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[Federal Register Volume 81, Number 23 (Thursday, February 4, 2016)]
[Rules and Regulations]
[Pages 5908-5916]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-01949]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9748]
RIN 1545-BM57

Allocation of Creditable Foreign Taxes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains temporary regulations that provide 
guidance relating to the allocation by a partnership of creditable 
foreign tax expenditures. These temporary regulations are necessary to 
improve the operation of an existing safe harbor rule that is used for 
determining whether allocations of creditable foreign tax expenditures 
are deemed to be in accordance with the partners' interests in the 
partnership. The text of these temporary regulations also serves as the 
text of the proposed regulations set forth in the notice of proposed 
rulemaking (REG-100861-15) published in the Proposed Rules section in 
this issue of the Federal Register. These regulations affect 
partnerships that pay or accrue foreign income taxes, and their 
partners.

DATES: Effective Date: These regulations are effective on February 4, 
2016.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.704-1T(b)(1)(ii)(b)(1) and (b)(1)(ii)(b)(3)(B).

FOR FURTHER INFORMATION CONTACT: Suzanne M. Walsh, (202) 317-4908 (not 
a toll-free call).

SUPPLEMENTARY INFORMATION: 

Background and Explanation of Provisions

    Allocations of creditable foreign tax expenditures (``CFTEs'') do 
not have substantial economic effect, and accordingly a CFTE must be 
allocated in accordance with the partners' interests in the 
partnership. See Sec.  1.704-1(b)(4)(viii). Section 1.704-1(b)(4)(viii) 
provides a safe harbor under which CFTE allocations are deemed to be in 
accordance with the partners' interests in the partnership. In general, 
the purpose of the safe harbor is to match allocations of CFTEs with 
the income to which the CFTEs relate.
    In order to apply the safe harbor, a partnership must (1) determine 
the partnership's ``CFTE categories,'' (2) determine the partnership's 
net income in each CFTE category, and (3) allocate the partnership's 
CFTEs to each category. Section 1.704-1(b)(4)(viii)(c)(2) requires a 
partnership to assign its income to activities and provides for the 
grouping of a partnership's activities into one or more CFTE categories 
based generally on whether net income from the activities is allocated 
to partners in the same sharing ratios. Section 1.704-
1(b)(4)(viii)(c)(3) provides rules for determining the partnership's 
net income (for U.S. federal income tax purposes) in a CFTE category, 
including rules for allocating and apportioning expenses, losses, and 
other deductions to gross income. Section 1.704-1(b)(4)(viii)(d) 
assigns CFTEs to the CFTE category that includes the related income 
under the principles of Sec.  1.904-6, with certain modifications. In 
order to satisfy the safe harbor, partnership allocations of CFTEs in a 
CFTE category must be in proportion to the allocations of the 
partnership's net income in the CFTE category.

I. Effect of Section 743(b) Adjustments

    Section 1.704-1(b)(4)(viii)(c)(3)(i) of the current final 
regulations provides that a partnership determines its net income in a 
CFTE category by taking into account all partnership items attributable 
to the relevant activity or group of activities, including items of 
gross income, gain, loss, deduction, and expense, and items allocated 
pursuant to section 704(c). The current final regulations do not state 
whether an adjustment under section 743(b) is taken into account in 
computing the partnership's net income in a CFTE category.
    In the case of a transfer of a partnership interest that results in 
an adjustment under section 743(b) (because the partnership has a 
section 754 election in effect, or because there is a substantial 
built-in loss (as defined in section 743(d)) in the partnership), the 
partnership must adjust the basis of partnership property with respect 
to the transferee partner only (a section 743(b) adjustment). No 
adjustment is made to the common basis of partnership property, and the 
section 743(b) adjustment has no effect on the partnership's 
computation of any item under section 703. Sec.  1.743-1(j)(1).
    The Treasury Department and the IRS believe that a transferee 
partner's section 743(b) adjustment with respect to its interest in a 
partnership should not be taken into account in computing such 
partnership's net income in a CFTE category because the basis 
adjustment is unique to the transferee partner and because the basis 
adjustment ordinarily would not be taken into account by a foreign 
jurisdiction in computing its foreign

[[Page 5909]]

taxable base. As such, taking a transferee partner's section 743(b) 
adjustment into account for purposes of computing the partnership's net 
income in a CFTE category could change the partners' relative shares of 
net income in a CFTE category and their allocable shares of CFTEs under 
the safe harbor solely as a result of the transfer of the partnership 
interest and not as a result of a change to the allocation of any 
partnership items under the partnership agreement. Accordingly, Sec.  
1.704-1T(b)(4)(viii)(c)(3)(i) of these temporary regulations provides 
that, for purposes of computing a partnership's net income in a CFTE 
category, the partnership determines its items without regard to any 
section 743(b) adjustments that its partners may have to the basis of 
property of the partnership.
    A partnership that is a transferee partner may have a section 
743(b) adjustment in its capacity as a direct or indirect partner in a 
lower-tier partnership. Under Sec.  1.704-1T(b)(4)(viii)(c)(3)(i), such 
section 743(b) adjustment of the partnership is taken into account in 
determining the partnership's net income in a CFTE category. 
Nevertheless, in the case of a section 743(b) adjustment of a 
partnership that is a transferee partner, it may be appropriate to 
alter the way in which the section 743(b) adjustment is taken into 
account in determining the partnership's net income in a CFTE category 
when the section 743(b) adjustment gives rise to basis differences 
subject to section 901(m). The Treasury Department and the IRS intend 
to address section 901(m) in a separate guidance project.
    No inference is intended from Sec.  1.704-1T(b)(4)(viii)(c)(3)(i) 
as to how a section 743(b) adjustment is taken into account for other 
federal income tax purposes. The Treasury Department and the IRS 
request comments regarding whether final regulations should provide 
further guidance on how to compute a partnership's net income in a CFTE 
category, including how other types of items or adjustments to 
distributive shares that are specific to a partner should be taken into 
account in computing a partnership's net income in a CFTE category (for 
example, where property is contributed with a built-in loss and the 
built-in loss is taken into account only in determining the amount of 
items allocated to the contributing partner under section 
704(c)(1)(C)). The Treasury Department and the IRS also request 
comments on whether, and the extent to which, the application of the 
safe harbor should differ with respect to CFTEs that are determined by 
taking into account partner-specific adjustments that are similar to 
those that apply for U.S. tax purposes in computing the foreign taxable 
base of a partnership.

II. Special Rules for Deductible Allocations and Nondeductible 
Guaranteed Payments

    For purposes of the safe harbor, Sec.  1.704-
1(b)(4)(viii)(c)(3)(ii) provides, among other rules, a special rule 
that reduces the partnership's net income in a CFTE category to the 
extent foreign law allows a deduction for an allocation (or payment of 
an allocated amount) to a partner, for example, because foreign law 
characterizes a preferential allocation of gross income as deductible 
interest expense. The basis for this rule is that a CFTE category 
should not include income of the partnership that has not been included 
in a foreign taxable base due to the fact that an allocation (or 
payment of an allocated amount) to a partner of that income results in 
a foreign law deduction. Because the income out of which the allocation 
is made was not included in the taxable base of the foreign 
jurisdiction that allowed the deduction, no CFTEs are imposed on that 
income; therefore, the allocation of that income should not be taken 
into account in testing whether allocations of CFTEs of that 
jurisdiction match related income allocations for purposes of the safe 
harbor.
    Deductible guaranteed payments under section 707(c) reduce the 
partnership's net income in a CFTE category. Therefore, in the case of 
a guaranteed payment that results in a deduction under both U.S. and 
foreign law, no special rule reducing the partnership's net income in a 
CFTE category is necessary. However, to the extent that foreign law 
does not allow a deduction for a guaranteed payment that is deductible 
under U.S. law, Sec.  1.704-1(b)(4)(viii)(c)(3)(ii) provides another 
special rule that requires an upward adjustment to the partnership's 
net income in a CFTE category (this rule, together with the special 
rule described in the preceding paragraph, are referred to in this 
preamble as the ``special rules''). Adding the amount of a guaranteed 
payment that is not deductible under foreign law to the partnership's 
net income in a CFTE category results in CFTEs attributable to tax 
imposed on the income out of which the guaranteed payment is made 
following the payment for purposes of the safe harbor. An additional 
rule in Sec.  1.704-1(b)(4)(viii)(c)(4) treats the guaranteed payment 
as a distributive share of the partnership's net income in a CFTE 
category to the extent of the upward adjustment. Together, these rules 
for guaranteed payments provide a more appropriate matching under the 
safe harbor of CFTEs and the income to which they relate.
    However, the current final regulations do not expressly address 
situations in which an allocation or distribution of an allocated 
amount or guaranteed payment gives rise to a deduction for purposes of 
one foreign tax, but is made out of income subject to another tax 
imposed by the same or a different foreign jurisdiction. For example, a 
partnership may make a preferential allocation of gross income that is 
deductible in the foreign jurisdiction in which the partnership is a 
resident (foreign jurisdiction X) but that is made out of income earned 
by a disregarded entity or branch owned by the partnership that is 
subject to net basis tax in the jurisdiction in which the disregarded 
entity or branch is located (foreign jurisdiction Y). In this case, the 
Treasury Department and the IRS are aware that some taxpayers have 
suggested that Sec.  1.704-1(b)(4)(viii)(c)(3)(ii) may be interpreted 
to provide that the income related to the preferential allocation 
should not be included in a CFTE category because it is not included in 
the foreign jurisdiction X base, even though there are foreign 
jurisdiction Y CFTEs that clearly relate to the income out of which the 
preferential allocation is made. This interpretation is inconsistent 
with the purpose of the special rules to apply the safe harbor in a 
manner that matches income with the related CFTEs.
    The special rules were not intended to permit taxpayers to adjust 
or fail to adjust income in a CFTE category in a manner that distorts a 
partner's share of the income to which the CFTEs assigned to that 
category relate. Therefore, these temporary regulations revise the 
special rules to address situations in which allocations (or 
distributions of allocated amounts) and guaranteed payments that give 
rise to foreign law deductions are made out of income with related 
CFTEs. Specifically, Sec.  1.704-1T(b)(4)(viii)(c)(4)(ii) provides that 
a partnership's net income in a CFTE category from which a guaranteed 
payment that is not deductible in a foreign jurisdiction is made shall 
be increased by the amount of the guaranteed payment that is deductible 
for U.S. federal income tax purposes, and such amount shall be treated 
as an allocation to the recipient of the guaranteed payment for 
purposes of determining the partners' shares of income in the CFTE 
category, but only for purposes of testing allocations of CFTEs 
attributable to a foreign tax that

[[Page 5910]]

does not allow a deduction for the guaranteed payment. However, for 
purposes of testing allocations of CFTEs attributable to a foreign tax 
that does allow a deduction for the guaranteed payment, a partnership's 
net income in a CFTE category is increased only to the extent that the 
amount of the guaranteed payment that is deductible for U.S. federal 
income tax purposes exceeds the amount allowed as a deduction for 
purposes of that foreign tax, and such excess is treated as an 
allocation to the recipient of the guaranteed payment for purposes of 
determining the partners' shares of income in the CFTE category.
    Similarly, Sec.  1.704-1T(b)(4)(viii)(c)(4)(iii) provides that, to 
the extent that a foreign tax allows a deduction from its taxable base 
for an allocation (or distribution of an allocated amount) to a 
partner, then solely for purposes of testing allocations of CFTEs 
attributable to that foreign tax, the partnership's net income in the 
CFTE category from which the allocation is made is reduced by the 
amount of the foreign law deduction, and that amount is not treated as 
an allocation for purposes of determining the partners' shares of 
income in the CFTE category. For purposes of testing allocations of 
CFTEs attributable to a foreign tax that does not allow a deduction for 
an allocation (or distribution of an allocated amount) to a partner, 
the partnership's net income in a CFTE category is not reduced.
    Finally, the current final regulations provide that the adjustment 
to income attributable to an activity for a preferential allocation 
depends on whether the allocation of the item of income (or payment 
thereof) ``results'' in a deduction under foreign law. This rule was 
intended to apply even if the foreign law deduction occurred in a 
different taxable year (for example, because the foreign jurisdiction 
allowed a deduction only upon a subsequent payment of accrued 
interest). These temporary regulations at Sec.  1.704-
1T(b)(4)(viii)(c)(4)(ii) and (iii) clarify that a guaranteed payment or 
preferential allocation is considered deductible under foreign law for 
purposes of the special rules if the foreign jurisdiction allows a 
deduction from its taxable base either in the current year or in a 
different taxable year.

III. Inter-Branch Payments

    For taxable years beginning before January 1, 2012, the special 
rules under Sec.  1.704-1(b)(4)(viii)(c)(3)(ii) included a cross-
reference confirming that certain inter-branch payments that were 
described in Sec.  1.704-1(b)(4)(viii)(d)(3) (the ``inter-branch 
payment rule'') were not subject to the special rules. On February 14, 
2012, temporary regulations (TD 9577) were published in the Federal 
Register (77 FR 8127) addressing situations in which foreign income 
taxes have been separated from the related income. As part of those 
regulations, the inter-branch payment rule was removed because it 
allowed taxpayers to separate foreign income taxes and related income. 
In conjunction with the removal of the inter-branch payment rule, the 
cross-reference to the eliminated rule was removed from Sec.  1.704-
1(b)(4)(viii)(c)(3)(ii).
    The Treasury Department and the IRS have become aware that some 
taxpayers claim that the inclusion and subsequent removal of the cross-
reference created uncertainty regarding the application of the special 
rules under Sec.  1.704-1(b)(4)(viii)(c)(3)(ii) to disregarded payments 
among branches of a partnership. As explained above, the purpose of the 
special rules is to match preferential allocations and guaranteed 
payments to partners with CFTEs that relate to the income out of which 
the allocation or guaranteed payment is made, and also to ensure proper 
testing of CFTE allocations when no CFTEs relate to such income. The 
special rules accomplish this matching by treating preferential 
allocations and guaranteed payments as distributive shares of income, 
but only for purposes of allocating CFTEs attributable to taxes imposed 
by a foreign jurisdiction that does not allow deductions for such 
allocations and payments. Because an inter-branch payment is not made 
to a partner, it can never be treated as a distributive share, and is 
outside the scope of the special rules. By its terms, current Sec.  
1.704-1(b)(4)(viii)(c)(3)(ii) applies only to partnership allocations 
that are deductible under foreign law, guaranteed payments that are not 
deductible under foreign law, and (not discussed herein) income that is 
excluded from a foreign tax base as a result of the status of a 
partner. The inclusion and subsequent removal of the cross-reference 
did not change the purpose of current Sec.  1.704-
1(b)(4)(viii)(c)(3)(ii) or expand its scope to provide for reductions 
in income in a CFTE category if a partnership makes a disregarded 
payment that is deductible under foreign law. These regulations under 
Sec.  1.704-1T(b)(4)(viii)(c)(4)(iii) clarify that the special rule for 
preferential allocations applies only to allocations (or distributions 
of allocated amounts) to a partner that are deductible under foreign 
law, and not to other items that give rise to deductions under foreign 
law. For example, the special rule does not apply to reduce income in a 
CFTE category by reason of a disregarded inter-branch payment, even if 
the income out of which the inter-branch payment is made is not subject 
to tax in any foreign jurisdiction.
    In addition, the Treasury Department and the IRS are aware of 
transactions involving serial disregarded payments in which taxpayers 
take the position that withholding taxes assessed on the first payment 
in a series of back-to-back disregarded payments do not need to be 
apportioned among the CFTE categories that include the income out of 
which the payment is made. These regulations include new examples 
clarifying that under Sec.  1.704-1(b)(4)(viii)(d)(1) withholding taxes 
must be apportioned among the CFTE categories that include the related 
income. See Sec.  1.704-1T(b)(5) Example 36 and Example 37.

IV. Other Non-Substantive Clarifications

    These regulations make certain organizational and other non-
substantive changes that clarify how items of income under U.S. federal 
income tax law are assigned to an activity and how a partnership's net 
income in a CFTE category is determined.
    For the avoidance of doubt, Sec.  1.704-1(b)(4)(viii)(c)(2)(iii) is 
revised to more clearly describe when income from a divisible part of a 
single activity must be treated as income from a separate activity. 
Section 1.704-1(b)(4)(viii)(c)(2)(iii) provides that whether a 
partnership has one or more activities, and the scope of each activity, 
is determined in a reasonable manner taking into account all the facts 
and circumstances, with the principal consideration being whether the 
proposed determination has the effect of separating CFTEs from the 
related foreign income. The rule also provides that income from a 
divisible part of a single activity is treated as income from a 
separate activity if necessary to prevent separating CFTEs from the 
related foreign income. Example 24(iii) of Sec.  1.704-1(b)(5) 
illustrates that if a partnership agreement makes a special allocation 
of income earned by a disregarded entity (DE1) in order to reflect a 
disregarded inter-branch payment paid by DE1 to a second disregarded 
entity, then the payment is treated as a divisible part of an activity 
and treated as a separate activity. These regulations confirm this 
result by adding language in Sec.  1.704-1T(b)(4)(viii)(c)(2)(iii) 
clarifying that income from a divisible part of a single

[[Page 5911]]

activity is treated as income from a separate activity whenever the 
income is subject to different allocations.
    These regulations also confirm in Sec.  1.704-
1T(b)(4)(viii)(c)(2)(iii) that a guaranteed payment or preferential 
allocation of income that is determined by reference to all the income 
from a single activity generally will not result in dividing a single 
activity into separate activities. This clarification is consistent 
with the rule in Sec.  1.704-1(b)(4)(viii)(c)(2)(ii), which generally 
provides that a guaranteed payment, gross income allocation, or other 
preferential allocation that is determined by reference to income from 
all of the partnership's activities does not result in different 
allocations of income from separate activities. For an illustration of 
the application of Sec.  1.704-1(b)(4)(viii)(c)(2)(iii) prior to this 
clarification, see Sec.  1.704-1(b)(5) Example 22 and Example 25, the 
latter of which has also been updated as part of these temporary 
regulations.
    In order to more clearly explain how the rules for determining a 
partnership's net income in a CFTE category operate and to assist 
taxpayers in applying these rules, these temporary regulations 
reorganize Sec.  1.704-1(b)(4)(viii)(c)(3) and provide an introductory 
paragraph at Sec.  1.704-1T(b)(4)(viii)(c)(3)(i) that describes the 
steps for computing a partnership's net income in a CFTE category.
    The current final regulations provide that only items of gross 
income recognized by a branch for U.S. income tax purposes are taken 
into account to determine net income attributable to any activity of a 
branch. Example 24 in Sec.  1.704-1(b)(5) further illustrates that a 
disregarded inter-branch payment does not move income from one activity 
to another. These temporary regulations confirm at Sec.  1.704-
1T(b)(4)(viii)(c)(3)(iv) that disregarded payments are never taken into 
account in determining the amount of net income attributable to an 
activity (although, as noted above, a special allocation of income used 
to make a disregarded payment may result in that income being treated 
as a divisible part of the activity giving rise to the income), and 
that therefore an item of gross income is assigned to the activity that 
generates the item of income that is recognized for U.S. federal income 
tax purposes.
    In addition, the current final regulations use the term 
``distributive share of income,'' which has a general meaning under 
subchapter K but is used for a different purpose under Sec.  1.704-
1(b)(4)(viii)(c)(4). To avoid confusion, these temporary regulations at 
Sec.  1.704-1T(b)(4)(viii)(c)(4)(i) revise the term ``distributive 
share of income'' to ``CFTE category share of income.'' No difference 
in meaning or purpose is intended by the change in terminology. The 
Treasury Department and the IRS will update Examples 20, 21, 22, 23, 
24, 26, and 27 in Sec.  1.704-1(b)(5) (which are not revised under 
these temporary regulations) to reflect the new terminology when these 
temporary regulations are finalized. In the interim, any reference to 
``distributive share of income'' under the current final regulations 
should be treated as a reference to a ``CFTE category share of income'' 
as defined in Sec.  1.704-1T(b)(4)(viii)(c)(4)(i).

V. Effective Date

    These temporary regulations apply for partnership taxable years 
that both begin on or after January 1, 2016, and end after February 4, 
2016. The temporary regulations also modify an existing transition rule 
with respect to certain inter-branch payments for partnerships whose 
agreements were entered into prior to February 14, 2012. The current 
transition rule provides that if there has been no material 
modification to their partnership agreements on or after February 14, 
2012, then, for tax years beginning on or after January 1, 2012, these 
partnerships may apply the provisions of Sec. Sec.  1.704-
1(b)(4)(viii)(c)(3)(ii) and 1.704-1(b)(4)(viii)(d)(3) (revised as of 
April 1, 2011). That transition rule is modified to provide that for 
tax years that both begin on or after January 1, 2016, and end after 
February 4, 2016, these partnerships may continue to apply the 
provisions of Sec.  1.704-1(b)(4)(viii)(d)(3) (revised as of April 1, 
2011) but must apply the provisions of Sec.  1.704-
1T(b)(4)(viii)(c)(3)(ii). See Sec.  1.704-1T(b)(1)(ii)(b)(3)(B). For 
purposes of this transition rule, any change in ownership constitutes a 
material modification to the partnership agreement. This transition 
rule does not apply to any taxable year (and all subsequent taxable 
years) in which persons bearing a relationship to each other that is 
specified in section 267(b) or section 707(b) collectively have the 
power to amend the partnership agreement without the consent of any 
unrelated party.
    No inference is intended as to the application of the provisions 
amended by these temporary regulations under current law. The IRS may, 
where appropriate, challenge transactions, including those described in 
these temporary regulations and this preamble, under currently 
applicable Code or regulatory provisions or judicial doctrines.

Special Analyses

    Certain IRS regulations, including this one, are exempt from the 
requirements of Executive Order 12866, as supplemented and reaffirmed 
by Executive Order 13563. Therefore, a regulatory impact 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 regulations do not impose a 
collection of information on small entities, the Regulatory Flexibility 
Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of 
the Code, these regulations have been submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

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

0
Par. 2. Section 1.704-1 is amended as follows:
0
1. In Paragraph (b)(0):
0
i. Add an entry for Sec.  1.704-1(b)(1)(ii)(b)(1).
0
ii. Revise the entries for Sec.  1.704-1(b)(4)(viii)(c)(1) through (4) 
and (b)(4)(viii)(d)(1).

0
2. Revise paragraphs (b)(1)(ii)(b)(1), (b)(1)(ii)(b)(3)(B), 
(b)(4)(viii)(a)(1), (b)(4)(viii)(c)(1), (b)(4)(viii)(c)(2)(ii) and 
(iii), (b)(4)(viii)(c)(3) and (4), (b)(4)(viii)(d)(1), and Example 25 
of paragraph (b)(5).

0
3. Add Examples 36 and 37 to paragraph (b)(5).
    The revisions and additions read as follows:

Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) Determination of partner's distributive share-(0) Cross-
references.

[[Page 5912]]

------------------------------------------------------------------------
                  Heading                              Section
------------------------------------------------------------------------
 
                                * * * * *
[Reserved]................................  1.704-1(b)(1)(ii)(b)(1)
 
                                * * * * *
[Reserved]................................  1.704-1(b)(4)(viii)(c)(1)
[Reserved]................................  1.704-1(b)(4)(viii)(c)(2)
[Reserved]................................  1.704-1(b)(4)(viii)(c)(3)
[Reserved]................................  1.704-1(b)(4)(viii)(c)(4)
 
                                * * * * *
[Reserved]................................   1.704-1(b)(4)(viii)(d)(1)
 
                                * * * * *
------------------------------------------------------------------------

    (1) * * *
    (ii) * * *
    (b) Rules relating to foreign tax expenditures. (1) [Reserved]. For 
further guidance, see Sec.  1.704-1T(b)(1)(ii)(b)(1).
* * * * *
    (3) * * *
    (B) [Reserved]. For further guidance, see Sec.  1.704-
1T(b)(1)(ii)(b)(3)(B).
* * * * *
    (4) * * *
    (viii) * * *
    (a) * * *
    (1) [Reserved]. For further guidance, see Sec.  1.704-
1T(b)(4)(viii)(a)(1).
* * * * *
    (c) Income to which CFTEs relate. (1) [Reserved]. For further 
guidance, see Sec.  1.704-1T(b)(4)(viii)(c)(1).
    (2) * * *
    (ii) and (iii) [Reserved]. For further guidance, see Sec.  1.704-
1T(b)(4)(viii)(c)(2)(ii) and (iii).
    (3) [Reserved]. For further guidance, see Sec.  1.704-
1T(b)(4)(viii)(c)(3).
    (4) [Reserved]. For further guidance, see Sec.  1.704-
1T(b)(4)(viii)(c)(4).
* * * * *
    (d) Allocation and apportionment of CFTEs to CFTE categories. (1) 
[Reserved]. For further guidance, see Sec.  1.704-1T(b)(4)(viii)(d)(1).
* * * * *
    (5) * * *
    Example 25.  [Reserved]. For further guidance, see Sec.  1.704-
1T(b)(5) Example 25.
* * * * *
    Example 36.  [Reserved]. For further guidance, see Sec.  1.704-
1T(b)(5) Example 36.
    Example 37.  [Reserved]. For further guidance, see Sec.  1.704-
1T(b)(5) Example 37.
* * * * *

0
Par. 3. Section 1.704-1T is added to read as follows:

Sec.  1.704-1T  Partner's distributive share (temporary).

    (a) through (b)(1)(ii)(a) [Reserved]. For further guidance, see 
Sec.  1.704-1(a) through (b)(1)(ii)(a).
    (b) Rules relating to foreign tax expenditures--(1) In general. 
Except as otherwise provided in this paragraph (b)(1)(ii)(b)(1), the 
provisions of paragraphs (b)(3)(iv) and (b)(4)(viii) of this section 
(regarding the allocation of creditable foreign taxes) apply for 
partnership taxable years beginning on or after October 19, 2006. The 
rules that apply to allocations of creditable foreign taxes made in 
partnership taxable years beginning before October 19, 2006 are 
contained in Sec.  1.704-1T(b)(1)(ii)(b)(1) and (b)(4)(xi) as in effect 
prior to October 19, 2006 (see 26 CFR part 1 revised as of April 1, 
2005). However, taxpayers may rely on the provisions of paragraphs 
(b)(3)(iv) and (b)(4)(viii) of this section for partnership taxable 
years beginning on or after April 21, 2004. The provisions of 
paragraphs (b)(4)(viii)(a)(1), (b)(4)(viii)(c)(1), 
(b)(4)(viii)(c)(2)(ii) and (iii), (b)(4)(viii)(c)(3) and (4), 
(b)(4)(viii)(d)(1), and Examples 25, 36, and 37 of paragraph (b)(5) of 
this section apply for partnership taxable years that both begin on or 
after January 1, 2016, and end after February 4, 2016. For the rules 
that apply to partnership taxable years beginning on or after October 
19, 2006, and before January 1, 2016, and to taxable years that both 
begin on or after January 1, 2016, and end on or before February 4, 
2016, see Sec.  1.704-1(b)(1)(ii)(b), (b)(4)(viii)(a)(1), 
(b)(4)(viii)(c)(1), (b)(4)(viii)(c)(2)(ii) and (iii), 
(b)(4)(viii)(c)(3) and (4), (b)(4)(viii)(d)(1), and (b)(5), Example 25 
(as contained in 26 CFR part 1 revised as of April 1, 2015).
    (b)(1)(ii)(b)(2) through (b)(1)(ii)(b)(3)(A) [Reserved]. For 
further guidance, see Sec.  1.704-1(b)(1)(ii)(b)(2) through 
(b)(1)(ii)(b)(3)(A).
    (B) Transition rule. Transition relief is provided herein to 
partnerships whose agreements were entered into prior to February 14, 
2012. In such cases, if there has been no material modification to the 
partnership agreement on or after February 14, 2012, then, for taxable 
years beginning on or after January 1, 2012, and before January 1, 
2016, and for taxable years that both begin on or after January 1, 
2012, and end on or before February 4, 2016, these partnerships may 
apply the provisions of Sec.  1.704-1(b)(4)(viii)(c)(3)(ii) (see 26 CFR 
part 1 revised as of April 1, 2011) and Sec.  1.704-1(b)(4)(viii)(d)(3) 
(see 26 CFR part 1 revised as of April 1, 2011). For taxable years that 
both begin on or after January 1, 2016, and end after February 4, 2016, 
these partnerships may apply the provisions of Sec.  1.704-
1(b)(4)(viii)(d)(3) (see 26 CFR part 1 revised as of April 1, 2011). 
For purposes of this paragraph (b)(1)(ii)(b)(3), any change in 
ownership constitutes a material modification to the partnership 
agreement. This transition rule does not apply to any taxable year in 
which persons bearing a relationship to each other that is specified in 
section 267(b) or section 707(b) collectively have the power to amend 
the partnership agreement without the consent of any unrelated party 
(and all subsequent taxable years).
    (b)(1)(iii) through (b)(4)(viii)(a) [Reserved]. For further 
guidance, see Sec.  1.704-1(b)(1)(iii) through (b)(4)(viii)(a).
    (1) The CFTE is allocated (whether or not pursuant to an express 
provision in the partnership agreement) to each partner and reported on 
the partnership return in proportion to the partners' CFTE category 
shares of income to which the CFTE relates; and
    (b)(4)(viii)(a)(2) through (b)(4)(viii)(b) [Reserved]. For further 
guidance, see Sec.  1.704-1(b)(4)(viii)(a)(2) through (b)(4)(viii)(b).
    (c) Income to which CFTEs relate--(1) In general. For purposes of 
paragraph (b)(4)(viii)(a) of this section, CFTEs are related to net 
income in the partnership's CFTE category or categories to which the 
CFTE is allocated and apportioned in accordance with the rules of 
paragraph (b)(4)(viii)(d) of this section. Paragraph (b)(4)(viii)(c)(2) 
of this section provides rules for determining a partnership's CFTE 
categories. Paragraph (b)(4)(viii)(c)(3) of this section provides rules 
for determining the net income in each CFTE category. Paragraph 
(b)(4)(viii)(c)(4) of this section provides rules for determining a 
partner's CFTE category share of income, including rules that require 
adjustments to net income in a CFTE category for purposes of 
determining the partners' CFTE category share of income with respect to 
certain CFTEs. Paragraph (b)(4)(viii)(c)(5) of this section provides a 
special rule for allocating CFTEs when a partnership has no net income 
in a CFTE category.
    (2)(i) [Reserved]. For further guidance, see Sec.  1.704-
1(b)(4)(viii)(c)(2)(i).
    (ii) Different allocations. Different allocations of net income (or 
loss) generally will result from provisions of the partnership 
agreement providing for different sharing ratios for net income (or 
loss) from separate activities. Different allocations of net income (or 
loss) from separate activities generally will also result if any 
partnership item is shared in a different ratio than any other 
partnership item. A guaranteed payment described in paragraph 
(b)(4)(viii)(c)(4)(ii) of this section, gross income allocation, or 
other preferential allocation will result in different allocations of 
net income (or loss) from

[[Page 5913]]

separate activities only if the amount of the payment or the allocation 
is determined by reference to income from less than all of the 
partnership's activities.
    (iii) Activity. Whether a partnership has one or more activities, 
and the scope of each activity, is determined in a reasonable manner 
taking into account all the facts and circumstances. In evaluating 
whether aggregating or disaggregating income from particular business 
or investment operations constitutes a reasonable method of determining 
the scope of an activity, the principal consideration is whether the 
proposed determination has the effect of separating CFTEs from the 
related foreign income. Relevant considerations include whether the 
partnership conducts business in more than one geographic location or 
through more than one entity or branch, and whether certain types of 
income are exempt from foreign tax or subject to preferential foreign 
tax treatment. In addition, income from a divisible part of a single 
activity is treated as income from a separate activity if necessary to 
prevent separating CFTEs from the related foreign income, such as when 
income from divisible parts of a single activity is subject to 
different allocations. A guaranteed payment, gross income allocation, 
or other preferential allocation of income that is determined by 
reference to all the income from a single activity generally will not 
result in the division of an activity into divisible parts. See 
Examples 22 and 25 of paragraph (b)(5) of this section. The 
partnership's activities must be determined consistently from year to 
year absent a material change in facts and circumstances.
    (3) Net income in a CFTE category--(i) In general. A partnership 
computes net income in a CFTE category as follows: First, the 
partnership determines for U.S. federal income tax purposes all of its 
partnership items, including items of gross income, gain, loss, 
deduction, and expense, and items allocated pursuant to section 704(c). 
For this purpose, the items of the partnership are determined without 
regard to any adjustments under section 743(b) that its partners may 
have to the basis of property of the partnership. However, if the 
partnership is a transferee partner that has a basis adjustment under 
section 743(b) in its capacity as a direct or indirect partner in a 
lower-tier partnership, the partnership does take such basis adjustment 
into account. Second, the partnership must assign those partnership 
items to its activities pursuant to paragraph (b)(4)(viii)(c)(3)(ii) of 
this section. Third, partnership items attributable to each activity 
are aggregated within the relevant CFTE category as determined under 
paragraph (b)(4)(viii)(c)(2) of this section in order to compute the 
net income in a CFTE category.
    (ii) Assignment of partnership items to activities. The items of 
gross income attributable to an activity must be determined in a 
consistent manner under any reasonable method taking into account all 
the facts and circumstances. Except as otherwise provided in paragraph 
(b)(4)(viii)(c)(3)(iii) of this section, expenses, losses, or other 
deductions must be allocated and apportioned to gross income 
attributable to an activity in accordance with the rules of Sec. Sec.  
1.861-8 and 1.861-8T. Under these rules, if an expense, loss, or other 
deduction is allocated to gross income from more than one activity, 
such expense, loss, or deduction must be apportioned among each such 
activity using a reasonable method that reflects to a reasonably close 
extent the factual relationship between the deduction and the gross 
income from such activities. See Sec.  1.861-8T(c). For the effect of 
disregarded payments in determining the amount of net income 
attributable to an activity, see paragraph (b)(4)(viii)(c)(3)(iv) of 
this section.
    (iii) Interest expense and research and experimental expenditures. 
The partnership's interest expense and research and experimental 
expenditures described in section 174 may be allocated and apportioned 
under any reasonable method, including but not limited to the methods 
prescribed in Sec. Sec.  1.861-9 through 1.861-13T (interest expense) 
and Sec.  1.861-17 (research and experimental expenditures).
    (iv) Disregarded payments. An item of gross income is assigned to 
the activity that generates the item of income that is recognized for 
U.S. federal income tax purposes. Consequently, disregarded payments 
are not taken into account in determining the amount of net income 
attributable to an activity, although a special allocation of income 
used to make a disregarded payment may result in the subdivision of an 
activity into divisible parts. See paragraph (b)(4)(viii)(c)(2)(iii) of 
this section and Examples 24, 36, and 37 of paragraph (b)(5) of this 
section (relating to inter-branch payments).
    (4) CFTE category share of income--(i) In general. CFTE category 
share of income means the portion of the net income in a CFTE category, 
determined in accordance with paragraph (b)(4)(viii)(c)(3) of this 
section as modified by paragraphs (b)(4)(viii)(c)(4)(ii) through (iv) 
of this section, that is allocated to a partner. To the extent provided 
in paragraph (b)(4)(viii)(c)(4)(ii) of this section, a guaranteed 
payment is treated as an allocation to the recipient of the guaranteed 
payment for this purpose. If more than one partner receives positive 
income allocations (income in excess of expenses) from a CFTE category, 
which in the aggregate exceed the total net income in the CFTE 
category, then such partner's CFTE category share of income equals the 
partner's positive income allocation from the CFTE category, divided by 
the aggregate positive income allocations from the CFTE category, 
multiplied by the net income in the CFTE category. Paragraphs 
(b)(4)(viii)(c)(4)(ii) through (iv) of this section require adjustments 
to the net income in a CFTE category for purposes of determining the 
partners' CFTE category share of income if one or more foreign 
jurisdictions impose a tax that provides for certain exclusions or 
deductions from the foreign taxable base. Such adjustments apply only 
with respect to CFTEs attributable to the taxes that allow such 
exclusions or deductions. Thus, net income in a CFTE category may vary 
for purposes of applying paragraph (b)(4)(viii)(a)(1) of this section 
to different CFTEs within that CFTE category.
    (ii) Guaranteed payments. Except as otherwise provided in this 
paragraph (b)(4)(viii)(c)(4)(ii), solely for purposes of applying the 
safe harbor provisions of paragraph (b)(4)(viii)(a)(1) of this section, 
net income in the CFTE category from which a guaranteed payment (within 
the meaning of section 707(c)) is made is increased by the amount of 
the guaranteed payment that is deductible for U.S. federal income tax 
purposes, and such amount is treated as an allocation to the recipient 
of such guaranteed payment for purposes of determining the partners' 
CFTE category shares of income. If a foreign tax allows (whether in the 
current or in a different taxable year) a deduction from its taxable 
base for a guaranteed payment, then solely for purposes of applying the 
safe harbor provisions of paragraph (b)(4)(viii)(a)(1) of this section 
to allocations of CFTEs that are attributable to that foreign tax, net 
income in the CFTE category is increased only to the extent that the 
amount of the guaranteed payment that is deductible for U.S. federal 
income tax purposes exceeds the amount allowed as a deduction for 
purposes of the foreign tax, and such excess is treated as an 
allocation to the recipient of the guaranteed payment for purposes of

[[Page 5914]]

determining the partners' CFTE category shares of income. See Example 
25 of paragraph (b)(5) of this section.
    (iii) Preferential allocations. To the extent that a foreign tax 
allows (whether in the current or in a different taxable year) a 
deduction from its taxable base for an allocation (or distribution of 
an allocated amount) to a partner, then solely for purposes of applying 
the safe harbor provisions of paragraph (b)(4)(viii)(a)(1) of this 
section to allocations of CFTEs that are attributable to that foreign 
tax, the net income in the CFTE category from which the allocation is 
made is reduced by the amount of the allocation, and that amount is not 
treated as an allocation for purposes of determining the partners' CFTE 
category shares of income. See Example 25 of paragraph (b)(5) of this 
section.
    (iv) Foreign law exclusions due to status of partner. If a foreign 
tax excludes an amount from its taxable base as a result of the status 
of a partner, then solely for purposes of applying the safe harbor 
provisions of paragraph (b)(4)(viii)(a)(1) of this section to 
allocations of CFTEs that are attributable to that foreign tax, the net 
income in the relevant CFTE category is reduced by the excluded amounts 
that are allocable to such partners. See Example 27 of paragraph (b)(5) 
of this section.
    (b)(4)(viii)(c)(5) [Reserved]. For further guidance, see Sec.  
1.704-1(b)(4)(viii)(c)(5).
    (d) Allocation and apportionment of CFTEs to CFTE categories--(1) 
In general. CFTEs are allocated and apportioned to CFTE categories in 
accordance with the principles of Sec.  1.904-6. Under these 
principles, a CFTE is related to income in a CFTE category if the 
income is included in the base upon which the foreign tax is imposed. 
See Examples 36 and 37 of paragraph (b)(5) of this section, which 
illustrate the application of this paragraph in the case of serial 
disregarded payments subject to withholding tax. In accordance with 
Sec.  1.904-6(a)(1)(ii) as modified by this paragraph (b)(4)(viii)(d), 
if the foreign tax base includes income in more than one CFTE category, 
the CFTEs are apportioned among the CFTE categories based on the 
relative amounts of taxable income computed under foreign law in each 
CFTE category. For purposes of this paragraph (b)(4)(viii)(d), 
references in Sec.  1.904-6 to a separate category or separate 
categories mean ``CFTE category'' or ``CFTE categories'' and the rules 
in Sec.  1.904-6(a)(1)(ii) are modified as follows:
    (b)(4)(viii)(d)(1)(i) through (b)(5) Example 24 [Reserved]. For 
further guidance, see Sec.  1.704-1(b)(4)(viii)(d)(1)(i) through (b)(5) 
Example 24.

    Example 25.  (i) A contributes $750,000 and B contributes 
$250,000 to form AB, a country X eligible entity (as defined in 
Sec.  301.7701-3(a) of this chapter) treated as a partnership for 
U.S. federal income tax purposes. AB operates business M in country 
X. Country X imposes a 20 percent tax on the net income from 
business M, which tax is a CFTE. In 2016, AB earns $300,000 of gross 
income, has deductible expenses of $100,000, and pays or accrues 
$40,000 of country X tax. Pursuant to the partnership agreement, the 
first $100,000 of gross income each year is specially allocated to A 
as a preferred return on excess capital contributed by A. All 
remaining partnership items, including CFTEs, are split evenly 
between A and B (50 percent each). The gross income allocation is 
not deductible in determining AB's taxable income under country X 
law. Assume that allocations of all items other than CFTEs are 
valid.
    (ii) AB has a single CFTE category because all of AB's net 
income is allocated in the same ratio. See paragraph 
(b)(4)(viii)(c)(2) of this section. Under paragraph 
(b)(4)(viii)(c)(3) of this section, the net income in the single 
CFTE category is $200,000. The $40,000 of taxes is allocated to the 
single CFTE category and, thus, is related to the $200,000 of net 
income in the single CFTE category. In 2016, AB's partnership 
agreement results in an allocation of $150,000 or 75 percent of the 
net income to A ($100,000 attributable to the gross income 
allocation plus $50,000 of the remaining $100,000 of net income) and 
$50,000 or 25 percent of the net income to B. AB's partnership 
agreement allocates the country X taxes in accordance with the 
partners' shares of partnership items remaining after the $100,000 
gross income allocation. Therefore, AB allocates the country X taxes 
50 percent to A ($20,000) and 50 percent to B ($20,000). AB's 
allocations of country X taxes are not deemed to be in accordance 
with the partners' interests in the partnership under paragraph 
(b)(4)(viii) of this section because they are not in proportion to 
the allocations of the CFTE category shares of income to which the 
country X taxes relate. Accordingly, the country X taxes will be 
reallocated according to the partners' interests in the partnership. 
Assuming that the partners do not reasonably expect to claim a 
deduction for the CFTEs in determining their U.S. federal income tax 
liabilities, a reallocation of the CFTEs under paragraph (b)(3) of 
this section would be 75 percent to A ($30,000) and 25 percent to B 
($10,000). If the reallocation of the CFTEs causes the partners' 
capital accounts not to reflect their contemplated economic 
arrangement, the partners may need to reallocate other partnership 
items to ensure that the tax consequences of the partnership's 
allocations are consistent with their contemplated economic 
arrangement over the term of the partnership.
    (iii) The facts are the same as in paragraph (i) of this Example 
25, except that country X allows a deduction for the $100,000 
allocation of gross income and, as a result, AB pays or accrues only 
$20,000 of foreign tax. Under paragraph (b)(4)(viii)(c)(4)(iii) of 
this section, the net income in the single CFTE category is 
$100,000, determined by reducing the net income in the CFTE category 
by the $100,000 of gross income that is allocated to A and for which 
country X allows a deduction in determining AB's taxable income. 
Pursuant to the partnership agreement, AB allocates the country X 
tax 50 percent to A ($10,000) and 50 percent to B ($10,000). This 
allocation is in proportion to the partners' CFTE category shares of 
the $100,000 net income. Accordingly, AB's allocations of country X 
taxes are deemed to be in accordance with the partners' interests in 
the partnership under paragraph (b)(4)(viii)(a) of this section.
    (iv) The facts are the same as in paragraph (iii) of this 
Example 25, except that, in addition to $20,000 of country X tax, AB 
is subject to $30,000 of country Y withholding tax with respect to 
the $300,000 of gross income that it earns in 2016. Country Y does 
not allow any deductions for purposes of determining the withholding 
tax. As described in paragraph (ii) of this Example 25, there is a 
single CFTE category with respect to AB's net income. Both the 
$20,000 of country X tax and the $30,000 of country Y withholding 
tax relate to that income and are therefore allocated to the single 
CFTE category. Under paragraph (b)(4)(viii)(c)(4)(iii) of this 
section, however, net income in a CFTE category is reduced by the 
amount of an allocation for which a deduction is allowed in 
determining a foreign taxable base, but only for purposes of 
applying paragraph (b)(4)(viii)(a) of this section to allocations of 
CFTEs that are attributable to that foreign tax. Accordingly, 
because the $100,000 allocation of gross income is deductible for 
country X tax purposes but not for country Y tax purposes, the 
allocations of the CFTEs attributable to country X tax and country Y 
tax are analyzed separately. For purposes of applying paragraph 
(b)(4)(viii)(a)(1) of this section to allocations of the CFTEs 
attributable to the $20,000 tax imposed by country X, the analysis 
described in paragraph (iii) of this Example 25 applies. For 
purposes of applying paragraph (b)(4)(viii)(a)(1) of this section to 
allocations of the CFTEs attributable to the $30,000 tax imposed by 
country Y, which did not allow a deduction for the $100,000 gross 
income allocation, the net income in the single CFTE category is 
$200,000. Pursuant to the partnership agreement, AB allocates the 
country Y tax 50 percent to A ($15,000) and 50 percent to B 
($15,000). These allocations are not deemed to be in accordance with 
the partners' interests in the partnership under paragraph 
(b)(4)(viii) of this section because they are not in proportion to 
the partners' CFTE category shares of the $200,000 of net income in 
the category, which is allocated 75 percent to A and 25 percent to B 
under the partnership agreement. Accordingly, the country Y taxes 
will be reallocated according to the partners' interests in the 
partnership as described in paragraph (ii) of this Example 25.
    (v) The amount of net income in the single CFTE category of AB 
for purposes of

[[Page 5915]]

applying paragraph (b)(4)(viii)(a)(1) of this section to allocations 
of CFTEs would be the same as in the fact patterns described in 
paragraphs (ii), (iii) and (iv) if, rather than being a preferential 
gross income allocation, the $100,000 was a guaranteed payment to A 
within the meaning of section 707(c). See paragraph 
(b)(4)(viii)(c)(4)(ii) of this section.

    (b)(5) Examples 26 through 35 [Reserved]. For further guidance, see 
Sec.  1.704-1(b)(5) Examples 26 through 35.

    Example 36. (i) A, B, and C form ABC, an eligible entity (as 
defined in Sec.  301.7701-3(a) of this chapter) treated as a 
partnership for U.S. federal income tax purposes. ABC owns three 
entities, DEX, DEY, and DEZ, which are organized in, and treated as 
corporations under the laws of, countries X, Y, and Z, respectively, 
and as disregarded entities for U.S. federal income tax purposes. 
DEX operates business X in country X, DEY operates business Y in 
country Y, and DEZ operates business Z in country Z. Businesses X, 
Y, and Z relate to the licensing and sublicensing of intellectual 
property owned by DEZ. During 2016, DEX earns $100,000 of royalty 
income from unrelated payors on which it pays no withholding taxes. 
Country X imposes a 30 percent tax on DEX's net income. DEX makes 
royalty payments of $90,000 during 2016 to DEY that are deductible 
by DEX for country X purposes and subject to a 10 percent 
withholding tax imposed by country X. DEY earns no other income in 
2016. Country Y does not impose income or withholding taxes. DEY 
makes royalty payments of $80,000 during 2016 to DEZ. DEZ earns no 
other income in 2016. Country Z does not impose income or 
withholding taxes. The royalty payments from DEX to DEY and from DEY 
to DEZ are disregarded for U.S. federal income tax purposes.
    As a result of these payments, DEX has taxable income of $10,000 
for country X purposes on which $3,000 of taxes are imposed, and DEY 
has $90,000 of income for country X withholding tax purposes on 
which $9,000 of withholding taxes are imposed. Pursuant to the 
partnership agreement, all partnership items from business X, 
excluding CFTEs paid or accrued by business X, are allocated 80 
percent to A and 10 percent each to B and C. All partnership items 
from business Y, excluding CFTEs paid or accrued by business Y, are 
allocated 80 percent to B and 10 percent each to A and C. All 
partnership items from business Z, excluding CFTEs paid or accrued 
by business Z, are allocated 80 percent to C and 10 percent each to 
A and B. Because only business X has items that are regarded for 
U.S. federal income tax purposes (the $100,000 of royalty income), 
only business X has partnership items. Accordingly A is allocated 80 
percent of the income from business X ($80,000) and B and C are each 
allocated 10 percent of the income from business X ($10,000 each). 
There are no partnership items of income from business Y or Z to 
allocate.
    (ii) Because the partnership agreement provides for different 
allocations of partnership net income attributable to businesses X, 
Y, and Z, the net income attributable to each of businesses X, Y, 
and Z is income in separate CFTE categories. See paragraph 
(b)(4)(viii)(c)(2) of this section. Under paragraph 
(b)(4)(viii)(c)(3)(iv) of this section, an item of gross income that 
is recognized for U.S. federal income tax purposes is assigned to 
the activity that generated the item, and disregarded inter-branch 
payments are not taken into account in determining net income 
attributable to an activity. Consequently, all $100,000 of ABC's 
income is attributable to the business X activity for U.S. federal 
income tax purposes, and no net income is in the business Y or Z 
CFTE category. Under paragraph (b)(4)(viii)(d)(1) of this section, 
the $3,000 of country X taxes imposed on DEX is allocated to the 
business X CFTE category. The additional $9,000 of country X 
withholding tax imposed with respect to the inter-branch payment to 
DEY is also allocated to the business X CFTE category because for 
U.S. federal income tax purposes the related $90,000 of income on 
which the country X withholding tax is imposed is in the business X 
CFTE category. Therefore, $12,000 of taxes ($3,000 of country X 
income taxes and $9,000 of the country X withholding taxes) is 
related to the $100,000 of net income in the business X CFTE. See 
paragraph (b)(4)(viii)(c)(1) of this section. The allocations of 
country X taxes will be in proportion to the CFTE category shares of 
income to which they relate and will be deemed to be in accordance 
with the partners' interests in the partnership if such taxes are 
allocated 80 percent to A and 10 percent each to B and C.
    Example 37.  (i) Assume that the facts are the same as in 
paragraph (i) of Example 36 of this section, except that in order to 
reflect the $90,000 payment from DEX to DEY and the $80,000 payment 
from DEY to DEZ, the partnership agreement treats only $10,000 of 
the gross income as attributable to the business X activity, which 
the partnership agreement allocates 80 percent to A and 10 percent 
each to B and C. Of the remaining $90,000 of gross income, the 
partnership agreement treats $10,000 of the gross income as 
attributable to the business Y activity, which the partnership 
agreement allocates 80 percent to B and 10 percent each to A and C; 
and the partnership agreement treats $80,000 of the gross income as 
attributable to the business Z activity, which the partnership 
agreement allocates 80 percent to C and 10 percent each to A and B. 
In addition, the partnership agreement allocates the country X taxes 
among A, B, and C in accordance with which disregarded entity is 
considered to have paid the taxes for country X purposes. The 
partnership agreement allocates the $3,000 of country X income taxes 
80 percent to A and 10 percent to each of B and C, and allocates the 
$9,000 of country X withholding taxes 80 percent to B and 10 percent 
to each of A and C. Thus, ABC allocates the country X taxes $3,300 
to A (80 percent of $3,000 plus 10 percent of $9,000), $7,500 to B 
(10 percent of $3,000 plus 80 percent of $9,000), and $1,200 to C 
(10 percent of $3,000 plus 10 percent of $9,000).
    (ii) In order to prevent separating the CFTEs from the related 
foreign income, the special allocations of the $10,000 and $80,000 
treated under the partnership agreement as attributable to the 
business Y and the business Z activities, respectively, which do not 
follow the allocation ratios that otherwise apply under the 
partnership agreement to items of income in the business X activity, 
are treated as divisible parts of the business X activity and, 
therefore, as separate activities. See paragraph 
(b)(4)(viii)(c)(2)(iii) of this section. Because the divisible part 
of the business X activity attributable to the portion of the 
disregarded payment received by DEY and not paid on to DEZ ($10,000) 
and the net income from the business Y activity ($0) are both shared 
80 percent to B and 10 percent each to A and C, that divisible part 
of the business X activity and the business Y activity are treated 
as a single CFTE category. Because the divisible part of the 
business X activity attributable to the disregarded payment paid to 
DEZ ($80,000) and the net income from the business Z activity ($0) 
are both shared 80 percent to C and 10 percent each to A and B, that 
divisible part of the business X activity and the business Z 
activity are also treated as a single CFTE category. See paragraph 
(b)(4)(viii)(c)(2)(i) of this section. Accordingly, $10,000 of net 
income attributable to business X is in the business X CFTE 
category, $10,000 of net income of business X attributable to the 
net disregarded payments of DEY is in the business Y CFTE category, 
and $80,000 of net income of business X attributable to the 
disregarded payment to DEZ is in the business Z CFTE category. Under 
paragraph (b)(4)(viii)(d)(1) of this section, the $3,000 of country 
X tax imposed on DEX's income is allocated to the business X CFTE 
category. Because the $90,000 on which the country X withholding tax 
is imposed is split between the business Y CFTE category and the 
business Z CFTE category, those withholding taxes are allocated on a 
pro rata basis, $1,000 [$9,000 x ($10,000/$90,000)] to the business 
Y CFTE category and $8,000 [$9,000 x ($80,000/$90,000)] to the 
business Z CFTE category. See paragraph (b)(4)(viii)(d)(1) of this 
section. To satisfy the safe harbor of paragraph (b)(4)(viii) of 
this section, the $3,000 of country X taxes allocated to the 
business X CFTE category must be allocated in proportion to the CFTE 
category shares of income to which they relate, and therefore would 
be deemed to be in accordance with the partners' interests in the 
partnership if such taxes were allocated 80 percent to A and 10 
percent each to B and C. The allocation of the $1,000 of country X 
withholding taxes allocated to the business Y CFTE category would be 
in proportion to the CFTE category shares of income to which they 
relate, and therefore would be deemed to be in accordance with the 
partners' interests in the partnership if such taxes were allocated 
80 percent to B and 10 percent each to A and C. The allocation of 
the $8,000 of country X withholding taxes allocated to the business 
Z CFTE category would be in proportion to the CFTE category shares 
of income to which they relate, and therefore would be deemed to be 
in accordance with the partners' interests in the partnership if 
such taxes were allocated 80 percent to C and

[[Page 5916]]

10 percent each to A and B. Thus, to satisfy the safe harbor, ABC 
must allocate the country X taxes $3,300 to A (80 percent of $3,000 
plus 10 percent of $1,000 plus 10 percent of $8,000), $1,900 to B 
(10 percent of $3,000 plus 80 percent of $1,000 plus 10 percent of 
$8,000), and $6,800 to C (10 percent of $3,000 plus 10 percent of 
$1,000 plus 80 percent of $8,000). ABC's allocations of country X 
taxes are not deemed to be in accordance with the partners' 
interests in the partnership under paragraph (b)(4)(viii) of this 
section because they are not in proportion to the partners' CFTE 
category shares of income to which the country X taxes relate. 
Accordingly, the country X taxes will be reallocated according to 
the partners' interests in the partnership.

    (c) through (e) [Reserved]. For further guidance, see Sec.  1.704-
1(c) through (e).
    (f) Expiration date. The applicability of this section expires on 
February 4, 2019.

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
    Approved: January 14, 2016.
 Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2016-01949 Filed 2-3-16; 8:45 am]
 BILLING CODE 4830-01-P
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