[Federal Register Volume 61, Number 131 (Monday, July 8, 1996)]
[Proposed Rules]
[Pages 35696-35702]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-17004]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-4-95]
RIN 1545-AT41


Allocation of Loss on Disposition of Stock

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed Income Tax Regulations 
relating to the allocation of loss realized on the disposition of 
stock. These regulations will affect United States and foreign 
shareholders of stock in domestic and foreign corporations. The 
regulations are necessary to modify existing guidance with respect to 
stock losses. This document also contains a notice of public hearing on 
the regulations.

DATES: Written comments must be received by October 7, 1996. Outlines 
of topics to be discussed at the public hearing scheduled for November 
6, 1996, at 10 a.m. must be received by October 16, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (INTL-4-95), room 5228, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. In the alternative, submissions may be hand delivered between 
the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (INTL-4-95), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. The public hearing will be held in room 2615, Internal

[[Page 35697]]

Revenue Building, 1111 Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Seth B. 
Goldstein, (202) 622-3850; concerning submissions and the hearing, 
Evangelista Lee, (202) 622-7190 (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).
    Comments on the collection of information should be sent to the 
Office of Management and Budget, Attn: Desk Officer for the Department 
of Treasury, Office of Information and Regulatory Affairs, Washington, 
DC 20503, with copies to the Internal Revenue Service, Attn: IRS 
Reports Clearance Officer, T:FP, Washington, DC 20224. Comments on the 
collection of information should be received by September 6, 1996.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number.
    The collection of information under section 865(j)(1) is in 
Sec. 1.865-2(e)(2)(ii). The proposed regulations provide that in order 
for taxpayers to elect retroactive application of the regulations, 
taxpayers must comply with the reporting requirements contained in 
Sec. 1.865-2(e)(2)(ii). This information is required by the IRS as a 
condition for a taxpayer to elect to apply the rules of Sec. 1.865-2 
retroactively. This information will be used to determine whether a 
taxpayer properly applied the regulations. The respondents generally 
will be U.S. corporations or individuals that sell or otherwise dispose 
of stock in a foreign corporation of which the seller owns more than 
10% of the vote or value.
    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.
    Estimated total annual reporting burden: 4,000 hours. The estimated 
annual burden per respondent varies from 1 hour to 5 hours, depending 
on individual circumstances, with an estimated average of 2 hours.
    Estimated number of respondents: 2,000.
    Estimated annual frequency of responses: Once.

Background

    This document contains proposed regulations amending the Income Tax 
Regulations (26 CFR Part 1) under sections 861, 865, and 904 of the 
Internal Revenue Code. These regulations are also issued under 
authority contained in section 7805 of the Internal Revenue Code.

Explanation of Provisions

    This notice of proposed rulemaking provides rules under section 
865(j) relating to the treatment of losses from the sale or other 
disposition of stock.
    Section 1.865-1 provides that the allocation of loss on the 
disposition of property not governed by Sec. 1.865-2 continues to be 
governed by the generally applicable rules of Sec. 1.861-8, except as 
provided in other administrative pronouncements. For example, Notice 
89-58 (1989-1 C.B. 699) remains in effect with respect to losses 
described in that Notice. The treatment of portfolio stock, which is 
excluded from Sec. 1.865-2, will be reviewed in the context of a 
broader project dealing with similar portfolio investments, including 
debt instruments and derivative financial products. Allocation of loss 
on the disposition of stock of a regulated investment company and stock 
of an S corporation also will continue to be governed by Secs. 1.861-
8(e)(7)(i) and (ii).
    Section 1.865-2(a) provides the general rule that stock losses are 
allocated in the same manner as stock gains (determined without regard 
to sections 1248 and 865(f)). Thus, stock loss generally is allocated 
to the residence of the seller. Loss recognized by a United States 
resident on the disposition of stock attributable to a foreign branch 
is allocated to foreign source income if a gain would have been taxable 
by the foreign country and the highest marginal rate of tax imposed in 
that foreign country is at least 10 percent. Loss recognized by a 
nonresident alien individual or foreign corporation with respect to 
stock constituting a United States real property interest reduces 
United States source income, in accordance with section 897.
    Section 1.865-2(b) provides exceptions to the general rule. Section 
1.865-2(b)(1) provides a dividend recapture rule that applies to losses 
realized on a disposition of stock within 24 months following the 
inclusion of a dividend or similar amount. To the extent of the 
dividend recapture amount, the loss shall be allocated to the same 
class of income as the dividend. Under a de minimis rule, the recapture 
rule will not apply if the sum of all dividend recapture amounts is 
less than 10 percent of the realized loss.
    A dividend recapture amount includes an actual dividend, a subpart 
F or qualified electing fund inclusion attributable to a dividend 
received by a controlled foreign corporation in a separate limitation 
category other than that for passive income, and an inclusion 
attributable to section 956 or 956A. Dividends from foreign 
corporations, which often are sheltered from United States tax by 
foreign tax credits and do not reduce the shareholder's basis in the 
stock, may reduce the selling price of the stock, thereby creating or 
increasing a loss on sale. Similarly, the identified subpart F 
inclusions may increase the shareholder's stock basis without 
substantially affecting the value of the stock, offering similar 
opportunities to create a tax mismatch from an economic ``wash'' by 
pairing tax-sheltered foreign source inclusions and United States 
source loss.
    Section 1.865-2(b)(2) provides a consistency rule requiring 
generally that loss recognized on the disposition of an 80%-owned 
foreign affiliate reduces foreign source passive income if, within the 
past five years, the seller or any member of its consolidated group 
recognized gain on the disposition of a foreign affiliate that was 
sourced under section 865(f). In order to provide relief for taxpayers 
that could have taken steps to avoid section 865(f) treatment on gain 
sales occurring prior to the publication of these proposed regulations, 
the five-year lookback period will be phased in so that losses will be 
tainted only by reason of gains recognized after September 6, 1996.
    Section 1.865-2(b)(3) provides anti-abuse rules designed to prevent 
taxpayers from changing the allocation of a loss with respect to stock 
or other property by entering into certain transactions.
    Section 1.865-2(c) provides rules of general application. Section 
1.865-2(c)(1) provides that a partner's distributive share of loss 
resulting from a disposition of stock by a partnership is allocated as 
if the partner disposed of the stock. In an appropriate case the loss 
may be attributable to a fixed place of business of the partnership 
rather than to the partner's residence.
    Section 1.865-2(c)(2) provides that worthlessness shall be treated 
as a disposition for purposes of the stock loss allocation rules.
    Section 1.865-2(d) provides definitions.

[[Page 35698]]

    Under Sec. 1.865-2(e), the regulations are proposed to be effective 
for taxable years beginning after 60 days after the date final 
regulations are published in the Federal Register. However, a taxpayer 
may elect to apply the regulations retroactively to stock losses in all 
open post-1986 taxable years. A taxpayer generally may make the 
election by attaching a statement to an original or amended federal 
income tax return filed after final regulations are published in the 
Federal Register. However, the election will not be effective unless 
amended returns are filed within 120 days of the date final regulations 
are published in the Federal Register.
    Section 1.904-4(c) is proposed to be amended to provide rules 
specifically addressing the treatment of loss allocated to the section 
904(d) separate category for passive income. The proposed amendments 
provide that, for purposes of the grouping rules relating to the high-
tax kick-out described in section 904(d)(2)(F), a passive loss is 
initially allocated to a group based on the foreign tax that was, or 
would have been, imposed on the transaction had the sale resulted in a 
gain under foreign law. If, after allocation and apportionment of all 
deductions, net income in a group is less than zero, any taxes imposed 
with respect to the group are considered related to general limitation 
income. The net loss is not considered related to general limitation 
income, but proportionately reduces income in the other passive income 
groups. The determination of whether income in the positive income 
groups is high-taxed is made after this allocation of loss groups. Any 
net loss in the section 904(d) separate category for passive income 
constitutes a separate limitation loss governed by section 904(f)(5).

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 is hereby 
certified that these regulations do not have a significant economic 
impact on a substantial number of small entities. This certification is 
based on the fact that these regulations will primarily affect U.S. 
owners of significant interests in foreign corporations, which owners 
generally are large multinational corporations. This certification is 
also based upon the fact that, even in cases in which the regulation 
applies to small entities, the burden imposed by the collection of 
information in the regulation, which is merely an election to apply the 
regulation to prior taxable years, is not substantial and, therefore, 
the collection of information will not impose a significant economic 
impact on such entities. Therefore, a Regulatory Flexibility Analysis 
under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not 
required. Pursuant to section 7805(f) of the Internal Revenue Code, 
this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on their impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (signed original 
and eight (8) copies) that are timely submitted to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for November 6, 1996, at 10 
a.m., in room 2615, Internal Revenue Building, 1111 Constitution Avenue 
NW., Washington DC. Because of access restrictions, visitors will not 
be admitted beyond the building lobby more than 15 minutes before the 
hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons 
that wish to present oral comments at the hearing must submit written 
comments by October 7, 1996 and submit an outline of topics to be 
discussed and time to be devoted to each topic (signed original and 
eight (8) copies) by October 16, 1996.
    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 Seth B. Goldstein, of 
the Office of the Associate Chief Counsel (International), IRS. 
However, other personnel from the IRS and Treasury Department 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.865-1 is also issued under 26 U.S.C. 865(j)(1).
    Section 1.865-2 is also issued under 26 U.S.C. 865(j)(1).

    Par. 2. Section 1.861-8 is amended by adding paragraph (e)(7)(iii) 
to read as follows:


Sec. 1.861-8  Computation of taxable income from sources within the 
United States and from other sources and activities.

* * * * *
    (e) * * *
    (7) * * *
    (iii) Special rules for allocation of loss from disposition of 
stock. See Sec. 1.865-2 for special rules regarding the allocation of 
loss recognized on certain dispositions of stock in taxable years 
beginning after December 31, 1986.
    Par. 3. Sections 1.865-1 and 1.865-2 are added under the 
undesignated center heading ``Determination of Sources of Income'' to 
read as follows:


Sec. 1.865-1  Loss from the disposition of personal property.

    Allocation of loss on the sale or other disposition of portfolio 
stock, stock of a regulated investment company (as defined in section 
851), stock of an S corporation (as defined in section 1361), and other 
personal property not governed by Sec. 1.865-2 is governed by 
Sec. 1.861-8 or other administrative pronouncements. Portfolio stock 
is, with respect to a taxpayer, stock in a corporation in which the 
taxpayer owns, or is considered to own under the rules of section 
267(c), less than 10 percent of the total combined voting power of all 
classes of stock entitled to vote of such corporation and less than 10 
percent of the total value of the stock of such corporation.


Sec. 1.865-2  Loss from the disposition of certain stock.

    (a) General rules for allocation of loss on disposition of stock--
(1) Allocation against gain. Except as otherwise provided in 
Sec. 1.865-1 and paragraph (b) of this section, loss recognized on the 
sale or other disposition of stock shall be allocated to the class of 
gross income and, if necessary, apportioned between the statutory 
grouping of gross income (or among the statutory groupings) and the 
residual grouping of gross income, with respect to which gain (other 
than gain treated as a dividend under section 1248) from the sale of 
such stock would give rise in the hands of the seller

[[Page 35699]]

(without regard to section 865(f)). For purposes of section 904, any 
such loss shall be allocated to the separate category to which such 
gain would have been assigned (without regard to section 
904(d)(2)(A)(iii)(III)). For purposes of Sec. 1.904-4(c)(2)(ii)(A), any 
loss allocated to passive income shall be allocated (prior to the 
application of Sec. 1.904-4(c)(2)(ii)(B)) to the group of passive 
income to which gain on the sale would have been assigned if the sale 
of the stock had resulted in the recognition of a gain under the law of 
the relevant foreign jurisdiction or jurisdictions. See section 
904(f)(5) and the regulations under that section for rules regarding 
the treatment of separate limitation losses.
    (2) Stock attributable to foreign office. Except as otherwise 
provided in Sec. 1.865-1 and paragraph (b) of this section, in the case 
of loss on the sale or other disposition of stock (other than stock 
constituting inventory) by a United States resident that is 
attributable to an office or other fixed place of business in a foreign 
country within the meaning of section 865(e)(3), the loss shall be 
allocated to reduce foreign source income if a gain would have been 
taxable by the foreign country and the highest marginal rate of tax 
imposed in the foreign country is at least 10 percent.
    (3) Stock constituting a United States real property interest. Loss 
recognized by a nonresident alien individual or a foreign corporation 
on the sale or other disposition of stock that constitutes a United 
States real property interest shall be allocated to reduce United 
States source income. For additional rules governing the treatment of 
such loss, see section 897 and the regulations thereunder.
    (b) Exceptions--(1) Dividend recapture exception--(i) In general. 
Except as otherwise provided in Sec. 1.865-1, if a taxpayer realizes a 
loss on a disposition of stock, and the taxpayer included in income a 
dividend recapture amount (or amounts) with respect to such stock at 
any time during the recapture period, then, to the extent of the 
dividend recapture amount (or amounts), the loss shall be allocated and 
apportioned on a proportionate basis to the class or classes of gross 
income or the statutory or residual grouping or groupings of gross 
income to which the dividend recapture amount was assigned.
    (ii) Exception for de minimis amounts. Paragraph (b)(1)(i) of this 
section shall not apply to a loss realized by a taxpayer on the 
disposition of stock if the sum of all dividend recapture amounts 
included in income by the taxpayer with respect to such stock during 
the recapture period is less than 10 percent of the realized loss.
    (2) Consistency exception--(i) In general. Except to the extent 
provided in paragraph (b)(1) of this section, loss recognized by a 
taxpayer with respect to the sale or other disposition of stock of a 
foreign affiliate (or of a corporation that was a foreign affiliate 
within the five-year period preceding the date of the sale) or a 
foreign affiliate holding company shall be allocated to reduce foreign 
source income if the taxpayer (or, in the case of a taxpayer that is a 
member of a consolidated group (within the meaning of Sec. 1.1502-1(h)) 
at the time the loss is recognized, the consolidated group) recognized 
gain on the disposition of any stock that was sourced under section 
865(f) within the five-year period ending on the last day of the 
taxable year in which the loss was recognized. See paragraph (a)(1) of 
this section for rules relating to the allocation of the loss to 
separate categories described in section 904(d).
    (ii) Phased-in lookback period. The rule of paragraph (b)(2)(i) of 
this section shall apply only if gain sourced under section 865(f) was 
recognized after September 6, 1996.
    (3) Anti-abuse rules. If one of the principal purposes of a 
reorganization within the meaning of section 368(a), liquidation under 
section 332, transfer to a corporation under section 351, transfer to a 
partnership under section 721, transfer to a trust, distribution by a 
partnership, distribution by a trust, or transfer to or from a 
qualified business unit (within the meaning of section 989(a)) is to 
change the allocation of a built-in loss on the disposition of stock 
(or other personal property), the loss shall be allocated as if it were 
recognized on the disposition of the stock (or other personal property) 
immediately prior to the reorganization, liquidation, transfer, or 
distribution. In addition, if a loss recognized by a taxpayer with 
respect to the sale or other disposition of stock in a corporation is 
primarily attributable to loss with respect to one or more financial 
instruments held by the corporation, and one of the taxpayer's 
principal purposes for holding the financial instrument or instruments 
through the corporation is to allocate loss under Sec. 1.865-2, the 
stock loss shall be allocated under Sec. 1.865-1 as if it were 
recognized on the disposition of such financial instrument or 
instruments. Whether a taxpayer has a principal purpose to allocate 
loss under Sec. 1.865-2 shall be determined by taking into account all 
the facts and circumstances, including whether the corporation engages 
in business activities (other than trading financial instruments) and 
whether the taxpayer or any related person or persons (within the 
meaning of section 267(b) or 954(d)(3)) hold positions that offset loss 
positions held by the corporation. For purposes of this paragraph 
(b)(3), positions are offsetting if the risk of loss of holding one or 
more positions is substantially diminished by holding one or more other 
positions. A person may have a principal purpose of affecting loss 
allocation even though this purpose is outweighed by other purposes 
(taken together or separately).
    (4) Example. The application of this paragraph (b) may be 
illustrated by the following example:

    Example. (i) P, a domestic corporation, is a United States 
shareholder of N, a controlled foreign corporation. N has never had 
any subpart F income and all of its earnings and profits are 
described in section 959(c)(3). On August 5, 1997, N distributes a 
dividend to P in the amount of $100. The dividend gives rise to a $5 
foreign withholding tax, and P is deemed to have paid an additional 
$45 of foreign income tax with respect to the dividend under section 
902. Under section 904(d)(3) the dividend is general limitation 
income described in section 904(d)(1)(I).
    (ii) On February 6, 1998, P sells its shares of N and recognizes 
a $110 loss. In 1998, P has the following taxable income, excluding 
the loss on the sale of N:
    (A) $1,000 of foreign source income that is general limitation 
income described in section 904(d)(1)(I), which is subject to 
foreign taxes of $400;
    (B) $1,000 of foreign source capital gain that is passive income 
described in section 904(d)(1)(A) attributable to gain on the sale 
of stock in a foreign affiliate that is sourced under section 
865(f), which is subject to foreign taxes of $30.
    (iii) The $100 dividend paid in 1997 is a dividend recapture 
amount that was included in P's income within the recapture period 
preceding the disposition of the N stock. The de minimis exception 
of paragraph (b)(1)(ii) of this section does not apply because the 
$100 dividend recapture amount exceeds 10 percent of the $110 loss. 
Therefore, to the extent of the $100 dividend recapture amount, the 
loss must be allocated under paragraph (b)(1)(i) of this section to 
the separate limitation category to which the dividend was assigned 
(general limitation income).
    (iv) Because P recognized gain on the sale of stock in a foreign 
affiliate that was sourced under section 865(f) within the period 
described in paragraph (b)(2)(i) of this section, P's remaining $10 
loss on the disposition of the N stock is allocated to foreign 
source passive income under paragraph (b)(2)(i) of this section.
    (v) After allocation of the stock loss, P's taxable income in 
1998 consists of $900 of foreign source general limitation income 
and $990 of foreign source passive income.

    (c) Rules of application--(1) Loss recognized by partnership. A 
partner's

[[Page 35700]]

distributive share of loss resulting from the sale or other disposition 
of stock by a partnership shall be allocated and apportioned in 
accordance with this section as if the partner had disposed of the 
stock. If a sale of stock is attributable to an office or other fixed 
place of business of the partnership within the meaning of section 
865(e)(3), such office or fixed place of business shall be considered 
to be an office of the partner for purposes of this section.
    (2) Worthless stock. For purposes of this section, worthlessness 
giving rise to a deduction under section 165(g) (including section 
165(g)(3)) with respect to stock shall be treated as a disposition.
    (d) Definitions--(1) Terms defined in Sec. 1.861-8. See Sec. 1.861-
8 for the meaning of class of gross income, statutory grouping of gross 
income, and residual grouping of gross income.
    (2) Dividend recapture amount. A dividend recapture amount is a 
dividend (except for an amount treated as a dividend under section 78), 
an inclusion described in section 951(a)(1)(A)(i) (but only to the 
extent attributable to a dividend included in the earnings of a 
controlled foreign corporation that is included in foreign personal 
holding company income under section 954(c)(1)(A) and that, pursuant to 
section 904(d)(3)(B), is treated as income in a separate category other 
than the separate category for passive income described in section 
904(d)(2)(A)), an inclusion described in section 951(a)(1)(B) or (C), 
and an inclusion described in section 1293(a)(1) (but only to the 
extent attributable to a dividend that is included in the earnings of a 
qualified electing fund and that, pursuant to section 904(d)(3)(I), is 
treated as income in a separate category other than the separate 
category for passive income described in section 904(d)(2)(A)).
    (3) Foreign affiliate. A foreign affiliate is a foreign corporation 
that is a member of the affiliated group (within the meaning of section 
1504(a) without regard to section 1504(b)) that includes the taxpayer.
    (4) Foreign affiliate holding company. A foreign affiliate holding 
company is any corporation, substantially all the assets of which 
consist of stock of one or more foreign affiliates, held directly or 
indirectly. For purposes of this paragraph, any assets acquired or held 
by a corporation with a principal purpose of avoiding foreign affiliate 
holding company status shall be disregarded.
    (5) Recapture period. A recapture period is the 24-month period 
preceding the date on which a taxpayer realizes a loss on a disposition 
of stock, increased by any period of time in which the taxpayer has 
diminished its risk of loss in a manner described in section 246(c)(4) 
and the regulations thereunder.
    (6) Taxpayer. A taxpayer shall include all predecessors or 
successors of the taxpayer.
    (7) United States resident. See section 865(g) and the regulations 
thereunder for the definition of United States resident.
    (e) Effective date--(1) In general. This section is effective for 
taxable years beginning after the date that is 60 days after the date 
these regulations are published as final regulations in the Federal 
Register.
    (2) Prior year election--(i) In general. A taxpayer may elect to 
apply the rules of this section to all (but not less than all) of its 
taxable years that begin after December 31, 1986, and on or before the 
date that is 60 days after the date these regulations are published as 
final regulations in the Federal Register, and with respect to which 
the statute of limitations expires after the date that is 120 days 
after the date these regulations are published as final regulations in 
the Federal Register. The election shall be effective only if the 
taxpayer satisfies all the applicable requirements specified in 
paragraph (e)(2)(ii) of this section.
    (ii) Requirements for election--(A) Statement filed with original 
or amended return. For each taxable year subject to the election, a 
taxpayer shall file an original or amended federal income tax return 
that reflects the rules of this section and includes the statement 
described in paragraph (e)(2)(ii)(C) of this section. Amended returns 
filed pursuant to this section must be filed on or before the date that 
is 120 days after the date these regulations are published as final 
regulations in the Federal Register.
    (B) Presentation of statement upon audit. A taxpayer that is under 
examination with respect to any taxable year subject to the election on 
the date that is 120 days after the date these regulations are 
published as final regulations in the Federal Register must furnish a 
copy of the statement described in paragraph (e)(2)(ii)(C) of this 
section for all years subject to the election to the revenue agent 
responsible for examining its federal income tax returns on or before 
the date that is 140 days after the date these regulations are 
published as final regulations in the Federal Register. For purposes of 
this paragraph (e)(2)(ii)(B), a taxpayer is under examination beginning 
on the date the taxpayer (or any member of the consolidated group of 
which the taxpayer is a member) has been contacted in any manner by a 
representative of the Internal Revenue Service for the purpose of 
scheduling any type of examination of any of its federal income tax 
returns and ending on the earliest of the date: the taxpayer (or 
consolidated group of which the taxpayer is a member) receives a ``no 
change'' letter; the taxpayer (or consolidated group of which the 
taxpayer is a member) pays the deficiency (or proposed deficiency); or 
on which a deficiency, jeopardy, termination, bankruptcy, or 
receivership assessment is made. An electing taxpayer that is not under 
examination with respect to any taxable year subject to the election on 
the date that is 120 days after the date these regulations are 
published as final regulations in the Federal Register and is contacted 
thereafter by a representative of the Internal Revenue Service for the 
purpose of scheduling any type of examination of any of its federal 
income tax returns for a year subject to the election must furnish a 
copy of the statement described in paragraph (e)(2)(ii)(C) of this 
section for all years subject to the election to the revenue agent 
responsible for examining its federal income tax returns within 20 days 
of being contacted.
    (C) Contents of statement. The statement shall be entitled 
``ELECTION UNDER Sec. 1.865-2(e)(2) TO APPLY RETROACTIVELY Sec. 1.865-2 
STOCK LOSS ALLOCATION RULES.'' The statement shall identify, for the 
taxable year subject to the election, each loss from the disposition of 
stock that is subject to this section and that was incurred by the 
taxpayer or by any controlled foreign corporation (within the meaning 
of section 953(c)(1)(B) or 957) with respect to which the taxpayer is a 
United States shareholder (within the meaning of section 951(b) or 
953(c)(1)(A)). For each such loss, the statement shall provide the name 
and identifying number of the entity that incurred the loss, the amount 
of the loss, and the paragraph of this section under which the loss is 
allocated. Each loss subject to paragraph (b)(1) of this section shall 
be separately identified with a notation stating ``Subject to dividend 
recapture under Sec. 1.865-2(b)(1).'' The statement shall also include 
the following declaration: ``No losses, other than those so identified 
herein, are subject to Sec. 1.865-2(b)(1).'' The statement shall 
indicate whether the taxpayer or any controlled foreign corporation 
(within the meaning of section 953(c)(1)(B) or 957) with respect to 
which the taxpayer is a United States

[[Page 35701]]

shareholder (within the meaning of section 951(b) or 953(c)(1)(A)) 
acquired the stock after July 8, 1996 as a result of a transaction 
described in paragraph (b)(3) of this section (regardless of the 
purpose or purposes of the transaction). An election shall not be 
effective unless each statement required by this paragraph (e)(2)(ii) 
contains all the information specified herein.
    Par. 4. Section 1.904-0 is amended by revising the entry for 
Sec. 1.904-4(c)(2)(ii) and adding entries for paragraphs (c)(2(ii)(A) 
and (B) of that section to read as follows:


Sec. 1.904-0  Outline of regulation provisions for section 904.

* * * * *


Sec. 1.904-4  Separate application of section 904 with respect to 
certain categories of income.

* * * * *
    (c) * * *
    (2) * * *
    (ii) Grouping rules.
    (A) Initial allocation and apportionment of deductions.
    (B) Reallocation of loss groups.
    Par. 5. Section 1.904-4 is amended by revising paragraphs (c)(1) 
and (c)(2) and adding paragraph (c)(8) Example 11 and Example 12 to 
read as follows:
    (c) High-taxed income--(1) In general. Income received or accrued 
by a United States person that would otherwise be passive income shall 
not be treated as passive income if the income is determined to be 
high-taxed income. Income shall be considered to be high-taxed income 
if, after allocating expenses, losses and other deductions of the 
United States person to that income under paragraph (c)(2)(ii) of this 
section, the sum of the foreign income taxes paid or accrued by the 
United States person with respect to such income and the foreign taxes 
deemed paid or accrued by the United States person with respect to such 
income under section 902 or section 960 exceeds the highest rate of tax 
specified in section 1 or section 11, whichever applies (and with 
reference to section 15 if applicable), multiplied by the amount of 
such income (including the amount treated as a dividend under section 
78). If, after application of this paragraph (c), income that would 
otherwise be passive income is determined to be high-taxed income, such 
income shall be treated as general limitation income, and any taxes 
imposed on that income shall be considered related to general 
limitation income under Sec. 1.904-6. If, after application of this 
paragraph (c), passive income is less than zero, the loss shall 
constitute a passive separate limitation loss (subject to the rules of 
section 904(f)(5) and the regulations under that section), but any 
taxes imposed on passive income shall be considered related to general 
limitation income under Sec. 1.904-6. For additional rules regarding 
losses related to passive income, see paragraph (c)(2) of this section. 
Income and taxes shall be translated at the appropriate rates, as 
determined under sections 986, 987 and 989 and the regulations under 
those sections, before application of this paragraph (c). For purposes 
of allocating taxes to groups of income, United States source passive 
income is treated as any other passive income. In making the 
determination whether income is high-taxed, however, only foreign 
source income, as determined under United States tax principles, is 
relevant. See paragraph (c)(8) Examples (10), (11) and (12) of this 
section for examples illustrating the application of this paragraph 
(c)(1) and paragraph (c)(2) of this section.
    (2) Grouping of items of income in order to determine whether 
passive income is high-taxed income--(i) Effective date. For purposes 
of determining whether passive income is high-taxed income, the 
grouping rules of paragraphs (c)(3), (c)(4), and (c)(5) of this section 
apply to taxable years beginning after December 31, 1987. See notice 
87-6 for the grouping rules applicable to taxable years beginning after 
December 31, 1986 and before January 1, 1988. Paragraph (2)(ii)(B) of 
this section is effective for taxable years beginning after the date 
that is 60 days after the date these regulations are published as final 
regulations in the Federal Register.
    (ii) Grouping rules--(A) Initial allocation and apportionment of 
deductions. For purposes of determining whether passive income is high-
taxed, expenses, losses and other deductions shall be allocated and 
apportioned initially to each of the groups of passive income 
(described in paragraphs (c)(3), (4), and (5) of this section) under 
the rules of Secs. 1.861-8 through 1.861-14T, 1.865-1, and 1.865-2. 
Taxpayers that allocate and apportion interest expense on an asset 
basis may nevertheless apportion passive interest expense among the 
groups of passive income on a gross income basis. If loss from the 
disposition of property gives rise to foreign tax (e.g., the 
transaction giving rise to the loss is treated under foreign law as 
having given rise to a gain), the foreign tax shall be allocated to the 
group of passive income to which the loss is allocated under this 
paragraph (c)(2)(ii)(A), without regard to paragraph (c)(2)(ii)(B) of 
this section. A determination of whether passive income is high-taxed 
shall be made only after application of paragraph (c)(2)(ii)(B) of this 
section (if applicable).
    (B) Reallocation of loss groups. If, after allocation and 
apportionment of expenses, losses and other deductions under paragraph 
(c)(2)(ii)(A) of this section, the sum of the allocable deductions 
exceeds the gross income in one or more groups, the excess deductions 
shall proportionately reduce income in the other groups (but not below 
zero), and any taxes imposed with respect to such loss group or groups 
shall be considered related to general limitation income.
* * * * *
    (8) * * *

    Example 11. P, a domestic corporation, earns the following items 
of gross income: $100 of foreign source, passive limitation interest 
income not subject to any foreign tax, $200 of foreign source, 
passive limitation royalty income subject to a 5 percent foreign 
withholding tax (foreign tax paid is $10), $1300 of foreign source, 
passive limitation rental income subject to a 25 percent foreign 
withholding tax (foreign tax paid is $325), $500 of foreign source, 
general limitation income that gives rise to a $250 foreign tax, and 
$2000 of U.S. source capital gain that is not subject to any foreign 
tax. P has a $700 deduction allocable to its passive rental income. 
P's only other deduction is a $500 capital loss on a sale of stock 
that is allocated to foreign source passive limitation income under 
Sec. 1.865-2(b)(2). If P had recognized a gain on the stock sale 
under foreign law, the gain would not have been subject to foreign 
tax. The $500 capital loss is initially allocated to the group of 
passive income not subject to any foreign tax, and the $400 amount 
by which the capital loss exceeds the income in the group must be 
reapportioned to the other groups under paragraph (c)(2)(ii)(B) of 
this section. The net royalty income is thus reduced by $100 to $100 
($200-($400 x (200/800))) and the net rental income is reduced by 
$300 to $300 ($1300-$700-($400 x (600/800))). The $100 net royalty 
income is not high-taxed and remains passive income. The $300 net 
rental income is high-taxed because the foreign taxes exceed the 
highest United States rate of tax on that income. Under the high-tax 
kick-out, the $300 of net rental income (the gross rental income and 
expenses allocated and apportioned thereto) and the $325 of 
associated foreign tax are assigned to the general limitation 
category.
    Example 12. The facts are the same as in Example 11 except the 
amount of the capital loss that is allocated under Sec. 1.865-
2(b)(2) and paragraph (c)(2) of this section to the group of foreign 
source passive income subject to no foreign tax is $1100. Under 
paragraph (c)(2)(ii)(B) of this section, the excess deductions of 
$1000 must be reapportioned to the $200 of net royalty income 
subject to a 5% withholding tax and the $600 of net rental income 
subject to a

[[Page 35702]]

25% withholding tax. The income in each of these groups is reduced 
to zero, and the foreign taxes imposed on the rental and royalty 
income are considered related to general limitation income. The 
remaining loss of ($200) constitutes a separate limitation loss with 
respect to passive income.
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-17004 Filed 7-5-96; 8:45 am]
BILLING CODE 4830-01-P