that own foreign distributing 
corporation stock after a non pro rata distribution. [Reserved]
    (3) Foreign income taxes.
    (4) Previously taxed earnings and profits. [Reserved]
    (5) Coordination with Sec. 1.367(b)-5.
    (6) Examples.
    (e) Foreign divisive transactions involving a foreign 
distributing corporation and a foreign controlled corporation.
    (1) Scope.
    (2) Earnings and profits of foreign controlled corporation.
    (i) In general.
    (ii) Special rule for pre-transaction earnings allocated to a 
newly created controlled corporation.
    (3) Foreign income taxes.
    (4) Previously taxed earnings and profits. [Reserved]
    (5) Coordination with Sec. 1.367(b)-5.
    (6) Examples.
    (f) Effective date.

Sec. 1.367(b)-9  Special rule for F reorganizations and similar 
transactions.

    (a) Scope.
    (b) Hovering deficit rules inapplicable.
    (c) Example.
    (d) Effective date.

    Par. 4. Section 1.367(b)-1 is amended by:
    1. Removing the language ``and'' at the end of paragraph 
(c)(2)(iii).
    2. Removing the period at the end of paragraph (c)(2)(iv)(B) and 
adding ``;'' in its place.
    3. Adding paragraphs (c)(2)(v), (c)(2)(vi), and (c)(2)(vii).
    4. Revising paragraphs (c)(3)(ii)(A), (c)(4)(iv), and (c)(4)(v).
    The additions and revisions read as follows:


Sec. 1.367(b)-1  Other transfers.

* * * * *
    (c) * * *
    (2) * * *
    (v) A foreign surviving corporation described in Sec. 1.367(b)-
7(a);
    (vi) A distributing corporation that is subject to the rules of 
Sec. 1.367(b)-8; and
    (vii) A controlled corporation that is subject to the rules of 
Sec. 1.367(b)-8.
    (3) * * *
    (ii) * * *
    (A) United States shareholders (as defined in Sec. 1.367(b)-
3(b)(2)) of foreign corporations described in paragraph (c)(2)(i), (v), 
(vi), or (vii) of this section; and
* * * * *
    (4) * * *
    (iv) A statement that describes any amount (or amounts) required, 
under the section 367(b) regulations, to be taken into account as 
income or loss or

[[Page 69149]]

as an adjustment (including an adjustment under Sec. 1.367(b)-7, 
1.367(b)-8, or 1.367(b)-9) to basis, earnings and profits, or other tax 
attributes as a result of the exchange;
    (v) Any information that is or would be required to be furnished 
with a Federal income tax return pursuant to regulations under section 
332, 351, 354, 355, 356, 361, 368, or 381 (whether or not a Federal 
income tax return is required to be filed), if such information has not 
otherwise been provided by the person filing the section 367(b) notice;
* * * * *
    Par. 5. Section 1.367(b)-2 is amended by:
    1. Revising paragraph (j)(1)(i).
    2. Redesignating paragraph (j)(3) as paragraph (j)(5).
    3. Adding new paragraphs (j)(3) and (j)(4).
    4. Adding paragraph (l).
    The revision and addition read as follows:


Sec. 1.367(b)-2  Definitions and special rules.

* * * * *
    (j) Sections 985 through 989--(1) Change in functional currency of 
a qualified business unit--(i) Rule. If, as a result of a section 
367(b) exchange described in section 381(a) or 312(h), a qualified 
business unit (as defined in section 989(a)) (QBU) has a different 
functional currency determined under the rules of section 985(b) than 
it used prior to the transaction, then the QBU shall be deemed to have 
automatically changed its functional currency immediately prior to the 
transaction. A QBU that is deemed to change its functional currency 
pursuant to this paragraph (j) must make the adjustments described in 
Sec. 1.985-5.
* * * * *
    (3) Dividend described in section 243(e). Dividend distributions by 
a foreign corporation out of earnings and profits accumulated by a 
domestic corporation that are eligible for the dividends received 
deduction under section 243(e) shall not exceed an amount equal to the 
U.S. dollar value of the earnings and profits at the time the earnings 
and profits were accumulated by such domestic corporation. See 
Sec. 1.367(b)-8(c)(3), Example 1 and Example 3. 
    (4) Coordination with Sec. 1.367(b)-8(c)(2). Solely for purposes of 
Chapter 3 of subtitle A of the Internal Revenue Code, dividend 
distributions by a foreign corporation that are treated under 
Sec. 1.367(b)--8(c)(2) as U.S. source shall not exceed an amount equal 
to the U.S. dollar value of the earnings and profits at the time 
allocated to the foreign corporation. See Sec. 1.367(b)-8(c)(3), 
Example 1.
* * * * *
    (1) Additional definitions--(1) Foreign income taxes. The term 
foreign income taxes has the meaning set forth in Sec. 1.902-1(a)(7).
    (2) Post-1986 undistributed earnings. The term post-1986 
undistributed earnings has the meaning set forth in Sec. 1.902-1(a)(9).
    (3) Post-1986 foreign income taxes. The term post-1986 foreign 
income taxes has the meaning set forth in Sec. 1.902-1(a)(8).
    (4) Pre-1987 accumulated profits. The term pre-1987 accumulated 
profits means the earnings and profits described in Sec. 1.902-
1(a)(10)(i), computed in accordance with the rules of Sec. 1.902-
1(a)(10)(ii).
    (5) Pre-1987 foreign income taxes. The term pre-1987 foreign income 
taxes has the meaning set forth in Sec. 1.902-1(a)(10)(iii).
    (6) Pre-1987 section 960 earnings and profits. The term pre-1987 
section 960 earnings and profits means the earnings and profits of a 
foreign corporation accumulated in taxable years beginning before 
January 1, 1987, computed under Sec. 1.964-1(a) through (e), and 
translated into the functional currency (as determined under section 
985) of the foreign corporation at the spot rate on the first day of 
the foreign corporation's taxable year beginning after December 31, 
1986. For further guidance, see Notice 88-70 (1988-2 C.B. 369, 370) 
(see also Sec. 601.601(d)(2) of this chapter). The term pre-1987 
section 960 earnings and profits does not include earnings and profits 
that represent previously taxed earnings and profits for purposes of 
section 959.
    (7) Pre-1987 section 960 foreign income taxes. The term pre-1987 
section 960 foreign income taxes means the foreign income taxes related 
to pre-1987 section 960 earnings and profits, determined in accordance 
with the rules of Sec. 1.902-1(a)(10)(iii), except that the U.S. dollar 
amounts of pre-1987 section 960 foreign income taxes are determined by 
reference to the exchange rates in effect when the taxes were paid or 
accrued.
    (8) Earnings and profits. The term earnings and profits means post-
1986 undistributed earnings, pre-1987 accumulated profits, and pre-1987 
section 960 earnings and profits.
    (9) Look-through corporation. The term look-through corporation 
means a foreign corporation that is subject to the look-through rules 
of section 904(d)(3) or section 904(d)(4) (as in effect for taxable 
years beginning after December 31, 2002 (the day before the effective 
date of section 1105(b) of Public Law 105-34 (111 Stat. 788)) and 
regulations thereunder.
    (10) Non-look-through 10/50 corporation. The term non-look-through 
10/50 corporation means a noncontrolled section 902 corporation as 
defined in section 904(d)(2)(E) that is not a look-through corporation.
    (11) Less-than-10%-U.S.-owned foreign corporation. The term less-
than-10%-U.S.-owned foreign corporation means a foreign corporation 
that is neither a look-through corporation nor a non-look-through 10/50 
corporation.
    (12) Separate category. The term separate category has the meaning 
set forth in section 904(d)(1), and shall also include any other 
category of income to which section 904(a), (b), and (c) are applied 
separately under any other provision of the Internal Revenue Code 
(e.g., sections 56(g)(4)(C)(iii)(IV), 245(a)(10), 865(h), 901(j), and 
904(g)(10)).
    (13) Statutory grouping of earnings and profits. The term statutory 
grouping of earnings and profits means the earnings and profits from a 
specific source or activity that must be determined for purposes of 
applying a provision of the Internal Revenue Code. Compare Sec. 1.861-
8(a)(4) (providing an analogous definition for statutory grouping of 
gross income).
    Par. 6. Section 1.367(b)-3 is amended by adding paragraphs (e) and 
(f) to read as follows:


Sec. 1.367(b)-3  Repatriation of foreign corporate assets in certain 
nonrecognition transactions.

* * * * *
    (e) Net operating loss and capital loss carryovers. A net operating 
loss or capital loss carryover of the foreign acquired corporation is 
described in section 381(c)(1) and (c)(3) and thus is eligible to carry 
over from the foreign acquired corporation to the domestic acquiring 
corporation only to the extent the underlying deductions or losses were 
allowable under chapter 1 of subtitle A of the Internal Revenue Code. 
Thus, only a net operating loss or capital loss carryover that is 
effectively connected with the conduct of a trade or business within 
the United States (or that is attributable to a permanent 
establishment, in the context of an applicable United States income tax 
treaty) is eligible to be carried over under section 381. For further 
guidance, see Rev. Rul. 72-421 (1972-2 C.B. 166) (see also 
Sec. 601.601(d)(2) of this chapter).
    (f) Carryover of earnings and profits. Except to the extent 
otherwise specifically provided (see, e.g., 89-79

[[Page 69150]]

(1989-2 C.B. 392) (see also Sec. 601.601(d)(2) of this chapter)), 
earnings and profits of the foreign acquired corporation that are not 
included in income as a deemed dividend under the section 367(b) 
regulations (or deficit in earnings and profits) are eligible to carry 
over from the foreign acquired corporation to the domestic acquiring 
corporation under section 381(c)(2) or Sec. 1.367(b)-8(b)(1)(i) only to 
the extent such earnings and profits (or deficit in earnings and 
profits) are effectively connected with the conduct of a trade or 
business within the United States (or are attributable to a permanent 
establishment, in the context of an applicable United States income tax 
treaty). All other earnings and profits (or deficit in earnings and 
profits) of the foreign acquired corporation shall not carry over to 
the domestic acquiring corporation and, as a result, shall be 
eliminated.
    Par. 7. Section 1.367(b)-5 is amended by:
    1. Revising paragraphs (b)(1)(ii) and (c)(2).
    2. Adding paragraph (e)(3).
    The revisions and addition read as follows:


Sec. 1.367(b)-5  Distributions of stock described in section 355.

* * * * *
    (b) * * *
    (1) * * *
    (ii) If the distributee is an individual or a tax-exempt entity as 
described in Sec. 1.337(d)-4(c)(2) then, solely for purposes of 
determining the gain recognized by the distributing corporation, the 
controlled corporation shall not be considered to be a corporation, and 
the distributing corporation shall recognize any gain (but not loss) 
realized on the distribution.
* * * * *
    (c) * * *
    (2) Adjustment to basis in stock and income inclusion--(i) In 
general. If the distributee's postdistribution amount (as defined in 
paragraph (e)(2) of this section) with respect to the distributing or 
controlled corporation is less than the distributee's predistribution 
amount (as defined in paragraph (e)(1) of this section) with respect to 
such corporation, then the distributee's basis in such stock 
immediately after the distribution (determined under the normal 
principles of section 358) shall be reduced by the amount of the 
difference. However, the distributee's basis in such stock shall not be 
reduced below zero, and to the extent the foregoing reduction would 
have reduced basis below zero, the distributee shall instead include 
such amount in income as a deemed dividend from such corporation. See, 
e.g., paragraph (g) Example 1 of this section.
    (ii) Exception. The basis reduction rule of paragraph (c)(2)(i) of 
this section shall apply only to the extent such reduction increases 
the distributee's section 1248 amount (as defined in Sec. 1.367(b)-
2(c)(1)) with respect to the distributing or controlled corporation; 
otherwise such basis reduction shall be replaced by the income 
inclusion rule of paragraph (c)(2)(i) of this section. See, e.g., 
Sec. 1.367(b)-8(d)(6) Example 2.
* * * * *
    (e) * * *
    (3) Divisive D reorganization with a preexisting controlled 
corporation. In the case of a transaction described in Sec. 1.367(b)-
8(b)(4), the predistribution amount with respect to a distributing or 
controlled corporation shall be computed after the allocation of the 
distributing corporation's earnings and profits described in 
Sec. 1.367(b)-8(b)(4)(i)(A) and (b)(4)(ii)(A) (without regard to the 
parenthetical phrase in Sec. 1.367(b)-8(b)(4)(ii)(A)), but before the 
reduction in the distributing corporation's earnings and profits 
described in Sec. 1.367(b)-8(b)(4)(i)(B). See, e.g., Sec. 1.367(b)-
8(d)(6) Example 3 and Sec. 1.367(b)-8(e)(7) Example 3.
* * * * *
    Par. 8. In Sec. 1.367(b)-6, paragraph (a)(1) is revised to read as 
follows:


Sec. 1.367(b)-6  Effective dates and coordination rules.

    (a) Effective date--(1) In general. Sections 1.367(b)-1 through 
1.367(b)-5, and this section, apply to section 367(b) exchanges that 
occur on or after the date that is 30 days after the date these 
regulations are published as final regulations in the Federal Register. 
For guidance with respect to section 367(b) exchanges that occur prior 
to the date 30 days after these regulations are published as final 
regulations in the Federal Register, see Secs. 1.367(b)-1 through 
1.367(b)-6 in effect prior to the date 30 days after these regulations 
are published in the Federal Register (see 26 CFR part 1 revised as of 
April 1, 2000).
    Par. 9. Section 1.367(b)-7 is added to read as follows:


Sec. 1.367(b)-7  Carryover of earnings and profits and foreign income 
taxes in certain foreign-to-foreign nonrecognition transactions.

    (a) Scope. This section applies to an acquisition by a foreign 
corporation (foreign acquiring corporation) of the assets of another 
foreign corporation (foreign target corporation) in a transaction 
described in section 381 (foreign 381 transaction). This section 
describes the manner and extent to which earnings and profits and 
foreign income taxes of the foreign acquiring corporation and the 
foreign target corporation carry over to the surviving foreign 
corporation (foreign surviving corporation). See Sec. 1.367(b)-9 for 
special rules governing reorganizations described in section 
368(a)(1)(F) and foreign 381 transactions in which either the foreign 
target corporation or the foreign acquiring corporation is newly 
created.
    (b) General rules--(1) Non-previously taxed earnings and profits 
and related taxes. Earnings and profits and related foreign income 
taxes of the foreign acquiring corporation and the foreign target 
corporation (pre-transaction earnings and pre-transaction taxes, 
respectively) shall carry over to the foreign surviving corporation in 
the manner described in paragraphs (d), (e), (f), and (g) of this 
section. Dividend distributions by the foreign surviving corporation 
(post-transaction distributions) shall be out of earnings and profits 
and shall reduce related foreign income taxes in the manner described 
in paragraph (c) of this section.
    (2) Previously taxed earnings and profits. [Reserved]
    (c) Ordering rule for post-transaction distributions. Dividend 
distributions out of a foreign surviving corporation's earnings and 
profits shall be ordered in accordance with the rules of paragraph 
(c)(1), (2), or (3) of this section, depending on whether the foreign 
surviving corporation is a look-through corporation, a non-look-through 
10/50 corporation, or a less-than-10%-U.S.-owned foreign corporation.
    (1) If foreign surviving corporation is a look-through corporation. 
In the case of a foreign surviving corporation that is a look-through 
corporation, post-transaction distributions shall be first out of the 
look-through pool (as described in paragraph (d) of this section), 
second out of the non-look-through pool (as described in paragraph 
(e)(1) of this section), and third out of the pre-pooling annual layers 
(as described in paragraph (f)(1) of this section) under an annual 
last-in, first-out (LIFO) method.
    (2) If foreign surviving corporation is a non-look-through 10/50 
corporation. In the case of a foreign surviving corporation that is a 
non-look-through 10/50 corporation, post-transaction distributions 
shall be first out of the non-look-through pool (as described in 
paragraph (e)(2) of this section), and

[[Page 69151]]

second out of the pre-pooling annual layers (as described in paragraph 
(f)(1) of this section) under the LIFO method.
    (3) If foreign surviving corporation is a less-than-10%-U.S.-owned 
foreign corporation. In the case of a foreign surviving corporation 
that is a less-than-10%-U.S.-owned corporation, post-transaction 
distributions shall be out of the pre-pooling annual layers (as 
described in paragraph (f)(2) of this section) under the LIFO method.
    (d) Look-through pool. If the foreign surviving corporation is a 
look-through corporation, then the look-through pool shall be 
determined under the rules of this paragraph (d).
    (1) In general--(i) Qualifying earnings and taxes. The look-through 
pool shall consist of the post-1986 undistributed earnings and related 
post-1986 foreign income taxes of the foreign acquiring corporation and 
the foreign target corporation that were subject to the look-through 
provisions of section 904(d)(3) or section 904(d)(4) (as in effect for 
taxable years beginning after December 31, 2002 (the day before the 
effective date of section 1105(b) of Public Law 105-34 (111 Stat. 788)) 
and regulations thereunder.
    (ii) Carryover rule. Subject to paragraph (d)(2) of this section, 
the amounts described in paragraph (d)(1)(i) of this section 
attributable to the foreign acquiring corporation and the foreign 
target corporation shall carry over to the foreign surviving 
corporation and shall be combined on a separate category-by-separate 
category basis.
    (2) Hovering deficit. The rules of this paragraph (d)(2) apply when 
the foreign acquiring corporation or the foreign target corporation has 
a deficit in one or more separate categories of post-1986 undistributed 
earnings described in paragraph (d)(1)(i) of this section immediately 
prior to the foreign 381 transaction. In the event both the foreign 
acquiring corporation and the foreign target corporation have a deficit 
in the same separate category of earnings and profits, such deficits 
and their related foreign income taxes shall be combined for purposes 
of applying this paragraph (d)(2). See also paragraphs (g)(1) and (4) 
of this section (describing other rules applicable to a deficit 
described in this paragraph (d)(2)).
    (i) Offset rule. A deficit in a separate category of earnings and 
profits described in this paragraph (d)(2) shall offset only earnings 
and profits accumulated by the foreign surviving corporation after the 
foreign 381 transaction (post-transaction earnings) in the same 
separate category of earnings and profits.
    (ii) Related taxes. Foreign income taxes that are related to a 
deficit in a separate category of earnings and profits described in 
this paragraph (d)(2) shall be added to the foreign surviving 
corporation's post-1986 foreign income taxes related to that separate 
category of earnings and profits only after post-transaction earnings 
in the same separate category have been offset by and exceed the entire 
amount of the deficit.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (d). The examples presume the following facts: Foreign 
corporations A and B were both incorporated after December 31, 1986, 
always have been controlled foreign corporations, and always have had 
calendar taxable years. None of the shareholders of foreign 
corporations A and B are required to include any amount in income under 
Sec. 1.367(b)-4 as a result of the foreign 381 transaction. Foreign 
corporations A and B (and all of their respective qualified business 
units as defined in section 989) maintain a ``u'' functional currency. 
Finally, unless otherwise stated, any earnings and profits described in 
section 904(d)(1)(D) and 904(d)(1)(E) (shipping income and 10/50 
dividends, respectively) qualified for the high tax exception from 
subpart F income under section 954(b)(4), and all United States 
shareholders elected to exclude such earnings and profits from subpart 
F income under section 954(b)(4) and Sec. 1.954-1(d)(5). The examples 
are as follows:

    Example 1--(i) Facts. (A) On December 31, 2001, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                                               E & P       Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Separate Category:
        10/50 dividends from FC1, a                 100u             $40
         noncontrolled section 902
         corporation....................
        General.........................            300u              60
                                         -------------------------------
                                                    400u             100
                                         -------------------------------
Foreign Corporation B:
    Separate Category:
        Shipping........................            200u              40
        10/50 dividends from FC2, a                  50u              20
         noncontrolled section 902
         corporation....................
        General.........................            300u              70
                                         -------------------------------
                                                    550u             130
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a controlled foreign 
corporation (CFC).
    (ii) Result. Under the rules described in paragraph (d)(1) of 
this section, foreign surviving corporation has the following 
earnings and profits and foreign income taxes accounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
Shipping................................            200u             $40
General.................................            600u             130
10/50 dividends from FC1................            100u              40
10/50 dividends from FC2................             50u              20
                                         -------------------------------
                                                    950u             230
------------------------------------------------------------------------


[[Page 69152]]

    (iii) Post-transaction distribution. (A) During 2002, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2002, 
foreign surviving corporation distributes 475u to its shareholders. 
Under the rules described in Sec. 1.902-1(d)(1) and paragraph (c)(1) 
of this section, the distribution is out of separate categories and 
reduces foreign income taxes as follows:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
Shipping................................            100u             $20
General.................................            300u              65
10/50 dividends from FC1................             50u              20
10/50 dividends from FC2................             25u              10
                                         -------------------------------
                                                    475u             115
------------------------------------------------------------------------

    (B) The foreign income taxes available to foreign surviving 
corporation shareholders upon the distribution are subject to the 
generally applicable rules and limitations, such as those of 
sections 902 and 904(d).
    (C) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
Shipping................................            100u             $20
General.................................            300u              65
10/50 dividends from FC1................             50u              20
10/50 dividends from FC2................             25u              10
                                         -------------------------------
                                                    475u             115
------------------------------------------------------------------------

    Example 2--(i) Facts. (A) On December 31, 2001, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Separate Category:
        Shipping.......................           (100u)              $5
        10/50 dividends................            400u              160
        General........................           (200u)              25
                                        --------------------------------
                                                   100u              190
Foreign Corporation B:
    Separate Category:
        Shipping.......................            100u               20
        General........................            300u               60
                                        --------------------------------
                                                   400u               80
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. Under the rules described in paragraphs (d)(1) and 
(2) of this section, foreign surviving corporation has the following 
earnings and profits and foreign income taxes accounts:

----------------------------------------------------------------------------------------------------------------
                                                                Earnings and profits          Foreign taxes
                                                            ----------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                     Separate category                         Positive     Hovering      Foreign     associated
                                                                 E&P         deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Shipping...................................................         100u        (100u)          $20           $5
10/50 dividends............................................         400u           0u           160            0
General....................................................         300u        (200u)           60           25
                                                            ----------------------------------------------------
                                                                    800u        (300u)          240           30
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2002, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2002, 
foreign surviving corporation distributes 400u to its shareholders. 
Under the rules described in section 904(d)(3) and paragraph (c)(1) 
of this section, the distribution is out of separate categories and 
reduces foreign income taxes as follows:

[[Page 69153]]



------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
Shipping................................             50u             $10
10/50 dividends.........................            200u              80
General.................................            150u              30
                                         -------------------------------
                                                    400u             120
------------------------------------------------------------------------

    (B) The foreign income taxes available to foreign surviving 
corporation shareholders upon the distribution are subject to the 
generally applicable rules and limitations, such as those of 
sections 902 and 904(d).
    (C) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

----------------------------------------------------------------------------------------------------------------
                                                                Earnings and profits          Foreign taxes
                                                            ----------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                     Separate category                         Positive     Hovering      Foreign     associated
                                                                 E&P         deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Shipping...................................................          50u        (100u)          $10           $5
10/50 dividends............................................         200u           0u            80            0
General....................................................         150u        (200u)           30           25
                                                            ----------------------------------------------------
                                                                    400u        (300u)          120           30
----------------------------------------------------------------------------------------------------------------

    (iv) Post-transaction earnings. (A) In its taxable year ending 
on December 31, 2003, foreign surviving corporation accumulates 
earnings and profits and pays related foreign income taxes as 
follows:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
Shipping................................            105u             $20
General.................................            100u              20
                                         -------------------------------
                                                    205u              40
------------------------------------------------------------------------

    (B) None of foreign surviving corporation's earnings and profits 
for its 2003 taxable year qualify as subpart F income as defined in 
section 952(a). Under the rules described in paragraphs (d)(2)(i) 
and (ii) of this section, foreign surviving corporation has the 
following earnings and profits and foreign income taxes accounts on 
December 31, 2003:

----------------------------------------------------------------------------------------------------------------
                                                                Earnings and profits          Foreign taxes
                                                            ----------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                     Separate category                         Positive     Hovering      Foreign     associated
                                                                 E&P         deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Shipping...................................................          55u           0u           $35           $0
10/50 dividends............................................         200u           0u            80            0
General....................................................         150u        (100u)           50           25
                                                            ----------------------------------------------------
                                                                    405u        (100u)          165           25
----------------------------------------------------------------------------------------------------------------

    Example 3--(i) Facts. The facts are the same as Example 2 (i), 
(ii), (iii), and (iv)(A), except that the 105u in the section 
904(d)(1)(D) shipping separate category accumulated by foreign 
surviving corporation during 2003 qualify as subpart F income, all 
of which is included in income under section 951(a) by United States 
shareholders (as defined in section 951(b)).
    (ii) Result. (A) Under the rule described in paragraph (g)(1) of 
this section, the 100u hovering deficit in the shipping separate 
category does not reduce foreign surviving corporation's current 
earnings and profits for purposes of determining subpart F income. 
Thus, foreign surviving corporation's United States shareholders 
include their pro rata shares of the 105u in taxable income for the 
year and are eligible for a deemed paid foreign tax credit under 
section 960, computed by reference to their pro rata shares of 
$20.32 (105u subpart F inclusion <divide> (105u + 50u accumulated 
earnings and profits in the shipping category = 155u) = 0.68%,  x  
$30 foreign income taxes in the shipping category = $20.32).
    (B) Immediately after the subpart F inclusion and section 960 
deemed paid taxes (and taking into account the taxable year 2003 
earnings and profits and related taxes in the general category), 
foreign surviving corporation has the following earnings and profits 
and foreign income taxes accounts:

[[Page 69154]]



----------------------------------------------------------------------------------------------------------------
                                                                Earnings and profits          Foreign taxes
                                                            ----------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                     Separate category                         Positive     Hovering      Foreign     associated
                                                                 E&P         deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Shipping...................................................          50u        (100u)        $9.68           $5
10/50 dividends............................................         200u           0u         80.00            0
General....................................................         150u        (100u)        50.00           25
                                                            ----------------------------------------------------
                                                                    400u        (200u)       139.68           30
----------------------------------------------------------------------------------------------------------------

    (C) The 105u included as subpart F income constitutes previously 
taxed earnings and profits under section 959.

    (e) Non-look-through pool--(1) If foreign surviving corporation is 
a look-through corporation. If the foreign surviving corporation is a 
look-through corporation, then the non-look-through pool shall be 
determined under the rules of this paragraph (e)(1).
    (i) Qualifying earnings and taxes. The non-look-through pool shall 
consist of the post-1986 undistributed earnings and related post-1986 
foreign income taxes that were accumulated (or treated as accumulated) 
by the foreign target corporation or the foreign acquiring corporation 
while it was a non-look-through 10/50 corporation.
    (ii) Carryover rule. Subject to paragraph (e)(1)(iii) of this 
section, the amounts described in pararaph (e)(1)(i) of this section 
attributable to the foreign acquiring corporation and the foreign 
target corporation shall carry over to the foreign surviving 
corporation but shall not be combined. Thus, post-transaction 
distributions by the foreign surviving corporation out of the non-look-
through pool shall be made from the separate amounts attributable to 
the foreign acquiring corporation and the foreign target corporation on 
a pro rata basis, and shall reduce a pro rata portion of any related 
foreign income taxes.
    (iii) Hovering deficit. The rules of this paragraph (e)(1)(iii) 
apply when the foreign acquiring corporation or the foreign target 
corporation (or both) has a deficit in the post-1986 undistributed 
earnings described in paragraph (e)(1)(i) of this section immediately 
prior to the foreign 381 transaction. In the event that this paragraph 
(e)(1)(iii) applies to a deficit of both the foreign acquiring 
corporation and the foreign target corporation, the deficits shall not 
be combined and the rules of this paragraph (e)(1)(iii) shall be 
applied separately to each of such deficits on a pro rata basis. See 
also paragraphs (g)(1) and (g)(4) of this section (describing other 
rules applicable to a deficit described in this paragraph (e)(1)(iii)).
    (A) Offset rule. A deficit described in this paragraph (e)(i)(iii) 
shall offset only post-transaction earnings. The deficit shall offset a 
pro rata portion of post-transaction earnings accumulated in each 
separate category of earnings and profits by the foreign surviving 
corporation.
    (B) Related taxes. Foreign income taxes that are related to a 
deficit described in this paragraph (e)(1)(iii) shall be added to the 
foreign surviving corporation's post-1986 foreign income taxes (in the 
applicable segregated portion of the non-look-through pool) only after 
post-transaction earnings have been offset by and exceed the entire 
amount of the deficit.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (e)(1). The examples presume the following facts: Foreign 
corporation A was a non-look-through 10/50 corporation from its 
incorporation on January 1, 1995 until December 31, 1997; foreign 
corporation A became a CFC on January 1, 1998 and has been a CFC since 
that time. Foreign corporation B has been a non-look-through 10/50 
corporation since its incorporation on January 1, 1993. Both foreign 
corporation A and foreign corporation B always have had calendar 
taxable years. None of the shareholders of foreign corporation A are 
required to include any amount in income under Sec. 1.367(b)-4 as a 
result of the foreign 381 transaction. Foreign corporations A and B 
(and all of their respective qualified business units as defined in 
section 989) maintain a ``u'' functional currency. Finally, any 
earnings and profits described in section 904(d)(1)(E) (10/50 
dividends) qualified for the high tax exception from subpart F income 
under section 954(b)(4), and all United States shareholders elected to 
exclude such earnings and profits from subpart F income under section 
954(b)(4) and Sec. 1.954-1(d)(5). The examples are as follows:

    Example 1--(i) Facts. (A) On December 31, 2001, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Separate Category:
        10/50 dividends.................            100u             $40
        General.........................            300u              60
E&P Accumulated as Non-Look-Through 10/             400u             100
 50 Corporation.........................
                                         -------------------------------
                                                    800u             200
Foreign Corporation B:
    E&P Accumulated as Non-Look-Through             200u             $40
     10/50 Corporation..................
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. Under the rules described in paragraphs (d)(1), 
(e)(1)(i), and (e)(1)(ii) of this section, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

[[Page 69155]]



------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Look-Through Pool Separate Category:
    10/50 dividends.....................            100u             $40
    General.............................            300u              60
Two Side-by-Side Non-Look-Through Pool
 Amounts:
    Non-look-through pool amount #1                 400u             100
     (from Corp A)......................
    Non-look-through pool amount #2                 200u              40
     (from Corp B)......................
                                         -------------------------------
                                                  1,000u             240
------------------------------------------------------------------------

    (iii) Post-transaction distribution.--(A) During 2002, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2002, 
foreign surviving corporation distributes 700u to its shareholders. 
Under the rules described in paragraphs (c)(1) and (e)(1)(ii) of 
this section, the distribution is first out of the look-through 
pool, then out of the non-look-through pool, as follows:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Look-Through Pool Separate Category:
    10/50 dividends.....................            100u             $40
    General.............................            300u              60
Non-Look-Through Pool Amounts:
    Non-look-through pool amount #1.....            200u              50
    Non-look-through pool amount #2.....            100u              20
                                                    700u             170
------------------------------------------------------------------------

    (B) The foreign income taxes available to foreign surviving 
corporation shareholders upon the distribution are subject to the 
generally applicable rules and limitations, such as those of 
sections 902 and 904(d).
    (C) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Two Side-by-Side Non-Look-Through Pool
 Amounts:
    Non-look-through pool amount #1.....            200u             $50
    Non-look-through pool amount #2.....            100u              20
                                         -------------------------------
                                                    300u              70
------------------------------------------------------------------------

    Example 2--(i) Facts.--(A) On December 31, 2001, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Look-through Pool Separate
     Category:
        10/50 dividends................            100u              $40
        General........................            300u               60
E&P Accumulated as Non-Look-Through 10/            400u              100
 50 Corporation........................
                                        --------------------------------
                                                   800u              200
Foreign Corporation B:
    E&P Accumulated as Non-Look-Through           (200u)               5
     10/50 Corporation.................
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. Under the rules described in paragraphs (d)(1), 
(e)(1)(i), (e)(1)(ii), and (e)(1)(iii) of this section, foreign 
surviving corporation has the following earnings and profits and 
foreign income taxes accounts:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                                                                Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Look-through Pool Separate Category:
    10/50 dividends.........................................         100u  ...........          $40  ...........
    General.................................................         300u  ...........           60  ...........

[[Page 69156]]

 
Two Side-by-Side Non-Look-Through Pool Amounts:
    Non-look-through pool amount #1.........................         400u  ...........          100  ...........
    Non-look-through pool amount #2.........................  ...........       (200u)  ...........           $5
                                                             ---------------------------------------------------
                                                                     800u       (200u)          200            5
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction distribution.--(A) During 2002, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2002, 
foreign surviving corporation distributes 600u to its shareholders. 
Under the rules described in paragraphs (c)(1) and (e)(1)(ii) of 
this section, the distribution is first out of the look-through 
pool, then out of the non-look-through pool, as follows:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Look-Through Pool Separate Category:
    10/50 dividends.....................            100u             $40
    General.............................            300u              60
Non-Look-Through Pool Amount:
    Non-look-through pool amount #1.....            200u              50
                                         -------------------------------
                                                    600u             150
------------------------------------------------------------------------

    (B) The foreign income taxes available to foreign surviving 
corporation shareholders upon the distribution are subject to the 
generally applicable rules and limitations, such as those of 
sections 902 and 904(d).
    (C) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                                                                Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Two Side-by-Side Non-Look-Through Pool Amounts:
    Non-look-through pool amount #1.........................         200u                       $50
    Non-look-through pool amount #2.........................                    (200u)                        $5
                                                             ---------------------------------------------------
                                                                     200u       (200u)           50            5
----------------------------------------------------------------------------------------------------------------

    (iv) Post-transaction earnings.--(A) In the taxable year ending 
on December 31, 2003, foreign surviving corporation accumulates 
earnings and profits and pays related foreign income taxes as 
follows:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Separate Category:
    10/50 dividends.....................            150u             $60
    General.............................            300u              60
                                         -------------------------------
                                                    450u             120
------------------------------------------------------------------------

    (B) None of the earnings and profits qualify as subpart F income 
as defined in section 952(a). Under the rules described in paragraph 
(e)(1)(iii)(A) of this section, the 200u deficit in non-look-through 
pool amount #2 offsets a pro rata portion of the foreign surviving 
corporation's post-transaction earnings in each separate category. 
Thus, the 200u deficit offsets 66.66u of section 904(d)(1)(E) 10/50 
dividends separate category earnings (33.33% of 200u) and offsets 
133.34u of section 904(d)(1)(I) general separate category earnings 
(66.67% of 200u). Accordingly, foreign surviving corporation has the 
following earnings and profits and foreign income taxes accounts as 
of December 31, 2002:

------------------------------------------------------------------------
                                                 E&P       Foreign taxes
------------------------------------------------------------------------
Look-Through Pool Separate Category:
    10/50 dividends.....................          83.34u             $60
    General.............................         166.66u              60

[[Page 69157]]

 
Two Side-by-Side Non-Look-Through Pool
 Amounts:
    Non-look-through pool amount #1.....            200u              50
    Non-look-through pool amount #2.....                               5
                                         -------------------------------
                                                    450u             175
------------------------------------------------------------------------

    (C) Under paragraph (e)(1)(iii)(B) of this section, the $5 of 
foreign income taxes associated with the non-look-through pool 
amount #2 hovering deficit are added to foreign surviving 
corporation's available foreign income taxes because post-
transaction earnings have been offset by and exceed the deficit in 
the non-look-through pool. However, the $5 of foreign income taxes 
generally will not be reduced or deemed paid unless a foreign tax 
refund restores a positive balance to the associated earnings 
pursuant to section 905(c), and thus will be trapped.

    (2) If foreign surviving corporation is a non-look-through 10/50 
corporation. If the foreign surviving corporation is a non-look-through 
10/50 corporation, then the non-look-through pool shall be determined 
under the rules of this paragraph (e)(2).
    (i) Qualifying earnings and taxes. The non-look-through pool shall 
consist of the post-1986 undistributed earnings and related post-1986 
foreign income taxes of the foreign acquiring corporation and the 
foreign target corporation.
    (ii) Carryover rule. Subject to paragraph (e)(2)(iii) of this 
section, the amounts described in paragraph (e)(2)(i) of this section 
attributable to the foreign acquiring corporation and the foreign 
target corporation shall carry over to the foreign surviving 
corporation and shall be combined as a single separate category of 
earnings and profits under section 904(d)(1)(E).
    (iii) Hovering deficit. The rules of this paragraph (e)(2)(iii) 
apply when the foreign acquiring corporation or the foreign target 
corporation (or both) has an aggregate deficit in its post-1986 
undistributed earnings described in paragraph (e)(2)(i) of this section 
immediately prior to the foreign 381 transaction. In the event that 
both the foreign acquiring corporation and the foreign target 
corporation have an aggregate deficit in post-1986 undistributed 
earnings, such deficits and their related foreign income taxes shall be 
combined for purposes of applying this paragraph (e)(2)(iii). See also 
paragraphs (g)(1) and (4) of this section (describing other rules 
applicable to a deficit described in this paragraph (e)(2)(iii)).
    (A) Offset rule. A deficit described in this paragraph (e)(2)(iii) 
shall offset only post-transaction earnings accumulated by the foreign 
surviving corporation.
    (B) Related taxes. Foreign income taxes that are related to a 
deficit described in this paragraph (e)(2)(iii) shall be added to the 
foreign surviving corporation's post-1986 foreign income taxes only 
after post-transaction earnings have been offset by and exceed the 
entire amount of the deficit.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (e)(2). The examples presume the following facts: Both 
foreign corporation A and foreign corporation B always have had 
calendar taxable years. Foreign corporations A and B (and all of their 
respective qualified business units as defined in section 989) maintain 
a ``u'' functional currency. Finally, any earnings and profits 
described in section 904(d)(1)(E) (10/50 dividends) qualified for the 
high tax exception from subpart F income under section 954(b)(4), and 
all United States shareholders elected to exclude such earnings and 
profits from subpart F income under section 954(b)(4) and Sec. 1.954-
1(d)(5). The examples are as follows:

    Example 1-- (i) Facts. (A) Foreign corporations A and B are and 
always have been non-look-through 10/50 corporations since they were 
incorporated in 1995. On December 31, 2001, foreign corporations A 
and B have the following earnings and profits and foreign income 
taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A: E&P accumulated              400u            $100
 as non-look-through 10/50 corporation..
Foreign Corporation B: E&P accumulated              200u              40
 as non-look-through 10/50 corporation..
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a non-look-through 10/
50 corporation.
    (ii) Result. Under the rules described in paragraphs (e)(2)(i) 
and (ii) of this section, foreign surviving corporation has the 
following earnings and profits and foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Non-Look-Through Pool...................            600u            $140
------------------------------------------------------------------------

    Example 2--(i) Facts. (A) Foreign corporation A is and always 
has been a CFC since it was incorporated in 1995. Foreign 
corporation B is and always has been a non-look-through 10/50 
corporation since it was incorporated in 1995. Immediately before 
the foreign 381 transaction (but after application of the rules of 
Sec. 1.367(b)-4 to foreign corporation A and its shareholders), 
foreign corporations A and B have the following earnings and profits 
and foreign income taxes accounts:

------------------------------------------------------------------------
                                               E&P         Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Separate Category:
        Passive........................           (200u)             $10
        10/50 dividends................            100u               40

[[Page 69158]]

 
        General........................            300u               60
                                        --------------------------------
                                                  (200u)            $110
Foreign Corporation B:
    E&P accumulated as non-look-through            200u              $30
     10/50 corporation.................
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a non-look-through 10/
50 corporation.
    (ii) Result. Because neither foreign corporation A nor foreign 
corporation B has an aggregate deficit in post-1986 undistributed 
earnings, the rules described in paragraphs (e)(2)(i) and (ii) of 
this section apply, but the rules described in paragraph (e)(2)(iii) 
do not. Accordingly, foreign corporation A's net positive earnings 
and profits of 200u (300u + 100u + (200u)) and its aggregate foreign 
income taxes of $110 ($10 + $40 + $60) are combined with the 
earnings and profits and foreign income taxes of foreign corporation 
B, so that foreign surviving corporation has the following earnings 
and profits and foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Non-Look-Through Pool...................            400u            $140
------------------------------------------------------------------------

    Example 3--(i) Facts. (A) Foreign corporation A is and always 
has been a CFC since it was incorporated in 1995. Foreign 
corporation B is and always has been a non-look-through 10/50 
corporation since it was incorporated in 1995. On December 31, 2001, 
foreign corporations A and B have the following earnings and profits 
and foreign income taxes accounts:

------------------------------------------------------------------------
                                               E&P         Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Separate Category:
        Passive........................           (200u)             $10
        10/50 dividends................            100u               40
        General........................           (300u)              60
                                        --------------------------------
                                                  (400u)            $110
Foreign Corporation B:
    E&P accumulated as non-look-through            200u              $30
     10/50 corporation.................
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a non-look-through 10/
50 corporation. (Assume that none of the shareholders of foreign 
corporation A are required to include an amount in income under 
Sec. 1.367(b)-4 with regard to this transaction.)
    (ii) Result. Because foreign corporation A has an aggregate 
deficit in post-1986 undistributed earnings, the rules of paragraph 
(e)(2)(iii) of this section apply. Accordingly, foreign corporation 
A's 400u aggregate deficit in earnings and profits ((200u) + 100u + 
(300u)) carries over as a hovering deficit to foreign surviving 
corporation, so that foreign surviving corporation has the following 
earnings and profits and foreign income taxes accounts:

----------------------------------------------------------------------------------------------------------------
                                                                Earnings and profits          Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                                                                Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Non-Look-Through Pool.......................................         200u       (400u)          $30         $110
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction earnings. (A) In the taxable year ending 
on December 31, 2002, foreign surviving corporation accumulates 
earnings and profits and pays related foreign income taxes as 
follows:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
E&P accumulated as non-look-through 10/             500u            $100
 50 corporation.........................
------------------------------------------------------------------------

    (B) Under the rule described in paragraph (e)(2)(iii)(A) of this 
section, the hovering deficit of 400u in the non-look-through pool 
offsets 400u of post-transaction earnings. Under the rules of 
paragraph (e)(2)(iii)(B) of this section, the foreign income taxes 
related to the hovering deficit are added to foreign surviving 
corporation's available foreign income taxes because post-
transaction earnings have been offset by and exceed the deficit in 
the non-look-through pool. Accordingly, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts as of December 31, 2002:

[[Page 69159]]



------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Non-Look-Through Pool...................            300u            $240
------------------------------------------------------------------------


    (f) Pre-pooling annual layers--(1) If foreign surviving corporation 
is a look-through corporation or a non-look-through 10/50 corporation. 
If the foreign surviving corporation is a look-through corporation or a 
non-look-through 10/50 corporation, the pre-pooling annual layers shall 
be determined under the rules of this paragraph (f)(1).
    (i) Qualifying earnings and taxes. The pre-pooling annual layers 
shall consist of the pre-1987 accumulated profits and the pre-1987 
foreign income taxes of the foreign acquiring corporation and the 
foreign target corporation.
    (ii) Carryover rule. Subject to paragraph (f)(1)(iii) of this 
section, the amounts described in paragraph (f)(1)(i) of this section 
attributable to the foreign acquiring corporation and the foreign 
target corporation shall carry over to the foreign surviving 
corporation but shall not be combined. Thus, when the foreign acquiring 
corporation and the foreign target corporation have pre-1987 
accumulated profits in the same year and a distribution is made 
therefrom, the rules of Sec. 1.902-1(b)(2)(ii) and (b)(3) shall apply 
separately to reduce pre-1987 accumulated profits and pre-1987 foreign 
income taxes of the foreign acquiring corporation and the foreign 
target corporation on a pro rata basis. For further guidance, see Rev. 
Rul. 68-351 (1968-2 C.B. 307); Rev. Rul. 70-373 (1970-2 C.B. 152) (see 
also Sec. 601.601(d)(2) of this chapter); see also paragraph (g)(2) of 
this section (governing the reconciliation of taxable years).
    (iii) Deficits. The rules of this paragraph (f)(1)(iii) apply when 
the foreign acquiring corporation or the foreign target corporation (or 
both) has a deficit in one or more years that comprise its pre-1987 
accumulated profits immediately prior to the foreign 381 transaction 
(see also paragraphs (g)(1) and (g)(4) of this section, describing 
other rules applicable to a deficit described in this paragraph 
(f)(1)(iii)).
    (A) Aggregate positive earnings and profits. If the foreign 
acquiring corporation or the foreign target corporation (or both) has 
an aggregate positive (or zero) amount of pre-1987 accumulated profits, 
but a deficit in one or more individual years, then the rules otherwise 
applicable to such deficits shall apply separately to the pre-1987 
accumulated profits and related foreign income taxes of such 
corporation. For further guidance, see Rev. Rul. 74-550 (1974-2 C.B. 
209) (see also Sec. 601.601(d)(2) of this chapter); Champion Int'l 
Corp. v. Commissioner, 81 T.C. 424 (1983), acq. in result, 1987-2 C.B. 
1; Rev. Rul. 87-72 (1987-2 C.B. 170) (see also Sec. 601.601(d)(2) of 
this chapter). As a result, no amount in excess of the aggregate 
positive amount of pre-1987 accumulated profits shall be distributed 
from the pre-transaction earnings of the foreign acquiring corporation 
or the foreign target corporation.
    (B) Aggregate deficit in earnings and profits. If the foreign 
acquiring corporation or the foreign target corporation (or both) has 
an aggregate deficit in pre-1987 accumulated profits, then the rules 
under Sec. 1.902-2(b) shall apply to such deficit (and related foreign 
income taxes) immediately prior to the transaction, except that the 
aggregate deficit that is carried forward into the look-through pool 
(in the case of a foreign surviving corporation that is a look-through 
corporation) or non-look-through pool (in the case of a foreign 
surviving corporation that is a non-look-through 10/50 corporation) 
shall be available to offset only post-transaction earnings accumulated 
by the foreign surviving corporation.
    (iv) Pre-1987 section 960 earnings and profits and foreign income 
taxes. The pre-1987 section 960 earnings and profits and pre-1987 
section 960 foreign income taxes attributable to the foreign acquiring 
corporation and the foreign target corporation shall carry over to the 
foreign surviving corporation but shall not be combined. The rules 
otherwise applicable to such amounts shall apply separately to the pre-
1987 section 960 earnings and profits and pre-1987 section 960 foreign 
income taxes of the foreign acquiring corporation and the foreign 
target corporation on a pro rata basis. For further guidance, see 
Notice 88-70 (1988-2 C.B. 369) (see also Sec. 601.601(d)(2) of this 
chapter).
    (v) Examples. The following examples illustrate the rules of this 
paragraph (f)(1). The examples presume the following facts: foreign 
corporation A was incorporated in 1998 and was a less-than-10%-U.S.-
owned foreign corporation through December 31, 1999. Foreign 
corporation A became a non-look-through 10/50 corporation on January 1, 
2000 and, as a result, began to maintain a pool of post-1986 
undistributed earnings on that date.
    Foreign corporation B was incorporated in 1998 and always has been 
owned by foreign shareholders (and thus never has met the requirements 
of section 902(c)(3)(B)). Both foreign corporation A and foreign 
corporation B always have had calendar taxable years. Foreign 
corporations A and B (and all of their respective qualified business 
units as defined in section 989) maintain a ``u'' functional currency. 
The examples are as follows:

    Example 1--(i) Facts. (A) On December 31, 2001, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
E&P accumulated as non-look-through 10/           1,000u            $350
 50 corporation.........................
    1999................................            400u            160u
    1998................................            100u              5u
                                         ----------------
                                                  1,500u
Foreign Corporation B:
    2001................................            100u             20u
    2000................................            150u             30u
    1999................................              0u             50u
    1998................................             50u              5u
                                         -------------------------------
                                                    300u            105u
------------------------------------------------------------------------


[[Page 69160]]

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a non-look-through 10/
50 corporation.
    (ii) Result. Under the rules described in paragraphs (e)(2)(i), 
(e)(2)(ii), (f)(1)(i), and (f)(1)(ii) of this section, foreign 
surviving corporation has the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Non-look-through pool...................          1,000u            $350
2001....................................            100u             20u
2000....................................            150u             30u
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1 (from Corp A).........            400u            160u
    1999 layer #2 (from Corp B).........              0u             50u
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1 (from Corp A).........            100u              5u
    1998 layer #2 (from Corp B).........             50u              5u
                                         ----------------
                                                  1,800u
------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2002, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2002, 
foreign surviving corporation distributes 1,700u to its 
shareholders. Under the rules of paragraph (c)(2) of this section, 
the distribution is first out of the non-look-through pool, and then 
out of the pre-pooling annual layers under the LIFO method, as 
follows:

------------------------------------------------------------------------
              Distribution                      E&P        Foreign taxes
------------------------------------------------------------------------
Non-look-through pool...................          1,000u            $350
2001....................................            100u             20u
2000....................................            150u             30u
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1.......................            400u            160u
    1999 layer #2.......................              0u              0u
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1 (100u in layer                  33.33u           1.67u
     <divide> 150u aggregate 1997
     earnings = 66.67%  x  50u
     distribution)......................
    1998 layer #2 (50u in layer <divide>          16.67u           1.67u
     150u aggregate 1997 earnings =
     33.33%  x  50u distribution).......
                                         ----------------
                                                  1,700u
------------------------------------------------------------------------

    (B) The foreign income taxes available to foreign surviving 
corporation shareholders upon the distribution are subject to the 
generally applicable rules and limitations, such as those of 
sections 902 and 904(d).
    (C) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
1999 layer #2...........................           0.00u          50.00u
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1.......................          66.67u           3.33u
    1998 layer #2.......................          33.33u           3.33u
                                         -------------------------------
                                                 100.00u          56.66u
------------------------------------------------------------------------

    (iv) Post-transaction earnings. For the taxable year ending on 
December 31, 2003, foreign surviving corporation accumulates 500u of 
current earnings and profits and pays $70 in foreign income taxes. 
As of the close of the 2003 taxable year, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

------------------------------------------------------------------------
                                                 E&P       Foreign taxes
------------------------------------------------------------------------
E&P accumulated as non-look-through 10/          500.00u          $70.00
 50 corporation.........................
1999....................................           0.00u          50.00u
Two Side-by-Side Layers of 1998 E&P:....
    1998 layer #1.......................          66.67u           3.33u
    1998 layer #2.......................          33.33u           3.33u
                                         ----------------
                                                    600u
------------------------------------------------------------------------

    Example 2--(i) Facts. (A) On December 31, 2001, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes accounts:

[[Page 69161]]



------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Foreign Corporation A:
    E&P accumulated as non-look-though 10/50         1,000u         $350
     corporation..............................
    1999......................................         100u          20u
    1998......................................        (50u)           5u
                                               -------------
                                                     1,050u
Foreign Corporation B:
    E&P Foreign Taxes.........................
    2001......................................         100u          20u
    2000......................................        (50u)           5u
    1999......................................           0u          50u
    1998......................................         100u          10u
                                               -------------------------
                                                       150u          85u
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a non-look-through 10/
50 corporation.
    (ii) Result. Because foreign corporations A and B have aggregate 
positive amounts of pre-1987 accumulated profits with a deficit in 
one or more individual years, the rules of paragraph (f)(1)(iii)(A) 
of this section apply. Accordingly, after the foreign 381 
transaction, foreign surviving corporation has the following 
earnings and profits and foreign income taxes accounts:

----------------------------------------------------------------------------------------------------------------
                                                                Earnings and profits          Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                          Foreign       taxes
                                                                Positive   Deficit E&P     taxes      associated
                                                                  E&P                    available       with
                                                                                                     deficit E&P
----------------------------------------------------------------------------------------------------------------
Non-Look-Through 10/50 Pool.................................       1,000u  ...........         $350  ...........
2001........................................................         100u  ...........          20u  ...........
2000........................................................  ...........        (50u)  ...........           5u
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1 (from foreign corporation A)..............         100u  ...........          20u  ...........
    1999 layer #2 (from foreign corporation B)..............           0u  ...........          50u  ...........
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1 (from foreign corporation A)..............  ...........        (50u)  ...........           5u
    1998 layer #2 (from foreign corporation B)..............         100u  ...........          10u  ...........
-------------------------------------------------------------
                                                                   1,300u       (100u)  ...........          10u
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2002, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2002, 
foreign surviving corporation distributes 1,175u to its 
shareholders. Under the rules described in paragraphs (c)(2) and 
(f)(1)(iii)(A) of this section, the distribution is first out of the 
non-look-through pool, and then out of the pre-pooling annual 
layers, as follows:

------------------------------------------------------------------------
              Distribution                      E&P        Foreign taxes
------------------------------------------------------------------------
Non-Look-Through 10/50 Amount...........          1,000u            $350
2001....................................            100u             20u
2000....................................              0u              0u
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1.......................             50u             20u
    1999 layer #2.......................              0u              0u
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1.......................              0u              0u
    1998 layer #2.......................             25u              5u
                                                         ---------------
                                                  1,175u
------------------------------------------------------------------------

    (B) Under the rules described in paragraph (f)(1)(iii)(A) of 
this section, the rules otherwise applicable when a foreign 
corporation has an aggregate positive (or zero) amount of pre-1987 
accumulated profits, but a deficit in one or more individual years, 
apply separately to the pre-1987 accumulated profits and related 
foreign income taxes of foreign corporation A and foreign 
corporation B. As a result, distributions out of the pre-pooling 
annual layers of foreign corporation A and foreign corporation B can 
not exceed the aggregate positive amount of pre-1987 accumulated 
profits of each corporation. Accordingly, only 50u can be 
distributed from foreign corporation A's pre-pooling annual layers 
and is out of its 1999 layer #1. Under Champion Int'l Corp. v. 
Commissioner, 81 T.C. 424 (1983), the full 20u of taxes related to 
1999 layer #1 is reduced or deemed paid ($20  x  (50 <divide> 50)). 
Under Rev. Rul. 74-550 (1974-2 C.B. 209) (see also 
Sec. 601.601(d)(2) of this chapter), 100u is distributed from 
foreign corporation B's 2001 annual layer. Foreign corporation B's 
deficit in 2000 is then rolled back to offset its 1998 annual layer 
to reduce

[[Page 69162]]

earnings in that layer to 50u, 25u of which is distributed (and 
reduces one-half of that year's foreign income taxes).
    (C) The foreign income taxes available to foreign surviving 
corporation shareholders upon the distribution are subject to the 
generally applicable rules and limitations, such as those of 
sections 902 and 904(d).
    (D) Immediately after the distribution foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
2000..........................................           0u           5u
1999 layer #2.................................           0u          50u
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1.............................           0u           5u
    1998 layer #2.............................          25u           5u
                                               -------------------------
                                                        25u          65u
------------------------------------------------------------------------

    (E) Under the rules described in paragraph (f)(1)(iii)(A) of 
this section, the 5u, 50u, and 5u of foreign income taxes related to 
foreign surviving corporation's 2000 layer, 1999 layer #2, and 1998 
layer #1, respectively, remain in those layers. These foreign income 
taxes generally will not be reduced or deemed paid unless a foreign 
tax refund restores a positive balance to the associated earnings 
pursuant to section 905(c), and thus will be trapped.
    Example 3--(i) Facts. (A) On December 31, 2001, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                                               E&P         Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    E&P accumulated as non-look-through          1,000u             $350
     10/50 corporation.................
    1999...............................            150u              20u
    1998...............................            100u               5u
                                        -----------------
                                                 1,250u
Foreign Corporation B:
    2001...............................            100u              20u
    2000...............................           (250u)              5u
    1999...............................              0u              50u
    1998...............................            100u              10u
                                        --------------------------------
                                                   (50u)             85u
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a non-look-through 10/
50 corporation.
    (ii) Result. (A) Because foreign corporation B has an aggregate 
deficit in pre-1987 accumulated profits, the rules of paragraph 
(f)(1)(iii)(B) of this section apply. Accordingly, Sec. 1.902-2(b) 
applies immediately prior to the foreign 381 transaction, except 
that foreign corporation B's aggregate deficit in pre-1987 
accumulated profits is carried forward into the post-1986 
undistributed earnings pool and is available to offset only post-
transaction earnings accumulated by foreign surviving corporation. 
Accordingly, after the foreign 381 transaction, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

----------------------------------------------------------------------------------------------------------------
                                                       Earnings and profits                Foreign taxes
                                                 ---------------------------------------------------------------
                                                                                                   Foreign taxes
                                                                     Hovering      Foreign taxes    associated
                                                   Positive E&P       deficit        available     with hovering
                                                                                                      deficit
----------------------------------------------------------------------------------------------------------------
Non-Look-Through 10/50 Pool.....................          1,000u           (50u)            $350              $0
2001............................................              0u  ..............             20u  ..............
2000............................................              0u  ..............              5u               ;
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1 (from Corp A).................            150u  ..............             20u  ..............
    1999 layer #2 (from Corp B).................              0u  ..............             50u  ..............
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1 (from Corp A).................            100u  ..............              5u  ..............
    1998 layer #2 (from Corp B).................              0u  ..............             10u  ..............
                                                 --------------------------------                ---------------
                                                          1,250u           (50u)  ..............               0
----------------------------------------------------------------------------------------------------------------

    (B) Under paragraph (f)(1)(iii)(B) of this section, the 20u, 5u, 
50u, and 10u of foreign income taxes associated with foreign 
corporation B's earnings and profits for 2001, 2000, 1999 layer #2, 
and 1998 layer #2, respectively, remain in those layers. These 
foreign income taxes generally will not be reduced or deemed paid 
unless a foreign tax refund restores a positive balance to the 
associated earnings pursuant to section 905(c), and thus will be 
trapped.


[[Page 69163]]


    (2) If foreign surviving corporation is a less-than-10%-U.S.-owned 
foreign corporation. If the foreign surviving corporation is a less-
than-10%-U.S.-owned foreign corporation, then the pre-pooling annual 
layers shall be determined under the rules of this paragraph (f)(2).
    (i) Qualifying earnings and taxes. The pre-pooling annual layers 
shall consist of the pre-1987 accumulated profits and the pre-1987 
foreign income taxes of the foreign acquiring corporation and the 
foreign target corporation. If the foreign acquiring corporation or the 
foreign target corporation (or both) has post-1986 undistributed 
earnings or a deficit in post-1986 undistributed earnings, then those 
earnings or deficits and any related post-1986 foreign income taxes 
shall be recharacterized as pre-1987 accumulated profits or deficits 
and pre-1987 foreign income taxes of the foreign acquiring corporation 
or the foreign target corporation accumulated immediately prior to the 
foreign 381 transaction.
    (ii) Carryover rule. Subject to paragraph (f)(2)(iii) of this 
section, the amounts described in paragraph (f)(2)(i) of this section 
attributable to the foreign acquiring corporation and the foreign 
target corporation shall carry over to the foreign surviving 
corporation but shall not be combined. Thus, when the foreign acquiring 
corporation and the foreign target corporation have pre-1987 
accumulated profits in the same year and a distribution is made 
therefrom, the principles of Sec. 1.902-1(b)(2)(ii) and (3) shall apply 
separately to reduce pre-1987 accumulated profits and pre-1987 foreign 
income taxes of the foreign acquiring corporation and the foreign 
target corporation on a pro rata basis. For further guidance, see Rev. 
Rul. 68-351 (1968-2 C.B. 307); Rev. Rul. 70-373 (1970-2 C.B. 152) (see 
also Sec. 601.601(d)(2) of this chapter); see also paragraph (g)(2) of 
this section (governing the reconciliation of taxable years).
    (iii) Deficits. The rules of this paragraph (f)(2)(iii) apply when 
the foreign acquiring corporation or the foreign target corporation (or 
both) has a deficit in one or more years that comprise its pre-1987 
accumulated profits immediately prior to the foreign 381 transaction 
(and after application of the last sentence of paragraph (f)(2)(i) of 
this section). See also paragraphs (g)(1) and (4) of this section 
(describing other rules applicable to a deficit described in this 
paragraph (f)(2)(iii)).
    (A) Aggregate positive earnings and profits. If the foreign 
acquiring corporation or the foreign target corporation (or both) has 
an aggregate positive (or zero) amount of pre-1987 accumulated profits, 
but a deficit in one or more individual years, then the rules otherwise 
applicable to such deficits shall apply separately to the pre-1987 
accumulated profits and related foreign income taxes of such 
corporation. For further guidance, see Rev. Rul. 74-550 (1974-2 C.B. 
209) (see also Sec. 601.601(d)(2) of this chapter); Champion Int'l 
Corp. v. Commissioner, 81 T.C. 424 (1983), acq. in result, 1987-2 C.B. 
1; Rev. Rul. 87-72 (1987-2 C.B. 170) (see also Sec. 601.601(d)(2) of 
this chapter). As a result, no amount in excess of the aggregate 
positive amount of pre-1987 accumulated profits shall be distributed 
from the pre-transaction earnings of the foreign acquiring corporation 
or the foreign target corporation.
    (B) Aggregate deficit in earnings and profits. If the foreign 
acquiring corporation or the foreign target corporation (or both) has 
an aggregate deficit in pre-1987 accumulated profits, then the rules 
otherwise applicable to such deficits shall apply separately to the 
pre-transaction earnings and profits and related taxes of the 
applicable corporation. See, e.g., sections 316(a) and 381(c)(2)(B). 
Thus, any aggregate net deficit shall be available to offset only post-
transaction earnings accumulated by the foreign surviving corporation.
    (iv) Pre-1987 section 960 earnings and profits and foreign income 
taxes. The pre-1987 section 960 earnings and profits and pre-1987 
section 960 foreign income taxes attributable to the foreign acquiring 
corporation and the foreign target corporation shall carry over to the 
foreign surviving corporation but shall not be combined. The rules 
otherwise applicable to such amounts shall apply separately to the pre-
1987 section 960 earnings and profits and pre-1987 section 960 foreign 
income taxes of the foreign acquiring corporation and the foreign 
target corporation on a pro rata basis. For further guidance, see 
Notice 88-70 (1988-2 C.B. 369) (see also Sec. 601.601(d)(2) of this 
chapter).
    (v) Examples. The following examples illustrate the rules of this 
paragraph (f)(2). The examples presume the following facts: Both 
foreign corporation A and foreign corporation B always have had 
calendar taxable years. Foreign corporations A and B (and all of their 
respective qualified business units as defined in section 989) maintain 
a ``u'' functional currency. The examples are as follows:

    Example 1--(i) Facts. (A) Foreign corporations A and B both were 
incorporated in 1998. Nine percent of the voting stock of foreign 
corporation A is owned by domestic corporate shareholder C. Nine 
percent of the voting stock of foreign corporation B is owned by 
domestic corporate shareholder D. Shareholders C and D are 
unrelated. The remaining 91% of the voting stock of each foreign 
corporation is owned by unrelated foreign shareholders. Thus, 
neither corporation meets the requirements of section 902(c)(3)(B). 
On December 31, 2001, foreign corporations A and B have the 
following earnings and profits and foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    2001................................            500u            350u
    2000................................            400u            300u
    1999................................            400u            160u
    1998................................            100u              5u
                                         -------------------------------
                                                  1,400u            815u
Foreign Corporation B:
    2001................................            100u             20u
    2000................................            300u             60u
    1999................................              0u             50u
    1998................................             50u              5u
                                         -------------------------------
                                                    450u            135u
------------------------------------------------------------------------


[[Page 69164]]

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a less-than-10%-U.S.-
owned foreign corporation that does not meet the requirements of 
section 902(c)(3)(B).
    (ii) Result. Under the rules described in paragraphs (f)(2)(i) 
and (ii) of this section, foreign surviving corporation has the 
following earnings and profits and foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Two Side-by-Side Layers of 2001 E&P:
    2001 layer #1 (from Corp A).........            500u            350u
    2001 layer #2 (from Corp B).........            100u             20u
Two Side-by-Side Layers of 2000 E&P:
    2000 layer #1 (from Corp A).........            400u            300u
    2000 layer #2 (from Corp B).........            300u             60u
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1 (from Corp A).........            400u            160u
    1999 layer #2 (from Corp B).........              0u             50u
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1 (from Corp A).........            100u              5u
    1998 layer #2 (from Corp B).........             50u              5u
                                         -------------------------------
                                                  1,850u            950u
------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2002, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2002, 
foreign surviving corporation distributes 600u to its shareholders. 
Under the rules of paragraph (c)(3) of this section, the 
distribution is out of pre-pooling annual layers under the LIFO 
method as follows:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Two Side-by-Side Layers of 2001 E&P:
    2001 layer #1 (from Corp A).........            500u            350u
    2001 layer #2 (from Corp B).........            100u             20u
                                         -------------------------------
                                                    600u            370u
------------------------------------------------------------------------

    (B) Foreign surviving corporation's foreign income tax accounts 
are reduced to reflect the distribution of earnings and profits, see 
Sec. 1.902-1(a)(10)(iii), notwithstanding that no shareholders are 
eligible to claim deemed paid foreign income taxes under section 
902.
    (C) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Two Side-by-Side Layers of 2000 E&P:
    2000 layer #1 (from Corp A).........            400u            300u
    2000 layer #2 (from Corp B).........            300u             60u
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1 (from Corp A).........            400u            160u
    1999 layer #2 (from Corp B).........              0u             50u
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1 (from Corp A).........            100u              5u
    1998 layer #2 (from Corp B).........             50u              5u
                                         -------------------------------
                                                  1,250u            580u
------------------------------------------------------------------------

    Example 2--(i) Facts. (A) The facts are the same as in Example 1 
(i)(A), except that foreign corporation A met the requirements of 
section 902(c)(3)(B) on January 1, 2000, when U.S. corporate 
shareholder C acquired an additional 1% of voting stock for a total 
ownership interest of 10%; foreign corporation A thereby became a 
non-look-through 10/50 corporation. On December 31, 2001, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    E&P Accumulated as Non-Look-Through             900u            $650
     10/50 Corporation..................
    1999................................            400u            160u
    1998................................            100u              5u
                                         ----------------
                                                  1,400u
Foreign Corporation B:
    2001................................            100u             20u
    2000................................            300u             60u

[[Page 69165]]

 
    1999................................              0u             50u
    1998................................             50u              5u
                                         -------------------------------
                                                    450u            135u
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a less-than-10%-U.S.-
owned foreign corporation that does not meet the requirements of 
section 902(c)(3)(B).
    (ii) Result. Under the rules described in paragraphs (f)(2)(i) 
and (ii) of this section, foreign surviving corporation has the 
following earnings and profits and foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Two Side-by-Side Layers of 2001 E&P:
    2001 layer #1 (from Corp A's pool)..            900u            $650
    2001 layer #2 (from Corp B's layer).            100u             20u
    2000 (from Corp B):.................            300u             60u
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1 (from Corp A).........            400u            160u
    1999 layer #2 (from Corp B).........              0u             50u
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1 (from Corp A).........            100u              5u
    1998 layer #2 (from Corp B).........             50u              5u
                                         -------------------------------
                                                  1,850u
------------------------------------------------------------------------

    (iii) Subsequent ownership change. On January 1, 2007, USS (a 
domestic corporation) acquires 100% of the stock of foreign 
surviving corporation. Under the rules of paragraph (g)(3) of this 
section, foreign surviving corporation begins to pool its earnings 
and profits under section 902(c)(3) as of January 1, 2007. Foreign 
surviving corporation's earnings and profits and foreign income 
taxes accrued before January 1, 2007 retain their character as pre-
1987 accumulated profits and pre-1987 foreign income taxes.
    Example 3--(i) Facts. (A) The facts are the same as in Example 2 
(i)(A), except that on December 31, 2001, foreign corporations A and 
B have the following earnings and profits and foreign income taxes 
accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    E&P Accumulated as Non-Look-Through           1,000u            $500
     10/50 Corporation:.................
    1999................................          (200u)             10u
    1998................................            400u              5u
                                         -------------------------------
                                                  1,200u
Foreign Corporation B:
    2001................................            300u             20u
    2000................................          (100u)             60u
    1999................................              0u             50u
    1998................................             50u              5u
                                         -------------------------------
                                                    250u            135u
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a less-than-10%-U.S.-
owned foreign corporation that does not meet the requirements of 
section 902(c)(3)(B).
    (ii) Result. Because foreign corporations A and B have aggregate 
positive amounts of pre-1987 earnings and profits with a deficit in 
one or more individuals years, the rules of paragraphs 
(f)(2)(iii)(A) of this section apply. Accordingly, after the foreign 
381 transaction, foreign surviving corporation has the following 
earnings and profits and foreign income taxes accounts:

----------------------------------------------------------------------------------------------------------------
                                                                Earnings and profits          Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                          Foreign       taxes
                                                                Positive   Deficit E&P     taxes      associated
                                                                  E&P                    available       with
                                                                                                     deficit E&P
----------------------------------------------------------------------------------------------------------------
Two Side-by-Side Layers of 2001 E&P:
    2001 layer #1 (from Corp A's non-look-through 10/50            1,000u                      $500
     pool)..................................................
    2001 layer #2 (from Corp B's layer).....................         300u  ...........          20u  ...........
    2000 (from Corp B)......................................  ...........       (100u)  ...........          60u

[[Page 69166]]

 
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1 (from Corp A).............................  ...........       (200u)  ...........          10u
    1999 layer #2 (from Corp B).............................           0u  ...........          50u  ...........
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1 (from Corp A).............................         400u  ...........           5u  ...........
    1998 layer #2 (from Corp B).............................          50u  ...........           5u  ...........
                                                             --------------------------             ------------
                                                                   1,750u       (300u)  ...........          70u
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction distribution.--(A) During 2002, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2002, 
foreign surviving corporation distributes 1,300u to its 
shareholders. Under the rules described in paragraphs (c)(3) and 
(f)(2)(iii)(A) of this section, the distribution is out of the pre-
pooling annual layers, as follows:

------------------------------------------------------------------------
                                                           Foreign taxes
                                                E&P            paid
------------------------------------------------------------------------
Two Side-by-Side Layers of 2001 E&P:
    2001 layer #1.......................          1,000u            $500
    2001 layer #2.......................            250u             20u
1998 E&P:
    1998 layer #1.......................             50u          *1.25u
                                         ----------------
                                                  1,300u
------------------------------------------------------------------------
* 25% of 5u taxes.

    (B) Under the rules described in paragraph (f)(2)(iii)(A) of 
this section, the rules otherwise applicable when a foreign 
corporation has an aggregate positive (or zero) amount of pre-1987 
accumulated profits, but a deficit in one or more individual years, 
apply separately to the pre-1987 accumulated profits and related 
foreign income taxes of foreign corporation A and foreign 
corporation B. As a result, distributions out of the pre-pooling 
annual layers of foreign corporation A and foreign corporation B 
cannot exceed the aggregate positive amount of pre-1987 accumulated 
profits of each corporation. Accordingly, only 1,200u and 250u can 
be distributed out of foreign corporation A's and foreign 
corporation B's pre-pooling annual layers, respectively. Thus, 
1,250u of the distribution is out of 1,000u of foreign corporation 
A's 2001 layer #1 and 250u of foreign corporation B's 2001 layer #2. 
Under the principles of Sec. 1.902-1(b)(3) and Champion Int'l Corp. 
v. Commissioner, 81 T.C. 424 (1983), all of the taxes in each of 
those respective layers are reduced. Applying Rev. Rul. 74-550 
(1974-2 C.B. 209) (see also Sec. 601.601(d)(2) of this chapter), the 
remaining 50u is distributed from foreign corporation A's 1998 layer 
#1 (after rolling back the 200u deficit in 1999 layer #1 to reduce 
earnings in 1998 layer #1 to 200u (400u-200u)). Thus, after the 
distribution, 150u remains in the 1998 layer #1 along with 3.75u of 
foreign income taxes (5u  x  (150u <divide> 200u)).
    (C) Foreign surviving corporation's foreign income tax accounts 
are reduced to reflect the distribution of earnings and profits, see 
Sec. 1.902-1(a)(10)(iii), notwithstanding that no shareholders are 
eligible to claim a credit for deemed paid foreign income taxes 
under section 902.
    (D) Immediately after the distribution foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
2000....................................              0u             60u
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1.......................              0u             10u
    1999 layer #2.......................              0u             50u
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1.......................            150u           3.75u
    1998 layer #2.......................              0u              5u
                                         -------------------------------
                                                    150u         128.75u
------------------------------------------------------------------------

    (E) Under the rules described in paragraph (f)(2)(iii)(A) of 
this section, the 60u, 10u, 50u, and 5u of foreign income taxes 
related to foreign surviving corporation's 2000 layer, 1999 layer 
#1, 1999 layer #2, and 1998 layer #2, respectively, remain in those 
layers. These foreign income taxes generally will not be reduced or 
deemed paid unless a foreign tax refund restores a positive balance 
to the associated earnings pursuant to section 905(c), and thus will 
be trapped.
    Example 4--(i) Facts. (A) The facts are the same as in Example 2 
(i)(A), except that on December 31, 2001, foreign corporations A and 
B have the following earnings and profits and foreign income taxes 
accounts:

[[Page 69167]]



------------------------------------------------------------------------
                                               E&P         Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    E&P Accumulated as Non-Look-Through         (1,000u)             $20
     10/50 Corporation:................
    1999...............................           (200u)             10u
    1998...............................            400u               5u
                                        -----------------
                                                  (800u)
Foreign Corporation B:
    2001...............................            100u              20u
    2000...............................            300u              60u
    1999...............................              0u              50u
    1998...............................             50u               5u
                                        --------------------------------
                                                   450u             135u
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation A acquires the 
assets of foreign corporation B in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a less-than-10%-U.S.-
owned foreign corporation.
    (ii) Result. Because foreign corporation A has an aggregate 
deficit in pre-1987 earnings and profits, the rules of paragraph 
(f)(2)(iii)(B) of this section apply and the rules otherwise 
applicable apply separately to the pre-1987 accumulated profits that 
carry over to foreign surviving corporation from foreign corporation 
A. Accordingly, after the foreign 381 transaction, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes accounts:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                          Foreign       taxes
                                                                Positive   Deficit E&P     taxes      associated
                                                                  E&P                    available       with
                                                                                                     deficit E&P
----------------------------------------------------------------------------------------------------------------
Two Side-by-Side Layers of 2001 E&P:
    2001 layer #1 (from Corp A).............................                  (1,000u)                       $20
    2001 layer #2 (from Corp B).............................         100u                       20u
    2000....................................................         300u                       60u
Two Side-by-Side Layers of 1999 E&P:
    1999 layer #1 (from Corp A).............................                    (200u)                       10u
    1999 layer #2 (from Corp B).............................           0u                       50u
Two Side-by-Side Layers of 1998 E&P:
    1998 layer #1 (from Corp A).............................         400u                        5u
    1998 layer #2 (from Corp B).............................          50u                        5u
                                                             ---------------------------------------------------
                                                                     850u     (1,200u)         140u
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2002, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2002, 
foreign surviving corporation distributes 200u to its shareholders. 
Under the rules described in paragraph (f)(2)(iii)(B) of this 
section, no distribution can be made out of the pre-1987 accumulated 
profits of foreign corporation A (and the 800u aggregate deficit is 
available to offset only post-transaction earnings accumulated by 
foreign surviving corporation). Thus, the distribution is out of 
pre-pooling annual layers as follows:

------------------------------------------------------------------------
                                                           Foreign taxes
                                                E&P            paid
------------------------------------------------------------------------
2001 layer #2...........................            100u             20u
2000....................................            100u             20u
                                         -------------------------------
                                                    200u             40u
------------------------------------------------------------------------

    (B) Foreign surviving corporation's foreign income tax accounts 
are reduced to reflect the distribution of earnings and profits, see 
Sec. 1.902-1(a)(10)(iii), notwithstanding that no shareholders are 
eligible to claim deemed paid foreign income taxes under section 
902.

    (g) Special rules--(1) Treatment of deficit. Any deficit described 
in paragraph (d)(2), (e)(1)(iii), (e)(2)(iii), (f)(1)(iii), or 
(f)(2)(iii) of this section shall not be taken into account in 
determining current or accumulated earnings and profits of a foreign 
surviving corporation, including for purposes of calculating--
    (A) The earnings and profits limitation of section 952(c)(1)(A) and 
(c)(1)(C); and
    (B) the amount of the foreign surviving corporation's subpart F 
income as defined in section 952(a).
    (2) Reconciling taxable years. If a foreign acquiring corporation 
and a foreign target corporation had taxable years ending on different 
dates, then the pro rata distribution rules of paragraphs (f)(1)(ii) 
and (f)(2)(ii) of this section shall apply with respect to the taxable 
years that end within the same calendar year.
    (3) Post-transaction change of status. If a foreign surviving 
corporation that is subject to the rules of paragraph (c)(2) of this 
section subsequently becomes a look-through corporation, or if a 
foreign surviving corporation that is subject to the rules of paragraph 
(c)(3) of this

[[Page 69168]]

section subsequently becomes a non-look-through 10/50 corporation or a 
look-through corporation, by reason, for example, of a reorganization, 
liquidation, or change of ownership, then post-1986 undistributed 
earnings and post-1986 foreign income taxes that have lost their look-
through or pooling character by reason of this section shall not have 
such look-through or pooling character restored. See, e.g., paragraph 
(f)(2)(v) Example 2 of this section.
    (4) Ordering rule for offsetting multiple hovering deficits--(i) 
Rule. A foreign surviving corporation shall apply the deficit rules of 
paragraphs (d)(2), (e)(1)(iii), (e)(2)(iii), (f)(1)(iii), and 
(f)(2)(iii) of this section in that order (in the event that more than 
one of such rules applies to the foreign surviving corporation).
    (ii) Example. The following example illustrates the rules of this 
paragraph (g)(4). The examples presume the following facts: Foreign 
corporation A was a non-look-through 10/50 corporation from its 
incorporation on January 1, 1995 until December 31, 1997; foreign 
corporation A became a CFC on January 1, 1998 and has been a CFC since 
that time. Foreign corporation B has been a non-look-through 10/50 
corporation since its incorporation on January 1, 1993. Foreign 
corporations A and B always have had calendar taxable years. Foreign 
corporations A and B (and all of their respective qualified business 
units as defined in section 989) maintain a ``u'' functional currency. 
Finally, any earnings and profits described in section 904(d)(1)(E) 
(10/50 dividends) qualified for the high tax exception from subpart F 
income under section 954(b)(4), and all shareholders elected to exclude 
such earnings and profits from subpart F income under section 954(b)(4) 
and Sec. 1.954-1(d)(5). The example is as follows:

    Example--(i) Facts. (A) On December 31, 2001, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Separate Category:
        10/50 dividends from FC1, a                100u              $60
         noncontrolled section 902
         corporation...................
        General........................           (300u)              25
E&P Accumulated as Non-Look-Through 10/            300u              100
 50 Corporation........................
                                        --------------------------------
                                                   100u              185
Foreign Corporation B:
    E&P Accumulated as Non-Look-Through           (200u)              50
     10/50 Corporation.................
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. Under the rules described in paragraphs (d)(1), 
(d)(2), (e)(1)(i), (e)(1)(ii), and (e)(1)(iii) of this section, 
foreign surviving corporation has the following earnings and profits 
and foreign income taxes accounts:

----------------------------------------------------------------------------------------------------------------
                                                                Earnings and profits          Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                                                                Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Look-Through Pool:
    10/50 dividends.........................................         100u  ...........          $60  ...........
    General.................................................  ...........       (300u)  ...........          $25
Two Side-by-Side Non-Look-Through Pool Amounts:
    Non-look-through pool amount #1 (from Corp A)...........         300u  ...........          100  ...........
    Non-look-through pool amount #2 (from Corp B)...........  ...........       (200u)  ...........           50
                                                             ---------------------------------------------------
                                                                     400u       (500u)          160           75
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction earnings. (A) In the taxable year ending 
on December 31, 2002, foreign surviving corporation accumulates 
earnings and profits and pays related foreign income taxes as 
follows:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
10/50 dividends from FC1................            150u             $40
General.................................            400u              60
                                         -------------------------------
                                                    550u             100
------------------------------------------------------------------------

    (B) None of the earnings and profits qualify as subpart F income 
as defined in section 952(a). Under the rules of paragraph (g)(4)(i) 
of this section, the rules of paragraph (d)(2) of this section apply 
before the rules of paragraph (e)(1)(iii) of this section. 
Accordingly, post-transaction earnings in a separate category are 
first offset by a hovering deficit in the same separate category in 
the look-through pool. Thus, foreign surviving corporation's 300u 
deficit in the section 904(d)(1)(I) general separate category 
offsets 300u of post-transaction general separate category earnings. 
After application of paragraph (d)(2) ofthis section, foreign 
surviving corporation has the following post-transaction earnings 
available for further offset by a hovering deficit: 150u in the 
section 904(d)(1)(E) 10/50 dividends separate category and 100u in 
the general separate category. Under paragraph (e)(1)(iii) of this 
section, a deficit in the non-look-through pool offsets a pro rata 
portion of post-transaction earnings in each separate

[[Page 69169]]

category. Thus, foreign surviving corporation's 200u deficit in non-
look-through pool amount #2 offsets the remaining post-transaction 
earnings on a pro rata basis (200u  x  (150u <divide> 250u) = 120u 
against 10/50 dividends separate category earnings and 200u  x  
(100u <divide> 250u) = 80u against general separate category 
earnings). Accordingly, foreign surviving corporation has the 
following earnings and profits and foreign income taxes accounts at 
the end of 2002:

------------------------------------------------------------------------
                                                E&P        Foreign taxes
------------------------------------------------------------------------
Look-Through Pool Separate Category:
    10/50 dividends.....................            130u            $100
    General.............................             20u              85
Two Side-by-Side Non-Look-Through Pool
 Amounts:
    Non-look-through pool amount #1.....            300u             100
    Non-look-through pool amount #2.....              0u              50
                                         -------------------------------
                                                    450u             335
------------------------------------------------------------------------

    (C) Under paragraph (d)(2)(ii) of this section, the $25 of 
foreign income taxes related to the 300u hovering deficit in the 
section 904(d)(1)(I) general separate category is added to foreign 
surviving corporation's post-1986 foreign income taxes in that 
separate category (because post-transaction earnings in the general 
separate category have been offset by and exceed the deficit in that 
category). Under paragraph (e)(1)(iii)(B) of this section, the $50 
of foreign income taxes related to the 200u hovering deficit in non-
look-through pool amount #2 is added to foreign surviving 
corporation's post-1986 foreign income taxes for non-look-through 
pool amount #2 (because post-transaction earnings have been offset 
by and exceed the deficit in the non-look-through pool). However, 
the $50 of foreign income taxes generally will not be reduced or 
deemed paid unless a foreign tax refund restores a positive balance 
to the associated earnings pursuant to section 905(c), and thus will 
be trapped.
    (5) Pro rata rule for earnings during transaction year. For 
purposes of offsetting post-transaction earnings of a foreign surviving 
corporation under the rules described in paragraphs (d)(2), 
(e)(1)(iii), (e)(2)(iii), (f)(1)(iii), and (f)(2)(iii), the earnings 
and profits for the taxable year of the foreign surviving corporation 
in which the transaction occurs shall be deemed to have been 
accumulated after such transaction in an amount which bears the same 
ratio to the undistributed earnings and profits of the foreign 
surviving corporation for such taxable year (computed without regard to 
any earnings and profits carried over) as the number of days in the 
taxable year after the date of transaction bears to the total number of 
days in the taxable year. See, e.g., Sec. 1.381(c)(2)-1(a)(7) Example 2 
(illustrating application of this rule with respect to domestic 
corporations).
    (6) Nonapplicability of hovering deficit rules to certain 
transactions--(i) Rule. If a principal purpose of a foreign 381 
transaction is to gain a tax benefit from affirmative use of the 
hovering deficit rule described in paragraph (d)(2), (e)(1)(iii), 
(e)(2)(iii), (f)(1)(iii), or (f)(2)(iii) of this section, then the 
Commissioner may exercise discretion to apply the principles of 
Sec. 1.367(b)-9 to such transaction.
    (ii) Example. The following example illustrates the rules of this 
paragraph (h)(6). The example is as follows:

    Example--(i) Facts.--(A) Foreign corporations A and B are and 
always have been wholly owned subsidiaries of USP, a domestic 
corporation. Both foreign corporations A and B were incorporated in 
1990, and both always have been CFCs using a calendar taxable year. 
Both foreign corporations A and B (and all of their respective 
qualified business units as defined in section 989) maintain a ``u'' 
functional currency and 1u = US$1 at all times. Any earnings and 
profits described in section 904(d)(1)(E) (10/50 dividends) 
qualified for the high tax exception from subpart F income under 
section 954(b)(4), and USP elected to exclude such earnings and 
profits from subpart F income under section 954(b)(4) and 
Sec. 1.954-1(d)(5). On December 31, 2001, foreign corporation A and 
foreign corporation B have the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                                               E&P         Foreign taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Separate Category:
        Passive........................         (1,000u)              $5
        General........................            200u              200
                                        --------------------------------
                                                  (800u)             205
Foreign Corporation B:
    Separate Category:
        10/50 dividends................              5u                3
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). A principal purpose of the foreign 381 
transaction is to gain a tax benefit from affirmative use of the 
hovering deficit rule described in paragraph (d)(2) of this section. 
Immediately following the foreign 381 transaction, foreign surviving 
corporation is a CFC.
    (ii) Result under general rules. (A) If the rules of paragraphs 
(d) (1) and (2) of this section were to apply, foreign surviving 
corporation would have the following earnings and profits and 
foreign income taxes accounts immediately after the foreign 381 
transaction:

[[Page 69170]]



----------------------------------------------------------------------------------------------------------------
                                                                Earnings and profits          Foreign taxes
                                                            ----------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                                                               Positive     Hovering      Foreign     associated
                                                                 E&P         deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Passive....................................................  ...........      (1,000u)  ...........           $5
10/50 dividends............................................           5u  ............           $3
General....................................................         200u  ............          200  ...........
                                                            ----------------------------------------------------
                                                                    205u      (1,000u)          203            5
----------------------------------------------------------------------------------------------------------------

    (B) Accordingly, if the hovering deficit rules of paragraph 
(d)(2) of this section were to apply, foreign surviving corporation 
would be able to pay to USP a dividend of $205 that would carry 
deemed paid foreign income taxes of $203 under section 902.
    (iii) Result under this paragraph (g)(6). Because a principal 
purpose of the foreign 381 transaction was to gain a tax benefit 
from affirmative use of the hovering deficit rule described in 
paragraph (d)(2) of this section, the Commissioner may exercise 
discretion to apply the principles of Sec. 1.367(b)-9 to the 
transaction. Under the principles of Sec. 1.367(b)-9, the earnings 
and profits and foreign income taxes accounts of foreign corporation 
A and foreign corporation B are combined under paragraph (d)(1) of 
this section without reference to the hovering deficit rule of 
paragraph (d)(2) of this section. Accordingly, foreign surviving 
corporation would have the following earnings and profits and 
foreign income taxes accounts immediately after the transaction:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
Passive.................................        (1,000u)             $ 5
10/50 dividends.........................              5u               3
General.................................            200u             200
                                         -------------------------------
                                                  (795u)             208
------------------------------------------------------------------------

    (h) Effective date. This section shall apply to section 367(b) 
exchanges that occur on or after the date 30 days after these 
regulations are published as final regulations in the Federal Register.
    Par. 10. Section 1.367(b)-8 is added to read as follows:


Sec. 1.367(b)-8  Allocation of earnings and profits and foreign income 
taxes in certain foreign corporate separations.

    (a) Scope. This section applies to distributions to which section 
355 (or so much of section 356 as relates to section 355) applies, 
whether or not in connection with a section 368(a)(1)(D) reorganization 
(D reorganization), in which the distributing corporation or the 
controlled corporation (or both) is a foreign corporation (foreign 
divisive transaction). For purposes of this section, the terms 
distributing corporation and controlled corporation have the same 
meaning as used in section 355 and the regulations thereunder. 
Paragraph (b) of this section provides general rules governing the 
allocation and reduction of a distributing corporation's earnings and 
profits and foreign income taxes (pre-transaction earnings and pre-
transaction taxes, respectively) in foreign divisive transactions. 
Paragraphs (c), (d), and (e) of this section describe special rules for 
the application of paragraph (b) of this section to specific 
situations, depending upon whether the distributing corporation or the 
controlled corporation (or both the distributing and the controlled 
corporation) is a foreign corporation.
    (b) General rules--(1) Application of Sec. 1.312-10--(i) In 
general. Pre-transaction earnings of a distributing corporation shall 
be allocated between the distributing corporation and the controlled 
corporation in accordance with the rules of Sec. 1.312-10(a) and shall 
be reduced in accordance with the rules of Sec. 1.312-10(b), except to 
the extent otherwise provided in this section.
    (ii) Special rules for application of Sec. 1.312-10(b)--(A) 
Distributing corporation. The pre-transaction earnings of a 
distributing corporation shall be reduced without taking into account 
Sec. 1.312-10(b)(2).
    (B) Controlled corporation. Section 1.312-10(b) shall not apply to 
increase or replace the earnings and profits of a controlled 
corporation by the amount of any decrease in the pre-transaction 
earnings of a distributing corporation.
    (iii) Net deficit in pre-transaction earnings. Nothing in this 
section shall permit any portion of the pre-transaction earnings of a 
distributing corporation that has a net deficit in pre-transaction 
earnings to be allocated or reduced under paragraph (b)(1)(i) of this 
section. See Sec. 1.312-10(c). Compare paragraph (b)(2) of this section 
(requiring an allocation or reduction of a pro rata portion of deficits 
in statutory groupings of earnings and profits when a distributing 
corporation has a net positive amount of pre-transaction earnings).
    (iv) Use of net bases. All allocations and reductions described in 
paragraph (b)(1)(i) of this section shall be determined in accordance 
with the net bases in assets. Net basis shall have the same meaning as 
under Sec. 1.312-10(a).
    (v) Gain recognized by distributing corporation. The pre-
transaction earnings that are subject to allocation or reduction under 
paragraph (b)(1)(i) of this section shall include any increase in 
earnings and profits from gain recognized or income included by the 
distributing corporation as a result of the foreign divisive 
transaction. See, for example, section 367 (a) and (e), section 
1248(f), and Sec. 1.367(b)-5(b).
    (vi) Coordination with branch profits tax. An allocation or 
reduction in a distributing corporation's pre-transaction earnings 
under paragraph (b)(1)(i) of this section shall not be out of or reduce 
effectively connected earnings and profits or non-previously taxed 
accumulated effectively connected earnings and profits, as defined in 
section 884. See also Sec. 1.884-2T(d)(5)(iii) (providing that such 
earnings and profits are not subject to reduction under Sec. 1.312-
10(b)).
    (2) Cross-section of earnings and profits. Except to the extent 
provided in paragraphs (b)(1)(iii), (b)(1)(vi), (d)(2)(ii), (d)(4), and 
(e)(4) of this section and other than any portion attributable to an 
inclusion under Sec. 1.367(b)-5 or

[[Page 69171]]

paragraph (d)(2)(i) of this section, an allocation or reduction of pre-
transaction earnings described in paragraph (b)(1)(i) of this section 
shall decrease, on a pro rata basis, the statutory groupings of 
earnings and profits (or deficits in statutory groupings of earnings 
and profits) of the distributing corporation. Thus, for example, a pro 
rata portion of a foreign distributing corporation's separate 
categories, post-1986 undistributed earnings, and annual layers of pre-
1987 accumulated profits and pre-1987 section 960 earnings and profits 
shall be allocated or reduced.
    (3) Foreign income taxes. Pre-transaction taxes of a distributing 
corporation shall be ratably allocated or reduced only to the extent 
described in paragraphs (d)(3) and (e)(3) of this section. Thus, a 
distributing corporation's excess foreign taxes described in section 
904(c) shall not be allocated or reduced under this section.
    (4) Divisive D reorganization with a preexisting controlled 
corporation. In the case of a foreign divisive transaction that 
includes a D reorganization with a controlled corporation that is not 
newly created (a preexisting controlled corporation), paragraph 
(b)(1)(i) of this section shall apply in the following manner:
    (i) Calculation of earnings and profits of distributing 
corporation. The pre-transaction earnings of a distributing corporation 
shall be reduced by the sum of--
    (A) The amount of the reduction in the pre-transaction earnings of 
the distributing corporation as described in Sec. 1.312-10(a) (as 
determined under this section); and
    (B) The amount of the reduction in the pre-transaction earnings of 
the distributing corporation as described in Sec. 1.312-10(b) (as 
determined under this section).
    (ii) Calculation of earnings and profits of controlled corporation. 
The amount of earnings and profits of the controlled corporation 
immediately after the foreign divisive transaction shall equal the sum 
of--
    (A) The amount described in paragraph (b)(4)(i)(A) of this section 
(except to the extent such amounts are included in income as a deemed 
dividend pursuant to the foreign divisive transaction or are subject to 
the rule of Sec. 1.367(b)-3(f)); and
    (B) The amount of earnings and profits of the controlled 
corporation immediately before the foreign divisive transaction.
    (c) Foreign divisive transactions involving a domestic distributing 
corporation and a foreign controlled corporation--(1) Scope. The rules 
of this paragraph (c) apply to a foreign divisive transaction involving 
a domestic distributing corporation and a foreign controlled 
corporation.
    (2) Earnings and profits allocated to a foreign controlled 
corporation. Pre-transaction earnings of a domestic distributing 
corporation that are allocated to a foreign controlled corporation 
under the rules described in paragraph (b)(1)(i) of this section shall 
not be included in the foreign controlled corporation's post-1986 
undistributed earnings, pre-1987 accumulated profits, or pre-1987 
section 960 earnings and profits. In addition, if a distribution by the 
domestic distributing corporation out of pre-transaction earnings 
immediately before the foreign divisive transaction would have been 
treated as a U.S. source dividend under section 861(a)(2)(A) that would 
not be exempt from tax under section 871(i)(2)(B) or 881(d), a 
distribution out of such earnings and profits by the foreign controlled 
corporation shall be treated as a U.S. source dividend under section 
904(g) and for purposes of Chapter 3 of subtitle A of the Internal 
Revenue Code. See Georday Enterprises v. Commissioner, 126 F.2d 384 
(4th Cir. 1942). See also sections 243(e) and 861(a)(2)(C) and 
Sec. 1.367(b)-2(j) for other rules that may apply.
    (3) Examples. The following examples illustrate the application of 
the rules of this section to transactions described in paragraph (c)(1) 
of this section. The examples presume the following facts: USD is a 
domestic corporation engaged in manufacturing and shipping activities 
through Business A and Business B, respectively. FC is a foreign 
corporation that is wholly owned by USD. USD and FC use calendar 
taxable years. FC (and all of its qualified business units as defined 
in section 989) maintains a ``u'' functional currency and, except as 
otherwise specified, 1u = US$1 at all times. The examples are as 
follows:

    Example 1--(i) Facts. The stock of USD is owned in equal parts 
by three shareholders, USP (a domestic corporation), USI (a United 
States citizen), and FP (a foreign corporation). USD owns assets 
with total net bases of $260 (including $100 attributable to the 
Business B shipping assets, which have a $160 fair market value). 
USD has $500 of earnings and profits (that it accumulated). The 
entire $500 would have been treated as a U.S. source dividend under 
section 861(a)(2)(A) that would not be exempt from tax under 
sections 871(i)(2)(B) or 881(d) if distributed by USD immediately 
before the foreign divisive transaction. On January 1, 2002, USD 
incorporates FC and transfers to FC the Business B shipping assets. 
USD then distributes the FC stock pro rata to USP, USI, and FP. The 
transaction meets the requirements of sections 368(a)(1)(D) and 355.
    (ii) Result--(A) Gain Recognition. Under section 367(a)(5), USD 
recognizes gain equal to the difference between the fair market 
value and USD's adjusted basis in the Business B shipping assets 
($160 - $100 = $60).
    (B) Calculation of USD's earnings and profits. Under paragraph 
(b)(1)(v) of this section, USD's pre-transaction earnings include 
any gain recognized or income included as a result of the foreign 
divisive transaction. As described in this Example 1 (ii)(A), USD 
recognizes $60 of gain as a result of the foreign divisive 
transaction. Accordingly, USD has $560 of pre-transaction earnings 
($500 + $60). Under paragraph (b)(1)(i) of this section, USD's pre-
transaction earnings are reduced by an amount equal to its pre-
transaction earnings times the net bases of the assets transferred 
to FC divided by the net bases of the assets held by USD immediately 
before the foreign divisive transaction ($560  x  ($160 <divide> 
$320) = $280). Following this reduction, USD has $280 of earnings 
and profits ($560 - $280).
    (C) Calculation of FC's earnings and profits. Under paragraph 
(b)(1)(i) of this section, the $280 reduction in USD's pre-
transaction earnings is allocated to FC. Under Sec. 1.367(b)-
2(j)(1), the $280 is translated into ``u'' at the spot rate on 
January 1, 2002, to 280u. Under paragraph (c)(2) of this section, 
the 280u is not included as part of FC's post-1986 undistributed 
earnings, pre-1987 accumulated profits, or section 960 earnings and 
profits.
    (iii) Post-transaction distribution. During 2002, FC does not 
accumulate any earnings and profits or pay or accrue any foreign 
income taxes. On December 31, 2002, at a time when US$1 = 0.5u, FC 
distributes 180u (or $360) to its shareholders. Thus, FP, USP, and 
USI each receive a $120 dividend. See section 989(b)(1). Under 
paragraph (c)(2) of this section and Sec. 1.367(b)-2(j)(4), $93.33 
of the distribution to FP is subject to withholding under Chapter 3 
of subtitle A of the Internal Revenue Code ($280 <divide> 3 = 
$93.33). Under section 243(e) and Sec. 1.367(b)-2(j)(3), $93.33 of 
the distribution to USP is eligible for the dividends received 
deduction. See also section 861(a)(2)(C). Under paragraph (c)(2) of 
this section, the remaining $26.67 distribution to USP is treated as 
U.S. source under section 904(g) (and is not eligible for the 
dividends received deduction under section 243(e)). Under paragraph 
(c)(2) of this section, the $120 dividend distribution to USI is 
treated as U.S. source under section 904(g).
    Example 2--(i) Facts. The stock of USD is owned by the following 
unrelated persons: 20 percent by USP (a domestic corporation), 20 
percent by USI (a United States citizen), and 60 percent by FP (a 
foreign corporation). FC is a preexisting controlled corporation 
that was incorporated in 1995 and USD always has owned all of the FC 
stock. USD owns assets with total net bases of $320 (including $160 
attributable to the FC stock), and USD has $500 of earnings and 
profits. FC has 150u of earnings and profits in the section 
904(d)(1)(D) shipping separate

[[Page 69172]]

category and has $60 of related foreign income taxes. FC's earnings 
and profits qualified for the high tax exception from subpart F 
income under section 954(b)(4), and USD elected to exclude the 
earnings and profits from subpart F income under section 954(b)(4) 
and Sec. 1.954-1(d)(5). On January 1, 2002, USD distributes the 
stock of FC to its shareholders in a transaction that meets the 
requirements of section 355. FC is not a controlled foreign 
corporation after the foreign divisive transaction. On the date of 
the foreign divisive transaction, the FC stock has a $460 fair 
market value.
    (ii) Result--(A) Gain Recognition. Under Sec. 1.367(b)-
5(b)(1)(ii), USD recognizes gain equal to the difference between the 
fair market value and USD's adjusted basis in the FC stock 
distributed to USI. Under Sec. 1.367(e)-1(b)(1), USD recognizes gain 
equal to the difference between the fair market value and USD's 
adjusted basis in the FC stock distributed to FP. As a result of the 
transfers to USI and FP, USD recognizes gain of $240 (\4/5\  x  
($460 - $160)), $120 of which is included in USD's income as a 
dividend under section 1248(a) and (f)(1) (\4/5\  x  150u, 
translated at the spot rate under section 989(b)(2)). Under section 
1248(a) and (f)(1), USD includes as a dividend the difference 
between the fair market value and its adjusted basis in the FC stock 
distributed to USP to the extent of FC's earnings and profits 
attributable to the distributed stock. For further guidance, see 
also Notice 87-64 (1987-2 C.B. 375) (see also Sec. 601.601(d)(2) of 
this chapter). As a result of this transfer, USD includes a $30 
dividend under section 1248(a) and (f)(1) (\1/5\  x  150u). USD 
qualifies for a section 902 deemed paid foreign tax credit with 
respect to its $150 of section 1248 dividends.
    (B) Calculation of USD's earnings and profits. Under paragraph 
(b)(1)(v) of this section, USD's pre-transaction earnings include 
any gain recognized or income included as a result of the foreign 
divisive transaction. As described in this Example 2 (ii)(A), USD 
recognizes and includes a total of $270 of gain and dividend income 
as a result of the foreign divisive transaction. Accordingly, USD 
has $770 of pre-transaction earnings ($500 + $270). Under paragraphs 
(b)(1)(i) and (b)(1)(ii)(A) of this section, USD's pre-transaction 
earnings are reduced by the amount of the reduction that would have 
been required if USD had transferred the stock of FC to a new 
corporation in a D reorganization. Thus, USD's pre-transaction 
earnings are reduced by an amount equal to its pre-transaction 
earnings times its net basis in the FC stock divided by the net 
bases of the assets held by USD immediately before the foreign 
divisive transaction ($770  x  ($430 <divide> $590) = $561.19). 
Following this reduction, USD has $208.81 of earnings and profits 
($770 - $561.19).
    (C) Calculation of FC's earnings and profits. Under paragraph 
(b)(1)(ii)(B) of this section, FC's earnings and profits are not 
increased (or replaced) as a result of the foreign divisive 
transaction.
    Example 3--(i) Facts. USP, a domestic corporation, owns all of 
the stock of USD. FC is a preexisting controlled corporation and USD 
has owned all of the FC stock since FC was incorporated in 1995. USD 
owns assets with total net bases of $320 (including $100 
attributable to the FC stock and $160 attributable to the Business B 
shipping assets). USD has $500 of pre-transaction earnings. FC has 
150u of earnings and profits in the section 904(d)(1)(D) shipping 
separate category and has $60 of related foreign income taxes. FC's 
earnings and profits qualified for the high tax exception from 
subpart F income under section 954(b)(4), and USD elected to exclude 
the earnings and profits from subpart F income under section 
954(b)(4) and Sec. 1.954-1(d)(5). On January 1, 2002, USD transfers 
to FC the Business B shipping assets. USD then distributes the FC 
stock to USP. The transaction meets the requirements of sections 
368(a)(1)(D) and 355. USD's transfer of the Business B shipping 
assets to FC falls within the active trade or business exception to 
section 367(a)(1) described in Sec. 1.367(a)-2T. Immediately after 
the foreign divisive transaction, the FC stock has a $460 fair 
market value. USP and USD meet and comply with the requirements of 
section 367(a)(5) and 1248(f)(2) (and any regulations thereunder). 
(Sections 1.367(b)-5(b)(1)(ii) and 1.367(e)-1(b)(1) do not apply 
with respect to the foreign divisive transaction because the 
distributee, USP, is a domestic corporation.)
    (ii) Result--(A) Calculation of USD's earnings and profits. 
Under paragraph (b)(4)(i) of this section, USD's pre-transaction 
earnings are reduced by the sum of the amounts described in 
paragraphs (b)(4)(i)(A) and (b)(4)(i)(B) of this section. Under 
paragraph (b)(4)(i)(A) of this section, USD's pre-transaction 
earnings are reduced by an amount equal to USD's pre-transaction 
earnings times the net bases of the assets transferred to FC divided 
by the total net bases of the assets held by USD immediately before 
the foreign divisive transaction ($500  x  ($160 <divide> $320) = 
$250). Under paragraph (b)(4)(i)(B) of this section, USD's pre-
transaction earnings are reduced by an amount equal to USD's pre-
transaction earnings times USD's net basis in the stock of FC 
(immediately before USD's transfer of the shipping assets) divided 
by the total net bases of the assets held by USD immediately before 
the foreign divisive transaction ($500  x  ($100 <divide> $320) = 
$156.25). The sum of the amounts described in paragraphs (b)(4)(i) 
(A) and (B) of this section is $406.25 ($250 + $156.25). Following 
the reduction described in paragraph (b)(4)(i) of this section, USD 
has $93.75 of earnings and profits ($500 - $406.25).
    (B) Calculation of FC's earnings and profits. Under paragraphs 
(b)(4)(ii) of this section, the earnings and profits of FC 
immediately after the foreign divisive transaction are increased by 
the amount of the reduction in USD's pre-transaction earnings 
described in paragraph (b)(4)(i)(A) of this section ($250). Under 
Sec. 1.367(b)-2(j)(1), this $250 is translated into ``u'' at the 
spot rate on January 1, 2002, to 250u. Under paragraph (c)(2) of 
this section, the 250u is not included as part of FC's post-1986 
undistributed earnings. FC has 400u in earnings and profits (250u + 
150u) immediately after the foreign divisive transaction.
    (iii) Post-transaction distribution. FC does not accumulate any 
earnings and profits or pay or accrue any foreign income taxes 
during 2002. On December 31, 2002, FC distributes 100u as a dividend 
to USP, which has remained its sole shareholder. Under section 
989(b)(1), the 100u distribution is translated into US$ at the spot 
rate on December 31, 2002, to $100. Proportionate parts of the $100 
dividend are attributable to the pre-transaction earnings of FC 
($37.50 = $100  x  (150 <divide> 400)) and USD ($62.50 = $100  x  
(250 <divide> 400)). See sections 243(e) and 245. Thus, under 
sections 243(e) and Sec. 1.367(b)-2(j)(3), $62.50 of the 
distribution is eligible for the dividends received deduction. See 
also section 861(a)(2)(C). The remaining $37.50 of the distribution 
(and $15 of related foreign income taxes) is subject to the 
generally applicable rules concerning dividends paid by foreign 
corporations.

    (d) Foreign divisive transactions involving a foreign distributing 
corporation and a domestic controlled corporation--(1) Scope. The rules 
of this paragraph (d) apply to a foreign divisive transaction involving 
a foreign distributing corporation and a domestic controlled 
corporation.
    (2) Coordination with Sec. 1.367(b)-3--(i) In general. In the case 
of a foreign divisive transaction that includes a D reorganization, the 
rules of Sec. 1.367(b)-3 are applicable with respect to the pre-
transaction earnings of a foreign distributing corporation that are 
allocable to a domestic controlled corporation under paragraph 
(b)(1)(i) of this section.
    (ii) Determination of all earnings and profits amount. An all 
earnings and profits amount inclusion under paragraph (d)(2)(i) of this 
section shall be computed with respect to the pre-transaction earnings 
that are allocable to the domestic controlled corporation, without 
regard to the parenthetical phrase in paragraph (b)(4)(ii)(A) of this 
section.
    (iii) Interaction with section 358 and Sec. 1.367(b)-2(e)(3)(ii). 
The basis increase provided in Sec. 1.367(b)-2(e)(3)(ii) shall apply to 
an all earnings and profits amount inclusion under paragraph (d)(2)(i) 
of this section, subject to the following rules--
    (A) Section 358 shall apply to determine the distributee's basis in 
the foreign distributing and domestic controlled corporation without 
regard to the all earnings and profits amount inclusion;
    (B) After application of the rule in paragraph (d)(2)(iii)(A) of 
this section, the basis increase provided in Sec. 1.367(b)-2(e)(3)(ii) 
shall be applied in a manner that attributes such basis increase solely 
to the exchanging

[[Page 69173]]

shareholder's stock in the domestic controlled corporation; and
    (C) the rule of paragraph (d)(2)(iii)(B) of this section shall 
apply prior to Sec. 1.367(b)-5(c)(4) and (d)(4).
    (iv) Coordination with Sec. 1.367(b)-3(c). In applying the rule of 
Sec. 1.367(b)-3(c)(2), an exchanging shareholder described in 
Sec. 1.367(b)-3(c)(1) shall recognize gain with respect to the stock of 
the domestic controlled corporation after the foreign divisive 
transaction.
    (v) Special rule for U.S. persons that own foreign distributing 
corporation stock after a non pro rata distribution. [Reserved]
    (3) Foreign income taxes. Pre-transaction taxes related to a 
foreign distributing corporation's pre-transaction earnings that are 
allocable or are reduced under the rules described in paragraph 
(b)(1)(i) of this section shall be ratably reduced. Pre-transaction 
taxes related to a foreign distributing corporation's pre-transaction 
earnings that are allocable to a domestic controlled corporation under 
the rules described in paragraph (b)(1)(i) of this section shall not 
carry over to the domestic controlled corporation. Nothing in this 
paragraph (d)(3) shall affect the deemed paid taxes that otherwise 
would accompany an inclusion under Sec. 1.367(b)-5 or paragraph 
(d)(2)(i) of this section.
    (4) Previously taxed earnings and profits. [Reserved]
    (5) Coordination with Sec. 1.367(b)-5. See also Sec. 1.367(b)-5(c) 
and (d) for other rules that may apply to a foreign divisive 
transaction described in paragraph (d)(1) of this section.
    (6) Examples. The following examples illustrate the application of 
the rules of this section to transactions described in paragraph (d)(1) 
of this section. The examples presume the following facts: FD is a 
foreign corporation engaged in manufacturing and shipping activities 
through Business A and Business B, respectively. Any earnings and 
profits of FD described in section 904(d)(1)(D) (shipping income) 
qualified for the high tax exception from subpart F income under 
section 954(b)(4), and FD's United States shareholders elected to 
exclude the earnings and profits from subpart F income under section 
954(b)(4) and Sec. 1.954-1(d)(5). USC is a domestic corporation that is 
wholly owned by FD. FD and USC use calendar taxable years. FD (and all 
of its qualified business units as defined in section 989) maintains a 
``u'' functional currency, and 1u = US$1 at all times. The examples are 
as follows:

    Example 1--(i) Facts. (A) USP, a domestic corporation, has owned 
all of the stock of FD since FD's incorporation in 1995. USP's 
adjusted basis in the FD stock is $100, and the FD stock has a fair 
market value of $800. FD owns assets with total net bases of 320u 
(including 160u attributable to the Business B shipping assets), and 
has the following pre-transaction earnings and pre-transaction taxes 
accounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
 General................................            300u             $60
 Shipping...............................            200u              80
                                         -------------------------------
                                                    500u             140
------------------------------------------------------------------------

    (B) On January 1, 2002, FD incorporates USC and transfers to USC 
the Business B shipping assets. FD then distributes the USC stock to 
USP. The transaction meets the requirements of sections 368(a)(1)(D) 
and 355. Immediately after the foreign divisive transaction, the FD 
stock and the USC stock each have a fair market value of $400.
    (ii) Results--(A) Calculation of FD's earnings and profits. 
Under paragraph (b)(1)(i) of this section, FD's pre-transaction 
earnings are reduced by an amount equal to its pre-transaction 
earnings times the net bases of the assets transferred to USC 
divided by the net bases of the assets held by FD immediately before 
the foreign divisive transaction (500u  x  (160u <divide> 320u) = 
250u). Following this reduction, FD has 250u of earnings and profits 
(500u--250u).
    (B) All earnings and profits amount inclusion. Under 
Sec. 1.367(b)-3 and paragraph (d)(2)(i) of this section, USP 
includes in income as an all earnings and profits amount the pre-
transaction earnings of FD that are allocable to USC under paragraph 
(b)(1)(i) of this section. Thus, USP's all earnings and profits 
amount inclusion is $250. See also section 989(b)(1) and paragraph 
(d)(2)(ii) of this section. Under Sec. 1.367(b)-3(b)(3)(i) and 
Sec. 1.367(b)-2(e), USP includes the all earnings and profits amount 
as a deemed dividend received from FD immediately before the foreign 
divisive transaction. Because the requirements of section 902 are 
met, USP qualifies for a deemed paid foreign tax credit with respect 
to the deemed dividend that it receives from FD. Under Sec. 1.902-
1(d)(1), the $250 deemed dividend is out of FD's separate categories 
and reduces foreign income taxes as follows:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................            150u             $30
Shipping................................            100u              40
                                         -------------------------------
                                                    250u              70
------------------------------------------------------------------------

    (C) Calculation of USP's basis in USC and USC's earnings and 
profits. Under paragraph (d)(2)(iii) of this section, the 
Sec. 1.367(b)-2(e)(3)(ii) basis increase applies with respect to 
USP's all earnings and profits amount inclusion from FD and is 
attributed solely to USP's basis in USC (after application of 
section 358). Accordingly, USP has a $300 basis in the USC stock 
($50 section 358 basis, determined by reference to the relative 
values of USP's FD and USC stock: $100 pre-transaction basis  x  
($400 <divide> $800) + $250 Sec. 1.367(b)-2(e)(3)(ii) basis increase 
= $300). Because USP included in income as a deemed dividend under 
Sec. 1.367(b)-3 and paragraph (d)(2) of this section the pre-
transaction earnings of FD that are allocable to USC under paragraph 
(b)(1)(i) of this section, such earnings and profits are not 
available to increase USC's earnings and profits. As a result, USC 
has zero earnings and profits immediately after the foreign divisive 
transaction.
    (D) Application of Sec. 1.367(b)-5(c). The basis adjustment and 
income inclusion rules of Sec. 1.367(b)-5(c)(2) apply if USP's 
postdistribution amount with respect to FD stock is less than its 
predistribution amount with respect to FD stock. Under 
Sec. 1.367(b)-5(e)(1), USP's predistribution amount with respect to 
FD stock is USP's section 1248 amount attributable to such stock 
computed immediately before the distribution but after taking into 
account the allocation of earnings and profits as a result of the D 
reorganization. Thus, USP's predistribution amount with respect to 
FD stock is $250 (500u-250u). See also section 989(b)(2). Under 
section 358, USP allocates its $100 basis in FD stock between FD 
stock and USC stock according to the stock blocks' relative values, 
yielding a $50 ($100 x ($400 <divide> $800)) basis in FD stock. See 
also paragraph (d)(2)(iii) of this section. Under Sec. 1.367(b)-
5(e)(2), USP's postdistribution amount with respect to FD

[[Page 69174]]

stock is USP's section 1248 amount with respect to such stock, 
computed immediately after the distribution. Accordingly, USP's 
postdistribution amount with respect to FD stock is $250. Because 
USP's postdistribution amount with respect to FD stock is not less 
than its predistribution amount, USP is not required to make any 
basis adjustment or include any income under Sec. 1.367(b)-5(c).
    (E) FD's earnings and profits after the foreign divisive 
transaction. Following the reduction described in this Example 1 
(ii)(A) and (B), FD has the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
 General................................            150u             $30
Shipping................................            100u              40
                                         -------------------------------
                                                    250u              70
------------------------------------------------------------------------

    Example 2--(i) Facts. (A) USP, a domestic corporation, has owned 
all of the stock of FD since FD's incorporation in 1995. USP's 
adjusted basis in the FD stock is $400 and the FD stock has a fair 
market value of $800. USC is a preexisting controlled corporation. 
FD owns assets with net total bases of 320u (including 160u 
attributable to the USC stock), and has the following pre-
transaction earnings and pre-transaction taxes accounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................            300u             $60
Shipping................................            200u              80
                                         -------------------------------
                                                    500u             140
------------------------------------------------------------------------

    (B) On January 1, 2002, FD distributes the USC stock to USP in a 
transaction that meets the requirements of section 355. Immediately 
after the foreign divisive transaction, the FD stock and the USC 
stock each have a $400 fair market value.
    (ii) Results--(A) Calculation of FD's earnings and profits. 
Under paragraphs (b)(1)(i) and (b)(1)(ii)(A) of this section, FD's 
pre-transaction earnings are reduced by the amount of the reduction 
that would have been required if FD had transferred the stock of USC 
to a new corporation in a D reorganization. Thus, FD's pre-
transaction earnings are reduced by an amount equal to its pre-
transaction earnings times its net basis in the USC stock divided by 
the net bases of the assets held by FD immediately before the 
foreign divisive transaction (500u x (160u<divide>320u)=250u). 
Following this reduction, FD has 250u of earnings and profits 
(500u-250u).
    (B) Calculation of USC's earnings and profits. Under paragraph 
(b)(1)(ii)(B) of this section, USC's earnings and profits are not 
increased (or replaced) as a result of the foreign divisive 
transaction. As a result, USP is not required to include an amount 
in income under paragraph (d)(2)(i) of this section.
    (C) Application of Sec. 1.367(b)-5(c). The basis adjustment and 
income inclusion rules of Sec. 1.367(b)-5(c)(2) apply if USP's 
postdistribution amount with respect to FD stock is less than its 
predistribution amount with respect to FD stock. Under 
Sec. 1.367(b)-5(e)(1), USP's predistribution amount with respect to 
FD stock is USP's section 1248 amount attributable to such stock 
computed immediately before the distribution. Thus, USP's 
predistribution amount with respect to FD stock is $400 (the 
predistribution amount is limited to USP's built-in gain in FD stock 
immediately before the distribution ($800-$400)). See also section 
989(b)(2). Under section 358, USP allocates its $400 basis in FD 
stock between FD stock and USC stock according to the stock blocks' 
relative values, yielding a $200 ($400 x ($400<divide>$800)) basis 
in each block. Under Sec. 1.367(b)-5(e)(2), USP's postdistribution 
amount with respect to FD stock is USP's section 1248 amount with 
respect to such stock, computed immediately after the distribution. 
Accordingly, USP's postdistribution amount with respect to FD stock 
is $200 (the postdistribution amount is limited to USP's built-in 
gain in FD stock immediately after the distribution ($400-$200)). 
Because USP's postdistribution amount with respect to FD stock is 
$200 less than its predistribution amount with respect to such stock 
($400-$200), Sec. 1.367(b)-5(c)(2)(i) and (ii) require USP to reduce 
its basis in FD stock by the $200 difference, but only to the extent 
such reduction increases USP's section 1248 amount with respect to 
the FD stock. As a result, USP reduces its basis in the FD stock 
from $200 to $150 and includes $150 in income as a deemed dividend 
from FD. Because the requirements of section 902 are met, USP 
qualifies for a deemed paid foreign tax credit with respect to the 
deemed dividend that it receives from FD. Under Sec. 1.902-1(d)(1), 
the $150 deemed dividend is out of FD's separate categories and 
reduces foreign income taxes as follows:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................             90u             $18
Shipping................................             60u              24
                                         -------------------------------
                                                    150u              42
------------------------------------------------------------------------

    (D) Basis adjustment. Under Sec. 1.367(b)-5(c)(3), USP does not 
increase its basis in FD stock as a result of USP's $150 deemed 
dividend from FD. Under Sec. 1.367(b)-5(c)(4), USP increases its 
basis in the USC stock by the amount by which it decreased its basis 
in the FD stock, as well as by the amount of its deemed dividend 
inclusion. The Sec. 1.367(b)-5(c)(4) basis increase applies in full 
because USP's basis in the USC stock is not increased above the fair 
market value of such stock. Thus, USP increases its basis in USC 
stock to $400 ($200+$50+$150).
    (E) Reduction in FD's statutory groupings of earnings and 
profits. Under paragraph (b)(2) of this section, the reduction in 
FD's pre-transaction earnings that is not attributable to USP's 
inclusion under Sec. 1.367(b)-5 decreases FD's statutory groupings 
of earnings and profits on a pro rata basis. Under paragraph (d)(3) 
of this section, FD's pre-transaction taxes also are ratably 
reduced. As described in this Example 2 (ii)(A), the reduction in 
FD's pre-transaction earnings is 250u. As described in this Example 
2 (ii)(C), 150u of the 250u reduction is attributable to an 
inclusion under Sec. 1.367(b)-5. As a result, under paragraphs 
(b)(2) and (d)(3) of this section the remaining 100u reduction in 
FD's pre-transaction earnings is out of the following separate 
categories of earnings and profits and foreign income taxes:

[[Page 69175]]



------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................             60u             $12
Shipping................................             40u              16
                                         -------------------------------
                                                    100u              28
------------------------------------------------------------------------

    (F) FD's earnings and profits after the foreign divisive 
transaction. After the reductions described in this Example 2 
(ii)(C) and (E), FD has the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................            150u             $30
Shipping................................            100u              40
                                         -------------------------------
                                                    250u              70
------------------------------------------------------------------------

    Example 3--(i) Facts. (A) USP, a domestic corporation, has owned 
all of the stock of FD since FD's incorporation in 1995. USP's 
adjusted basis in the FD stock is $400 and the FD stock has a fair 
market value of $800. USC is a preexisting controlled corporation. 
FD owns assets with total net bases of 320u (including 160u 
attributable to the USC stock and 80u attributable to the Business B 
shipping assets), and has the following pre-transaction earnings and 
pre-transaction taxes accounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................            300u            $ 60
Shipping................................            200u              80
                                         -------------------------------
                                                    500u             140
------------------------------------------------------------------------

    (B) On January 1, 2002, FD transfers to USC the Business B 
shipping assets. FD then distributes the USC stock to USP. The 
transaction meets the requirements of sections 368(a)(1)(D) and 355. 
Immediately after the foreign divisive transaction, the FD stock has 
a $200 fair market value and the USC stock has a $600 fair market 
value.
    (ii) Results--(A) Calculation of FD's earnings and profits. 
Under paragraph (b)(4)(i) of this section, FD's pre-transaction 
earnings are reduced by the sum of the amounts described in 
paragraphs (b)(4)(i)(A) and (B) of this section. Under paragraph 
(b)(4)(i)(A) of this section, FD's pre-transaction earnings are 
reduced by an amount equal to FD's pre-transaction earnings times 
the net bases of the Business B shipping assets transferred to USC 
divided by the total net bases of the assets held by FD immediately 
before the foreign divisive transaction (500u  x  (80u <divide> 
320u) = 125u). Under paragraph (b)(4)(i)(B) of this section, FD's 
pre-transaction earnings are reduced by an amount equal to FD's pre-
transaction earnings times FD's net basis in the stock of USC 
divided by the total net bases of the assets held by FD immediately 
before the foreign divisive transaction (500u  x  (160u <divide> 
320u) = 250u). The sum of the amounts described in paragraphs 
(b)(4)(i)(A) and (B) of this section is 375u (125u + 250u).
    (B) All earnings and profits amount inclusion. Under 
Sec. 1.367(b)-3 and paragraph (d)(2)(i) of this section, USP is 
required to include in income as an all earnings and profits amount 
the pre-transaction earnings of FD that are allocable to USC under 
paragraph (b)(1)(i) of this section. Under paragraph (b)(4)(ii)(A) 
of this section, the 125u of pre-transaction earnings described in 
paragraph (b)(4)(i)(A) are allocable to USC. Thus, the all earnings 
and profits amount is $125. See also section 989(b)(1) and paragraph 
(d)(2)(ii) of this section. Under Secs. 1.367(b)-3(b)(3)(i) and 
1.367(b)-2(e), USP includes the all earnings and profits amount as a 
deemed dividend received from FD immediately before the foreign 
divisive transaction. Because the requirements of section 902 are 
met, USP qualifies for a deemed paid foreign tax credit with respect 
to the deemed dividend that it receives from FD. Under Sec. 1.902-
1(d)(1), the $125 deemed dividend is out of FD's separate categories 
and reduces foreign income taxes as follows:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................             75u             $15
Shipping................................             50u              20
                                         -------------------------------
                                                    125u              35
------------------------------------------------------------------------

    (C) Calculation of USP's basis in USC and USC's earnings and 
profits. Under paragraph (d)(2)(iii) of this section, the 
Sec. 1.367(b)-2(e)(3)(ii) basis increase applies with respect to 
USP's all earnings and profits amount inclusion and is attributed 
solely to USP's basis in USC (after application of section 358). 
Accordingly, USP has a $425 basis in the USC stock ($300 section 358 
basis, determined by reference to the relative values of USP's FD 
and USC stock: $400 pre-transaction basis  x  ($600 <divide> $800) + 
$125 Sec. 1.367(b)-2(e)(3)(ii) basis increase = $425). Because USP 
included in income as a deemed dividend under Sec. 1.367(b)-3 and 
paragraph (d)(2) of this section the pre-transaction earnings of FD 
that are allocable to USC under paragraph (b)(1)(i) of this section, 
such earnings and profits are not available to increase USC's 
earnings and profits. As a result, USC's earnings and profits are 
not increased as a result of the foreign divisive transaction.
    (D) Application of Sec. 1.367(b)-5(c). The basis adjustment and 
income inclusion rules of Sec. 1.367(b)-5(c)(2) apply if USP's 
postdistribution amount with respect to FD stock is less than its 
predistribution amount with respect to FD stock. Under 
Sec. 1.367(b)-5(e)(1) and (3), USP's predistribution amount with 
respect to FD stock is USP's section 1248 amount attributable to 
such stock computed immediately before the distribution, after the 
allocation of FD's pre-transaction earnings described in paragraphs 
(b)(4)(i)(A) and (ii)(A) of this section, but without regard to the 
reduction in FD's pre-transaction earnings described in paragraph 
(b)(4)(i)(B) of this section. Thus, USP's predistribution amount 
with respect to FD stock is $375 ($500--$125). See also section 
989(b)(2). Under section 358, USP allocates its $400 basis in FD 
stock between FD stock and USC stock according to the stock blocks' 
relative values, yielding a $100 ($400  x  ($200

[[Page 69176]]

<divide> $800)) basis in FD stock. See also paragraph (d)(2)(iii) of 
this section. Under Sec. 1.367(b)-5(e)(2), USP's postdistribution 
amount with respect to FD stock is USP's section 1248 amount with 
respect to such stock, computed immediately after the distribution. 
Accordingly, USP's postdistribution amount with respect to FD stock 
is $100. (While FD has earnings and profits of 125u immediately 
after the foreign divisive transaction, USP's postdistribution 
amount is limited to its built-in gain in FD stock immediately after 
the distribution ($200--$100).) Because USP's postdistribution 
amount with respect to FD stock is $275 less than its 
predistribution amount with respect to such stock ($375--$100), 
Sec. 1.367(b)-5(c)(2)(i) and (ii) require USP to reduce its basis in 
FD stock, but only to the extent such reduction increases USP's 
section 1248 amount with respect to the FD stock. As a result, USP 
reduces its basis in the FD stock from $100 to $75 and includes $250 
in income as a deemed dividend from FD. Because the requirements of 
section 902 are met, USP qualifies for a deemed paid foreign tax 
credit with respect to the deemed dividend that it receives from FD. 
Under Sec. 1.902-1(d)(1), the $250 deemed dividend is out of FD's 
separate categories and reduces foreign income taxes as follows:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................            150u             $30
Shipping................................            100u              20
                                         -------------------------------
                                                    250u              50
------------------------------------------------------------------------

    (E) Basis adjustment. Under Sec. 1.367(b)-5(c)(3), USP does not 
increase its basis in FD stock as a result of USP's $250 deemed 
dividend from FD. Under Sec. 1.367(b)-5(c)(4), USP increases its 
basis in the USC stock by the amount by which it decreased its basis 
in the FD stock, as well as by the amount of its deemed dividend 
inclusion, but only up to the fair market value of USP's USC stock. 
As described in this Example 3 (ii)(C), USP has already increased 
its basis in the USC stock to $525. Because the fair market value of 
FD's USC stock is $600, USP's basis increase under Sec. 1.367(b)-
5(c)(4) is limited to $75. See also paragraph (d)(2)(iii)(C) of this 
section. Thus, USP has a $600 basis in the USC stock immediately 
after the foreign divisive transaction.
    (F) Reduction in FD's statutory groupings of earnings and 
profits. Under paragraph (b)(2) of this section, the reduction in 
FD's pre-transaction earnings that is not attributable to USP's 
inclusion under paragraph (d)(2)(i) of this section or 
Sec. 1.367(b)-5 decrease FD's statutory groupings of earnings and 
profits on a pro rata basis. Under paragraph (d)(3) of this section, 
FD's pre-transaction taxes are also ratably reduced. As described in 
this Example 3 (ii)(A), the reduction in FD's pre-transaction 
earnings is 375u. As described in this Example 3 (ii)(B) and (D), 
the entire 375u reduction was subject to inclusion as a deemed 
dividend by USP under paragraph (d)(2)(i) of this section or 
Sec. 1.367(b)-5. Thus, none of FD's pre-transaction earnings remain 
to be reduced under paragraph (b)(2) of this section.
    (G) FD's earnings and profits after the foreign divisive 
transaction. After the reductions described in this Example 3 
(ii)(B) and (D), FD has the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................             75u             $15
Shipping................................             50u              20
                                         -------------------------------
                                                    125u              35
------------------------------------------------------------------------

    (e) Foreign divisive transactions involving a foreign distributing 
corporation and a foreign controlled corporation--
    (1) Scope. The rules of this paragraph (e) apply to a foreign 
divisive transaction involving a foreign distributing corporation and a 
foreign controlled corporation.
    (2) Earnings and profits of foreign controlled corporation--(i) In 
general. Except to the extent specified in paragraph (e)(2)(ii) of this 
section, pre-transaction earnings of a foreign distributing corporation 
that are allocated to a foreign controlled corporation under the rules 
described in paragraphs (b)(1)(i) and (4) of this section shall carry 
over to the foreign controlled corporation in accordance with the rules 
described in Sec. 1.367(b)-7.
    (ii) Special rule for pre-transaction earnings allocated to a newly 
created controlled corporation. Section 1.367(b)-9 shall apply to pre-
transaction earnings that are allocated from a foreign distributing 
corporation to a newly created foreign controlled corporation under the 
rules described in paragraph (b)(1)(i) of this section.
    (3) Foreign income taxes. Pre-transaction taxes related to a 
foreign distributing corporation's pre-transaction earnings that are 
allocated or reduced under the rules described in paragraph (b)(1)(i) 
of this section shall be ratably reduced. Pre-transaction taxes related 
to a foreign distributing corporation's pre-transaction earnings that 
are allocated to a foreign controlled corporation under the rules 
described in paragraph (b)(1)(i) of this section shall carry over to 
the foreign controlled corporation in accordance with the rules of 
Sec. 1.367(b)-7. Section 1.367(b)-9 shall apply to pre-transaction 
taxes that are allocated from a foreign distributing corporation to a 
newly created foreign controlled corporation under the rules described 
in paragraph (b)(1)(i) of this section.
    (4) Previously taxed earnings and profits. [Reserved]
    (5) Coordination with Sec. 1.367(b)-5. See also Sec. 1.367(b)-5(c) 
and (d) for other rules that may apply to a foreign divisive 
transaction described in paragraph (e)(1) of this section.
    (6) Examples. The following examples illustrate the application of 
the rules of this section to transactions described in paragraph (e)(1) 
of this section. The examples presume the following facts: FD is a 
foreign corporation engaged in manufacturing and shipping activities 
through Business A and Business B, respectively. FC is a foreign 
corporation that is wholly owned by FD. Any earnings and profits of FD 
or FC described in section 904(d)(1)(D) (shipping income) qualified for 
the high tax exception from subpart F income under section 954(b)(4), 
and FD's and FC's United States shareholders elected to exclude the 
earnings and profits from subpart F income under section 954(b)(4) and 
Sec. 1.954-1(d)(1). FD and FC have calendar taxable years. FD and FC 
(and all of their respective qualified business units as defined in 
section 989) maintain a ``u'' functional currency, and 1u = US$1 at all 
times. The examples are as follows:


[[Page 69177]]


    Example 1--(i) Facts. (A) USP, a domestic corporation, has owned 
all of the stock of FD since FD's incorporation in 1995. USP's 
adjusted basis in the FD stock is $400 and the FD stock has a fair 
market value of $800. FD owns assets with total net bases of 320u 
(including 160u attributable to the Business B shipping assets), and 
has the following pre-transaction earnings and pre-transaction taxes 
accounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................            300u             $60
Shipping................................            200u              80
                                         -------------------------------
                                                    500u             140
------------------------------------------------------------------------

    (B) On January 1, 2002, FD incorporates FC and transfers to FC 
the Business B shipping assets. FD then distributes the FC stock to 
USP. The transaction meets the requirements of sections 368(a)(1)(D) 
and 355. Immediately after the foreign divisive transaction, the FD 
stock and the FC stock each have a $400 fair market value.
    (ii) Result--(A) Calculation of FD's earnings and profits. Under 
paragraph (b)(1)(i) of this section, FD's pre-transaction earnings 
are reduced by an amount equal to its pre-transaction earnings times 
the net bases of the assets transferred to FC divided by the net 
bases of the assets held by FD immediately before the foreign 
divisive transaction (500u  x  (160u <divide> 320u) = 250u). 
Following this reduction, FD has 250u of earnings and profits (500u-
250u).
    (B) Application of Sec. 1.367(b)-5(c). The basis adjustment and 
income inclusion rules of Sec. 1.367(b)-5(c)(2) apply if USP's 
postdistribution amount with respect to FD or FC stock is less than 
its predistribution amount with respect to such stock. Under 
Sec. 1.367(b)-5(e)(1), USP's predistribution amount with respect to 
FD or FC stock is USP's section 1248 amount attributable to such 
stock computed immediately before the distribution but after taking 
into account the allocation of earnings and profits as a result of 
the D reorganization. Thus, USP's predistribution amounts with 
respect to FD and FC stock are both $200. See also section 989(b)(2) 
and Sec. 1.1248-1(d)(3). Under section 358, USP allocates its $400 
basis in FD stock between FD stock and FC stock according to the 
stock blocks' relative values, yielding a $200 ($400  x  ($400 
<divide> $800)) basis in each block. Under Sec. 1.367(b)-5(e)(2), 
USP's postdistribution amount with respect to FD or FC stock is 
USP's section 1248 amount with respect to such stock, computed 
immediately after the distribution. Accordingly, USP's 
postdistribution amounts with respect to FD and FC stock are both 
$200. Because USP's postdistribution amounts with respect to FD and 
FC stock are not less than USP's respective predistribution amounts, 
USP is not required to make any basis adjustment or include any 
income under Sec. 1.367(b)-5(c).
    (C) Reduction in FD's statutory groupings of earnings and 
profits. Under paragraph (b)(2) of this section, the 250u reduction 
in FD's pre-transaction earnings decreases FD's statutory groupings 
of earnings and profits on a pro rata basis. Under paragraph (e)(3) 
of this section, FD's pre-transaction taxes also are ratably 
reduced. Accordingly, FD's pre-transaction earnings and pre-
transaction taxes are reduced by the following amounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................            150u             $30
Shipping................................            100u              40
                                         -------------------------------
                                                    250u              70
------------------------------------------------------------------------

    (D) Calculation of FC's earnings and profits. Under paragraph 
(e)(2) of this section, the pre-transaction earnings of FD that are 
allocated to FC under paragraph (b)(1)(i) of this section carry over 
to FC in accordance with the rules of Sec. 1.367(b)-7, subject to 
the rule of Sec. 1.367(b)-9. Under paragraph (e)(3) of this section, 
FD's pre-transaction taxes related to the pre-transaction earnings 
that are allocated to FC similarly carry over to FC in accordance 
with the rules of Sec. 1.367(b)-7, subject to the rule of 
Sec. 1.367(b)-9. As a result, under Sec. 1.367(b)-7(d), FC has the 
following earnings and profits and foreign income taxes accounts 
immediately after the foreign divisive transaction:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................            150u             $30
Shipping................................            100u              40
                                         -------------------------------
                                                    250u              70
------------------------------------------------------------------------

    Example 2--(i) Facts. (A) USP, a domestic corporation, has owned 
all of the stock of FD since FD's incorporation in 1995. USP's 
adjusted basis in the FD stock is $300 and the FD stock has a fair 
market value of $1,500. FC is a preexisting controlled corporation 
and FD has always owned all of the FC stock. FD owns assets with 
total net bases of 320u (including 160u attributable to the FC 
stock). FD and FC have the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
                   FD                          E&P         Foreign taxes
------------------------------------------------------------------------
Separate Category:
    General............................            400u             $ 50
    Passive............................           (100u)               6
    Shipping...........................            200u               80
                                        --------------------------------
                                                   500u              136
------------------------------------------------------------------------


[[Page 69178]]


------------------------------------------------------------------------
                   FC                          E&P         Foreign taxes
------------------------------------------------------------------------
Separate Category:
    General............................            600u             $100
    Passive............................            (50u)               6
    Shipping...........................            100u               40
                                        --------------------------------
                                                   650u              146
------------------------------------------------------------------------

    (B) On January 1, 2002, FD distributes the FC stock to USP in a 
transaction that meets the requirements of section 355. Immediately 
after the foreign divisive transaction, the FD stock and the FC 
stock each have a $750 fair market value.
    (ii) Result--(A) Calculation of FD's earnings and profits. Under 
paragraph (b)(1)(i) and (ii)(A) of this section, FD's pre-
transaction earnings are reduced by the amount of the reduction that 
would have been required if FD had transferred the stock of FC to a 
new corporation in a D reorganization. Thus, FD's pre-transaction 
earnings are reduced by an amount equal to its pre-transaction 
earnings times its net basis in the FC stock divided by the net 
bases of the assets held by FD immediately before the foreign 
divisive transaction (500u  x  (160u <divide> 320u) = 250u). 
Following this reduction, FD has 250u of earnings and profits (500u-
250u).
    (B) Application of Sec. 1.367(b)-5(c). The basis adjustment and 
income inclusion rules of Sec. 1.367(b)-5(c) apply if USP's 
postdistribution amount with respect to FD or FC stock is less than 
its predistribution amount with respect to such stock. Under 
Sec. 1.367(b)-5(e)(1), USP's predistribution amount with respect to 
FD or FC stock is USP's section 1248 amount attributable to such 
stock computed immediately before the distribution. Thus, USP's 
predistribution amounts with respect to FD and FC stock are $500 and 
$650, respectively. See also section 989(b)(2). Under section 358, 
USP allocates its $300 basis in FD stock between FD stock and FC 
stock according to the stock blocks' relative values, yielding a 
$150 ($300  x  ($750 <divide> $1,500)) basis in each block. Under 
Sec. 1.367(b)-5(e)(2), USP's postdistribution amount with respect to 
FD or FC stock is USP's section 1248 amount with respect to such 
stock, computed immediately after the distribution. Accordingly, 
USP's postdistribution amount with respect to FD stock is $250 (500u 
-250u), and its postdistribution amount with respect to FC stock is 
$600 (while FC has 650u of earnings and profits immediately after 
the foreign divisive transaction, USP's postdistribution amount is 
limited to its built-in gain in FC stock immediately after the 
distribution ($750-$150)). USP's postdistribution amount with 
respect to both the FD and FC stock is less than its predistribution 
amount with respect to such stock. This difference is $50 with 
respect to FC ($650-$600), and $250 with respect to FD ($500-$250). 
Under Sec. 1.367(b)-5(c)(2)(i) and (ii), USP is required to reduce 
its basis in the FD and FC stock, but only to the extent such 
reductions increase USP's section 1248 amount with respect to the 
stock. Accordingly, USP reduces its basis in the FC stock by $50, 
and thereafter USP has a $100 basis in such stock ($150-$100). 
Because a reduction in USP's basis in FD stock would not increase 
any of USP's section 1248 amount with respect to such stock, USP 
includes the entire $250 difference between its predistribution and 
postdistribution amounts with respect to the FD stock as a deemed 
dividend from FD. Because the requirements of section 902 are met, 
USP qualifies for a deemed paid foreign tax credit with respect to 
the deemed dividend that it receives from FD. Under Sec. 1.960-
1(i)(4), the 100u deficit in the section 904(d)(1)(A) passive 
separate category is allocated proportionately against the other 
separate categories for purposes of computing the deemed paid credit 
on the distribution. Thus, there are 333.33u (400u-(100u  x  (400u 
<divide> 600u))) of available earnings in the section 904(d)(1)(I) 
general separate category (along with $50 of foreign income taxes) 
and 166.67u (200u-(100u  x  (200u <divide> 600u))) of available 
earnings in the section 904(d)(1)(D) shipping separate category 
(along with $50 of foreign income taxes) and 166.67u (200u--(100u 
x  (200u <divide> 600u))) of available earnings in the section 
904(d)(1)(D) shipping separate category (along with $80 of foreign 
income taxes). Under Sec. 1.902-1(d)(1), the $250 deemed dividend is 
out of FD's separate categories and reduces foreign income taxes as 
follows:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................         166.67u             $25
Passive.................................              0u               0
Shipping................................          83.33u              40
                                         -------------------------------
                                                    250u              65
------------------------------------------------------------------------

    (C) Basis adjustments. Under Sec. 1.367(b)-5(c)(3), USP does not 
increase its basis in FD stock as a result of USP's $250 deemed 
dividend from FD. Under Sec. 1.367(b)-5(c)(4), USP increases its 
basis in the FD and FC stock by the amount of its basis decrease or 
deemed dividend inclusion with respect to the other corporation, but 
only to the extent such basis increase does not diminish USP's 
postdistribution amount with respect to that other corporation and 
only to the extent of the other corporation's fair market value. 
Under these rules, USP increases its basis in the FD stock by the 
full amount by which it decreased its basis in FC ($150 + $50 = 
$200). USP does not increase its basis in the FC stock as a result 
of its deemed dividend from FD because any increase in the FC stock 
basis would diminish USP's postdistribution amount with respect to 
such stock.
    (D) FD's earnings and profits after the foreign divisive 
transaction. Because the entire $250 reduction in FD's pre-
transaction earnings was subject to inclusion under Sec. 1.367(b)-5 
(as described in this Example 2 (ii)(B)), paragraph (b)(2) of this 
section does not apply. FD has the following earnings and profits 
and foreign income taxes accounts immediately after the foreign 
divisive transaction (see Sec. 1.960-1(i)(4)):

[[Page 69179]]



------------------------------------------------------------------------
           Separate category                   E&P         Foreign taxes
------------------------------------------------------------------------
General................................         233.33u              $25
Passive................................           (100u)               6
Shipping...............................         116.67u               40
                                        --------------------------------
                                                   250u               71
------------------------------------------------------------------------

    (E) Calculation of FC's earnings and profits. Under paragraph 
(b)(1)(ii)(B) of this section, FC's earnings and profits are not 
increased (or replaced) as a result of the foreign divisive 
transaction. FC's earnings and profits also are not reduced because 
USP was not required to include a deemed dividend out of FC under 
Sec. 1.367(b)-5.
    Example 3--(i) Facts.--(A) USP, a domestic corporation, has 
owned all of the stock of FD since FD's incorporation in 1995. USP's 
adjusted basis in the FD stock is $100 and the FD stock has a fair 
market value of $2,000. FC is a preexisting controlled corporation 
and FD has always owned all of the FC stock. FD owns assets with 
total net bases of 320u (including 100u attributable to the FC stock 
and 160u attributable to the Business B shipping assets). FD and FC 
have the following earnings and profits and foreign income taxes 
accounts:

------------------------------------------------------------------------
                   FD                           E&P        Foreign taxes
------------------------------------------------------------------------
Separate Category:
    General.............................            300u             $50
    10/50 dividends from FC1, a                     100u               6
     noncontrolled section 902
     corporation........................
    Shipping............................            200u              80
                                         -------------------------------
                                                    600u             136
------------------------------------------------------------------------


------------------------------------------------------------------------
                   FC                          E&P         Foreign taxes
------------------------------------------------------------------------
Separate Category:
    General............................            100u              $10
    Passive............................            (50u)               6
Shipping...............................            100u               40
                                        --------------------------------
      .................................            150u               56
------------------------------------------------------------------------

    (B) On January 1, 2002, FD transfers to FC the Business B 
shipping assets. FD then distributes the FC stock to USP. The 
transaction meets the requirements of sections 368(a)(1)(D) and 355. 
Immediately after the foreign divisive transaction, the FD stock and 
the FC stock each have a $1,000 fair market value.
    (ii) Result--(A) Calculation of FD's earnings and profits. Under 
paragraph (b)(4)(i) of this section, FD's pre-transaction earnings 
are reduced by the sum of the amounts described in paragraphs 
(b)(4)(i)(A) and (B) of this section. Under paragraph (b)(4)(i)(A) 
of this section, FD's pre-transaction earnings are reduced by an 
amount equal to FD's pre-transaction earnings times the net bases of 
the Business B shipping assets transferred to FC divided by the 
total net bases in the assets held by FD immediately before the 
foreign divisive transaction (600u  x  (160u <divide> 320u) = 300u). 
Under paragraph (b)(4)(i)(B) of this section, FD's pre-transaction 
earnings are reduced by an amount equal to FD's pre-transaction 
earnings times FD's net bases in the stock of FC divided by the 
total net bases of the assets held by FD immediately before the 
foreign divisive transaction (600u  x  (100u <divide> 320u) = 
187.50u). The sum of the amounts described in paragraphs 
(b)(4)(i)(A) and (B) of this section is 487.50u.
    (B) Application of Sec. 1.367(b)-5(c). The basis adjustment and 
income inclusion rules of Sec. 1.367(b)-5(c)(2) apply if USP's 
postdistribution amount with respect to FD or FC stock is less than 
its predistribution amount with respect to such stock. Under 
Sec. 1.367(b) -5(e)(1) and (3), USP's predistribution amount with 
respect to FD or FC stock is USP's section 1248 amount attributable 
to such stock computed immediately before the distribution, after 
the allocation of FD's pre-transaction earnings described in 
paragraphs (b)(4)(i)(A) and (ii)(A) of this section, but before the 
reduction in FD's pre-transaction earnings described in paragraph 
(b)(4)(i)(B) of this section. Thus, USP's predistribution amounts 
with respect to FD and FC stock are $300 (600u-300u) and $450 (150u 
+ 300u), respectively. See also section 989(b)(2). Under section 
358, USP allocates its $100 basis in FD stock between FD stock and 
FC stock according to the stock blocks' relative values, yielding a 
$50 ($100  x  ($1,000 <divide> $2,000)) basis in each block. Under 
Sec. 1.367(b)-5(e)(2), USP's postdistribution amount with respect to 
FD or FC stock is USP's section 1248 amount with respect to such 
stock, computed immediately after the distribution. Accordingly, 
USP's postdistribution amount with respect to FD stock is $112.50 
(600u-300u--187.50u), and its postdistribution amount with respect 
to FC stock is $450 (150u + 300u). Because USP's postdistribution 
amount with respect to FC stock is not less than its predistribution 
amount with respect to such stock, the Sec. 1.367(b)-5(c)(2) basis 
adjustment and income inclusion rules do not apply with respect to 
the FC stock. Because USP's postdistribution amount with respect to 
FD stock is $187.50 less than its predistribution amount with 
respect to such stock ($300-$112.50), Sec. 1.367(b)-5(c)(2)(i) and 
(ii) require USP to reduce its basis in FD stock, but only to the 
extent such reduction increases USP's section 1248 amount with 
respect to the FD stock. Because a reduction in USP's basis in the 
FD stock would not increase any of USP's section 1248 amount with 
respect to such stock, USP includes the entire $187.50 difference 
between its predistribution and postdistribution amounts with 
respect to the FD stock as a deemed dividend from FD. Because the 
requirements of section 902 are met, USP qualifies for a deemed paid 
foreign tax credit with respect to the deemed dividend that it 
receives from FD. Under Sec. 1.902-1(d)(1), the $187.50 deemed 
dividend is out of FD's separate categories and reduces foreign 
income taxes as follows:

[[Page 69180]]



------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................          93.75u           15.63
10/50 dividends from FC1................          31.25u            1.88
Shipping................................          62.50u              25
                                         -------------------------------
                                                 187.50u           42.51
------------------------------------------------------------------------

    (C) Basis adjustment. Under Sec. 1.367(b)-5(c)(3), the basis 
increase provided in Sec. 1.367(b)-2(e)(3)(ii) does not apply with 
respect to USP's $187.50 deemed dividend from FD. Under 
Sec. 1.367(b)-5(c)(4), USP increases its basis in the FC stock by 
the amount of its deemed dividend inclusion from FD, but only to the 
extent such basis increase does not diminish USP's postdistribution 
amount with respect to FC stock and only up to the fair market value 
of the FC stock. Under these rules, USP increases its basis in the 
FC stock by the full amount of its deemed dividend from FD ($50 + 
$187.50 = $237.50).
    (D) Reduction in FD's statutory groupings of earnings and 
profits. Under paragraph (b)(2) of this section, the reduction in 
FD's pre-transaction earnings that is not attributable to USP's 
inclusion under Sec. 1.367(b)-5 decreases FD's statutory groupings 
of earnings and profits on a pro rata basis. Under paragraph (e)(3) 
of this section, FD's pre-transaction taxes are also ratably 
reduced. As described in this Example 3 (ii)(A), the reduction in 
FD's pre-transaction earnings is 487.50u. As described in this 
Example 3 (ii)(B), 187.50u of the 487.50u reduction is attributable 
to a deemed dividend inclusion by USP under Sec. 1.367(b)-5. Thus, 
under paragraphs (b)(2) and (e)(3) of this section, the remaining 
300u reduction in FD's pre-transaction earnings and related pre-
transaction taxes is out of FD's separate categories and reduces 
foreign income taxes as follows:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................            150u             $25
10/50 dividends from FC1................             50u               3
Shipping................................            100u              40
                                         -------------------------------
                                                    300u              68
------------------------------------------------------------------------

    (E) Calculation of FC's earnings and profits. Under paragraph 
(b)(4)(ii) of this section, FC's earnings and profits immediately 
after the foreign divisive transaction equal the sum of FC's 
earnings and profits immediately before the foreign divisive 
transaction, plus the amount of the reduction in FD's earnings and 
profits described in paragraph (b)(4)(i)(A) of this section, except 
to the extent such amount was included in income as a deemed 
dividend pursuant to the foreign divisive transaction. The reduction 
in FD's earnings and profits described in paragraph (b)(4)(i)(A) of 
this section is 300u, none of which was included in income by USP as 
a deemed dividend pursuant to the foreign divisive transaction. 
Under paragraphs (e)(2) and (3) of this section, the 300u of pre-
transaction earnings and related pre-transaction taxes carry over to 
FC and combine with FC's earnings and profits and foreign income 
taxes accounts in accordance with the rules described in 
Sec. 1.367(b)-7. Under Sec. 1.367(b)-7(d), FC has the following 
earnings and profits and foreign income taxes accounts immediately 
after the foreign divisive transactions

[[Page 69181]]



----------------------------------------------------------------------------------------------------------------
                                                                                                       Taxes
                                                                     Hovering                      associated w/
                Separate category                       E&P           deficit          Taxes         hovering
                                                                                                      deficit
----------------------------------------------------------------------------------------------------------------
General.........................................            250u  ..............             $35  ..............
10/50 dividends from FC1........................             50u  ..............               3  ..............
Passive.........................................  ..............           (50u)  ..............              $6
Shipping........................................            200u  ..............             $80  ..............
                                                 ---------------------------------------------------------------
                                                            500u           (50u)             118               6
----------------------------------------------------------------------------------------------------------------

    (F) FD's earnings and profits after the foreign divisive 
transaction. Following the reductions described in this Example 3 
(ii)(B) and (D), FD has the following earnings and profits and 
foreign income taxes accounts:

------------------------------------------------------------------------
            Separate category                   E&P        Foreign taxes
------------------------------------------------------------------------
General.................................          56.25u           $9.37
10/50 dividends from FC1................          18.75u            1.12
Shipping................................          37.50u              15
                                         -------------------------------
                                                 112.50u           25.49
------------------------------------------------------------------------

    (f) Effective date. This section shall apply to section 367(b) 
exchanges that occur on or after the date 30 days after these 
regulations are published as final regulations in the Federal Register.
    Par. 11. Section 1.367(b)-9 is added to read as follows:


Sec. 1.367(b)-9  Special rule for F reorganizations and similar 
transactions.

    (a) Scope. This section applies to any foreign 381 transaction (as 
described in Sec. 1.367(b)-7(a)) described in section 368(a)(1)(F) or 
in which either the foreign target corporation or the foreign acquiring 
corporation is newly created. This section also applies to any foreign 
divisive transaction (as described in Sec. 1.367(b)-8(a)) that is 
described in Sec. 1.367(b)-8(e)(1) and that involves a newly created 
foreign distributing or foreign controlled corporation.
    (b) Hovering deficit rules inapplicable. If a transaction is 
described in paragraph (a) of this section, a foreign surviving 
corporation or a newly created controlled corporation shall succeed to 
earnings and profits, deficits in earnings and profits, and foreign 
income taxes without regard to the hovering deficit rules of 
Sec. 1.367(b)-7(d)(2), (e)(1)(iii), (e)(2)(iii), (f)(1)(iii), and 
(f)(2)(iii). In the case of a foreign divisive transaction, nothing in 
this section shall affect the application of Sec. 1.367(b)-8(b)(iii).
    (c) Example. The following example illustrates the rules of this 
section:

    Example--(i) Facts. (A) Foreign corporation A is and always has 
been a wholly owned subsidiary of USP, a domestic corporation. 
Foreign corporation A was incorporated in 1990, and always has been 
a controlled foreign corporation using a calendar taxable year. 
Foreign corporation A (and all of its respective qualified business 
units as defined in section 989) maintains a ``u'' functional 
currency, and 1u = US$1 at all times. On December 31, 2001, foreign 
corporation A has the following earnings and profits and foreign 
income taxes accounts:

[[Page 69182]]



------------------------------------------------------------------------
           Separate category                   E&P         Foreign taxes
------------------------------------------------------------------------
Passive................................         (1,000u)              $5
General................................            200u              200
                                        --------------------------------
                                                  (800u)             205
------------------------------------------------------------------------

    (B) On January 1, 2002, foreign corporation A moves its place of 
incorporation from Country 1 to Country 2 in a reorganization 
described in section 368(a)(1)(F).
    (ii) Result. Under Sec. 1.367(b)-7(d), as modified by paragraph 
(b) of this section, foreign surviving corporation has the following 
earnings and profits and foreign income taxes accounts immediately 
after the foreign 381 transaction:

------------------------------------------------------------------------
           Separate category                   E&P         Foreign taxes
------------------------------------------------------------------------
Passive................................         (1,000u)             $ 5
General................................            200u              200
                                        --------------------------------
                                                  (800u)             205
------------------------------------------------------------------------

    (d) Effective date. This section shall apply to section 367(b) 
exchanges that occur on or after the date 30 days after these 
regulations are published as final regulations in the Federal Register.
    Par. 12. In Sec. 1.367(e)-1, paragraph (a) is amended by adding a 
sentence at the end of the paragraph to read as follows:


Sec. 1.367(e)-1  Distributions described in section 367(e)(1).

    (a) * * * See Sec. 1.367(b)-8(c)(3) for an example illustrating the 
interaction of Sec. 1.367(e)-1 with other sections of the Internal 
Revenue Code (such as sections 367(b) and 1248).
* * * * *
    Par. 13. In Sec. 1.381(a)-1, paragraph (c) is revised to read as 
follows:


Sec. 1.381(a)-1  General rule relating to carryovers in certain 
corporate acquisitions.

* * * * *
    (c) Foreign corporations. For additional rules involving foreign 
corporations see Secs. 1.367(b)-7 and 1.367(b)-9.
* * * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 00-28950 Filed 11-8-00; 8:45 am]
BILLING CODE 4830-01-U