[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2003 Edition]
[From the U.S. Government Printing Office]



[[Page i]]



                    26


          Part 1 (Secs. 1.851 to 1.907)

                         Revised as of April 1, 2003

Internal Revenue





          Containing a codification of documents of general 
          applicability and future effect
          As of April 1, 2003
          With Ancillaries
          Published by
          Office of the Federal Register
          National Archives and Records
          Administration

A Special Edition of the Federal Register



[[Page ii]]

                                      




                     U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2003



  For sale by the Superintendent of Documents, U.S. Government Printing 
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[[Page iii]]




                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   3
  Finding Aids:
      Table of CFR Titles and Chapters........................     777
      Alphabetical List of Agencies Appearing in the CFR......     795
      Table of OMB Control Numbers............................     805
      List of CFR Sections Affected...........................     823



[[Page iv]]


      


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

                     Cite this Code:  CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.851-1 
                       refers to title 26, part 
                       1, section 851-1.

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

[[Page v]]



                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2003), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
number of the Federal Register and date of publication. Publication 
dates and effective dates are usually not the same and care must be 
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instances where the effective date is beyond the cut-off date for the 
Code a note has been inserted to reflect the future effective date. In 
those instances where a regulation published in the Federal Register 
states a date certain for expiration, an appropriate note will be 
inserted following the text.

OMB CONTROL NUMBERS

    The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires 
Federal agencies to display an OMB control number with their information 
collection request.

[[Page vi]]

Many agencies have begun publishing numerous OMB control numbers as 
amendments to existing regulations in the CFR. These OMB numbers are 
placed as close as possible to the applicable recordkeeping or reporting 
requirements.

OBSOLETE PROVISIONS

    Provisions that become obsolete before the revision date stated on 
the cover of each volume are not carried. Code users may find the text 
of provisions in effect on a given date in the past by using the 
appropriate numerical list of sections affected. For the period before 
January 1, 2001, consult either the List of CFR Sections Affected, 1949-
1963, 1964-1972, 1973-1985, or 1986-2000, published in 11 separate 
volumes. For the period beginning January 1, 2001, a ``List of CFR 
Sections Affected'' is published at the end of each CFR volume.

CFR INDEXES AND TABULAR GUIDES

    A subject index to the Code of Federal Regulations is contained in a 
separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of Statutory 
Authorities and Agency Rules (Table I). A list of CFR titles, chapters, 
and parts and an alphabetical list of agencies publishing in the CFR are 
also included in this volume.
    An index to the text of ``Title 3--The President'' is carried within 
that volume.
    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
the daily Federal Register.
    A List of CFR Sections Affected (LSA) is published monthly, keyed to 
the revision dates of the 50 CFR titles.

REPUBLICATION OF MATERIAL

    There are no restrictions on the republication of material appearing 
in the Code of Federal Regulations.

INQUIRIES

    For a legal interpretation or explanation of any regulation in this 
volume, contact the issuing agency. The issuing agency's name appears at 
the top of odd-numbered pages.
    For inquiries concerning CFR reference assistance, call 202-741-6000 
or write to the Director, Office of the Federal Register, National 
Archives and Records Administration, Washington, DC 20408 or e-mail 
info@fedreg.nara.gov.

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ELECTRONIC SERVICES

    The full text of the Code of Federal Regulations, the LSA (List of 
CFR Sections Affected), The United States Government Manual, the Federal 
Register, Public Laws, Public Papers, Weekly Compilation of Presidential 
Documents and the Privacy Act Compilation are available in electronic 
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free). E-mail, gpoaccess@gpo.gov.

[[Page vii]]

    The Office of the Federal Register also offers a free service on the 
National Archives and Records Administration's (NARA) World Wide Web 
site for public law numbers, Federal Register finding aids, and related 
information. Connect to NARA's web site at www.archives.gov/federal--
register. The NARA site also contains links to GPO Access.

                              Raymond A. Mosley,
                                    Director,
                          Office of the Federal Register.

April 1, 2003.



[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
2003. The first thirteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Secs. 1.0-1-1.60; 
Secs. 1.61-1.169; Secs. 1.170-1.300; Secs. 1.301-1.400; Secs. 1.401-
1.440; Secs. 1.441-1.500; Secs. 1.501-1.640; Secs. 1.641-1.850; 
Secs. 1.851-1.907; Secs. 1.908-1.1000; Secs. 1.1001-1.1400; 
Secs. 1.1401-1.1503-2A; and Sec. 1.1551-1 to end. The fourteenth volume 
containing parts 2-29, includes the remainder of subchapter A and all of 
Subchapter B--Estate and Gift Taxes. The last six volumes contain parts 
30-39 (Subchapter C--Employment Taxes and Collection of Income Tax at 
Source); parts 40-49; parts 50-299 (Subchapter D--Miscellaneous Excise 
Taxes); parts 300-499 (Subchapter F--Procedure and Administration); 
parts 500-599 (Subchapter G--Regulations under Tax Conventions); and 
part 600 to end (Subchapter H--Internal Revenue Practice).

    The OMB control numbers for Title 26 appear in Sec. 602.101 of this 
chapter. For the convenience of the user, Sec. 602.101 appears in the 
Finding Aids section of the volumes containing parts 1 to 599.

[[Page x]]





[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




            (This book contains part 1, Secs. 1.851 to 1.907)

  --------------------------------------------------------------------
                                                                    Part

chapter i--Internal Revenue Service, Department of the 
  Treasury (Continued)......................................           1

[[Page 3]]



    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)




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


  Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980, 
deleting statutory sections from their regulations. In chapter I cross 
references to the deleted material have been changed to the 
corresponding sections of the IRS Code of 1954 or to the appropriate 
regulations sections. When either such change produced a redundancy, the 
cross reference has been deleted. For further explanation, see 45 FR 
20795, March 31, 1980.

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
1               Income taxes................................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System.

  Additional supplementary publications are issued covering Alcohol and 
Tobacco Tax Regulations and Regulations Under Tax Conventions.

[[Page 5]]



                  SUBCHAPTER A--INCOME TAX (CONTINUED)





PART 1--INCOME TAXES--Table of Contents




                        Normal Taxes and Surtaxes

    Regulated Investment Companies and Real Estate Investment Trusts

Sec.
1.851-1  Definition of regulated investment company.
1.851-2  Limitations.
1.851-3  Rules applicable to section 851(b)(4).
1.851-4  Determination of status.
1.851-5  Examples.
1.851-6  Investment companies furnishing capital to development 
          corporations.
1.851-7  Certain unit investment trusts.
1.852-1  Taxation of regulated investment companies.
1.852-2  Method of taxation of regulated investment companies.
1.852-3  Investment company taxable income.
1.852-4  Method of taxation of shareholders of regulated investment 
          companies.
1.852-5  Earnings and profits of a regulated investment company.
1.852-6  Records to be kept for purpose of determining whether a 
          corporation claiming to be a regulated investment company is a 
          personal holding company.
1.852-7  Additional information required in returns of shareholders.
1.852-8  Information returns.
1.852-9  Special procedural requirements applicable to designation under 
          section 852(b)(3)(D).
1.852-10  Distributions in redemption of interests in unit investment 
          trusts.
1.852-11  Treatment of certain losses attributable to periods after 
          October 31 of a taxable year.
1.852-12  Non-RIC earnings and profits.
1.853-1  Foreign tax credit allowed to shareholders.
1.853-2  Effect of election.
1.853-3  Notice to shareholders.
1.853-4  Manner of making election.
1.854-1  Limitations applicable to dividends received from regulated 
          investment company.
1.854-2  Notice to shareholders.
1.854-3  Definitions.
1.855-1  Dividends paid by regulated investment company after close of 
          taxable year.

                      Real Estate Investment Trusts

1.856-0  Revenue Act of 1978 amendments not included.
1.856-1  Definition of real estate investment trust.
1.856-2  Limitations.
1.856-3  Definitions.
1.856-4  Rents from real property.
1.856-5  Interest.
1.856-6  Foreclosure property.
1.856-7  Certain corporations, etc., that are considered to meet the 
          gross income requirements.
1.856-8  Revocation or termination of election.
1.857-1  Taxation of real estate investment trusts.
1.857-2  Real estate investment trust taxable income and net capital 
          gain.
1.857-3  Net income from foreclosure property.
1.857-4  Tax imposed by reason of the failure to meet certain source-of-
          income requirements.
1.857-5  Net income and loss from prohibited transactions.
1.857-6  Method of taxation of shareholders of real estate investment 
          trusts.
1.857-7  Earnings and profits of a real estate investment trust.
1.857-8  Records to be kept by a real estate investment trust.
1.857-9  Information required in returns of shareholders.
1.857-10  Information returns.
1.857-11  Non-REIT earnings and profits.
1.858-1  Dividends paid by a real estate investment trust after close of 
          taxable year.
1.860-1  Deficiency dividends.
1.860-2  Requirements for deficiency dividends.
1.860-3  Interest and additions to tax.
1.860-4  Claim for credit or refund.
1.860-5  Effective date.
1.860A-0  Outline of REMIC provisions.
1.860A-1  Effective dates and transition rules.
1.860C-1  Taxation of holders of residual interests.
1.860C-2  Determination of REMIC taxable income or net loss.
1.860D-1  Definition of a REMIC.
1.860E-1  Treatment of taxable income of a residual interest holder in 
          excess of daily accruals.
1.860E-2  Tax on transfers of residual interests to certain 
          organizations.
1.860F-1  Qualified liquidations.
1.860F-2  Transfers to a REMIC.
1.860F-4  REMIC reporting requirements and other administrative rules.
1.860G-1  Definition of regular and residual interests.
1.860G-2  Other rules.
1.860G-3  Treatment of foreign persons.

[[Page 6]]

  TAX BASED ON INCOME FROM SOURCES WITHIN OR WITHOUT THE UNITED STATES

                   Determination of Sources of Income

1.861-1  Income from sources within the United States.
1.861-2  Interest.
1.861-3  Dividends.
1.861-4  Compensation for labor or personal services.
1.861-5  Rentals and royalties.
1.861-6  Sale of real property.
1.861-7  Sale of personal property.
1.861-8  Computation of taxable income from sources within the United 
          States and from other sources and activities.
1.861-8T  Computation of taxable income from sources within the United 
          States and from other sources and activities (temporary).
1.861-9  Allocation and apportionment of interest expense.
1.861-9T  Allocation and apportionment of interest expense (temporary 
          regulations).
1.861-10  Special allocations of interest expense.
1.861-10T  Special allocations of interest expense (temporary 
          regulations).
1.861-11  Special rules for allocating and apportioning interest expense 
          of an affiliated group of corporations.
1.861-11T  Special rules for allocating and apportioning interest 
          expense of an affiliated group of corporations (temporary 
          regulations).
1.861-12T  Characterization rules and adjustments for certain assets 
          (temporary regulations).
1.861-13T  Transition rules for interest expenses (temporary 
          regulations).
1.861-14  Special rules for allocating and apportioning certain expenses 
          (other than interest expense) of an affiliated group of 
          corporations.
1.861-14T  Special rules for allocating and apportioning certain 
          expenses (other than interest expense) of an affiliated group 
          of corporations (temporary regulations).
1.861-15  Income from certain aircraft or vessels first leased on or 
          before December 28, 1980.
1.861-16  Income from certain craft first leased after December 28, 
          1980.
1.861-17  Allocation and apportionment of research and experimental 
          expenditures.
1.861-18  Classification of transactions involving computer programs.
1.862-1  Income specifically from sources without the United States.
1.863-0  Table of contents.
1.863-1  Allocation of gross income under section 863(a).
1.863-2  Allocation and apportionment of taxable income.
1.863.3  Allocation and apportionment of income from certain sales of 
          inventory.

   Regulations Applicable to Taxable Years Prior to December 30, 1996

1.863-3A  Income from the sale of personal property derived partly from 
          within and partly from without the United States.
1.863-3AT  Income from the sale of personal property derived partly from 
          within and partly from without the United States (temporary 
          regulations).
1.863-4  Certain transportation services.
1.863-6  Income from sources within a foreign country or possession of 
          the United States.
1.863-7  Allocation of income attributable to certain notional principal 
          contracts under section 863(a).
1.864-1  Meaning of sale, etc.
1.864-2  Trade or business within the United States.
1.864-3  Rules for determining income effectively connected with U.S. 
          business of nonresident aliens or foreign corporations.
1.864-4  U.S. source income effectively connected with U.S. business.
1.864-5  Foreign source income effectively connected with U.S. business.
1.864-6  Income, gain, or loss attributable to an office or other fixed 
          place of business in the United States.
1.864-7  Definition of office or other fixed place of business.
1.864-8T  Treatment of related person factoring income (temporary).
1.865-1  Loss with respect to personal property other than stock.
1.865-2  Loss with respect to stock.

               Nonresident Aliens and Foreign Corporations

                      nonresident alien individuals

1.871-1  Classification and manner of taxing alien individuals.
1.871-2  Determining residence of alien individuals.
1.871-3  Residence of alien seamen.
1.871-4  Proof of residence of aliens.
1.871-5  Loss of residence by an alien.
1.871-6  Duty of withholding agent to determine status of alien payees.
1.871-7  Taxation of nonresident alien individuals not engaged in U.S. 
          business.
1.871-8  Taxation of nonresident alien individuals engaged in U.S. 
          business or treated as having effectively connected income.
1.871-9  Nonresident alien students or trainees deemed to be engaged in 
          U.S. business.
1.871-10  Election to treat real property income as effectively 
          connected with U.S. business.

[[Page 7]]

1.871-11  Gains from sale or exchange of patents, copyrights, or similar 
          property.
1.871-12  Determination of tax on treaty income.
1.871-13  Taxation of individuals for taxable year of change of U.S. 
          citizenship or residence.
1.871-14  Rules relating to repeal of tax on interest of nonresident 
          alien individuals and foreign corporations received from 
          certain portfolio debt investments.
1.872-1  Gross income of nonresident alien individuals.
1.872-2  Exclusions from gross income of nonresident alien individuals.
1.873-1  Deductions allowed nonresident alien individuals.
1.874-1  Allowance of deductions and credits to nonresident alien 
          individuals.
1.874-1T  Allowance of deductions and credits to nonresident alien 
          individuals (temporary).
1.875-1  Partnerships.
1.875-2  Beneficiaries of estates or trusts.
1.876-1  Alien residents of Puerto Rico.
1.879-1  Treatment of community income.

                          foreign corporations

1.881-0  Table of contents.
1.881-1  Manner of taxing foreign corporations.
1.881-2  Taxation of foreign corporations not engaged in U.S. business.
1.881-3  Conduit financing arrangements.
1.881-4  Recordkeeping requirements concerning conduit financing 
          arrangements.
1.882-0  Table of contents.
1.882-1  Taxation of foreign corporations engaged in U.S. business or of 
          foreign corporations treated as having effectively connected 
          income.
1.882-2  Income of foreign corporations treated as effectively connected 
          with U.S. business.
1.882-3  Gross income of a foreign corporation.
1.882-4  Allowance of deductions and credits to foreign corporations.
1.882-4T  Allowance of deductions and credits to foreign corporations 
          (temporary).
1.882-5  Determination of interest deduction.
1.883-1  Exclusions from gross income of foreign corporations.
1.884-0  Overview of regulation provisions for section 884.
1.884-1  Branch profits tax.
1.884-2  Special rules for termination or incorporation of a U.S. trade 
          or business or liquidation or reorganization of a foreign 
          corporation or its domestic subsidiary.
1.884-2T  Special rules for termination or incorporation of a U.S. trade 
          or business or liquidation or reorganization of a foreign 
          corporation or its domestic subsidiary (temporary).
1.884-3T  Coordination of branch profits tax with second-tier 
          withholding (temporary). [Reserved]
1.884-4  Branch-level interest tax.
1.884-5  Qualified resident.

                        miscellaneous provisions

1.891  Statutory provisions; doubling of rates of tax on citizens and 
          corporations of certain foreign countries.
1.892-1T  Purpose and scope of regulations (temporary regulations).
1.892-2T  Foreign government defined (temporary regulations).
1.892-3T  Income of foreign governments (temporary regulations).
1.892-4T  Commercial activities (temporary regulations).
1.892-5  Controlled commercial entity.
1.892-5T  Controlled commercial entity (temporary regulations).
1.892-6T  Income of international organizations (temporary regulations).
1.892-7T  Relationship to other Internal Revenue Code sections 
          (temporary regulations).
1.893-1  Compensation of employees of foreign governments or 
          international organizations.
1.894-1  Income affected by treaty.
1.895-1  Income derived by a foreign central bank of issue, or by Bank 
          for International Settlements, from obligations of the United 
          States or from bank deposits.
1.897-1  Taxation of foreign investment in United States real property 
          interests, definition of terms.
1.897-2  United States real property holding corporations.
1.897-3  Election by foreign corporation to be treated as a domestic 
          corporation under section 897(i).
1.897-4AT  Table of contents (temporary).
1.897-5T  Corporate distributions (temporary).
1.897-6T  Nonrecognition exchanges applicable to corporations, their 
          shareholders, and other taxpayers, and certain transfers of 
          property in corporate reorganizations (temporary).
1.897-7T  Treatment of certain partnership interests as entirely U.S. 
          real property interests under sections 897(g) and 1445(e) 
          (temporary).
1.897-8T  Status as a U.S. real property holding corporation as a 
          condition for electing section 897(i) pursuant to Sec. 1.897-3 
          (temporary).
1.897-9T  Treatment of certain interest in publicly traded corporations, 
          definition of foreign person, and foreign governments and 
          international organizations (temporary).

[[Page 8]]

              Income From Sources Without the United States

                           foreign tax credit

1.901-1  Allowance of credit for taxes.
1.901-2  Income, war profits, or excess profits tax paid or accrued.
1.901-2A  Dual capacity taxpayers.
1.901-3  Reduction in amount of foreign taxes on foreign mineral income 
          allowed as a credit.
1.902-0  Outline of regulations provisions for section 902.
1.902-1  Credit for domestic corporate shareholder of a foreign 
          corporation for foreign income taxes paid by the foreign 
          corporation.
1.902-2  Treatment of deficits in post-1986 undistributed earnings and 
          pre-1987 accumulated profits of a first-, second-, or third-
          tier corporation for purposes of computing an amount of 
          foreign taxes deemed paid under Sec. 1.902-1.
1.902-3  Credit for domestic corporate shareholder of a foreign 
          corporation for foreign income taxes paid with respect to 
          accumulated profits of taxable years of the foreign 
          corporation beginning before January 1, 1987.
1.902-4  Rules for distributions attributable to accumulated profits for 
          taxable years in which a first-tier corporation was a less 
          developed country corporation.
1.903-1  Taxes in lieu of income taxes.
1.904-0  Outline of regulation provisions for section 904.
1.904-1  Limitation on credit for foreign taxes.
1.904-2  Carryback and carryover of unused foreign tax.
1.904-3  Carryback and carryover of unused foreign tax by husband and 
          wife.
1.904-4  Separate application of section 904 with respect to certain 
          categories of income.
1.904-5  Look-through rules as applied to controlled foreign 
          corporations and other entities.
1.904-6  Allocation and apportionment of taxes.
1.904-7  Transition rules.
1.904(b)-1  Treatment of capital gains for corporations.
1.904(b)-2  Treatment of capital gains for other taxpayers.
1.904(b)-3  Sale of personal property.
1.904(b)-4  Effective date.
1.904(f)-1  Overall foreign loss and the overall foreign loss account.
1.904(f)-2  Recapture of overall foreign losses.
1.904(f)-3  Allocation of net operating losses and net capital losses.
1.904(f)-4  Recapture of foreign losses out of accumulation 
          distributions from a foreign trust.
1.904(f)-5  Special rules for recapture of overall foreign losses of a 
          domestic trust.
1.904(f)-6  Transitional rule for recapture of FORI and general 
          limitation overall foreign losses incurred in taxable years 
          beginning before January 1, 1983, from foreign source taxable 
          income subject to the general limitation in taxable years 
          beginning after December 31, 1982.
1.904(f)-7--1.904(f)-11  [Reserved]
1.904(f)-12  Transition rules.
1.904(i)-1  Limitation on use of deconsolidation to avoid foreign tax 
          credit limitations.
1.905-1  When credit for taxes may be taken.
1.905-2  Conditions of allowance of credit.
1.905-3T  Adjustments to the pools of foreign taxes and earnings and 
          profits when the allowable foreign tax credit changes 
          (temporary).
1.905-4T  Notification and redetermination of United States tax 
          liability (temporary).
1.905-5T  Foreign tax redeterminations and currency translation rules 
          for foreign tax redeterminations occurring in taxable years 
          beginning prior to January 1, 1987 (temporary).
1.907-0  Outline of regulation provisions for section 907.
1.907(a)-0  Introduction (for taxable years beginning after December 31, 
          1982).
1.907(a)-1  Reduction in taxes paid on FOGEI (for taxable years 
          beginning after December 31, 1982).
1.907(b)-1  Reduction of creditable FORI taxes (for taxable years 
          beginning after December 31, 1982).
1.907(c)-1  Definitions relating to FOGEI and FORI (for taxable years 
          beginning after December 31, 1982).
1.907(c)-2  Section 907(c)(3) items (for taxable years beginning after 
          December 31, 1982).
1.907(c)-3  FOGEI and FORI taxes (for taxable years beginning after 
          December 31, 1982).
1.907(d)-1  Disregard of posted prices for purposes of chapter 1 of the 
          Code (for taxable years beginning after December 31, 1982).
1.907(e)-1  [Reserved].
1.907(f)-1  Carryback and carryover of credits disallowed by section 
          907(a) (for amounts carried between taxable years that each 
          begin after December 31, 1982).

    Authority: 26 U.S.C. 7805.
    Section 1.852-11 is also issued under 26 U.S.C. 852(b)(3)(C), 
852(b)(8), and 852(c).
    Section 1.860D-1 also issued under 26 U.S.C. 860G(e).
    Section 1.860E-1 also issued under 26 U.S.C. 860E and 860G(e).
    Section 1.860E-2 also issued under 26 U.S.C. 860E(e).
    Section 1.860F-2 also issued under 26 U.S.C. 860G(e).

[[Page 9]]

    Section 1.860F-4T also issued under 26 U.S.C. 860G(c)(3) and (e).
    Section 1.860G-1 also issued under 26 U.S.C. 860G(a)(1)(B) and (e).
    Section 1.860G-3 also issued under 26 U.S.C. 860G(b) and 26 U.S.C. 
860G(e).
    Section 1.861-2 also issued under 26 U.S.C. 863(a).
    Section 1.861-3 also issued under 26 U.S.C. 863(a).
    Section 1.861-8 also issued under 26 U.S.C. 882(c).
    Section 1.861-9 also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f).
    Section 1.861-10(e) also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e), 26 U.S.C. 865(i) and 26 U.S.C. 7701(f).
    Section 1.861-11 also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f).
    Section 1.861-14 also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f).
    Sections 1.861-8T through 1.861-14T also issued under 26 U.S.C. 
863(a), 26 U.S.C. 864(e), 26 U.S.C. 865(i) and 26 U.S.C. 7701(f).
    Section 1.863-1 also issued under 26 U.S.C. 863(a).
    Section 1.863-2 also issued under 26 U.S.C. 863.
    Section 1.863-3 also issued under 26 U.S.C. 863(a) and (b), and 26 
U.S.C. 936(h).
    Section 1.863-4 also issued under 26 U.S.C. 863.
    Section 1.863-6 also issued under 26 U.S.C. 863.
    Section 1.863-7 is issued under 26 U.S.C. 863(a).
    Section 1.864-5 also issued under 26 U.S.C. 7701(l).
    Section 1.864-8T also issued under 26 U.S.C. 864(d)(8).
    Section 1.865-1 also issued under 26 U.S.C. 863(a) and 865(j)(1).
    Section 1.865-2 also issued under 26 U.S.C. 863(a) and 865(j)(1).
    Section 1.871-1 also issued under 26 U.S.C. 7701(l).
    Section 1.871-7 also issued under 26 U.S.C. 7701(l).
    Section 1.871-9 also issued under 26 U.S.C. 7701(b)(11).
    Section 1.874-1 also issued under 26 U.S.C. 874.
    Section 1.881-2 also issued under 26 U.S.C. 7701(l).
    Section 1.881-3 also issued under 26 U.S.C. 7701(l).
    Section 1.881-4 also issued under 26 U.S.C. 7701(l).
    Section 1.882-4 also issued under 26 U.S.C. 882(c).
    Section 1.882-5 also issued under 26 U.S.C. 882, 26 U.S.C. 864(e), 
26 U.S.C. 988(d), and 26 U.S.C. 7701(l).
    Section 1.884-0 also issued under 26 U.S.C. 884 (g).
    Section 1.884-1 also issued under 26 U.S.C. 884 (g).
    Section 1.884-1 (d) also issued under 26 U.S.C. 884 (c) (2) (A).
    Section 1.884-1 (d) (13) (i) also issued under 26 U.S.C. 884 (c) 
(2).
    Section 1.884-1 (e) also issued under 26 U.S.C. 884 (c) (2) (B).
    Section 1.884-2 also issued under 26 U.S.C. 884(g).
    Section 1.884-2T also issued under 26 U.S.C. 884 (g).
    Section 1.884-4 also issued under 26 U.S.C. 884 (g).
    Section 1.884-5 also issued under 26 U.S.C. 884 (g).
    Section 1.884-5 (e) and (f) also issued under 26 U.S.C. 884 (e) (4) 
(C).
    Section 1.892-1T also issued under 26 U.S.C. 892(c).
    Section 1.892-2T also issued under 26 U.S.C. 892(c).
    Section 1.892-3T also issued under 26 U.S.C. 892(c).
    Section 1.892-4T also issued under 26 U.S.C. 892(c).
    Section 1.892-5 also issued under 26 U.S.C. 892(c).
    Section 1.892-5T also issued under 26 U.S.C. 892(c).
    Section 1.892-6T also issued under 26 U.S.C. 892(c).
    Section 1.892-7T also issued under 26 U.S.C. 892(c).
    Section 1.894-1 also issued under 26 U.S.C. 894 and 7701(l).
    Sections 1.897-5T, 1.897-6T and 1.897-7T also issued under 26 U.S.C. 
897 (d), (e), (g) and (j) and 26 U.S.C. 367(e)(2).
    Sections 1.902-1 and 902-2 also issued under 26 U.S.C. 902(c)(7).
    Sections 1.904-4 through 1.904-7 also issued under 26 U.S.C. 
904(d)(5).
    Section 1.904(b)-3 also issued under 26 U.S.C. 7701(b)(11).
    Section 1.904(f)-(2) also issued under 26 U.S.C. 904 (f)(3)(b).
    Sections 1.904-4 through 1.904-7 also issued under 26 U.S.C. 
904(d)(5).
    Section 1.904(i)-1 also issued under 26 U.S.C. 904(i).
    Sections 1.905-3T and 1.905-4T also issued under 26 U.S.C. 
989(c)(4).
    Section 1.907(b)-1 is also issued under 26 U.S.C. 907(b).
    Section 1.907(b)-1T also issued under 26 U.S.C. 907(b).

    Source: T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 
1960, unless otherwise noted.

[[Page 10]]

    REGULATED INVESTMENT COMPANIES AND REAL ESTATE INVESTMENT TRUSTS



Sec. 1.851-1  Definition of regulated investment company.

    (a) In general. The term ``regulated investment company'' is defined 
to mean any domestic corporation (other than a personal holding company 
as defined in section 542) which meets (1) the requirements of section 
851(a) and paragraph (b) of this section, and (2) the limitations of 
section 851(b) and Sec. 1.851-2. As to the definition of the term 
``corporation'', see section 7701(a)(3).
    (b) Requirement. To qualify as a regulated investment company, a 
corporation must be:
    (1) Registered at all times during the taxable year, under the 
Investment Company Act of 1940, as amended (15 U.S.C. 80a-1 to 80b-2), 
either as a management company or a unit investment trust, or
    (2) A common trust fund or similar fund excluded by section 3(c)(3) 
of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)) from the 
definition of ``investment company'' and not included in the definition 
of ``common trust fund'' by section 584(a).



Sec. 1.851-2  Limitations.

    (a) Election to be a regulated investment company. Under the 
provisions of section 851(b)(1), a corporation, even though it satisfies 
the other requirements of part I, subchapter M, chapter 1 of the Code, 
for the taxable year, will not be considered a regulated investment 
company for such year, within the meaning of such part I, unless it 
elects to be a regulated investment company for such taxable year, or 
has made such an election for a previous taxable year which began after 
December 31, 1941. The election shall be made by the taxpayer by 
computing taxable income as a regulated investment company in its return 
for the first taxable year for which the election is applicable. No 
other method of making such election is permitted. An election once made 
is irrevocable for such taxable year and all succeeding taxable years.
    (b) Gross income requirement--(1) General rule. Section 851(b) (2) 
and (3) provides that (i) at least 90 percent of the corporation's gross 
income for the taxable year must be derived from dividends, interest, 
and gains from the sale or other disposition of stocks or securities, 
and (ii) less than 30 percent of its gross income must have been derived 
from the sale or other disposition of stock or securities held for less 
than three months. In determining the gross income requirements under 
section 851(b) (2) and (3), a loss from the sale or other disposition of 
stock or securities does not enter into the computation. A determination 
of the period for which stock or securities have been held shall be 
governed by the provisions of section 1223 insofar as applicable.
    (2) Special rules. (i) For purposes of section 851(b)(2), there 
shall be treated as dividends amounts which are included in gross income 
for the taxable year under section 951(a)(1)(A)(i) to the extent that 
(a) a distribution out of a foreign corporation's earnings and profits 
of the taxable year is not included in gross income by reason of section 
959 (a)(1), and (b) the earnings and profits are attributable to the 
amounts which were so included in gross income under section 
951(a)(1)(A)(i). For allocation of distributions to earnings and profits 
of foreign corporations, see Sec. 1.959-3. The provisions of this 
subparagraph shall apply with respect to taxable years of controlled 
foreign corporations beginning after December 31, 1975, and to taxable 
years of United States shareholders (within the meaning of section 
951(b) within which or with which such taxable years of such controlled 
foreign corporations end.
    (ii) For purposes of subdivision (i) of this subparagraph, if by 
reason of section 959(a)(1) a distribution of a foreign corporation's 
earnings and profits for a taxable year described in section 959(c)(2) 
is not included in a shareholder's gross income, then such distribution 
shall be allocated proportionately between amounts attributable to 
amounts included under each clause of section 951(a)(1)(A). Thus, for 
example, M is a United States shareholder in X Corporation, a controlled 
foreign corporation. M and X each use the calendar year as the taxable 
year. For 1977, M is required by section

[[Page 11]]

951(a)(1)(a) to include $3,000 in its gross income, $1,000 of which is 
included under clause (i) thereof. In 1977, M received a distribution 
described in section 959(c)(2) of $2,700 out of X's earnings and profits 
for 1977, which is, by reason of section 959(a)(1), excluded from M's 
gross income. The amount of the distribution attributable to the amount 
included under section 951(a)(1)(A)(i) is $900, i.e., $2,700 multiplied 
by ($1,000/$3,000).
    (c) Diversification of investments. (1) Subparagraph (A) of section 
851(b)(4) requires that at the close of each quarter of the taxable year 
at least 50 percent of the value of the total assets of the taxpayer 
corporation be represented by one or more of the following:
    (i) Cash and cash items, including receivables;
    (ii) Government securities;
    (iii) Securities of other regulated investment companies; or
    (iv) Securities (other than those described in subdivisions (ii) and 
(iii) of this subparagraph) of any one or more issuers which meet the 
following limitations: (a) The entire amount of the securities of the 
issuer owned by the taxpayer corporation is not greater in value than 5 
percent of the value of the total assets of the taxpayer corporation, 
and (b) the entire amount of the securities of such issuer owned by the 
taxpayer corporation does not represent more than 10 percent of the 
outstanding voting securities of such issuer. For the modification of 
the percentage limitations applicable in the case of certain venture 
capital investment companies, see section 851(e) and Sec. 1.851-6.

Assuming that at least 50 percent of the value of the total assets of 
the corporation satisfies the requirements specified in this 
subparagraph, and that the limiting provisions of subparagraph (B) of 
section 851(b)(4) and subparagraph (2) of this paragraph are not 
violated, the corporation will satisfy the requirements of section 
851(b)(4), notwithstanding that the remaining assets do not satisfy the 
diversification requirements of subparagraph (A) of section 851(b)(4). 
For example, a corporation may own all the stock of another corporation, 
provided it otherwise meets the requirements of subparagraphs (A) and 
(B) of section 851(b)(4).
    (2) Subparagraph (B) of section 851(b)(4) prohibits the investment 
at the close of each quarter of the taxable year of more than 25 percent 
of the value of the total assets of the corporation (including the 50 
percent or more mentioned in subparagraph (A) of section 851(b)(4)) in 
the securities (other than Government securities or the securities of 
other regulated investment companies) of any one issuer, or of two or 
more issuers which the taxpayer company controls and which are engaged 
in the same or similar trades or businesses or related trades or 
businesses, including such issuers as are merely a part of a unit 
contributing to the completion and sale of a product or the rendering of 
a particular service. Two or more issuers are not considered as being in 
the same or similar trades or businesses merely because they are engaged 
in the broad field of manufacturing or of any other general 
classification of industry, but issuers shall be construed to be engaged 
in the same or similar trades or businesses if they are engaged in a 
distinct branch of business, trade, or manufacture in which they render 
the same kind of service or produce or deal in the same kind of product, 
and such service or products fulfill the same economic need. If two or 
more issuers produce more than one product or render more than one type 
of service, then the chief product or service of each shall be the basis 
for determining whether they are in the same trade or business.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6598, 27 FR 
4090, Apr. 28, 1962; T.D. 7555, 43 FR 32753, July 28, 1978]



Sec. 1.851-3  Rules applicable to section 851(b)(4).

    In determining the value of the taxpayer's investment in the 
securities of any one issuer, for the purposes of subparagraph (B) of 
section 851(b)(4), there shall be included its proper proportion of the 
investment of any other corporation, a member of a controlled group, in 
the securities of such issuer. See example 4 in Sec. 1.851-5. For 
purposes of Secs. 1.851-2, 1.851-4, 1.851-5, and 1.851-6, the terms 
``controls'', ``controlled group'',

[[Page 12]]

and ``value'' have the meaning assigned to them by section 851(c). All 
other terms used in such sections have the same meaning as when used in 
the Investment Company Act of 1940 (15 U.S.C., chapter 2D) or that act 
as amended.



Sec. 1.851-4  Determination of status.

    With respect to the effect which certain discrepancies between the 
value of its various investments and the requirements of section 
851(b)(4) and paragraph (c) of Sec. 1.851-2, or the effect that the 
elimination of such discrepancies will have on the status of a company 
as a regulated investment company for purposes of part I, subchapter M, 
chapter 1 of the Code, see section 851(d). A company claiming to be a 
regulated investment company shall keep sufficient records as to 
investments so as to be able to show that it has complied with the 
provisions of section 851 during the taxable year. Such records shall be 
kept at all times available for inspection by any internal revenue 
officer or employee and shall be retained so long as the contents 
thereof may become material in the administration of any internal 
revenue law.

[T.D. 6598, 27 FR 4090, Apr. 28, 1962]



Sec. 1.851-5  Examples.

    The provisions of section 851 may be illustrated by the following 
examples:

    Example 1. Investment Company W at the close of its first quarter of 
the taxable year has its assets invested as follows:

 
                                                                Percent
 
Cash.........................................................          5
Government securities........................................         10
Securities of regulated investment companies.................         20
Securities of Corporation A..................................         10
Securities of Corporation B..................................         15
Securities of Corporation C..................................         20
Securities of various corporations (not exceeding 5 percent           20
 of its assets in any one company)...........................
                                                              ----------
      Total..................................................        100
 


Investment Company W owns all of the voting stock of Corporations A and 
B, 15 percent of the voting stock of Corporation C, and less than 10 
percent of the voting stock of the other corporations. None of the 
corporations is a member of a controlled group. Investment Company W 
meets the requirements under section 851(b)(4) at the end of its first 
quarter. It complies with subparagraph (A) of section 851(b)(4) since it 
has 55 percent of its assets invested as provided in such subparagraph. 
It complies with subparagraph (B) of section 851(b)(4) since it does not 
have more than 25 percent of its assets invested in the securities of 
any one issuer, or of two or more issuers which it controls.
    Example 2. Investment Company V at the close of a particular quarter 
of the taxable year has its assets invested as follows:

 
                                                                Percent
 
Cash.........................................................         10
Government securities........................................         35
Securities of Corporation A..................................          7
Securities of Corporation B..................................         12
Securities of Corporation C..................................         15
Securities of Corporation D..................................         21
                                                              ----------
      Total..................................................        100
 


Investment Company V fails to meet the requirements of subparagraph (A) 
of section 851(b)(4) since its assets invested in Corporations A, B, C, 
and D exceed in each case 5 percent of the value of the total assets of 
the company at the close of the particular quarter.
    Example 3. Investment Company X at the close of the particular 
quarter of the taxable year has its assets invested as follows:

 
                                                                Percent
 
Cash and Government securities...............................         20
Securities of Corporation A..................................          5
Securities of Corporation B..................................         10
Securities of Corporation C..................................         25
Securities of various corporations (not exceeding 5 percent           40
 of its assets in any one company)...........................
                                                              ----------
      Total..................................................        100
 


Investment Company X owns more than 20 percent of the voting power of 
Corporations B and C and less than 10 percent of the voting power of all 
of the other corporations. Corporation B manufactures radios and 
Corporation C acts as its distributor and also distributes radios for 
other companies. Investment Company X fails to meet the requirements of 
subparagraph (B) of section 851(b)(4) since it has 35 percent of its 
assets invested in the securities of two issuers which it controls and 
which are engaged in related trades or businesses.
    Example 4. Investment Company Y at the close of a particular quarter 
of the taxable year has its assets invested as follows:

 
                                                                Percent
 
Cash and Government securities...............................         15
Securities of Corporation K (a regulated investment company).         30
Securities of Corporation A..................................         10
Securities of Corporation B..................................         20
Securities of various corporations (not exceeding 5 percent           25
 of its assets in any one company)...........................
                                                              ----------
      Total..................................................        100
 


[[Page 13]]


Corporation K has 20 percent of its assets invested in Corporation L and 
Corporation L has 40 percent of its assets invested in Corporation B. 
Corporation A also has 30 percent of its assets invested in Corporation 
B, and owns more than 20 percent of the voting power in Corporation B. 
Investment Company Y owns more than 20 percent of the voting power of 
Corporations A and K. Corporation K owns more than 20 percent of the 
voting power of Corporation L, and Corporation L owns more than 20 
percent of the voting power of Corporation L. Investment Company Y is 
disqualified under subparagraph (B) of section 851(b)(4) since more than 
25 percent of its assets are considered invested in Corporation B as 
shown by the following calculation:

 
                                                                Percent
 
Percentage of assets invested directly in Corporation B......       20.0
Percentage invested through the controlled group, Y-K-L-B (40        2.4
 percent of 20 percent of 30 percent)........................
Percentage invested in the controlled group, Y-A-B (30               3.0
 percent of 10 percent)......................................
                                                              ----------
    Total percentage of assets of investment Company Y              25.4
     invested in Corporation B...............................
 

    Example 5. Investment Company Z, which keeps its books and makes its 
returns on the basis of the calendar year, at the close of the first 
quarter of 1955 meets the requirements of section 851(b)(4) and has 20 
percent of its assets invested in Corporation A. Later during the 
taxable year it makes distributions to its shareholders and because of 
such distributions it finds at the close of the taxable year that it has 
more than 25 percent of its remaining assets invested in Corporation A. 
Investment Company Z does not lose its status as a regulated investment 
company for the taxable year 1955 because of such distributions, nor 
will it lose its status as a regulated investment company for 1956 or 
any subsequent year solely as a result of such distributions.
    Example 6. Investment Company Q, which keeps its books and makes its 
returns on the basis of a calendar year, at the close of the first 
quarter of 1955, meets the requirements of section 851(b)(4) and has 20 
percent of its assets invested in Corporation P. At the close of the 
taxable year 1955, it finds that it has more than 25 percent of its 
assets invested in Corporation P. This situation results entirely from 
fluctuations in the market values of the securities in Investment 
Company Q's portfolio and is not due in whole or in part to the 
acquisition of any security or other property. Corporation Q does not 
lose its status as a regulated investment company for the taxable year 
1955 because of such fluctuations in the market values of the securities 
in its portfolio, nor will it lose its status as a regulated investment 
company for 1956 or any subsequent year solely as a result of such 
market value fluctuations.



Sec. 1.851-6  Investment companies furnishing capital to development corporations.

    (a) Qualifying requirements. (1) In the case of a regulated 
investment company which furnishes capital to development corporations, 
section 851 (e) provides an exception to the rule relating to the 
diversification of investments, made applicable to regulated investment 
companies by section 851(b)(4)(A). This exception (as provided in 
paragraph (b) of this section) is available only to registered 
management investment companies which the Securities and Exchange 
Commission determines, in accordance with regulations issued by it, and 
certifies to the Secretary or his delegate, not earlier than 60 days 
before the close of the taxable year of such investment company, to be 
principally engaged in the furnishing of capital to other corporations 
which are principally engaged in the development or exploitation of 
inventions, technological improvements, new processes, or products not 
previously generally available.
    (2) For the purpose of the aforementioned determination and 
certification, unless the Securities and Exchange Commission determines 
otherwise, a corporation shall be considered to be principally engaged 
in the development or exploitation of inventions, technological 
improvements, new processes, or products not previously generally 
available, for at least 10 years after the date of the first acquisition 
of any security in such corporation or any predecessor thereof by such 
investment company if at the date of such acquisition the corporation or 
its predecessor was principally so engaged, and an investment company 
shall be considered at any date to be furnishing capital to any company 
whose securities it holds if within 10 years before such date it had 
acquired any of such securities, or any securities surrendered in 
exchange therefor, from such other company or its predecessor.
    (b) Exception to general rule. (1) The registered management 
investment company, which for the taxable year meets the requirements of 
paragraph (a) of this section, may (subject to the

[[Page 14]]

limitations of section 851(e)(2) and paragraph (c) of this section) in 
the computation of 50 percent of the value of its assets under section 
851(b)(4)(A) and paragraph (c)(1) of Sec. 1.851-2 for any quarter of 
such taxable year, include the value of any securities of an issuer 
(whether or not the investment company owns more than 10 percent of the 
outstanding voting securities of such issuer) if at the time of the 
latest acquisition of any securities of such issuer the basis of all 
such securities in the hands of the investment company does not exceed 5 
percent of the value of the total assets of the investment company at 
that time. The exception provided by section 851(e)(1) and this 
subparagraph is not applicable to the securities of an issuer if the 
investment company has continuously held any security of such issuer or 
of any predecessor company (as defined in paragraph (d) of this section) 
for 10 or more years preceding such quarter of the taxable year. The 
rule of section 851(e)(1) with respect to the relationship of the basis 
of the securities of an issuer to the value of the total assets of the 
investment company is, in substance, a qualification of the 5-percent 
limitation in section 851(b)(4)(A)(ii) and paragraph (c)(1)(iv) of 
Sec. 1.851-2. All other provisions and requirements of section 851 and 
Secs. 1.851-1 through 1.851-6 are applicable in determining whether such 
registered management investment company qualifies as a regulated 
investment company.
    (2) The application of subparagraph (1) of this paragraph may be 
illustrated by the following examples:

    Example 1. (i) The XYZ Corporation, a regulated investment company, 
qualified under section 851(e) as an investment company furnishing 
capital to development corporations. On June 30, 1954, the XYZ 
Corporation purchased 1,000 shares of the stock of the A Corporation at 
a cost of $30,000. On June 30, 1954, the value of the total assets of 
the XYZ Corporation was $1,000,000. Its investment in the stock of the A 
Corporation ($30,000) comprised 3 percent of the value of its total 
assets, and it therefore met the requirements prescribed by section 
851(b)(4)(A)(ii) as modified by section 851(e)(1).
    (ii) On June 30, 1955, the value of the total assets of the XYZ 
Corporation was $1,500,000 and the 1,000 shares of stock of the A 
Corporation which the XYZ Corporation owned appreciated in value so that 
they were then worth $60,000. On that date, the XYZ Investment Company 
increased its investment in the stock of the A Corporation by the 
purchase of an additional 500 shares of that stock at a total cost of 
$30,000. The securities of the A Corporation owned by the XYZ 
Corporation had a value of $90,000 (6 percent of the value of the total 
assets of the XYZ Corporation) which exceeded the limit provided by 
section 851(b)(4)(A)(ii). However, the investment of the XYZ Corporation 
in the A Corporation on June 30, 1955, qualified under section 
851(b)(4)(A) as modified by section 851(e)(1), since the basis of those 
securities to the investment company did not exceed 5 percent of the 
value of its total assets as of June 30, 1955, illustrated as follows:

 
 
 
Basis to the XYZ Corporation of the A Corporation's stock        $30,000
 acquired on June 30, 1954...................................
Basis of the 500 shares of the A Corporation's stock acquired     30,000
 by the XYZ Corporation on June 30, 1955.....................
                                                              ----------
      Basis of all stock of A Corporation....................     60,000
 

Basis of stock of A Corporation ($60,000)/Value of XYZ Corporation's 
          total assets at June 30, 1955, time of the latest acquisition 
          ($1,500,000)=4 percent
    Example 2. The same facts existed as in example 1, except that on 
June 30, 1955, the XYZ Corporation increased its investment in the stock 
of the A Corporation by the purchase of an additional 1,000 shares of 
that stock (instead of 500 shares) at a total cost of $60,000. No part 
of the investment of the XYZ Corporation in the A Corporation qualified 
under the 5 percent limitation provided by section 851(b)(4)(A) as 
modified by section 851(e)(1), illustrated as follows:

 
 
 
Basis to the XYZ Corporation of the 1,000 shares of the A        $30,000
 Corporation's stock acquired on June 30, 1954...............
Basis of the 1,000 shares of the A Corporation's stock            60,000
 acquired on June 30, 1955...................................
                                                              ----------
      Total..................................................     90,000
 

Basis of stock of A Corporation ($90,000)/Value of XYZ Corporation's 
          total assets at June 30, 1955, time of the latest acquisition 
          ($1,500,000)= 6 percent
    Example 3. The same facts existed as in example 2 and on June 30, 
1956, the XYZ Corporation increased its investment in the stock of the A 
Corporation by the purchase of an additional 100 shares of that stock at 
a total cost of $6,000. On June 30, 1956, the value of the total assets 
of the XYZ Corporation was $2,000,000 and on that date the investment in 
the A Corporation qualified under section 851(b)(4)(A) as modified by 
section 851(e)(1) illustrated as follows:

[[Page 15]]



 
 
 
Basis to the XYZ Corporation of investments in the A
 Corporation's stock:
  1,000 shares acquired June 30, 1954........................    $30,000
  1,000 shares acquired June 30, 1955........................     60,000
  100 shares acquired June 30, 1956..........................      6,000
                                                              ----------
      Total..................................................     96,000
 

Basis of stock of A Corporation ($96,000)/Value of XYZ Corporation's 
          total assets at June 30, 1956, time of the latest acquisition 
          ($2,000,000)=4.8 percent

    (c) Limitation. Section 851(e) and this section do not apply in the 
quarterly computation of 50 percent of the value of the assets of an 
investment company under subparagraph (A) of section 851(b)(4) and 
paragraph (c)(1) of Sec. 1.851-2 for any taxable year if at the close of 
any quarter of such taxable year more than 25 percent of the value of 
its total assets (including the 50 percent or more mentioned in such 
subparagraph (A)) is represented by securities (other than Government 
securities or the securities of other regulated investment companies) of 
issuers as to each of which such investment company (1) holds more than 
10 percent of the outstanding voting securities of such issuer, and (2) 
has continuously held any security of such issuer (or any security of a 
predecessor of such issuer) for 10 or more years preceding such quarter, 
unless the value of its total assets so represented is reduced to 25 
percent or less within 30 days after the close of such quarter.
    (d) Definition of predecessor company. As used in section 851(e) and 
this section, the term ``predecessor company'' means any corporation the 
basis of whose securities in the hands of the investment company was, 
under the provisions of section 358 or corresponding provisions of prior 
law, the same in whole or in part as the basis of any of the securities 
of the issuer and any corporation with respect to whose securities any 
of the securities of the issuer were received directly or indirectly by 
the investment company in a transaction or series of transactions 
involving nonrecognition of gain or loss in whole or in part. The other 
terms used in this section have the same meaning as when used in section 
851(b)(4). See paragraph (c) of Sec. 1.851-2 and Sec. 1.851-3.



Sec. 1.851-7  Certain unit investment trusts.

    (a) In general. For purposes of the Internal Revenue Code, a unit 
investment trust (as defined in paragraph (d) of this section) shall not 
be treated as a person (as defined in section 7701(a)(1)) except for 
years ending before January 1, 1969. A holder of an interest in such a 
trust will be treated as directly owning the assets of such trust for 
taxable years of such holder which end with or within any year of the 
trust to which section 851(f) and this section apply.
    (b) Treatment of unit investment trust. A unit investment trust 
shall not be treated as an individual, a trust estate, partnership, 
association, company, or corporation for purposes of the Internal 
Revenue Code. Accordingly, a unit investment trust is not a taxpayer 
subject to taxation under the Internal Revenue Code. No gain or loss 
will be recognized by the unit investment trust if such trust 
distributes a holder's proportionate share of the trust assets in 
exchange for his interest in the trust. Also, no gain or loss will be 
recognized by the unit investment trust if such trust sells the holder's 
proportionate share of the trust assets and distributes the proceeds 
from such share to the holder in exchange for his interest in the trust.
    (c) Treatment of holder of interest in unit investment trust. (1) 
Each holder of an interest in a unit investment trust shall be treated 
(to the extent of such interest) as owning a proportionate share of the 
assets of the trust. Accordingly, if the trust distributes to the holder 
of an interest in such trust his proportionate share of the trust assets 
in exchange for his interest in the trust, no gain or loss shall be 
recognized by such holder (or by any other holder of an interest in such 
trust). For purposes of this paragraph, each purchase of an interest in 
the trust by the holder will be considered a separate interest in the 
trust. Items of income, gain, loss, deduction, or credit received by the 
trust or a custodian thereof shall be taxed to the holders of interests 
in the trust (and not to the trust) as though they had received their 
proportionate share of the items directly

[[Page 16]]

on the date such items were received by the trust or custodian.
    (2) The basis of the assets of such trust which are treated under 
subparagraph (1) of this paragraph as being owned by the holder of an 
interest in such trust shall be the same as the basis of his interest in 
such trust. Accordingly, the amount of the gain or loss recognized by 
the holder upon the sale by the unit investment trust of the holder's 
pro rata share of the trust assets shall be determined with reference 
the basis, of his interest in the trust. Also, the basis of the assets 
received by the holder, if the trust distributes a holder's pro rata 
share of the trust assets in exchange for his interest in the trust, 
will be the same as the basis of his interest in the trust. If the unit 
investment trust sells less than all of the holder's pro rata share of 
the trust assets and the holder retains an interest in the trust, the 
amount of the gain or loss recognized by the holder upon the sale shall 
be determined with reference to the basis of his interest in the assets 
sold by the trust, and the basis of his interest in the trust shall be 
reduced accordingly. If the trust distributes a portion of the holder's 
pro rata share of the trust assets in exchange for a portion of his 
interest in the trust, the basis of the assets received by the holder 
shall be determined with reference to the basis of his interest in the 
assets distributed by the trust, and the basis of his interest in the 
trust shall be reduced accordingly. For purposes of this subparagraph 
the basis of the holder's interest in assets sold by the trust or 
distributed to him shall be an amount which bears the same relationship 
to the basis of his total interest in the trust that the fair market 
value of the assets so sold or distributed bears to the fair market 
value of such total interest in the trust, such fair market value to be 
determined on the date of such sale or distribution.
    (3) The period for which the holder of an interest in such trust has 
held the assets of the trust which are treated under subparagraph (1) of 
this paragraph as being owned by him is the same as the period for which 
such holder has held his interest in such trust. Accordingly, the 
character of the gain, loss, deduction, or credit recognized by the 
holder upon the sale by the unit investment trust of the holder's 
proportionate share of the trust assets shall be determined with 
reference to the period for which he has held his interest in the trust. 
Also, the holding period of the assets received by the holder if the 
trust distributes the holder's proportionate share of the trust assets 
in exchange for his interest in the trust will include the period for 
which the holder has held his interest in the trust.
    (4) The application of the provisions of this paragraph may be 
illustrated by the following example:

    Example. B entered a periodic payment plan of a unit investment 
trust (as defined in paragraph (d) of this section) with X Bank as 
custodian and Z as plan sponsor. Under this plan, upon B's demand, X 
must either redeem B's interest at a price substantially equal to the 
fair market value of the number of shares in Y, a management company, 
which are credited to B's account by X in connection with the unit 
investment trust, or at B's option distribute such shares of Y to B. B's 
plan provides for quarterly payments of $1,000. On October 1, 1969, B 
made his initial quarterly payment of $1,000 and X credited B's account 
with 110 shares of Y. On December 1, 1969, Y declared and paid a 
dividend of 25 cents per share, 5 cents of which was designated as a 
capital gain dividend pursuant to section 852(b)(3) and Sec. 1.852-4. X 
credited B's account with $27.50 but did not distribute the money to B 
in 1969. On December 31, 1969, X charged B's account with $1 for 
custodial fees for calendar year 1969. On January 1, 1970, B paid X 
$1,000 and X credited B's account with 105 shares of Y. On April 1, 
1970, B paid X $1,000 and X credited B's account with 100 shares of Y. B 
must include in his tax return for 1969 a dividend of $22 and a long-
term capital gain of $5.50. In addition, B is entitled to deduct the 
annual custodial fee of $1 under section 212 of the Code.
    (a) On April 4, 1970, at B's request, X sells the shares of Y 
credited to B's account (315 shares) for $10 per share and distributes 
the proceeds ($3,150) to B together with the remaining balance of $26.50 
in B's account. The receipt of the $26.50 does not result in any tax 
consequences to B. B recognizes a long-term capital gain of $100 and a 
short- term capital gain of $50, computed as follows:
    (1) B is treated as owning 110 shares of Y as of October 1, 1969. 
The basis of these shares is $1,000, and they were sold for $1,100 (110 
shares at $10 per share). Therefore, B recognizes a gain from the sale 
or exchange of a capital asset held for more than 6 months in the amount 
of $100.

[[Page 17]]

    (2) B is treated as owning 105 shares of Y as of January 1, 1970, 
and 100 shares as of April 1, 1970. With respect to the shares acquired 
on April 1, 1970, there is no gain recognized as the shares were sold 
for $1,000, which is B's basis of the shares. The shares acquired on 
January 1, 1970, were sold for $1,050 (105 shares at $10 per share), and 
B's basis of these shares is $1,000. Therefore, B recognizes a gain of 
$50 from the sale or exchange of a capital asset held for not more than 
6 months.
    (b) On April 4, 1970, at B's request, X distributes to B the shares 
of Y credited to his account and $26.50 in cash. The receipt of the 
$26.50 does not result in any tax consequences to B. B does not 
recognize gain or loss on the distribution of the shares of Y to him. 
The bases and holding periods of B's interests in Y are as follows:

------------------------------------------------------------------------
                                                        Date
                  Number of shares                    acquired    Basis
------------------------------------------------------------------------
110................................................     10-1-69    $9.09
105................................................      1-1-70     9.52
100................................................      4-1-70    10.00
------------------------------------------------------------------------

    (d) Definition. A unit investment trust to which this section refers 
is a business arrangement (other than a segregated asset account, 
whether or not it holds assets pursuant to a variable annuity contract, 
under the insurance laws or regulations of a State) which (except for 
taxable years ending before Jan. 1, 1969)--
    (1) Is a unit investment trust (as defined in the Investment Company 
Act of 1940);
    (2) Is registered under such Act;
    (3) Issues periodic payment plan certificates (as defined in such 
Act) in one or more series;
    (4) Possesses, as substantially all of its assets, as to all such 
series, securities issued by--
    (i) A single management company (as defined in such Act), and 
securities acquired pursuant to subparagraph (5) of this paragraph, or
    (ii) A single other corporation; and
    (5) Has no power to invest in any other securities except securities 
issued by a single other management company, when permitted by such Act 
or the rules and regulations of the Securities and Exchange Commission.
    (e) Investment in two single management companies. (1) A unit 
investment trust may possess securities issued by two or more separate 
single management companies (as defined in such Act) if--
    (i) The trust issues a separate series of periodic payment plan 
certificates (as defined in such Act) with respect to the securities of 
each separate single management company which it possesses; and
    (ii) None of the periodic payment plan certificates issued by the 
trust permits joint acquisition of an interest in each series nor the 
application of payments in whole or in part first to a series issued by 
one of the single management companies and then to any other series 
issued by any other single management company.
    (2) If a unit investment trust possesses securities of two or more 
separate single management companies as described in subparagraph (1) of 
this paragraph and issues a separate series of periodic payment plan 
certificates with respect to the securities of each such management 
company, then the holder of an interest in a series shall be treated as 
the owner of the securities in the single management company represented 
by such interest.
    (i) A holder of an interest in a series of periodic payment plan 
certificates of a trust who transfers or sells his interest in the 
series in exchange for an interest in another series of periodic payment 
plan certificates of the trust shall recognize the gain or loss realized 
from the transfer or sale as if the trust had sold the shares credited 
to his interests in the series at fair market value and distributed the 
proceeds of the sale to him.
    (ii) The basis of the interests in the series so acquired by the 
holder shall be the fair market value of his interests in the series 
transferred or sold.
    (iii) The period for which the holder has held his interest in the 
series so acquired shall be measured from the date of his acquisition of 
his interest in that series.
    (f) Cross references. (1) For reporting requirements imposed on 
custodians of unit investment trusts described in this section, see 
Secs. 1.852-4, 1.852-9, 1.853-3, 1.854-2, and 1.6042-2.

[[Page 18]]

    (2) For rules relating to redemptions of certain unit investment 
trusts not described in this section, see Sec. 1.852-10.

[T.D. 7187, 37 FR 13254, July 6, 1972, as amended by T.D. 7187, 37 FR 
20688, Oct. 3, 1972]



Sec. 1.852-1  Taxation of regulated investment companies.

    (a) Requirements applicable thereto--(1) In general. Section 852(a) 
denies the application of the provisions of part I, subchapter M, 
chapter 1 of the Code (other than section 852(c), relating to earnings 
and profits), to a regulated investment company for a taxable year 
beginning after February 28, 1958, unless--
    (i) The deduction for dividends paid for such taxable year as 
defined in section 561 (computed without regard to capital gain 
dividends) is equal to at least 90 percent of its investment company 
taxable income for such taxable year (determined without regard to the 
provisions of section 852(b)(2)(D) and paragraph (d) of Sec. 1.852-3); 
and
    (ii) The company complies for such taxable year with the provisions 
of Sec. 1.852-6 (relating to records required to be maintained by a 
regulated investment company).

See section 853(b)(1)(B) and paragraph (a) of Sec. 1.853-2 for amounts 
to be added to the dividends paid deduction, and section 855 and 
Sec. 1.855-1, relating to dividends paid after the close of the taxable 
year.
    (2) Special rule for taxable years of regulated investment companies 
beginning before March 1, 1958. The provisions of part I of subchapter M 
(including section 852(c)) are not applicable to a regulated investment 
company for a taxable year beginning before March 1, 1958, unless such 
company meets the requirements of section 852(a) and subparagraph (1) 
(i) and (ii) of this paragraph.
    (b) Failure to qualify. If a regulated investment company does not 
meet the requirements of section 852(a) and paragraph (a)(1) (i) and 
(ii) of this section for the taxable year, it will, even though it may 
otherwise be classified as a regulated investment company, be taxed in 
such year as an ordinary corporation and not as a regulated investment 
company. In such case, none of the provisions of part I of subchapter M 
(other than section 852(c) in the case of taxable years beginning after 
February 28, 1958) will be applicable to it. For the rules relating to 
the applicability of section 852(c), see Sec. 1.852-5.

[T.D. 6598, 27 FR 4091, Apr. 28, 1962]



Sec. 1.852-2  Method of taxation of regulated investment companies.

    (a) Imposition of normal tax and surtax. Section 852(b)(1) imposes a 
normal tax and surtax, computed at the rates and in the manner 
prescribed in section 11, on the investment company taxable income, as 
defined in section 852(b)(2) and Sec. 1.852-3, for each taxable year of 
a regulated investment company. The tax is imposed as if the investment 
company taxable income were the taxable income referred to in section 
11. In computing the normal tax under section 11, the regulated 
investment company's taxable income and the dividends paid deduction 
(computed without regard to the capital gains dividends) shall both be 
reduced by the deduction for partially tax-exempt interest provided by 
section 242.
    (b) Taxation of capital gains--(1) In general. Section 852(b)(3)(A) 
imposes (i) in the case of a taxable year beginning before January 1, 
1970, a tax of 25 percent, or (ii) in the case of a taxable year 
beginning after December 31, 1969, a tax determined as provided in 
section 1201(a) and paragraph (a)(3) of Sec. 1.1201-1, on the excess, if 
any, of the net long-term capital gain of a regulated investment company 
(subject to tax under part I, subchapter M, chapter 1 of the Code) over 
the sum of its net short-term capital loss and its deduction for 
dividends paid (as defined in section 561) determined with reference to 
capital gain dividends only. For the definition of capital gain dividend 
paid by a regulated investment company, see section 852(b)(3)(C) and 
paragraph (c) of Sec. 1.852-4. In the case of a taxable year ending 
after December 31, 1969, and beginning before January 1, 1975, such 
deduction for dividends paid shall first be made from the amount subject 
to tax in accordance with section 1201(a)(1)(B), to the extent thereof, 
and then from the amount subject to tax in accordance with section 
1201(a)(1)(A). See Sec. 1.852-10, relating to certain distributions in 
redemption of interests in

[[Page 19]]

unit investment trusts which, for purposes of the deduction for 
dividends paid with reference to capital gain dividends only, are not 
considered preferential dividends under section 562(c). See section 855 
and Sec. 1.855-1, relating to dividends paid after the close of the 
taxable year.
    (2) Undistributed capital gains--(i) In general. A regulated 
investment company (subject to tax under part I of subchapter M) may, 
for taxable years beginning after December 31, 1956, designate under 
section 852(b)(3)(D) an amount of undistributed capital gains to each 
shareholder of the company. For the definition of the term 
``undistributed capital gains'' and for the treatment of such amounts by 
a shareholder, see paragraph (b)(2) of Sec. 1.852-4. For the rules 
relating to the method of making such designation, the returns to be 
filed, and the payment of the tax in such cases, see paragraph (a) of 
Sec. 1.852-9.
    (ii) Effect on earnings and profits of a regulated investment 
company. If a regulated investment company designates an amount as 
undistributed capital gains for a taxable year, the earnings and profits 
of such regulated investment company for such taxable year shall be 
reduced by the total amount of the undistributed capital gains so 
designated. In such case, its capital account shall be increased--
    (a) In the case of a taxable year ending before January 1, 1970, by 
75 percent of the total amount designated,
    (b) In the case of a taxable year ending after December 31, 1969, 
and beginning before January 1, 1975, by the total amount designated 
decreased by the amount of tax imposed by section 852(b)(3)(A) with 
respect to such amount, or
    (c) In the case of a taxable year beginning after December 31, 1974, 
by 70 percent of the total amount designated. The earnings and profits 
of a regulated investment company shall not be reduced by the amount of 
tax which is imposed by section 852(b)(3)(A) on an amount designated as 
undistributed capital gains and which is paid by the corporation but 
deemed paid by the shareholder.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6598, 27 FR 
4091, Apr. 28, 1962; T.D. 6921, 32 FR 8754, June 20, 1967; T.D. 7337, 39 
FR 44972, Dec. 30, 1974]



Sec. 1.852-3  Investment company taxable income.

    Section 852(b)(2) requires certain adjustments to be made to convert 
taxable income of the investment company to investment company taxable 
income, as follows:
    (a) The excess, if any, of the net long-term capital gain over the 
net short-term capital loss shall be excluded;
    (b) The net operating loss deduction provided in section 172 shall 
not be allowed;
    (c) The special deductions provided in part VIII (section 241 and 
following, except section 248), subchapter B, chapter 1 of the Code, 
shall not be allowed. Those not allowed are the deduction for partially 
tax-exempt interest provided by section 242, the deductions for 
dividends received provided by sections 243, 244, and 245, and the 
deduction for certain dividends paid provided by section 247. However, 
the deduction provided by section 248 (relating to organizational 
expenditures), otherwise allowable in computing taxable income, shall 
likewise be allowed in computing the investment company taxable income. 
See section 852(b)(1) and paragraph (a) of Sec. 1.852-2 for treatment of 
the deduction for partially tax-exempt interest (provided by section 
242) for purposes of computing the normal tax under section 11;
    (d) The deduction for dividends paid (as defined in section 561) 
shall be allowed, but shall be computed without regard to capital gains 
dividends (as defined in section 852(b)(3)(C) and paragraph (c) of 
Sec. 1.852-4); and
    (e) The taxable income shall be computed without regard to section 
443(b). Thus, the taxable income for a period of less than 12 months 
shall not be placed on an annual basis even though such short taxable 
year results from a change of accounting period.

[[Page 20]]



Sec. 1.852-4  Method of taxation of shareholders of regulated investment companies.

    (a) Ordinary income. (1) Except as otherwise provided in paragraph 
(b) of this section (relating to capital gains), a shareholder receiving 
dividends from a regulated investment company shall include such 
dividends in gross income for the taxable year in which they are 
received.
    (2) See section 853 (b)(2) and (c) and paragraph (b) of Sec. 1.853-2 
and Sec. 1.853-3 for the treatment by shareholders of dividends received 
from a regulated investment company which has made an election under 
section 853(a) with respect to the foreign tax credit. See section 854 
and Secs. 1.854-1 through 1.854-3 for limitations applicable to 
dividends received from regulated investment companies for the purpose 
of the credit under section 34 (for dividends received on or before 
December 31, 1964), the exclusion from gross income under section 116, 
and the deduction under section 243. See section 855 (b) and (d) and 
paragraphs (c) and (f) of Sec. 1.855-1 for treatment by shareholders of 
dividends paid by a regulated investment company after the close of the 
taxable year in the case of an election under section 855(a).
    (b) Capital gains--(1) In general. Under section 852(b)(3)(B), 
shareholders of a regulated investment company who receive capital gain 
dividends (as defined in paragraph (c) of this section), in respect of 
the capital gains of an investment company for a taxable year for which 
it is taxable under part I, subchapter M, chapter 1 of the Code, as a 
regulated investment company, shall treat such capital gain dividends as 
gains from the sale or exchange of capital assets held for more than 1 
year (6 months for taxable years beginning before 1977; 9 months for 
taxable years beginning in 1977) and realized in the taxable year of the 
shareholder in which the dividend was received. In the case of dividends 
with respect to any taxable year of a regulated investment company 
ending after December 31, 1969, and beginning before January 1, 1975, 
the portion of a shareholder's capital gain dividend to which section 
1201(d) (1) or (2) applies is the portion so designated by the regulated 
investment company pursuant to paragraph (c)(2) of this section.
    (2) Undistributed capital gains. (i) A person who is a shareholder 
of a regulated investment company at the close of a taxable year of such 
company for which it is taxable under part I of subchapter M shall 
include in his gross income as a gain from the sale or exchange of a 
capital asset held for more than 1 year (6 months for taxable years 
beginning before 1977; 9 months for taxable years beginning in 1977) any 
amount of undistributed capital gains. The term ``undistributed capital 
gains'' means the amount designated as undistributed capital gains in 
accordance with paragraph (a) of Sec. 1.852-9, but the amount so 
designated shall not exceed the shareholder's proportionate part of the 
amount subject to tax under section 852(b)(3)(A). Such amount shall be 
included in gross income for the taxable year of the shareholder in 
which falls the last day of the taxable year of the regulated investment 
company in respect of which the undistributed capital gains were 
designated. The amount of such gains designated under paragraph (a) of 
Sec. 1.852-9 as gain described in section 1201(d) (1) or (2) shall be 
included in the shareholder's gross income as gain described in section 
1201(d) (1) or (2). For certain administrative provisions relating to 
undistributed capital gains, see Sec. 1.852-9.
    (ii) Any shareholder required to include an amount of undistributed 
capital gains in gross income under section 852(b)(3)(D)(i) and 
subdivision (i) of this subparagraph shall be deemed to have paid for 
his taxable year for which such amount is so includible--
    (a) In the case of an amount designated with respect to a taxable 
year of the company ending before January 1, 1970, a tax equal to 25 
percent of such amount.
    (b) In the case of a taxable year of the company ending after 
December 31, 1969, and beginning before January 1, 1975, a tax equal to 
the tax designated under paragraph (a)(1) of Sec. 1.852-9 by the 
regulated investment company as his proportionate share of the capital 
gains tax paid with respect to such amount, or
    (c) In the case of an amount designated with respect to a taxable 
year

[[Page 21]]

of the company beginning after December 31, 1974, a tax equal to 30 
percent of such amount.

Such shareholder is entitled to a credit or refund of the tax so deemed 
paid in accordance with the rules provided in paragraph (c)(2) of 
Sec. 1.852-9.
    (iii) Any shareholder required to include an amount of undistributed 
capital gains in gross income under section 852(b)(3)(D)(i) and 
subdivision (i) of this subparagraph shall increase the adjusted basis 
of the shares of stock with respect to which such amount is so 
includible--
    (a) In the case of an amount designated with respect to a taxable 
year of the company ending before January 1, 1970, by 75 percent of such 
amount.
    (b) In the case of an amount designated with respect to a taxable 
year of the company ending after December 31, 1969, and beginning before 
January 1, 1975, by the amount designated under paragraph (a)(1)(iv) of 
Sec. 1.852-9 by the regulated investment company, or
    (c) In the case of an amount designated with respect to a taxable 
year of the company beginning after December 31, 1974, by 70 percent of 
such amount.
    (iv) For purposes of determining whether the purchaser or seller of 
a share or regulated investment company stock is the shareholder at the 
close of such company's taxable year who is required to include an 
amount of undistributed capital gains in gross income, the amount of the 
undistributed capital gains shall be treated in the same manner as a 
cash dividend payable to shareholders of record at the close of the 
company's taxable year. Thus, if a cash dividend paid to shareholders of 
record as of the close of the regulated investment company's taxable 
year would be considered income to the purchaser, then the purchaser is 
also considered to be the shareholder of such company at the close of 
its taxable year for purposes of including an amount of undistributed 
capital gains in gross income. If, in such a case, notice on Form 2439 
is, pursuant to paragraph (a)(1) of Sec. 1.852-9, mailed by the 
regulated investment company to the seller, then the seller shall be 
considered the nominee of the purchaser and, as such, shall be subject 
to the provisions in paragraph (b) of Sec. 1.852-9. For rules for 
determining whether a dividend is income to the purchaser or seller of a 
share of stock, see paragraph (c) of Sec. 1.61-9.
    (3) Partners and partnerships. If the shareholder required to 
include an amount of undistributed capital gains in gross income under 
section 852(b)(3)(D) and subparagraph (2) of this paragraph is a 
partnership, such amount shall be included in the gross income of the 
partnership for the taxable year of the partnership in which falls the 
last day of the taxable year of the regulated investment company in 
respect of which the undistributed capital gains were designated. The 
amount so includible by the partnership shall be taken into account by 
the partners as distributive shares of the partnership gains and losses 
from sales or exchanges of capital assets held for more than 1 year (6 
months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) pursuant to section 702(a)(2) and paragraph 
(a)(2) of Sec. 1.702-1. The tax with respect to the undistributed 
capital gains is deemed paid by the partnership (under section 
852(b)(3)(D)(ii) and subparagraph (2)(ii) of this paragraph), and the 
credit or refund of such tax shall be taken into account by the partners 
in accordance with section 702(a)(8) and paragraph (a)(8)(ii) of 
Sec. 1.702-1 and paragraph (c)(2) of Sec. 1.852-9. In accordance with 
section 705(a), the partners shall increase the basis of their 
partnership interests under section 705(a)(1) by the distributive shares 
of such gains, and shall decrease the basis of their partnership 
interests by the distributive shares of the amount of the tax under 
section 705(a)(2)(B) (relating to certain nondeductible expenditures) 
and paragraph (a)(3) of Sec. 1.705-1.
    (4) Nonresident alien individuals. If the shareholder required to 
include an amount of undistributed capital gains in gross income under 
section 852(b)(3)(D) and subparagraph (2) of this paragraph is a 
nonresident alien individual, such shareholder shall be treated, for 
purposes of section 871 and the regulations thereunder, as having 
realized a long-term capital gain in such amount on the last day of the 
taxable

[[Page 22]]

year of the regulated investment company in respect of which the 
undistributed capital gains were designated.
    (5) Effect on earnings and profits of corporate shareholders of a 
regulated investment company. If a shareholder required to include an 
amount of undistributed capital gains in gross income under section 
852(b)(3)(D) and subparagraph (2) of this paragraph is a corporation, 
such corporation, in computing its earnings and profits for the taxable 
year for which such amount is so includible, shall treat such amount as 
if it had actually been received and the taxes paid shall include any 
amount of tax liability satisfied by a credit under section 852(b)(3)(D) 
and subparagraph (2) of this paragraph.
    (c) Definition of capital gain dividend--(1) General rule. A capital 
gain dividend, as defined in section 852(b)(3)(C), is any dividend or 
part thereof which is designated by a regulated investment company as a 
capital gain dividend in a written notice mailed to its shareholders 
within the period specified in paragraph (c)(4) of this section. If the 
aggregate amount so designated with respect to the taxable year 
(including capital gain dividends paid after the close of the taxable 
year pursuant to an election under section 855) is greater than the 
excess of the net long-term capital gain over the net short-term capital 
loss of the taxable year, the portion of each distribution which shall 
be a capital gain dividend shall be only that proportion of the amount 
so designated which such excess of the net long-term capital gain over 
the net short-term capital loss bears to the aggregate amount so 
designated. For example, a regulated investment company making its 
return on the calendar year basis advised its shareholders by written 
notice mailed December 30, 1955, that of a distribution of $500,000 made 
December 15, 1955, $200,000 constituted a capital gain dividend, 
amounting to $2 per share. It was later discovered that an error had 
been made in determining the excess of the net long-term capital gain 
over the net short-term capital loss of the taxable year, and that such 
excess was $100,000 instead of $200,000. In such case each shareholder 
would have received a capital gain dividend of $1 per share instead of 
$2 per share.
    (2) Shareholder of record custodian of certain unit investment 
trusts. In any case where a notice is mailed pursuant to subparagraph 
(1) of this paragraph by a regulated investment company with respect to 
a taxable year of the regulated investment company ending after December 
8, 1970, to a shareholder of record who is a nominee acting as a 
custodian of a unit investment trust described in section 851(f)(1) and 
paragraph (d) of Sec. 1.851-7, the nominee shall furnish each holder of 
an interest in such trust with a written notice mailed on or before the 
55th day following the close of the regulated investment company's 
taxable year. The notice shall designate the holder's proportionate 
share of the capital gain dividend shown on the notice received by the 
nominee pursuant to subparagraph (1) of this paragraph. The notice shall 
include the name and address of the nominee identified as such. This 
subparagraph shall not apply if the regulated investment company agrees 
with the nominee to satisfy the notice requirements of subparagraph (1) 
of this paragraph with respect to each holder of an interest in the unit 
investment trust whose shares are being held by the nominee as custodian 
and, not later than 45 days following the close of the company's taxable 
year, files with the Internal Revenue Service office where the company's 
income tax return is to be filed for the taxable year, a statement that 
the holders of the unit investment trust with whom the agreement was 
made have been directly notified by the regulated investment company. 
Such statement shall include the name, sponsor, and custodian of each 
unit investment trust whose holders have been directly notified. The 
nominee's requirements under this paragraph shall be deemed met if the 
regulated investment company transmits a copy of such statement to the 
nominee within such 45-day period; provided however, if the regulated 
investment company fails or is unable to satisfy the requirements of 
this subparagraph with respect to the holders of interest in the unit 
investment trust, it shall so notify the Internal

[[Page 23]]

Revenue Service within 45 days following the close of its taxable year. 
The custodian shall, upon notice by the Internal Revenue Service that 
the regulated investment company has failed to comply with the 
agreement, satisfy the requirements of this subparagraph within 30 days 
of such notice. If a notice under paragraph (c)(1) of this section is 
mailed within the 120-day period following the date of a determination 
pursuant to paragraph (c)(4)(ii) of this section, the 120-day period and 
the 130-day period following the date of the determination shall be 
substituted for the 45-day period and the 55-day period following the 
close of the regulated investment company's taxable year prescribed by 
this subparagraph (2).
    (3) Subsection (d) gain for certain taxable years. In the case of 
capital gain dividends with respect to any taxable year of a regulated 
investment company ending after December 31, 1969, and beginning before 
January 1, 1975 (including capital gain dividends paid after the close 
of the taxable year pursuant to an election under section 855), the 
company must include in its written notice under paragraph (c)(1) of 
this section a statement showing the shareholder's proportionate share 
of the capital gain dividend which is gain described in section 
1201(d)(1) and his proportionate share of such dividend which is gain 
described in section 1201(d)(2). In determining the portion of the 
capital gain dividend which, in the hands of a shareholder, is gain 
described in section 1201(d) (1) or (2), the regulated investment 
company shall consider that capital gain dividends for a taxable year 
are first made from its long-term capital gains for such year which are 
not described in section 1201(d) (1) or (2), to the extent thereof, and 
then from its long-term capital gains for such year which are described 
in section 1201(d) (1) or (2). A shareholder's proportionate share of 
gains which are described in section 1201(d)(1) is the amount which 
bears the same ratio to the amount paid to him as a capital gain 
dividend in respect of such year as (i) the aggregate amount of the 
company's gains which are described in section 1201(d)(1) and paid to 
all shareholders bears to (ii) the aggregate amount of the capital gain 
dividend paid to all shareholders in respect of such year. A 
shareholder's proportionate share of gains which are described in 
section 1201(d)(2) shall be determined in a similar manner. Every 
regulated investment company shall keep a record of the proportion of 
each capital gain dividend (to which this paragraph applies) which is 
gain described in section 1201(d) (1) or (2). If, for his taxable year, 
a shareholder must include in his gross income a capital gain dividend 
to which this paragraph applies, he shall attach to his income tax 
return for such taxable year a statement showing, with respect to the 
total of such dividends for such taxable year received from each 
regulated investment company, the name and address of the regulated 
investment company from which such dividends are received, the amount of 
such dividends, the portion of such dividends which was designated as 
gain described in section 1201(d)(1), and the portion of such dividends 
which was designated as gain described in section 1201(d)(2).
    (4) Mailing of written notice to shareholders. (i) Except as 
provided in paragraph (c)(4)(ii) of this section, the written notice 
designating a dividend or part thereof as a capital gain dividend must 
be mailed to the shareholders not later than 45 days (30 days for a 
taxable year ending before February 26, 1964) after the close of the 
taxable year of the regulated investment company.
    (ii) If a determination (as defined in section 860(e)) after 
November 6, 1978, increases the excess for the taxable year of the net 
capital gain over the deduction for capital gains dividends paid, then a 
regulated investment company may designate all or part of any dividend 
as a capital gain dividend in a written notice mailed to its 
shareholders at any time during the 120-day period immediately following 
the date of the determination. The aggregate amount designated during 
this period may not exceed this increase. A dividend may be designated 
if it is actually paid during the taxable year, is one paid after the 
close of the taxable year to which section 855 applies, or is a 
deficiency dividend (as defined in section 860(f)), including a 
deficiency dividend paid by an acquiring corporation to which section 
381(c)(25) applies. The

[[Page 24]]

date of a determination is established under Sec. 1.860-2(b)(1).
    (d) Special treatment of loss on the sale or exchange of regulated 
investment company stock held less than 31 days--(1) In general. Under 
section 852(b)(4), if any person, with respect to a share of regulated 
investment company stock acquired by such person after December 31, 
1957, and held for a period of less than 31 days, is required by section 
852(b)(3) (B) or (D) to include in gross income as a gain from the sale 
or exchange of a capital asset held for more than six months--
    (i) The amount of a capital gain dividend, or
    (ii) An amount of undistributed capital gains,

then such person shall, to the extent of such amount, treat any loss on 
the sale or exchange of such share of stock as a loss from the sale or 
exchange of a capital asset held for more than 1 year (6 months for 
taxable years beginning before 1977; 9 months for taxable years 
beginning in 1977). Such special treatment with respect to the sale of 
regulated investment company stock held for a period of less than 31 
days is applicable to losses for taxable years ending after December 31, 
1957.
    (2) Determination of holding period. The rules contained in section 
246(c)(3) (relating to the determination of holding periods for purposes 
of the deduction for dividends received) shall be applied in determining 
whether, for purposes of section 852(b)(4) and this paragraph, a share 
of regulated investment company stock has been held for a period of less 
than 31 days. In applying those rules, however, ``30 days'' shall be 
substituted for the number of days specified in subparagraph (B) of 
section 246(c)(3).
    (3) Example. The application of section 852(b)(4) and this paragraph 
may be illustrated by the following example:

    Example. On December 15, 1958, A purchased a share of stock in the X 
regulated investment company for $20. The X regulated investment company 
declared a capital gain dividend of $2 per share to shareholders of 
record on December 31, 1958. A, therefore, received a capital gain 
dividend of $2 which, pursuant to section 852(b)(3)(B), he must treat as 
a gain from the sale or exchange of a capital asset held for more than 6 
months. On January 5, 1959, A sold his share of stock in the X regulated 
investment company for $17.50, which sale resulted in a loss of $2.50. 
Under section 852(b)(4) and this paragraph, A must treat $2 of such loss 
(an amount equal to the capital gain dividend received with respect to 
such share of stock) as a loss from the sale or exchange of a capital 
asset held for more than 6 months.

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; 860(e) (92 Stat. 2849, 26 
U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6531, 26 FR 
413, Jan. 19, 1961; T.D. 6598, 27 FR 4091, Apr. 28, 1962; T.D. 6777, 29 
FR 17809, Dec. 16, 1964; T.D. 6921, 32 FR 8755, June 20, 1967; T.D. 
7187, 37 FR 13256, July 6, 1972; T.D. 7337, 39 FR 44972, Dec. 30, 1974; 
T.D. 7728, 45 FR 72650, Nov. 3, 1980; T.D. 7936, 49 FR 2106, Jan. 18, 
1984]



Sec. 1.852-5  Earnings and profits of a regulated investment company.

    (a) Any regulated investment company, whether or not such company 
meets the requirements of section 852(a) and paragraphs (a)(1) (i) and 
(ii) of Sec. 1.852-1, shall apply paragraph (b) of this section in 
computing its earnings and profits for a taxable year beginning after 
February 28, 1958. However, for a taxable year of a regulated investment 
company beginning before March 1, 1958, paragraph (b) of this section 
shall apply only if the regulated investment company meets the 
requirements of section 852(a) and paragraphs (a)(1) (i) and (ii) of 
Sec. 1.852-1.
    (b) In the determination of the earnings and profits of a regulated 
investment company, section 852(c) provides that such earnings and 
profits for any taxable year (but not the accumulated earnings and 
profits) shall not be reduced by any amount which is not allowable as a 
deduction in computing its taxable income for the taxable year. Thus, if 
a corporation would have had earnings and profits of $500,000 for the 
taxable year except for the fact that it had a net capital loss of 
$100,000, which amount was not deductible in determining its taxable 
income, its earnings and profits for that year if it is a regulated 
investment company would be $500,000. If the regulated investment 
company had no accumulated earnings and profits at the beginning of the 
taxable year, in determining its accumulated earnings and profits as of 
the beginning of the following taxable year,

[[Page 25]]

the earnings and profits for the taxable year to be considered in such 
computation would amount to $400,000 assuming that there had been no 
distribution from such earnings and profits. If distributions had been 
made in the taxable year in the amount of the earnings and profits then 
available for distribution, $500,000, the corporation would have as of 
the beginning of the following taxable year neither accumulated earnings 
and profits nor a deficit in accumulated earnings and profits, and would 
begin such year with its paid-in capital reduced by $100,000, an amount 
equal to the excess of the $500,000 distributed over the $400,000 
accumulated earnings and profits which would otherwise have been carried 
into the following taxable year.



Sec. 1.852-6  Records to be kept for purpose of determining whether a corporation claiming to be a regulated investment company is a personal holding company.

    (a) Every regulated investment company shall maintain in the 
internal revenue district in which it is required to file its income tax 
return permanent records showing the information relative to the actual 
owners of its stock contained in the written statements required by this 
section to be demanded from the shareholders. The actual owner of stock 
includes the person who is required to include in gross income in his 
return the dividends received on the stock. Such records shall be kept 
at all times available for inspection by any internal revenue officer or 
employee, and shall be retained so long as the contents thereof may 
become material in the administration of any internal revenue law.
    (b) For the purpose of determining whether a domestic corporation 
claiming to be a regulated investment company is a personal holding 
company as defined in section 542, the permanent records of the company 
shall show the maximum number of shares of the corporation (including 
the number and face value of securities convertible into stock of the 
corporation) to be considered as actually or constructively owned by 
each of the actual owners of any of its stock at any time during the 
last half of the corporation's taxable year, as provided in section 544.
    (c) Statements setting forth the information (required by paragraph 
(b) of this section) shall be demanded not later than 30 days after the 
close of the corporation's taxable year as follows:
    (1) In the case of a corporation having 2,000 or more record owners 
of its stock on any dividend record date, from each record holder of 5 
percent or more of its stock; or
    (2) In the case of a corporation having less than 2,000 and more 
than 200 record owners of its stock, on any dividend record date, from 
each record holder of 1 percent or more of its stock; or
    (3) In the case of a corporation having 200 or less record owners of 
its stock, on any dividend record date, from each record holder of one-
half of 1 percent or more of its stock.

When making demand for the written statements required of each 
shareholder by this paragraph, the company shall inform each of the 
shareholders of his duty to submit as a part of his income tax return 
the statements which are required by Sec. 1.852-7 if he fails or refuses 
to comply with such demand. A list of the persons failing or refusing to 
comply in whole or in part with a company's demand shall be maintained 
as a part of its record required by this section. A company which fails 
to keep such records to show the actual ownership of its outstanding 
stock as are required by this section shall be taxable as an ordinary 
corporation and not as a regulated investment company.



Sec. 1.852-7  Additional information required in returns of shareholders.

    Any person who fails or refuses to comply with the demand of a 
regulated investment company for the written statements which 
Sec. 1.852-6 requires the company to demand from its shareholders shall 
submit as a part of his income tax return a statement showing, to the 
best of his knowledge and belief--
    (a) The number of shares actually owned by him at any and all times 
during the period for which the return is filed in any company claiming 
to be a regulated investment company;
    (b) The dates of acquisition of any such stock during such period 
and the

[[Page 26]]

names and addresses of persons from whom it was acquired;
    (c) The dates of disposition of any such stock during such period 
and the names and addresses of the transferees thereof;
    (d) The names and addresses of the members of his family (as defined 
in section 544(a)(2)); the names and addresses of his partners, if any, 
in any partnership; and the maximum number of shares, if any, actually 
owned by each in any corporation claiming to be a regulated investment 
company, at any time during the last half of the taxable year of such 
company;
    (e) The names and addresses of any corporation, partnership, 
association, or trust in which he had a beneficial interest to the 
extent of at least 10 percent at any time during the period for which 
such return is made, and the number of shares of any corporation 
claiming to be a regulated investment company actually owned by each;
    (f) The maximum number of shares (including the number and face 
value of securities convertible into stock of the corporation) in any 
domestic corporation claiming to be a regulated investment company to be 
considered as constructively owned by such individual at any time during 
the last half of the corporation's taxable year, as provided in section 
544 and the regulations thereunder; and
    (g) The amount and date of receipt of each dividend received during 
such period from every corporation claiming to be a regulated investment 
company.



Sec. 1.852-8  Information returns.

    Nothing in Secs. 1.852-6 and 1.852-7 shall be construed to relieve 
regulated investment companies or their shareholders from the duty of 
filing information returns required by regulations prescribed under the 
provisions of subchapter A, chapter 61 of the Code.



Sec. 1.852-9  Special procedural requirements applicable to designation under section 852(b)(3)(D).

    (a) Regulated investment company--(1) Notice to shareholders. (i) A 
designation of undistributed capital gains under section 852(b)(3)(D) 
and paragraph (b)(2)(i) of Sec. 1.852-2 shall be made by notice on Form 
2439 mailed by the regulated investment company to each person who is a 
shareholder of record of the company at the close of the company's 
taxable year. The notice on Form 2439 shall show the name, address, and 
employer identification number of the regulated investment company; the 
taxable year of the company for which the designation is made; the name, 
address, and identifying number of the shareholder; the amount 
designated by the company for inclusion by the shareholder in computing 
his long-term capital gains; and the tax paid with respect thereto by 
the company which is deemed to have been paid by the shareholder.
    (ii) In the case of a designation of undistributed capital gains 
with respect to a taxable year of the regulated investment company 
ending after December 31, 1969, and beginning before January 1, 1975, 
Form 2439 shall also show the shareholder's proportionate share of such 
gains which is gain described in section 1201(d)(1), his proportionate 
share of such gains which is gain described in section 1201(d)(2), and 
the amount (determined pursuant to subdivision (iv) of this 
subparagraph) by which the shareholder's adjusted basis in his shares 
shall be increased.
    (iii) In determining under subdivision (ii) of this subparagraph the 
portion of the undistributed capital gains which, in the hands of the 
shareholder, is gain described in section 1201(d) (1) or (2), the 
company shall consider that capital gain dividends for a taxable year 
are made first from its long-term capital gains for such year which are 
not described in section 1201(d) (1) or (2), to the extent thereof, and 
then from its long-term capital gains for such year which are described 
in section 1201(d) (1) or (2). A shareholder's proportionate share of 
undistributed capital gains for a taxable year which is gain described 
in section 1201(d)(1) is the amount which bears the same ratio to the 
amount included in his income as designated undistributed capital gains 
for such year as (a) the aggregate amount of the company's gains for 
such year which are described in section 1201(d)(1) and designated as 
undistributed capital gains bears to (b) the aggregate amount of the 
company's gains for

[[Page 27]]

such year which are designated as undistributed capital gains. A 
shareholder's proportionate share of gains which are described in 
section 1201(d)(2) shall be determined in a similar manner. Every 
regulated investment company shall keep a record of the proportion of 
undistributed capital gains (to which this subdivision applies) which is 
gain described in section 1201(d) (1) or (2).
    (iv) In the case of a designation of undistributed capital gains for 
any taxable year ending after December 31, 1969, and beginning before 
January 1, 1975, Form 2439 shall also show with respect to the 
undistributed capital gains of each shareholder the amount by which such 
shareholder's adjusted basis in his shares shall be increased under 
section 852(b)(3)(D)(iii). The amount by which each shareholders' 
adjusted basis in his shares shall be increased is the amount includible 
in his gross income with respect to such shares under section 
852(b)(3)(D)(i) less the tax which the shareholder is deemed to have 
paid with respect to such shares. The tax which each shareholder is 
deemed to have paid with respect to such shares is the amount which 
bears the same ratio to the amount of the tax imposed by section 
852(b)(3)(A) for such year with respect to the aggregate amount of the 
designated undistributed capital gains as the amount of such gains 
includible in the shareholder's gross income bears to the aggregate 
amount of such gains so designated.
    (v) Form 2439 shall be prepared in triplicate, and copies B and C of 
the form shall be mailed to the shareholder on or before the 45th day 
(30th day for a taxable year ending before February 26, 1964) following 
the close of the company's taxable year. Copy A of each Form 2439 must 
be associated with the duplicate copy of the undistributed capital gains 
tax return of the company (Form 2438), as provided in subparagraph 
(2)(ii) of this paragraph.
    (2) Return of undistributed capital gains tax--(i) Form 2438. Every 
regulated investment company which designates undistributed capital 
gains for any taxable year beginning after December 31, 1956, in 
accordance with subparagraph (1) of this paragraph, shall file for such 
taxable year an undistributed capital gains tax return on Form 2438 
including on such return the total of its undistributed capital gains so 
designated and the tax with respect thereto. The return on Form 2438 
shall be prepared in duplicate and shall set forth fully and clearly the 
information required to be included therein. The original of Form 2438 
shall be filed on or before the 30th day after the close of the 
company's taxable year with the internal revenue officer designated in 
instructions applicable to Form 2438. The duplicate copy of form 2438 
for the taxable year shall be attached to and filed with the income tax 
return of the company on Form 1120 for such taxable year.
    (ii) Copies A of Form 2439. For each taxable year which ends on or 
before December 31, 1965, there shall be submitted with the company's 
return on Form 2438 all copies A of Form 2439 furnished by the company 
to its shareholders in accordance with subparagraph (1) of this 
paragraph. For each taxable year which ends after December 31, 1965, 
there shall be submitted with the duplicate copy of the company's return 
on Form 2438, which is attached to and filed with the income tax return 
of the company on Form 1120 for the taxable year, all copies A of Form 
2439 furnished by the company to its shareholders in accordance with 
subparagraph (1) of this paragraph. The copies A of Form 2439 shall be 
accompanied by lists (preferably in the form of adding machine tapes) of 
the amounts of undistributed capital gains and of the tax paid with 
respect thereto shown on such forms. The totals of the listed amounts of 
undistributed capital gains and of tax paid with respect thereto must 
agree with the corresponding entries on Form 2438.
    (3) Payment of tax. The tax required to be returned on Form 2438 
shall be paid by the regulated investment company on or before the 30th 
day after the close of the company's taxable year to the internal 
revenue officer with whom the return on Form 2438 is filed.
    (b) Shareholder of record not actual owner--(1) Notice to actual 
owner. In any case in which a notice on Form 2439 is mailed pursuant to 
paragraph (a)(1) of this section by a regulated investment company to a 
shareholder of record

[[Page 28]]

who is a nominee of the actual owner or owners of the shares of stock to 
which the notice relates, the nominee shall furnish to each such actual 
owner notice of the owner's proportionate share of the amounts of 
undistributed capital gains and tax with respect thereto, as shown on 
the Form 2439 received by the nominee from the regulated investment 
company. The nominee's notice to the actual owner shall be prepared in 
triplicate on Form 2439 and shall contain the information prescribed in 
paragraph (a)(1) of this section, except that the name and address of 
the nominee, identified as such, shall be entered on the form in 
addition to, and in the space provided for, the name and address of the 
regulated investment company, and the amounts of undistributed capital 
gains and tax with respect thereto entered on the form shall be the 
actual owner's proportionate share of the corresponding items shown on 
the nominee's notice from the regulated investment company. Copies B and 
C of the Form 2439 prepared by the nominee shall be mailed to the actual 
owner--
    (i) For taxable years of regulated investment companies ending after 
February 25, 1964, on or before the 75th day (55th day in the case of a 
nominee who is acting as a custodian of a unit investment trust 
described in section 851(f)(1) and paragraph (d) of Sec. 1.851-7 for 
taxable years of regulated investment companies ending after December 8, 
1970, and 135th day if the nominee is a resident of a foreign country) 
following the close of the regulated investment company's taxable year, 
or
    (ii) For taxable years of regulated investment companies ending 
before February 26, 1964, on or before the 60th day (120th day if the 
nominee is a resident of a foreign country) following the close of the 
regulated investment company's taxable year.
    (2) Transmittal of Form 2439. The nominee shall enter the word 
``Nominee'' in the upper right hand corner of copy B of the notice on 
Form 2439 received by him from the regulated investment company, and on 
or before the appropriate day specified in subdivision (i) or (ii) of 
subparagraph (1) of this paragraph shall transmit such copy B, together 
with all copies A of Form 2439 prepared by him pursuant to subparagraph 
(1) of this paragraph, to the internal revenue officer with whom his 
income tax return is required to be filed.
    (3) Custodian of certain unit investment trusts. The requirements of 
this paragraph shall not apply to a nominee who is acting as a custodian 
of the unit investment trust described in section 851(f)(1) and 
paragraph (d) of Sec. 1.851-7 provided that the regulated investment 
company agrees with the nominee to satisfy the notice requirements of 
paragraph (a) of this section with respect to each holder of an interest 
in the unit investment trust whose shares are being held by such nominee 
as custodian and on or before the 45th day following the close of the 
company's taxable year, files with the Internal Revenue Service office 
where the company's income tax return is to be filed for the taxable 
year, a statement that the holders of the unit investment trust with 
whom the agreement was made have been directly notified by the regulated 
investment company. Such statement shall include the name, sponsor, and 
custodian of each unit investment trust whose holders have been directly 
notified. The nominee's requirements under this paragraph shall be 
deemed met if the regulated investment company transmits a copy of such 
statement to the nominee within such 45-day period; provided however, if 
the regulated investment company fails or is unable to satisfy the 
requirements of this paragraph with respect to the holders of interest 
in the unit investment trust, it shall so notify the Internal Revenue 
Service within 45 days following the close of its taxable year. The 
custodian shall, upon notice by the Internal Revenue Service that the 
regulated investment company has failed to comply with the agreement, 
satisfy the requirements of this paragraph within 30 days of such 
notice.
    (c) Shareholders--(1) Return and Recordkeeping Requirements--(i) 
Return requirements for taxable years beginning before January 1, 2002. 
For taxable years beginning before January 1, 2002, the copy B of Form 
2439 furnished to a

[[Page 29]]

shareholder by the regulated investment company or by a nominee, as 
provided in Sec. 1.852-9(a) or (b) shall be attached to the income tax 
return of the shareholder for the taxable year in which the amount of 
undistributed capital gains is includible in gross income as provided in 
Sec. 1.852-4(b)(2).
    (ii) Recordkeeping requirements for taxable years beginning after 
December 31, 2001. For taxable years beginning after December 31, 2001, 
the shareholder shall retain a copy of Form 2439 for as long as its 
contents may become material in the administration of any internal 
revenue law.
    (2) Credit or refund--(i) In general. The amount of the tax paid by 
the regulated investment company with respect to the undistributed 
capital gains required under section 852(b)(3)(D) and paragraph (b)(2) 
of Sec. 1.852-4 to be included by a shareholder in his computation of 
long-term capital gains for any taxable year is deemed paid by such 
shareholder under section 852(b)(3)(D)(ii) and such payment constitutes, 
for purposes of section 6513(a) (relating to time tax considered paid), 
an advance payment in like amount of the tax imposed under chapter 1 of 
the Code for such taxable year. In the case of an overpayment of tax 
within the meaning of section 6401, see section 6402 and the regulations 
in part 301 of this chapter (Regulations on Procedure and 
Administration) for rules applicable to the treatment of an overpayment 
of tax and section 6511 and the regulations in part 301 of this chapter 
(Regulations on Procedure and Administration) with respect to the 
limitations applicable to the credit or refund of an overpayment of tax.
    (ii) Form to be used. Claim for refund or credit of the tax deemed 
to have been paid by a shareholder with respect to an amount of 
undistributed capital gains shall be made on the shareholder's income 
tax return for the taxable year in which such amount of undistributed 
capital gains is includable in gross income. In the case of a 
shareholder which is a partnership, claim shall be made by the partners 
on their income tax returns for refund or credit of their distributive 
shares of the tax deemed to have been paid by the partnership. In the 
case of a shareholder which is exempt from tax under section 501(a) and 
to which section 511 does not apply for the taxable year, claim for 
refund of the tax deemed to have been paid by such shareholder on an 
amount of undistributed capital gains for such year shall be made on 
Form 843 and copy B of Form 2439 furnished to such shareholder shall be 
attached to its claim. For other rules applicable to the filing of 
claims for credit or refund of an overpayment of tax, see Sec. 301.6402-
2 of this chapter (Regulations on Procedure and Administration), 
relating to claims for credit or refund, and Sec. 301.6402-3 of this 
chapter, relating to special rules applicable to income tax.
    (3) Records. The shareholder is required to keep copy C of the Form 
2439 furnished for the regulated investment company's taxable years 
ending after December 31, 1969, and beginning before January 1, 1975, as 
part of his records to show increases in the adjusted basis of his 
shares in such company.
    (d) Penalties. For criminal penalties for willful failure to file a 
return, supply information, or pay tax, and for filing a false or 
fraudulent return, statement, or other document, see sections 7203, 
7206, and 7207.

[T.D. 6500, 25 FR 11710, Nov. 26, 1960, as amended by T.D. 6921, 32 FR 
8755, June 20, 1967; T.D. 7012, 34 FR 7688, May 15, 1969; T.D. 7187, 37 
FR 13256, July 6, 1972; T.D. 7332, 39 FR 44217, Dec. 23, 1974; T.D. 
7337, 39 FR 44973, Dec. 30, 1974; T.D. 8989, 67 FR 20031, Apr. 24, 2002; 
T.D. 9040, 68 FR 4921, Jan. 31, 2003]



Sec. 1.852-10  Distributions in redemption of interests in unit investment trusts.

    (a) In general. In computing that part of the excess of its net 
long-term capital gain over net short-term capital loss on which it must 
pay a capital gains tax, a regulated investment company is allowed under 
section 852(b)(3)(A)(ii) a deduction for dividends paid (as defined in 
section 561) determined with reference to capital gains dividends only. 
Section 561(b) provides that in determining the deduction for dividends 
paid, the rules provided in section 562 are applicable. Section 562(c) 
(relating to preferential dividends) provides that the amount of any 
distribution shall not be considered as a dividend unless such 
distribution is pro-rata, with no preference to

[[Page 30]]

any share of stock as compared with other shares of the same class 
except to the extent that the former is entitled to such preference.
    (b) Redemption distributions made by unit investment trust--(1) In 
general. Where a unit investment trust (as defined in paragraph (c) of 
this section) liquidates part of its portfolio represented by shares in 
a management company in order to make a distribution to a holder of an 
interest in the trust in redemption of part or all of such interest, and 
by so doing, the trust realizes net long-term capital gain, that portion 
of the distribution by the trust which is equal to the amount of the net 
long-term capital gain realized by the trust on the liquidation of the 
shares in the management company will not be considered a preferential 
dividend under section 562(c). For example, where the entire amount of 
net long-term capital gain realized by the trust on such a liquidation 
is distributed to the redeeming interest holder, the trust will be 
allowed the entire amount of net long-term capital gain so realized in 
determining the deduction under section 852(b)(3)(A)(ii) for dividends 
paid determined with reference to capital gains dividends only. This 
paragraph and section 852(d) shall apply only with respect to the 
capital gain net income (net capital gain for taxable years beginning 
before January 1, 1977) realized by the trust which is attributable to a 
redemption by a holder of an interest in such trust. Such dividend may 
be designated as a capital gain dividend by a written notice to the 
certificate holder. Such designation should clearly indicate to the 
holder that the holder's gain or loss on the redemption of the 
certificate may differ from such designated amount, depending upon the 
holder's basis for the redeemed certificate, and that the holder's own 
records are to be used in computing the holder's gain or loss on the 
redemption of the certificate.
    (2) Example. The application of the provisions of this paragraph may 
be illustrated by the following example:

    Example. B entered into a periodic payment plan contract with X as 
custodian and Z as plan sponsor under which he purchased a plan 
certificate of X. Under this contract, upon B's demand, X must redeem 
B's certificate at a price substantially equal to the value of the 
number of shares in Y, a management company, which are credited to B's 
account by X in connection with the unit investment trust. Except for a 
small amount of cash which X is holding to satisfy liabilities and to 
invest for other plan certificate holders, all of the assets held by X 
in connection with the trust consist of shares in Y. Pursuant to the 
terms of the periodic payment plan contract, 100 shares of Y are 
credited to B's account. Both X and Y have elected to be treated as 
regulated investment companies. On March 1, 1965, B notified X that he 
wished to have his entire interest in the unit investment trust 
redeemed. In order to redeem B's interest, X caused Y to redeem 100 
shares of Y which X held. At the time of redemption, each share of Y had 
a value of $15. X then distributed the $1,500 to B. X's basis for each 
of the Y shares which was redeemed was $10. Therefore, X realized a 
long-term capital gain of $500 ($5x100 shares) which is attributable to 
the redemption by B of his interest in the trust. Under section 852(d), 
the $500 capital gain distributed to B will not be considered a 
preferential dividend. Therefore, X is allowed a deduction of $500 under 
section 852(b)(3)(A)(ii) for dividends paid determined with reference to 
capital gains dividends only, with the result that X will not pay a 
capital gains tax with respect to such amount.

    (c) Definition of unit investment trust. A unit investment trust to 
which paragraph (a) of this section refers is a business arrangement 
which--
    (1) Is registered under the Investment Company Act of 1940 as a unit 
investment trust;
    (2) Issues periodic payment plan certificates (as defined in such 
Act);
    (3) Possesses, as substantially all of its assets, securities issued 
by a management company (as defined in such Act);
    (4) Qualifies as a regulated investment company under section 851; 
and
    (5) Complies with the requirements provided for by section 852(a).

Paragraph (a) of this section does not apply to a unit investment trust 
described in section 851(f)(1) and paragraph (d) of Sec. 1.851-7.

[T.D. 6921, 32 FR 8755, June 20, 1967, as amended by T.D. 7187, 37 FR 
13527, July 6, 1972; T.D. 7728, 45 FR 72650, Nov. 3, 1980]

[[Page 31]]



Sec. 1.852-11  Treatment of certain losses attributable to periods after October 31 of a taxable year.

    (a) Outline of provisions. This paragraph lists the provisions of 
this section.

    (a) Outline of provisions.
    (b) Scope.
    (1) In general.
    (2) Limitation on application of section.
    (c) Post-October capital loss defined.
    (1) In general.
    (2) Methodology.
    (3) October 31 treated as last day of taxable year for purpose of 
determining taxable income under certain circumstances.
    (i) In general.
    (ii) Effect on gross income.
    (d) Post-October currency loss defined.
    (1) Post-October currency loss.
    (2) Net foreign currency loss.
    (3) Foreign currency gain or loss.
    (e) Limitation on capital gain dividends.
    (1) In general.
    (2) Amount taken into account in current year.
    (i) Net capital loss.
    (ii) Net long-term capital loss.
    (3) Amount taken into account in succeeding year.
    (f) Regulated investment company may elect to defer certain losses 
for purposes of determining taxable income.
    (1) In general.
    (2) Effect of election in current year.
    (3) Amount of loss taken into account in current year.
    (i) If entire amount of net capital loss deferred.
    (ii) If part of net capital loss deferred.
    (A) In general.
    (B) Character of capital loss not deferred.
    (iii) If entire amount of net long-term capital loss deferred.
    (iv) If part of net long-term capital loss deferred.
    (v) If entire amount of post-October currency loss deferred.
    (vi) If part of post-October currency loss deferred.
    (4) Amount of loss taken into account in succeeding year and 
subsequent years.
    (5) Effect on gross income.
    (g) Earnings and profits.
    (1) General rule.
    (2) Special rule--treatment of losses that are deferred for purposes 
of determining taxable income.
    (h) Examples.
    (i) Procedure for making election.
    (1) In general.
    (2) When applicable instructions not available.
    (j) Transition rules.
    (1) In general.
    (2) Retroactive election.
    (i) In general.
    (ii) Deadline for making election.
    (3) Amended return required for succeeding year in certain 
circumstances.
    (i) In general.
    (ii) Time for filing amended return.
    (4) Retroactive dividend.
    (i) In general.
    (ii) Method of making election.
    (iii) Deduction for dividends paid.
    (A) In general.
    (B) Limitation on ordinary dividends.
    (C) Limitation on capital gain dividends.
    (D) Effect on other years.
    (iv) Earnings and profits.
    (v) Receipt by shareholders.
    (vi) Foreign tax election.
    (vii) Example.
    (5) Certain distributions may be designated retroactively as capital 
gain dividends.
    (k) Effective date.

    (b) Scope--(1) In general. This section prescribes the manner in 
which a regulated investment company must treat a post-October capital 
loss (as defined in paragraph (c) of this section) or a post-October 
currency loss (as defined in paragraph (d)(1) of this section) for 
purposes of determining its taxable income, its earnings and profits, 
and the amount that it may designate as capital gain dividends for the 
taxable year in which the loss is incurred and the succeeding taxable 
year (the ``succeeding year'').
    (2) Limitation on application of section. This section shall not 
apply to any post-October capital loss or post-October currency loss of 
a regulated investment company attributable to a taxable year for which 
an election is in effect under section 4982(e)(4) of the Code with 
respect to the company.
    (c) Post-October capital loss defined--(1) In general. For purposes 
of this section, the term post-October capital loss means--
    (i) Any net capital loss attributable to the portion of a regulated 
investment company's taxable year after October 31; or
    (ii) If there is no such net capital loss, any net long-term capital 
loss attributable to the portion of a regulated investment company's 
taxable year after October 31.
    (2) Methodology. The amount of any net capital loss or any net long-
term capital loss attributable to the portion of the regulated 
investment company's

[[Page 32]]

taxable year after October 31 shall be determined in accordance with 
general tax law principles (other than section 1212) by treating the 
period beginning on November 1 of the taxable year of the regulated 
investment company and ending on the last day of such taxable year as 
though it were the taxable year of the regulated investment company. For 
purposes of this paragraph (c)(2), any item (other than a capital loss 
carryover) that is required to be taken into account or any rule that 
must be applied, for purposes of section 4982, on October 31 as if it 
were the last day of the regulated investment company's taxable year 
must also be taken into account or applied in the same manner as 
required under section 4982, both on October 31 and again on the last 
day of the regulated investment company's taxable year.
    (3) October 31 treated as last day of taxable year for purpose of 
determining taxable income under certain circumstances--(i) In general. 
If a regulated investment company has a post-October capital loss for a 
taxable year, any item that must be marked to market for purposes of 
section 4982 on October 31 as if it were the last day of the regulated 
investment company's taxable year must also be marked to market on 
October 31 and again on the last day of the regulated investment 
company's taxable year for purposes of determining its taxable income. 
If the regulated investment company does not have a post-October capital 
loss for a taxable year, the regulated investment company must treat 
items that must be marked to market for purposes of section 4982 on 
October 31 as if it were the last day of the regulated investment 
company's taxable year as marked to market only on the last day of its 
taxable year for purposes of determining its taxable income.
    (ii) Effect on gross income. The marking to market of any item on 
October 31 of a regulated investment company's taxable year for purposes 
of determining its taxable income under paragraph (c)(3)(i) of this 
section shall not affect the amount of the gross income of such company 
for such taxable year for purposes of section 851(b) (2) or (3).
    (d) Post-October currency loss defined. For purposes of this 
section--
    (1) Post-October currency loss. The term post-October currency loss 
means any net foreign currency loss attributable to the portion of a 
regulated investment company's taxable year after October 31. For 
purposes of the preceding sentence, principles similar to those of 
paragraphs (c)(2) and (c)(3) of this section shall apply.
    (2) Net foreign currency loss. The term ``net foreign currency 
loss'' means the excess of foreign currency losses over foreign currency 
gains.
    (3) Foreign currency gain or loss. The terms ``foreign currency 
gain'' and ``foreign currency loss'' have the same meaning as provided 
in section 988(b).
    (e) Limitation on capital gain dividends--(1) In general. For 
purposes of determining the amount a regulated investment company may 
designate as capital gain dividends for a taxable year, the amount of 
net capital gain for the taxable year shall be determined without regard 
to any post-October capital loss for such year.
    (2) Amount taken into account in current year--(i) Net capital loss. 
If the post-October capital loss referred to in paragraph (e)(1) of this 
section is a post-October capital loss as defined in paragraph (c)(1)(i) 
of this section, the net capital gain of the company for the taxable 
year in which the loss arose shall be determined without regard to any 
capital gains or losses (both long-term and short-term) taken into 
account in computing the post-October capital loss for the taxable year.
    (ii) Net long-term capital loss. If the post-October capital loss 
referred to in paragraph (e)(1) of this section is a post-October 
capital loss as defined in paragraph (c)(1)(ii) of this section, the net 
capital gain of the company for the taxable year in which the loss arose 
shall be determined without regard to any long-term capital gain or loss 
taken into account in computing the post-October capital loss for the 
taxable year.
    (3) Amount taken into account in succeeding year. If a regulated 
investment company has a post-October capital loss (as defined in 
paragraph (c)(1)(i) or (c)(1)(ii) of this section) for any taxable year, 
then, for purposes of determining the amount the company may designate 
as capital gain dividends for the

[[Page 33]]

succeeding year, the net capital gain for the succeeding year shall be 
determined by treating all gains and losses taken into account in 
computing the post-October capital loss as arising on the first day of 
the succeeding year.
    (f) Regulated investment company may elect to defer certain losses 
for purposes of determining taxable income--(1) In general. A regulated 
investment company may elect, in accordance with the procedures of 
paragraph (i) of this section, to compute its taxable income for a 
taxable year without regard to part or all of any post-October capital 
loss or post-October currency loss for that year.
    (2) Effect of election in current year. The taxable income of a 
regulated investment company for a taxable year to which an election 
under paragraph (f)(1) of this section applies shall be computed without 
regard to that part of any post-October capital loss or post-October 
currency loss to which the election applies.
    (3) Amount of loss taken into account in current year--(i) If entire 
amount of net capital loss deferred. If a regulated investment company 
elects, under paragraph (f)(1) of this section, to defer the entire 
amount of a post-October capital loss as defined in paragraph (c)(1)(i) 
of this section, the taxable income of the company for the taxable year 
in which the loss arose shall be determined without regard to any 
capital gains or losses (both long-term and short-term) taken into 
account in computing the post-October capital loss for the taxable year.
    (ii) If part of net capital loss deferred--(A) In general. If a 
regulated investment company elects, under paragraph (f)(1) of this 
section, to defer less than the entire amount of a post-October capital 
loss as defined in paragraph (c)(1)(i) of this section, the taxable 
income of the company for the taxable year in which the loss arose shall 
be determined by including an amount of capital loss taken into account 
in computing the post-October capital loss for the taxable year equal to 
the amount of the post-October capital loss that is not deferred. No 
amount of capital gain taken into account in computing the post-October 
capital loss for the taxable year shall be taken into account in the 
determination.
    (B) Character of capital loss not deferred. The capital loss 
includible in the taxable income of the company under this paragraph 
(f)(3)(ii) for the taxable year in which the loss arose shall consist 
first of any short-term capital losses to the extent thereof, and then 
of any long-term capital losses, taken into account in computing the 
post-October capital loss for the taxable year.
    (iii) If entire amount of net long-term capital loss deferred. If a 
regulated investment company elects, under paragraph (f)(1) of this 
section, to defer the entire amount of a post-October capital loss as 
defined in paragraph (c)(1)(ii) of this section, the taxable income of 
the company for the taxable year in which the loss arose shall be 
determined without regard to any long-term capital gains or losses taken 
into account in computing the post-October capital loss for the taxable 
year.
    (iv) If part of net long-term capital loss deferred. If a regulated 
investment company elects, under paragraph (f)(1) of this section, to 
defer less than the entire amount of a post-October capital loss as 
defined in paragraph (c)(1)(ii) of this section, the taxable income of 
the company for the taxable year in which the loss arose shall be 
determined by including an amount of long-term capital loss taken into 
account in computing the post-October capital loss for the taxable year 
equal to the amount of the post-October capital loss that is not 
deferred. No amount of long term capital gain taken into account in 
computing the post-October capital loss for the taxable year shall be 
taken into account in the determination.
    (v) If entire amount of post-October currency loss deferred. If a 
regulated investment company elects, under paragraph (f)(1) of this 
section, to defer the entire amount of a post-October currency loss, the 
taxable income of the company for the taxable year in which the loss 
arose shall be determined without regard to any foreign currency gains 
or losses taken into account in computing the post-October currency loss 
for the taxable year.
    (vi) If part of post-October currency loss deferred. If a regulated 
investment

[[Page 34]]

company elects, under paragraph (f)(1) of this section, to defer less 
than the entire amount of a post-October currency loss, the taxable 
income of the company for the taxable year in which the loss arose shall 
be determined by including an amount of foreign currency loss taken into 
account in computing the post-October currency loss for the taxable year 
equal to the amount of the post-October currency loss that is not 
deferred. No amount of foreign currency gain taken into account in 
computing the post-October currency loss for the taxable year shall be 
taken into account in the determination.
    (4) Amount of loss taken into account in succeeding year and 
subsequent years. If a regulated investment company has a post-October 
capital loss or a post-October currency loss for any taxable year and an 
election under paragraph (f)(1) is made for that year, then, for 
purposes of determining the taxable income of the company for the 
succeeding year and all subsequent years, all capital gains and losses 
taken into account in determining the post-October capital loss, and all 
foreign currency gains and losses taken into account in determining the 
post-October currency loss, that are not taken into account under the 
rules of paragraph (f)(3) of this section in determining the taxable 
income of the regulated investment company for the taxable year in which 
the loss arose shall be treated as arising on the first day of the 
succeeding year.
    (5) Effect on gross income. An election by a regulated investment 
company to defer any post-October capital loss or any post-October 
currency loss for a taxable year under paragraph (f)(1) of this section 
shall not affect the amount of the gross income of such company for such 
taxable year (or the succeeding year) for purposes of section 851(b) (2) 
or (3).
    (g) Earnings and profits--(1) General rule. The earnings and profits 
of a regulated investment company for a taxable year are determined 
without regard to any post-October capital loss or post-October currency 
loss for that year. If a regulated investment company distributes with 
respect to a calendar year amounts in excess of the limitation described 
in the succeeding sentence, then, with respect to those excess amounts, 
for the taxable year with respect to which the amounts are distributed, 
the earnings and profits of the company are computed without regard to 
the preceding sentence. The limitation described in this sentence is the 
amount that would be the required distribution for that calendar year 
under section 4982 if ``100 percent'' were substituted for each 
percentage set forth in section 4982(b)(1).
    (2) Special Rule--Treatment of losses that are deferred for purposes 
of determining taxable income. If a regulated investment company elects 
to defer, under paragraph (f)(1) of this section, any part of a post-
October capital loss or post-October currency loss arising in a taxable 
year, then, for both the taxable year in which the loss arose and the 
succeeding year, both the earnings and profits and the accumulated 
earnings and profits of the company are determined as if the part of the 
loss so deferred had arisen on the first day of the succeeding year.
    (h) Examples. The provisions of paragraphs (e), (f), and (g) of this 
section may be illustrated by the following examples. For each example, 
assume that X is a regulated investment company that computes its income 
on a calendar year basis, and that no election is in effect under 
section 4982(e)(4).

    Example 1. X has a $25 net foreign currency gain, a $50 net short-
term capital loss, and a $75 net long-term capital gain for the post-
October period of 1988. X has no post-October currency loss and no post-
October capital loss for 1988, and this section does not apply.
    Example 2. X has the following capital gains and losses for the 
periods indicated:

------------------------------------------------------------------------
                                                        Long-    Short-
                                                        term      term
------------------------------------------------------------------------
01/01 to 10/31/88...................................      115        80
                                                          (15)      (20)
                                                     -------------------
                                                          100        60
                                                     ===================
11/01 to 12/31/88...................................       75       150
                                                         (150)      (50)
                                                     -------------------
                                                          (75)      100
                                                     ===================
01/01 to 10/31/89...................................       30        40
                                                           (5)      (20)
                                                     -------------------
                                                           25        20
                                                     ===================
11/01 to 12/31/89...................................       35       100

[[Page 35]]

 
                                                           (0)      (50)
                                                     -------------------
                                                           35        50
------------------------------------------------------------------------


X has a post-October capital loss of $75 for its 1988 taxable year due 
to a net long-term capital loss for the post-October period of 1988. X 
does not make an election under paragraph (f)(1) of this section.
    (i) Capital gain dividends. X may designate up to $100 as a capital 
gain dividend for 1988 because X must disregard the $75 long-term 
capital gain and the $150 long-term capital loss for the post-October 
period of 1988 in computing its net capital gain for this purpose. In 
computing its net capital gain for 1989 for the purposes of determining 
the amount it may designate as a capital gain dividend for 1989, X must 
take into account the $75 long-term capital gain and the $150 long-term 
capital loss for the post-October period of 1988 in addition to the 
long-term and short-term capital gains and losses for 1989. Accordingly, 
X may not designate any amount as a capital gain dividend for 1989.
    (ii) Taxable income. X must include the $75 long-term capital gain 
and the $150 long-term capital loss for its post-October period of 1988 
in its taxable income for 1988 because it did not make an election under 
paragraph (f)(1) of this section for 1988. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $25 and a net short-
term capital gain of $160. X's taxable income for 1989 will include a 
net capital gain of $60 and a net short-term capital gain of $70.
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $75 long-term capital gain and 
the $150 long-term capital loss for the post-October period of 1988. X 
must, however, include the $75 long-term capital gain and $150 long-term 
capital loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $260 of 
capital gain in its earnings and profits for 1988, includes $185 in its 
accumulated earnings and profits for 1988, and includes $130 of capital 
gain in its earnings and profits for 1989.
    Example 3. Same facts as example 2, except that X elects to defer 
the entire $75 post-October capital loss for 1988 under paragraph (f)(1) 
of this section for purposes of determining its taxable income for 1988.
    (i) Capital gain dividends. Same result as in example 2.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $75 long-term capital gain and the $150 long-term 
capital loss for the post-October period of 1988 because it made an 
election to defer the entire $75 post-October capital loss for 1988 
under paragraph (f)(1) of this section. Accordingly, X's taxable income 
for 1988 will include a net capital gain of $100 and a net short-term 
capital gain of $160. X must include the $75 long-term capital gain and 
the $150 long-term capital loss for the post-October period of 1988 in 
its taxable income for 1989 in addition to the long-term and short-term 
capital gains and losses for 1989. Accordingly, X's taxable income for 
1989 will include a net long-term capital loss of $15 and a net short-
term capital gain of $70.
    (iii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $75 long-term capital gain and $150 long-term capital loss 
for the post-October period of 1988. In determining both its earnings 
and profits and its accumulated earnings and profits for 1989, X must 
include (in addition to the long-term and short-term capital gains and 
losses for 1989) the $75 long-term capital gain and $150 long-term 
capital loss for the post-October period of 1988 as if those deferred 
gains and losses arose on January 1, 1989. Thus, X will include $260 of 
capital gain in its earnings and profits for 1988 and $55 of capital 
gain in its earnings and profits for 1989.
    Example 4. Same facts as example 2, except that X elects to defer 
only $50 of the post-October capital loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Capital gain dividends. Same results as in example 2.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $75 long-term capital gain and $125 of the $150 
long-term capital loss for the post-October period of 1988 because it 
made an election to defer $50 of the $75 post-October capital loss for 
1988 under paragraph (f)(1) of this section. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $75 and a net short-
term capital gain of $160. X must include the $75 long-term capital gain 
and $125 of the $150 long-term capital loss for the post-October period 
of 1988 in its taxable income for 1989 in addition to the long-term and 
short-term capital gains and losses for 1989. Accordingly, X's taxable 
income for 1989 will include a net capital gain of $10 and a net short-
term capital gain of $70.
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $75 long-term capital gain and 
the $150 long-term capital loss for the post-October period of 1988. X 
must include $25 of the $150 long-term capital loss for the post-October 
period of 1988 in determining its accumulated earnings and profits for 
1988. In determining both its earnings and profits and its accumulated 
earnings and profits for 1989, X must include (in addition to the long-
term and short-term capital gains and losses for 1989) the $75 long-term 
capital gain and $125 of the $150 long-term capital loss for the

[[Page 36]]

post-October period of 1988 as if those deferred gains and losses arose 
on January 1, 1989. Thus, X includes $260 of capital gain in its 
earnings and profits for 1988, includes $235 in its accumulated earnings 
and profits for 1988, and includes $80 of capital gain in its earnings 
and profits for 1989.
    Example 5. X has the following capital gains and losses for the 
periods indicated:

------------------------------------------------------------------------
                                                        Long-    Short-
                                                        term      term
------------------------------------------------------------------------
01/01 to 10/31/88...................................      115        80
                                                          (15)      (20)
                                                     -------------------
                                                          100        60
                                                     ===================
11/01 to 12/31/88...................................      150        50
                                                          (75)     (150)
                                                     -------------------
                                                           75      (100)
                                                     ===================
01/01 to 10/31/89...................................       30        40
                                                           (5)      (20)
                                                     -------------------
                                                           25        20
                                                     ===================
11/01 to 12/31/89...................................       35       100
                                                           (0)      (50)
                                                     -------------------
                                                           35        50
------------------------------------------------------------------------


X has a post-October capital loss of $25 for its 1988 taxable year due 
to a net capital loss for the post-October period of 1988. X does not 
make an election under paragraph (f)(1) of this section.
    (i) Capital gain dividends. X may designate up to $100 as a capital 
gain dividend for 1988 because X must disregard the $150 long-term 
capital gain, the $75 long-term capital loss, the $50 short-term capital 
gain, and the $150 short-term capital loss for the post-October period 
of 1988 in computing its net capital gain for this purpose. In computing 
its net capital gain for 1989 for purposes of determining the amount it 
may designate as a capital gain dividend for 1989, X must take into 
account the $150 long-term capital gain, the $75 long-term capital loss, 
the $50 short-term capital gain, and the $150 short-term capital loss 
for the post-October period of 1988 in addition to the long-term and 
short-term capital gains and losses for 1989. Accordingly, X may 
designate up to $105 as a capital gain dividend for 1989.
    (ii) Taxable income. X must include the $150 long-term capital gain, 
the $75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988 in its 
taxable income for 1988 because it did not make an election under 
paragraph (f)(1) of this section for 1988. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $135 (consisting of a 
net long-term capital gain of $175 and a net short-term capital loss of 
$40). X's taxable income for 1989 will include a net capital gain of $60 
and a net short-term capital gain of $70.
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $150 long-term capital gain, the 
$75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988. X 
must, however, include the $150 long-term capital gain, the $75 long-
term capital loss, the $50 short-term capital gain, and the $150 short-
term capital loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $160 of 
capital gain in its earnings and profits for 1988, includes $135 in its 
accumulated earnings and profits for 1988, and includes $130 of capital 
gain in its earnings and profits for 1989.
    Example 6. Same facts as example 5, except that X elects to defer 
the entire $25 post-October capital loss for 1988 under paragraph (f)(1) 
of this section for purposes of determining its taxable income for 1988.
    (i) Capital gain dividends. Same result as in example 5.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $150 long-term capital gain, the $75 long-term 
capital loss, the $50 short-term capital gain, and the $150 short-term 
capital loss for the post-October period of 1988 because it made an 
election to defer the entire $25 post-October capital loss for 1988 
under paragraph (f)(1) of this section. Accordingly, X's taxable income 
for 1988 will include a net capital gain of $100 and a net short-term 
capital gain of $60. X must include the $150 long-term capital gain, the 
$75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988 in its 
taxable income for 1989 in addition to the long-term and short-term 
capital gains and losses for 1989. Accordingly, X's taxable income for 
1989 will include a net capital gain of $105 (consisting of a net long-
term capital gain of $135 and a net short-term capital loss of $30).
    (iii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $150 long-term capital gain, the $75 long-term capital 
loss, the $50 short-term capital gain, and the $150 short-term capital 
loss for the post-October period of 1988. In determining both its 
earnings and profits and its accumulated earnings and profits for 1989, 
X must include (in addition to the long-term and short-term capital 
gains and losses for 1989) the $150 long-term capital gain, the $75 
long-term capital loss, the $50 short-term capital gain, and the $150 
short-term capital loss for the post-October period of 1988 as if those 
deferred gains and losses arose on January 1, 1989. Thus, X will include 
$160 of capital gain in its earnings and profits for 1988

[[Page 37]]

and $105 of capital gain in its earnings and profits for 1989.
    Example 7. Same facts as example 5, except that X elects to defer 
only $20 of the post-October capital loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Capital gain dividends. Same result as in example 5.
    (ii) Taxable income. X must compute its taxable income for 1988 by 
including $5 of the $150 short-term capital loss for the post-October 
period of 1988, but without regard to the $150 long-term capital gain, 
the $75 long-term capital loss, the $50 short-term capital gain, and 
$145 of the $150 short-term capital loss for the post-October period of 
1988 because it made an election to defer $20 of the $25 post-October 
capital loss for 1988 under paragraph (f)(1) of this section. 
Accordingly, X's taxable income for 1988 will include a net capital gain 
of $100 and a net short-term capital gain of $55. X must include the 
$150 long-term capital gain, the $75 long-term capital loss, the $50 
short-term capital gain, and $145 of the $150 short-term capital loss 
for the post-October period of 1988 in its taxable income for 1989 in 
addition to the long-term and short-term capital gains and losses for 
1989. Accordingly, X's taxable income for 1989 will include a net 
capital gain of $110 (consisting of a long-term capital gain of $135 and 
a net short-term capital loss of $25).
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $150 long-term capital gain, the 
$75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988. In 
determining its accumulated earnings and profits for 1988, X must 
include $5 of the $150 short-term capital loss for the post-October 
period of 1988. In determining its accumulated earnings and profits for 
1989, X must include (in addition to the long-term and short-term 
capital gains and losses for 1989) the $150 long-term capital gain, the 
$75 long-term capital loss, the $50 short-term capital gain, and $145 of 
the $150 short-term capital loss for the post-October period of 1988 as 
if those deferred gains and losses arose on January 1, 1989. Thus, X 
includes $160 of capital gain in its earnings and profits for 1988, 
includes $155 in its accumulated earnings and profits for 1988, and 
includes $110 of capital gain in its earnings and profits for 1989.
    Example 8. X has the following capital gains and losses for the 
periods indicated:

------------------------------------------------------------------------
                                                        Long-    Short-
                                                        term      term
------------------------------------------------------------------------
01/01 to 10/31/88...................................      115        80
                                                          (15)      (20)
                                                     -------------------
                                                          100        60
                                                     ===================
11/01 to 12/31/88...................................       15        25
                                                          (75)      (10)
                                                     -------------------
                                                          (60)       15
                                                     ===================
01/01 to 10/31/89...................................       80        50
                                                           (5)     (100)
                                                     -------------------
                                                           75       (50)
                                                     ===================
11/01 to 12/31/89...................................       85        40
                                                           (0)      (20)
                                                     -------------------
                                                           85        20
------------------------------------------------------------------------


X has a post-October capital loss of $45 for its 1988 taxable year due 
to a net capital loss for the post-October period of 1988. X does not 
make an election under paragraph (f)(1) of this section.
    (i) Capital gain dividends. X may designate up to $100 as a capital 
gain dividend for 1988 because X must disregard the $15 long-term 
capital gain, the $75 long-term capital loss, the $25 short-term capital 
gain, and the $10 short-term capital loss for the post-October period of 
1988 in computing its net capital gain for this purpose. In computing 
its net capital gain for 1989 for purposes of determining the amount it 
may designate as a capital gain dividend for 1989, X must take into 
account the $15 long-term capital gain, the $75 long-term capital loss, 
the $25 short-term capital gain, and the $10 short-term capital loss for 
the post-October period of 1988 in addition to the long-term and short-
term capital gains and losses for 1989. Accordingly, X may designate up 
to $85 as a capital gain dividend for 1989.
    (ii) Taxable income. X must include the $15 long-term capital gain, 
the $75 long-term capital loss, the $25 short-term capital gain, and the 
$10 short-term capital loss for the post-October period of 1988 in its 
taxable income for 1988 because it did not make an election under 
paragraph (f)(1) of this section for 1988. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $40 and a net short-
term capital gain of $75. X's taxable income for 1989 will include a net 
capital gain of $130 for 1989 (consisting of a net long-term capital 
gain of $160 and a net short-term capital loss of $30).
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $15 long-term capital gain, the 
$75 long-term capital loss, the $25 short-term capital gain, and the $10 
short-term capital loss for the post-October period of 1988. X must, 
however, include the $15 long-term capital gain, the $75 long-term 
capital loss, the $25 short-term capital gain, and the $10 short-term 
capital loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $160 of 
capital gain in its earnings

[[Page 38]]

and profits for 1988, includes $115 in its accumulated earnings and 
profits for 1988, and includes $130 of capital gain in its earnings and 
profits for 1989.
    Example 9. Same facts as example 8, except that X elects to defer 
the entire $45 post-October capital loss for 1988 under paragraph (f)(1) 
of this section for purposes of determining its taxable income for 1988.
    (i) Capital gain dividends. Same result as in example 8.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $15 long-term capital gain, the $75 long-term 
capital loss, the $25 short-term capital gain, and the $10 short-term 
capital loss for the post-October period of 1988 because it made an 
election to defer the entire $45 post-October capital loss for 1988 
under paragraph (f)(1) of this section. Accordingly, X's taxable income 
for 1988 will include a net capital gain of $100 and a net short-term 
capital gain of $60. X must include the $15 long-term capital gain, the 
$75 long-term capital loss, the $25 short-term capital gain, and the $10 
short-term capital loss for the post-October period of 1988 in its 
taxable income for 1989 in addition to the long-term and short-term 
capital gains and losses for 1989. Accordingly, X's taxable income for 
1989 will include a net capital gain of $85 (consisting of a net long-
term capital gain of $100 and a net short-term capital loss of $15).
    (iii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $15 long-term capital gain, the $75 long-term capital 
loss, the $25 short-term capital gain, and the $10 short-term capital 
loss for the post-October period of 1988. In determining both its 
earnings and profits and its accumulated earnings and profits for 1989, 
X must include (in addition to the long-term and short-term capital 
gains and losses for 1989) the $15 long-term capital gain, the $75 long-
term capital loss, the $25 short-term capital gain, and the $10 short-
term capital loss for the post-October period of 1988 as if those 
deferred gains and losses arose on January 1, 1989. Thus, X will include 
$160 of capital gain in its earnings and profits for 1988 and $85 of 
capital gain in its earnings and profits for 1989.
    Example 10. Same facts as example 8, except that X elects to defer 
only $30 of the post-October capital loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Capital gain dividends. Same result as in example 8.
    (ii) Taxable income. X must compute its taxable income for 1988 by 
including $5 of the $75 long-term capital loss and the $10 short-term 
capital loss for the post-October period of 1988, but without regard to 
the $15 long-term capital gain, $70 of the $75 long-term capital loss, 
and the $25 short-term capital gain for the post-October period of 1988 
because it made an election to defer $30 of the $45 post-October capital 
loss for 1988 under paragraph (f)(1) of this section. Accordingly, X's 
taxable income for 1988 will include a net capital gain of $95 and a net 
short-term capital gain of $50. X must include the $15 long-term capital 
gain, $70 of the $75 long-term capital loss, and the $25 short-term 
capital gain for the post-October period of 1988 in its taxable income 
for 1989 in addition to the long-term and short-term capital gains and 
losses for 1989. Accordingly, X's taxable income for 1989 will include a 
net capital gain of $100 (consisting of a net long-term capital gain of 
$105 and a net short-term capital loss of $5).
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $15 long-term capital gain, the 
$75 long-term capital loss, the $25 short-term capital gain, and the $10 
short-term capital loss for the post-October period of 1988. In 
determining its accumulated earnings and profits for 1988, X must 
include $5 of the $75 long-term capital loss and the $10 short-term 
capital loss for the post-October period of 1988. In determining both 
its earnings and profits and its accumulated earnings and profits for 
1989, X must include (in addition to the long-term and short-term 
capital gains and losses for 1989) the $15 long-term capital gain, $70 
of the $75 long-term capital loss, and the $25 short-term capital gain 
for the post-October period of 1988 as if those deferred gains and 
losses arose on January 1, 1989. Thus, X includes $160 of capital gain 
in its earnings and profits for 1988, includes $145 in its accumulated 
earnings and profits for 1989, and includes $100 of capital gain in its 
earnings and profits for 1989 (consisting of a net long-term capital 
gain of $105 and a net short-term capital loss of $5).
    Example 11. X has the following foreign currency gains and losses 
attributable to the periods indicated:

  01/01 to 10/31/88.................................................200 
  11/01 to 12/31/88................................................(100)
  01/01 to 10/31/89.................................................110 
  11/01 to 12/31/89..................................................40 


X has a $100 post-October currency loss for its 1988 taxable year due to 
a net foreign currency loss for the post-October period of 1988. X does 
not make an election under paragraph (f)(1) of this section.
    (i) Taxable income. X must compute its taxable income for 1988 by 
including the $100 foreign currency loss for the post-October period of 
1988 because it did not make an election under paragraph (f)(1) of this 
section. Accordingly, X's taxable income for 1988 will include a net 
foreign currency gain of $100. X's taxable income for 1989 will include 
a net foreign currency gain of $150.

[[Page 39]]

    (ii) Earnings and profits. X must determine its earnings and profits 
for 1988 without regard to the foreign currency loss for the post-
October period of 1988. X must, however, include the $100 foreign 
currency loss for the post-October period 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $200 of 
foreign currency gain in its earnings and profits for 1988, includes 
$100 in its accumulated earnings and profits for 1988, and includes $150 
of foreign currency gain in its earnings and profits for 1989.
    Example 12. Same facts as example 11, except that X elects to defer 
the entire $100 post-October currency loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Taxable income. X must compute its taxable income for 1988 
without regard to the $100 foreign currency loss for the post-October 
period of 1988 because it made an election to defer the entire $100 
post-October currency loss for 1988 under paragraph (f)(1) of this 
section. Accordingly, X's taxable income for 1988 will include a net 
foreign currency gain of $200. X's taxable income for 1989 will include 
a net foreign currency gain of $50 because X must compute its taxable 
income for 1989 by including the $100 foreign currency loss for the 
post-October period of 1988 in addition to the foreign currency gains 
and losses for 1989.
    (ii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $100 foreign currency loss for the post-October period of 
1988. In determining both its earnings and profits and its accumulated 
earnings and profits for 1989, X must include (in addition to the 
foreign currency gains and losses for 1989) the $100 foreign currency 
loss for the post-October period 1988 as if that deferred loss arose on 
January 1, 1989. Thus, X will include $200 of foreign currency gain in 
its earnings and profits for 1988 and $50 of foreign currency gain in 
its earnings and profits for 1989.
    Example 13. Same facts as example 11, except that X elects to defer 
only $75 of the post-October currency loss under paragraph (f)(1) of 
this section for purposes of determining its taxable income for 1988.
    (i) Taxable income. X must compute its taxable income for 1988 by 
including $25 of the $100 foreign currency loss for the post-October 
period of 1988, but without regard to $75 of the $100 foreign currency 
loss for the post-October period of 1988 because it made an election to 
defer $75 of the $100 post-October currency loss for 1988 under 
paragraph (f)(1) of this section. Accordingly, X's taxable income for 
1988 will include a net foreign currency gain of $175. X's taxable 
income will include a net foreign currency gain of $75 for 1989 because 
X must compute its taxable income for 1989 by including $75 of the $100 
foreign currency loss for the post-October period of 1988 in addition to 
the foreign currency gains and losses for 1989.
    (ii) Earnings and profits. X must determine its earnings and profits 
for 1988 without regard to the $100 foreign currency loss for the post-
October period of 1988. X must, however, inlcude $25 of the $100 foreign 
currency loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. In determining both its 
earnings and profits and its accumulated earnings and profits for 1989, 
X must include (in addition to the foreign currency gains and losses for 
1989) the $75 of the $100 foreign currency loss for the post-October 
period of 1988 as if that loss arose on January 1, 1989. Thus, X 
includes $200 of foreign currency gain in its earnings and profits for 
1988, includes $175 in its accumulated earnings and profits for 1988, 
and includes $75 of foreign currency gain in its earnings and profits 
for 1989.

    (i) Procedure for making election--(1) In general. Except as 
provided in paragraph (i)(2) of this section, a regulated investment 
company may make an election under paragraph (f)(1) of this section for 
a taxable year to which this section applies by completing its income 
tax return (including any necessary schedules) for that taxable year in 
accordance with the instructions for the form that are applicable to the 
election.
    (2) When applicable instructions not available. If the instructions 
for the income tax returns of regulated investment companies for a 
taxable year to which this section applies do not reflect the provisions 
of this section, a regulated investment company may make an election 
under paragraph (f)(1) of this section for that year by entering the 
appropriate amounts on its income tax return (including any necessary 
schedules) for that year, and by attaching a written statement to the 
return that states--
    (i) The taxable year for which the election under this section is 
made;
    (ii) The fact that the regulated investment company elects to defer 
all or a part of its post-October capital loss or post-October currency 
loss for that taxable year for purposes of computing its taxable income 
under the terms of this section;
    (iii) The amount of the post-October capital loss or post-October 
currency loss that the regulated investment

[[Page 40]]

company elects to defer for that taxable year; and
    (iv) The name, address, and employer identification number of the 
regulated investment company.
    (j) Transition rules--(1) In general. For a taxable year ending 
before March 2, 1990 in which a regulated investment company incurred a 
post-October capital loss or post-October currency loss, the company may 
use any method that is consistently applied and in accordance with 
reasonable business practice to determine the amounts taken into account 
in that taxable year for purposes of paragraphs (e)(2), (f)(3), and (g) 
of this section and to determine the amount taken into account in the 
succeeding year for purposes of paragraphs (e)(3), (f)(4), and (g) of 
this section. For example, for purposes of paragraph (e), a taxpayer may 
use a method that treats as incurred in a taxable year all capital gains 
taken into account in computing the post-October capital loss for that 
year and an amount of capital loss for such period equal to the amount 
of such gains and that treats the remaining amount of capital loss for 
such period as arising on the first day of the succeeding year.

Similarly, for purposes of paragraph (e)(3), a taxpayer may use a method 
that treats as arising on the first day of the succeeding year only the 
excess of the capital losses from sales or exchanges after October 31 
over the capital gains for such period (that is, the net capital loss or 
net long-term capital loss for such period).
    (2) Retroactive election--(i) In general. A regulated investment 
company may make an election (a ``retroactive election'') under 
paragraph (f)(1) for a taxable year with respect to which it has filed 
an income tax return on or before May 1, 1990 (a ``retroactive election 
year'') by filing an amended return (including any necessary schedules) 
for the retroactive election year reflecting the appropriate amounts and 
by attaching a written statement to the return that complies with the 
requirements of paragraph (i)(2) of this section.
    (ii) Deadline for making election. A retroactive election may be 
made no later than December 31, 1990.
    (3) Amended return required for succeeding year in certain 
circumstances--(i) In general. If, at the time a regulated investment 
company makes a retroactive election under this section, it has already 
filed an income tax return for the succeeding year, the company must 
file an amended return for such succeeding year reflecting the 
appropriate amounts.
    (ii) Time for filing amended return. An amended return required 
under paragraph (j)(3)(i) of this section must be filed together with 
the amended return described in paragraph (j)(2)(i).
    (4) Retroactive dividend--(i) In general. A regulated investment 
company that makes a retroactive election under this section for a 
retroactive election year may elect to treat any dividend (or portion 
thereof) declared and paid (or treated as paid under section 852(b)(7)) 
by the regulated investment company after the retroactive election year 
and on or before December 31, 1990 as having been paid during the 
retroactive election year (a ``retroactive dividend''). This election 
shall be irrevocable with respect to the retroactive dividend to which 
it applies.
    (ii) Method of making election. The election under this paragraph 
(j)(4) must be made by the regulated investment company by treating the 
dividend (or portion thereof) to which the election applies as a 
dividend paid during the retroactive election year in computing its 
deduction for dividends paid in its tax returns for all applicable years 
(including the amended return(s) required to be filed under paragraphs 
(j)(2) and (3) of this section).
    (iii) Deduction for dividends paid--(A) In general. Subject to the 
rules of sections 561 and 562, a regulated investment company shall 
include the amount of any retroactive dividend in computing its 
deduction for dividends paid for the retroactive election year. No 
deduction for dividends paid shall be allowed under this paragraph 
(j)(4)(iii)(A) for any amount not paid (or treated as paid under section 
852(b)(7)) on or before December 31, 1990.
    (B) Limitation on ordinary dividends. The amount of retroactive 
dividends (other than retroactive dividends qualifying as capital gain 
dividends)

[[Page 41]]

paid for a retroactive election year under this section shall not exceed 
the increase, if any, in the investment company taxable income of the 
regulated investment company (determined without regard to the deduction 
for dividends paid (as defined in section 561)) that is attributable 
solely to the regulated investment company having made the retroactive 
election.
    (C) Limitation on capital gain dividends. The amount of retroactive 
dividends qualifying as capital gain dividends paid for a retroactive 
election year under this section shall not exceed the increase, if any, 
in the amount of the excess described in section 852(b)(3)(A) (relating 
to the excess of the net capital gain over the deduction for capital 
gain dividends paid) that is attributable solely to the regulated 
investment company having made the retroactive election.
    (D) Effect on other years. A retroactive dividend shall not be 
includible in computing the deduction for dividends paid for--
    (1) The taxable year in which such distribution is actually paid (or 
treated as paid under section 852(b)(7)); or
    (2) Under section 855(a), the taxable year preceding the retroactive 
election year.
    (iv) Earnings and profits. A retroactive dividend shall be 
considered as paid out of the earnings and profits of the retroactive 
election year (computed with the application of sections 852(c) and 855, 
Sec. 1.852-5, Sec. 1.855-1, and this section), and not out of the 
earnings and profits of the taxable year in which the distribution is 
actually paid (or treated as paid under section 852(b)(7)).
    (v) Receipt by shareholders. Except as provided in section 
852(b)(7), a retroactive dividend shall be included in the gross income 
of the shareholders of the regulated investment company for the taxable 
year in which the dividend is received by them.
    (vi) Foreign tax election. If a regulated investment company to 
which section 853 (relating to foreign taxes) is applicable for a 
retroactive election year elects to treat a dividend paid (or treated as 
paid under section 852(b)(7)) during the taxable year as a retroactive 
dividend, the shareholders of the regulated investment company shall 
consider the amounts described in section 853(b)(2) allocable to such 
distribution as paid or received, as the case may be, in the 
shareholder's taxable year in which the distribution is made.
    (vii) Example. The provisions of this paragraph (j)(4) may be 
illustrated by the following example:

    Example. X is a regulated investment company that computes its 
income on a calendar year basis. No election is in effect under section 
4982(e)(4). X has the following income for 1988:

                    Foreign Currency Gains and Losses

                            Gains and Losses

Jan. 1-Oct. 31--100
Nov. 1-Dec. 31--(75)

                        Capital Gains and Losses

Jan. 1-Oct. 31--short term, 100; long term, 100
Nov. 1-Dec. 31--short term, 50; long term, (100)

    (A) X had investment company taxable income of $175 and no net 
capital gain for 1988 for taxable income purposes. X distributed $175 of 
investment company taxable income as an ordinary dividend for 1988.
    (B) If X makes a retroactive election under this section to defer 
the entire $75 post-October currency loss and the entire $50 post-
October capital loss for the post-October period of its 1988 taxable 
year for purposes of computing its taxable income, that deferral 
increases X's investment company taxable income for 1988 by $25 (due to 
an increase in foreign currency gain of $75 and a decrease in short-term 
capital gain of $50) to $200 and increases the excess described in 
section 852(b)(3)(A) for 1988 by $100 from $0 to $100. The amount that X 
may treat as a retroactive ordinary dividend is limited to $25, and the 
amount that X may treat as a retroactive capital gain dividend is 
limited to $100.

    (5) Certain distributions may be designated retroactively as capital 
gain dividends. To the extent that a regulated investment company 
designated as capital gain dividends for a taxable year less than the 
maximum amount permitted under paragraph (e) of this section for that 
taxable year, the regulated investment company may designate an 
additional amount of dividends paid (or treated as paid under sections 
852(b)(7) or 855, or paragraph (j)(4) of this section) for the taxable 
year as capital gain dividends, notwithstanding that a written notice 
was not

[[Page 42]]

mailed to its shareholders within 60 days after the close of the taxable 
year in which the distribution was paid (or treated as paid under 
section 852(b)(7)).
    (k) Effective date. the provisions of this section shall apply to 
taxable years ending after October 31, 1987.

[T.D. 8287, 55 FR 3213, Jan. 31, 1990; 55 FR 7891, Mar. 6, 1990; 55 FR 
11110, Mar. 26, 1990. Redesignated and amended by T.D. 8320, 55 FR 
50176, Dec. 5, 1990; 56 FR 2808, Jan. 24, 1991; 56 FR 8130, Feb. 27, 
1991]



Sec. 1.852-12  Non-RIC earnings and profits.

    (a) Applicability of section 852(a)(2)(A)--(1) In general. An 
investment company does not satisfy section 852(a)(2)(A) unless--
    (i) Part I of subchapter M applied to the company for all its 
taxable years ending on or after November 8, 1983; and
    (ii) For each corporation to whose earnings and profits the 
investment company succeeded by the operation of section 381, part I of 
subchapter M applied for all the corporation's taxable years ending on 
or after November 8, 1983.
    (2) Special rule. See section 1071(a)(5)(D) of the Tax Reform Act of 
1984, Public Law 98-369 (98 Stat. 1051), for a special rule which treats 
part I of subchapter M as having applied to an investment company's 
first taxable year ending after November 8, 1983.
    (b) Applicability of section 852(a)(2)(B)--(1) In general. An 
investment company does not satisfy section 852(a)(2)(B) unless, as of 
the close of the taxable year, it has no earnings and profits other than 
earnings and profits that--
    (i) Were earned by a corporation in a year for which part I of 
subchapter M applied to the corporation and, at all times thereafter, 
were the earnings and profits of a corporation to which part I of 
subchapter M applied;
    (ii) By the operation of section 381 pursuant to a transaction that 
occurred before December 22, 1992, became the earnings and profits of a 
corporation to which part I of subchapter M applied and, at all times 
thereafter, were the earnings and profits of a corporation to which part 
I of subchapter M applied;
    (iii) Were accumulated in a taxable year ending before January 1, 
1984, by a corporation to which part I of subchapter M applied for any 
taxable year ending before November 8, 1983; or
    (iv) Were accumulated in the first taxable year of an investment 
company that began business in 1983 and that was not a successor 
corporation.
    (2) Prior law. For purposes of paragraph (b) of this section, a 
reference to part I of subchapter M includes a reference to the 
corresponding provisions of prior law.
    (c) Effective date. This regulation is effective for taxable years 
ending on or after December 22, 1992.
    (d) For treatment of net built-in gain assets of a C corporation 
that become assets of a RIC, see Sec. 1.337(d)-5T.

[T.D. 8483, 58 FR 43798, Aug. 18, 1993; 58 FR 49352, Sept. 22, 1993; 
T.D. 8872, 65 FR 5777, Feb. 7, 2000]



Sec. 1.853-1  Foreign tax credit allowed to shareholders.

    (a) In general. Under section 853, a regulated investment company, 
meeting the requirements set forth in section 853(a) and paragraph (b) 
of this section, may make an election with respect to the income, war-
profits, and excess profits taxes described in section 901(b)(1) which 
it pays to foreign countries or possessions of the United States during 
the taxable year, including such taxes as are deemed paid by it under 
the provisions of any income tax convention to which the United States 
is a party. If an election is made, the shareholders of the regulated 
investment company shall apply their proportionate share of such foreign 
taxes paid, or deemed to have been paid by it pursuant to any income tax 
convention, as either a credit (under section 901) or as a deduction 
(under section 164(a)) as provided by section 853(b)(2) and paragraph 
(b) of Sec. 1.853-2. The election is not applicable with respect to 
taxes deemed to have been paid under section 902 (relating to the credit 
allowed to corporate stockholders of a foreign corporation for taxes 
paid by such foreign corporation).
    (b) Requirements. To qualify for the election provided in section 
853(a), a regulated investment company (1) must have more than 50 
percent of the

[[Page 43]]

value of its total assets, at the close of the taxable year for which 
the election is made, invested in stocks and securities of foreign 
corporations, and (2) must also, for that year, comply with the 
requirements prescribed in section 852(a) and paragraph (a) of 
Sec. 1.852-1. The term ``value'', for purposes of the first requirement, 
is defined in section 851(c)(4). For the definition of foreign 
corporation, see section 7701(a).



Sec. 1.853-2  Effect of election.

    (a) Regulated investment company. A regulated investment company 
making a valid election with respect to a taxable year under the 
provisions of section 853(a) is, for such year, denied both the 
deduction for foreign taxes provided by section 164(a) and the credit 
for foreign taxes provided by section 901 with respect to all income, 
war-profits, and excess profits taxes (described in section 901(b)(1)) 
which it has paid to any foreign country or possession of the United 
States. See section 853(b)(1)(A). However, under section 853(b)(1)(B), 
the regulated investment company is permitted to add the amount of such 
foreign taxes paid to its dividends paid deduction for that taxable 
year. See paragraph (a) of Sec. 1.852-1.
    (b) Shareholder. Under section 853(b)(2), a shareholder of an 
investment company, which has made the election under section 853, is, 
in effect, placed in the same position as a person directly owning stock 
in foreign corporations, in that he must include in his gross income (in 
addition to taxable dividends actually received) his proportionate share 
of such foreign taxes paid and must treat such amount as foreign taxes 
paid by him for the purposes of the deduction under section 164(a) and 
the credit under section 901. For such purposes he must treat as gross 
income from a foreign country or possession of the United States (1) his 
proportionate share of the taxes paid by the regulated investment 
company to such foreign country or possession and (2) the portion of any 
dividend paid by the investment company which represents income derived 
from such sources.
    (c) Dividends paid after the close of the taxable year. For 
additional rules applicable to certain distributions made after the 
close of the taxable year which may be designated as income received 
from sources within and taxes paid to foreign countries or possessions 
of the United States, see section 855(d) and paragraph (f) of 
Sec. 1.855-1.
    (d) Example. This section may be illustrated as follows:
    (1) The X Corporation, a regulated investment company, has total 
assets, at the close of the taxable year, of $10 million invested as 
follows:

Domestic corporations......................................   $4,000,000
Foreign corporations in:
  Country A...................................   $3,500,000
  Country B...................................    2,500,000
                                                 ----------    6,000,000
                                                            ------------
      Total assets.........................................   10,000,000
 

    (2) The dividend income of X Corporation is received from the 
following sources:

Domestic corporations.......................................    $300,000
Foreign corporations:
  Country A.....................................    $250,000
  Country B.....................................     250,000
                                                 -------------
                                                                 500,000
                                                             -----------
      Total dividend income.................................     800,000
Operation and management expenses...........................      80,000
                                                 -------------
Net dividend income.........................................     720,000
Taxes withheld by Country B on dividends of           25,000
 $250,000 at a rate of 10 percent...............
Taxes withheld by Country B on dividends of           50,000
 $250,000 at a rate of 20 percent...............
                                                 -------------
      Total foreign taxes withheld..........................      75,000
                                                 -------------
      Income available for distribution.....................    $645,000
 

    (3) X Corporation has 250,000 shares of common stock outstanding and 
distributes the entire $645,000 as a dividend of $2.58 per share of 
stock.
    (4) The X Corporation meets the 50 percent requirement of section 
851(b)(4) and the requirements of section 852(a). It notifies each 
shareholder by mail, within the time prescribed by section 853(c), that 
by reason of the election they are to treat as foreign taxes paid $0.30 
per share of stock ($75,000 of foreign taxes paid, divided by the 
250,000 shares of stock outstanding), of which $0.20 represents taxes 
paid to Country B and $0.10 taxes paid to Country A. The shareholders 
must report as income $2.88 per share ($2.58 of dividends actually 
received plus the $0.30 representing foreign taxes paid). Of the $2.88 
per share, $1.80 per share ($450,000

[[Page 44]]

(which represents such part of the net dividend income of $720,000 as 
the foreign dividend income of $500,000 bears to the total dividend 
income of $800,000) divided by 250,000 shares) is to be considered as 
received from foreign sources. Ninety cents is to be considered as 
received from Country A, and ninety cents from Country B.



Sec. 1.853-3  Notice to shareholders.

    (a) General rule. If a regulated investment company makes an 
election under section 853(a), in the manner provided in Sec. 1.853-4, 
the investment company is required, under section 853(c), to furnish its 
shareholders with a written notice mailed not later than 45 days (30 
days for taxable years ending before February 26, 1964) after the close 
of its taxable year. The notice must designate the shareholder's portion 
of foreign taxes paid to each such country or possession and the portion 
of the dividend which represents income derived from sources within each 
such country or possession. For purposes of section 853(b)(2) and 
paragraph (b) of Sec. 1.853-2, the amount that a shareholder may treat 
as his proportionate share of foreign taxes paid and the amount to be 
included as gross income derived from any foreign country or possession 
of the United States shall not exceed the amounts so designated by the 
company in such written notice. If, however, the amount designated by 
the company in the notice exceeds the shareholder's proper proportionate 
share of foreign taxes or gross income from sources within any foreign 
country or possession, the shareholder is limited to the amount 
correctly ascertained.
    (b) Shareholder of record custodian of certain unit investment 
trusts. In any case where a notice is mailed pursuant to paragraph (a) 
of this section by a regulated investment company with respect to a 
taxable year of the regulated investment company ending after December 
8, 1970 to a shareholder of record who is a nominee acting as a 
custodian of a unit investment trust described in section 851(f)(1) and 
paragraph (b) of Sec. 1.851-7, the nominee shall furnish each holder of 
an interest in such trust with a written notice mailed on or before the 
55th day following the close of the regulated investment company's 
taxable year. The notice shall designate the holder's proportionate 
share of the amounts of foreign taxes paid to each such country or 
possession and the holder's proportionate share of the dividend which 
represents income derived from sources within each country or possession 
shown on the notice received by the nominee pursuant to paragraph (a) of 
this section. The notice shall include the name and address of the 
nominee identified as such. This paragraph shall not apply if the 
regulated investment company agrees with the nominee to satisfy the 
notice requirements of paragraph (a) of this section with respect to 
each holder of an interest in the unit investment trust whose shares are 
being held by the nominee as custodian and not later than 45 days 
following the close of the company's taxable year, files with the 
Internal Revenue Service office where such company's return for the 
taxable year is to be filed, a statement that the holders of the unit 
investment trust with whom the agreement was made have been directly 
notified by the regulated investment company. Such statement shall 
include the name, sponsor, and custodian of each unit investment trust 
whose holders have been directly notified. The nominee's requirements 
under this paragraph shall be deemed met if the regulated investment 
company transmits a copy of such statement to the nominee within such 
45-day period: Provided however, if the regulated investment company 
fails or is unable to satisfy the requirements of this paragraph with 
respect to the holders of interest in the unit investment trust, it 
shall so notify the Internal Revenue Service within 45 days following 
the close of its taxable year. The custodian shall, upon notice by the 
Internal Revenue Service that the regulated investment company has 
failed to comply with the agreement, satisfy the requirements of this 
paragraph within 30 days of such notice.

[T.D. 7187, 37 FR 13257, July 6, 1972]



Sec. 1.853-4  Manner of making election.

    (a) General rule. A regulated investment company, to make a valid 
election under section 853, must--

[[Page 45]]

    (1) File with Form 1099 and Form 1096 a statement as part of its 
return which sets forth the following information:
    (i) The total amount of income received from sources within foreign 
countries and possessions of the United States;
    (ii) The total amount of income, war profits, or excess profits 
taxes (described in section 901(b)(1)) paid, or deemed to have been paid 
under the provisions of any treaty to which the United States is a 
party, to such foreign countries or possessions;
    (iii) The date, form, and contents of the notice to its 
shareholders;
    (iv) The proportionate share of such taxes paid during the taxable 
year and foreign income received during such year attributable to one 
share of stock of the regulated investment company;

and
    (2) File as part of its return for the taxable year a Form 1118 
modified so that it becomes a statement in support of the election made 
by a regulated investment company for taxes paid to a foreign country or 
a possession of the United States.
    (b) Irrevocability of the election. The election is applicable only 
with respect to taxable years subject to the Code, shall be made with 
respect to all such foreign taxes, and must be made not later than the 
time prescribed for filing the return (including extensions thereof). 
Such election, if made, shall be irrevocable with respect to the 
dividend (or portion thereof), and the foreign taxes paid with respect 
thereto, to which the election applies.



Sec. 1.854-1  Limitations applicable to dividends received from regulated investment company.

    (a) In general. Section 854 provides special limitations applicable 
to dividends received from a regulated investment company for purposes 
of the exclusion under section 116 for dividends received by 
individuals, the deduction under section 243 for dividends received by 
corporations, and, in the case of dividends received by individuals 
before January 1, 1965, the credit under section 34.
    (b) Capital gain dividend. Under the provisions of section 854(a) a 
capital gain dividend as defined in section 852(b)(3) and paragraph (c) 
of Sec. 1.852-4 shall not be considered a dividend for purposes of the 
exclusion under section 116, the deduction under section 243, and, in 
the case of taxable years ending before January 1, 1965, the credit 
under section 34.
    (c) Rule for dividends other than capital gain dividends. (1) 
Section 854(b)(1) limits the amount that may be treated as a dividend 
(other than a capital gain dividend) by the shareholder of a regulated 
investment company, for the purposes of the credit, exclusion, and 
deduction specified in paragraph (b) of this section, where the 
investment company receives substantial amounts of income (such as 
interest, etc.) from sources other than dividends from domestic 
corporations, which dividends qualify for the exclusion under section 
116.
    (2) Where the ``aggregate dividends received'' (as defined in 
section 854(b)(3)(B) and paragraph (b) of Sec. 1.854-3) during the 
taxable year by a regulated investment company (which meets the 
requirements of section 852(a) and paragraph (a) of Sec. 1.852-1 for the 
taxable year during which it paid such dividend) are less than 75 
percent of its gross income for such taxable year (as defined in section 
854(b)(3)(A) and paragraph (a) of Sec. 1.854-3), only that portion of 
the dividend paid by the regulated investment company which bears the 
same ratio to the amount of such dividend paid as the aggregate 
dividends received by the regulated investment company, during the 
taxable year, bears to its gross income for such taxable year (computed 
without regard to gains from the sale or other disposition of stocks or 
securities) may be treated as a dividend for purposes of such credit, 
exclusion, and deduction.
    (3) Subparagraph (2) of this paragraph may be illustrated by the 
following example:

    Example. The XYZ regulated investment company meets the requirements 
of section 852(a) for the taxable year and has received income from the 
following sources:

Capital gains (from the sale of stock or securities).........   $100,000
Dividends (from domestic sources other than dividends             70,000
 described in section 116(b))................................
Dividend (from foreign corporations).........................      5,000
Interest.....................................................     25,000
                                                              ----------
      Total..................................................    200,000

[[Page 46]]

 
Expenses.....................................................     20,000
                                                              ----------
Taxable income...............................................    180,000
 


The regulated investment company decides to distribute the entire 
$180,000. It distributes a capital gain dividend of $100,000 and a 
dividend of ordinary income of $80,000. The aggregate dividends received 
by the regulated investment company from domestic corporations ($70,000) 
is less than 75 percent of its gross income ($100,000) computed without 
regard to capital gains from sales of securities. Therefore, an 
apportionment is required. Since $70,000 is 70 percent of $100,000, out 
of every $1 dividend of ordinary income paid by the regulated investment 
company only 70 cents would be available for the credit, exclusion, or 
deduction referred to in section 854(b)(1). The capital gains dividend 
and the dividend received from foreign corporations are excluded from 
the computation.
    (d) Dividends received from a regulated investment company during 
taxable years of shareholders ending after July 31, 1954, and subject to 
the Internal Revenue Code of 1939. For the application of section 854 to 
taxable years of shareholders of a regulated investment company ending 
after July 31, 1954, and subject to the Internal Revenue Code of 1939, 
see Sec. 1.34-5 and Sec. 1.116-2.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6921, 32 FR 
8756, June 20, 1967]



Sec. 1.854-2  Notice to shareholders.

    (a) General rule. Section 854(b)(2) provides that the amount that a 
shareholder may treat as a dividend for purposes of the exclusion under 
section 116 for dividends received by individuals, the deduction under 
section 243 for dividends received by corporation, and, in the case of 
dividends received by individuals before January 1, 1965, the credit 
under section 34, shall not exceed the amount so designated by the 
company in a written notice to its shareholders mailed not later than 45 
days (30 days for a taxable year ending before Feb. 26, 1964) after the 
close of the company's taxable year. If, however, the amount so 
designated by the company in the notice exceeds the amount which may be 
treated by the shareholder as a dividend for such purposes, the 
shareholder is limited to the amount as correctly ascertained under 
section 854(b)(1) and paragraph (c) of Sec. 1.854-1.
    (b) Shareholder of record custodian of certain unit investment 
trusts. In any case where a notice is mailed pursuant to paragraph (a) 
of this section by a regulated investment company with respect to a 
taxable year of the regulated investment company ending after December 
8, 1970 to a shareholder of record who is a nominee acting as a 
custodian of a unit investment trust described in section 851(f)(1) and 
paragraph (d) of Sec. 1.851-7, the nominee shall furnish each holder of 
an interest in such trust with a written notice mailed on or before the 
55th day following the close of the regulated investment company's 
taxable year. The notice shall designate the holder's proportionate 
share of the amounts that may be treated as a dividend for purposes of 
the exclusion under section 116 for dividends received by individuals 
and the deduction under section 243 for dividends received by 
corporations shown on the notice received by the nominee pursuant to 
paragraph (a) of this section. This notice shall include the name and 
address of the nominee identified as such. This paragraph shall not 
apply if the regulated investment company agrees with the nominee to 
satisfy the notice requirements of paragraph (a) of this section with 
respect to each holder of an interest in the unit investment trust whose 
shares are being held by the nominee as custodian and not later than 45 
days following the close of the company's taxable year, files with the 
Internal Revenue Service office where such company's return is to be 
filed for the taxable year, a statement that the holders of the unit 
investment trust with whom the agreement was made have been directly 
notified by the regulated investment company. Such statement shall 
include the name, sponsor, and custodian of each unit investment trust 
whose holders have been directly notified. The nominee's requirements 
under this paragraph shall be deemed met if the regulated investment 
company transmits a copy of such statement to the nominee within such 
45-day period; provided however, if the regulated investment company 
fails or is unable to satisfy the requirements of this paragraph with 
respect to the holders of interest in the unit investment trust, it

[[Page 47]]

shall so notify the Internal Revenue Service within 45 days following 
the close of its taxable year. The custodian shall, upon notice by the 
Internal Revenue Service that the regulated investment company has 
failed to comply with the agreement, satisfy the requirements of this 
paragraph within 30 days of such notice.

[T.D. 7187, 37 FR 13257, July 6, 1972]



Sec. 1.854-3  Definitions.

    (a) For the purpose of computing the limitation prescribed by 
section 854(b)(1)(B) and paragraph (c) of Sec. 1.854-1, the term ``gross 
income'' does not include gain from the sale or other disposition of 
stock or securities. However, capital gains arising from the sale or 
other disposition of capital assets, other than stock or securities, 
shall not be excluded from gross income for this purpose.
    (b) The term ``aggregate dividends received'' includes only 
dividends received from domestic corporations other than dividends 
described in section 116(b) (relating to dividends not eligible for 
exclusion from gross income). Accordingly, dividends received from 
foreign corporations will not be included in the computation of 
``aggregate dividends received''. In determining the amount of any 
dividend for purposes of this section, the rules provided in section 
116(c) (relating to certain distributions) shall apply.



Sec. 1.855-1  Dividends paid by regulated investment company after close of taxable year.

    (a) General rule. In--
    (1) Determining under section 852(a) and paragraph (a) of 
Sec. 1.852-1 whether the deduction for dividends paid during the taxable 
year (without regard to capital gain dividends) by a regulated 
investment company equals or exceeds 90 percent of its investment 
company taxable income (determined without regard to the provisions of 
section 852(b)(2)(D)),
    (2) Computing its investment company taxable income (under section 
852(b)(2) and Sec. 1.852-3), and
    (3) Determining the amount of capital gain dividends (as defined in 
section 852(b)(3) and paragraph (c) of Sec. 1.852-4 paid during the 
taxable year,

any dividend (or portion thereof) declared by the investment company 
either before or after the close of the taxable year but in any event 
before the time prescribed by law for the filing of its return for the 
taxable year (including the period of any extension of time granted for 
filing such return) shall, to the extent the company so elects in such 
return, be treated as having been paid during such taxable year. This 
rule is applicable only if the entire amount of such dividend is 
actually distributed to the shareholders in the 12-month period 
following the close of such taxable year and not later than the date of 
the first regular dividend payment made after such declaration.
    (b) Election--(1) Method of making election. The election must be 
made in the return filed by the company for the taxable year. The 
election shall be made by the taxpayer (the regulated investment 
company) by treating the dividend (or portion thereof) to which such 
election applies as a dividend paid during the taxable year in computing 
its investment company taxable income, or if the dividend (or portion 
thereof) to which such election applies is to be designated by the 
company as a capital gain dividend, in computing the amount of capital 
gain dividends paid during such taxable year. The election provided in 
section 855(a) may be made only to the extent that the earnings and 
profits of the taxable year (computed with the application of section 
852(c) and Sec. 1.852-5) exceed the total amount of distributions out of 
such earnings and profits actually made during the taxable year (not 
including distributions with respect to which an election has been made 
for a prior year under section 855(a)). The dividend or portion thereof, 
with respect to which the regulated investment company has made a valid 
election under section 855(a), shall be considered as paid out of the 
earnings and profits of the taxable year for which such election is 
made, and not out of the earnings and profits of the taxable year in 
which the distribution is actually made.
    (2) Irrevocability of the election. After the expiration of the time 
for filing the return for the taxable year for which an election is made 
under section

[[Page 48]]

855(a), such election shall be irrevocable with respect to the dividend 
or portion thereof to which it applies.
    (c) Receipt by shareholders. Under section 855(b), the dividend or 
portion thereof, with respect to which a valid election has been made, 
will be includible in the gross income of the shareholders of the 
regulated investment company for the taxable year in which the dividend 
is received by them.
    (d) Examples. The application of paragraphs (a), (b), and (c) of 
this section may be illustrated by the following examples:

    Example 1. The X Company, a regulated investment company, had 
taxable income (and earnings or profits) for the calendar year 1954 of 
$100,000. During that year the company distributed to shareholders 
taxable dividends aggregating $88,000. On March 10, 1955, the company 
declared a dividend of $37,000 payable to shareholders on March 20, 
1955. Such dividend consisted of the first regular quarterly dividend 
for 1955 of $25,000 plus an additional $12,000 representing that part of 
the taxable income for 1954 which was not distributed in 1954. On March 
15, 1955, the X Company filed its federal income tax return and elected 
therein to treat $12,000 of the total dividend of $37,000 to be paid to 
shareholders on March 20, 1955, as having been paid during the taxable 
year 1954. Assuming that the X Company actually distributed the entire 
amount of the dividend of $37,000 on March 20, 1955, an amount equal to 
$12,000 thereof will be treated for the purposes of section 852(a) as 
having been paid during the taxable year 1954. Such amount ($12,000) 
will be considered by the X Company as a distribution out of the 
earnings and profits for the taxable year 1954, and will be treated by 
the shareholders as a taxable dividend for the taxable year in which 
such distribution is received by them.
    Example 2. The Y Company, a regulated investment company, had 
taxable income (and earnings or profits) for the calendar year 1954 of 
$100,000, and for 1955 taxable income (and earnings or profits) of 
$125,000. On January 1, 1954, the company had a deficit in its earnings 
and profits accumulated since February 28, 1913, of $115,000. During the 
year 1954 the company distributed to shareholders taxable dividends 
aggregating $85,000. On March 5, 1955, the company declared a dividend 
of $65,000 payable to shareholders on March 31, 1955. On March 15, 1955, 
the Y Company filed its federal income tax return in which it included 
$40,000 of the total dividend of $65,000 payable to shareholders on 
March 31, 1955, as a dividend paid by it during the taxable year 1954. 
On March 31, 1955, the Y Company distributed the entire amount of the 
dividend of $65,000 declared on March 5, 1955. The election under 
section 855(a) is valid only to the extent of $15,000, the amount of the 
undistributed earnings and profits for 1954 ($100,000 earnings and 
profits less $85,000 distributed during 1954). The remainder ($50,000) 
of the $65,000 dividend paid on March 31, 1955, could not be the subject 
of an election, and such amount will be regarded as a distribution by 
the Y Company out of earnings and profits for the taxable year 1955. 
Assuming that the only other distribution by the Y Company during 1955 
was a distribution of $75,000 paid as a dividend on October 31, 1955, 
the total amount of the distribution of $65,000 paid on March 31, 1955, 
is to be treated by the shareholders as taxable dividends for the 
taxable year in which such dividend is received. The Y Company will 
treat the amount of $15,000 as a distribution of the earnings or profits 
of the company for the taxable year 1954, and the remaining $50,000 as a 
distribution of the earnings or profits for the year 1955. The 
distribution of $75,000 on October 31, 1955, is, of course, a taxable 
dividend out of the earnings and profits for the year 1955.

    (e) Notice to shareholders. Section 855(c) provides that in the case 
of dividends, with respect to which a regulated investment company has 
made an election under section 855(a), any notice to shareholders 
required under subchapter M, chapter 1 of the Code, with respect to such 
amounts, shall be made not later than 45 days (30 days for a taxable 
year ending before February 26, 1964) after the close of the taxable 
year in which the distribution is made. Thus, the notice requirements of 
section 852(b)(3)(C) and paragraph (c) of Sec. 1.852-4 with respect to 
capital gain dividends, section 853(c) and Sec. 1.853-3 with respect to 
allowance to shareholder of foreign tax credit, and section 854(b)(2) 
and Sec. 1.854-2 with respect to the amount of a distribution which may 
be treated as a dividend, may be satisfied with respect to amounts to 
which section 855(a) and this section apply if the notice relating to 
such amounts is mailed to the shareholders not later than 45 days (30 
days for a taxable year ending before February 26, 1964) after the close 
of the taxable year in which the distribution is made. If the notice 
under section 855(c) relates to an election with respect to any capital 
gain dividends, such capital gain dividends shall be aggregated by the 
investment company with the designated capital gain dividends actually 
paid during the taxable year to which the

[[Page 49]]

election applies (not including such dividends with respect to which an 
election has been made for a prior year under section 855) for the 
purpose of determining whether the aggregate of the designated capital 
gain dividends with respect to such taxable year of the company is 
greater than the excess of the net long-term capital gain over the net 
short-term capital loss of the company. See section 852(b)(3)(C) and 
paragraph (c) of Sec. 1.852-4.
    (f) Foreign tax election. Section 855(d) provides that in the case 
of an election made under section 853 (relating to foreign taxes), the 
shareholder of the investment company shall consider the foreign income 
received, and the foreign tax paid, as received and paid, respectively, 
in the shareholder's taxable year in which distribution is made.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6921, 32 FR 
8757, June 20, 1967]

                      Real Estate Investment Trusts



Sec. 1.856-0  Revenue Act of 1978 amendments not included.

    The regulations under part II of subchapter M of the Code do not 
reflect the amendments made by the Revenue Act of 1978, other than the 
changes made by section 362 of the Act, relating to deficiency 
dividends.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. 856(f)(2)); sec. 856 (g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954; 860(e) (92 Stat. 2849, 26 U.S.C. 860(e)); 
sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7767, 46 FR 11265, Feb. 6, 1981, as amended by T.D. 7936, 49 FR 
2106, Jan. 18, 1984]



Sec. 1.856-1  Definition of real estate investment trust.

    (a) In general. The term ``real estate investment trust'' means a 
corporation, trust, or association which (1) meets the status conditions 
in section 856(a) and paragraph (b) of this section, and (2) satisfies 
the gross income and asset diversification requirements under the 
limitations of section 856(c) and Sec. 1.856-2. (See, however, paragraph 
(f) of this section, relating to the requirement that, for taxable years 
beginning before October 5, 1976, a real estate investment trust must be 
an unincorporated trust or unincorporated association).
    (b) Qualifying conditions. To qualify as a ``real estate investment 
trust'', an organization must be one--
    (1) Which is managed by one or more trustees or directors,
    (2) The beneficial ownership of which is evidenced by transferable 
shares or by transferable certificates of beneficial interest,
    (3) Which would be taxable as a domestic corporation but for the 
provisions of part II, subchapter M, chapter 1 of the Code,
    (4) Which, in the case of a taxable year beginning before October 5, 
1976, does not hold any property (other than foreclosure property) 
primarily for sale to customers in the ordinary course of its trade or 
business,
    (5) Which is neither (i) a financial institution to which section 
585, 586, or 593 applies, nor (ii) an insurance company to which 
subchapter L applies,
    (6) The beneficial ownership of which is held by 100 or more 
persons, and
    (7) Which would not be a personal holding company (as defined in 
section 542) if all of its gross income constituted personal holding 
company income (as defined in section 543).
    (c) Determination of status. The conditions described in 
subparagraphs (1) through (5) of paragraph (b) of this section must be 
met during the entire taxable year and the condition described in 
subparagraph (6) of paragraph (b) of this section must exist during at 
least 335 days of a taxable year of 12 months or during a proportionate 
part of a taxable year of less than 12 months. The days during which the 
latter condition must exist need not be consecutive. In determining the 
minimum number of days during which the condition described in paragraph 
(b)(6) of this section is required to exist in a taxable year of less 
than 12 months, fractional days shall be disregarded. For example, in a 
taxable year of 310 days, the actual

[[Page 50]]

number of days prescribed would be 284 \38/73\ days (\310/365\ of 335). 
The fractional day is disregarded so that the required condition in such 
taxable year need exist for only 284 days.
    (d) Rules applicable to status requirements. For purposes of 
determining whether an organization meets the conditions and 
requirements in section 856(a), the following rules shall apply.
    (1) Trustee. The term ``trustee'' means a person who holds legal 
title to the property of the real estate investment trust, and has such 
rights and powers as will meet the requirement of ``centralization of 
management'' under paragraph (c) of Sec. 301.7701-2 of this chapter 
(Regulations on Procedure and Administration). Thus, the trustee must 
have continuing exclusive authority over the management of the trust, 
the conduct of its affairs, and (except as limited by section 856(d)(3) 
and Sec. 1.856-4) the management and disposition of the trust property. 
For example, such authority will be considered to exist even though the 
trust instrument grants to the shareholders any or all of the following 
rights and powers: To elect or remove trustees; to terminate the trust; 
and to ratify amendments to the trust instrument proposed by the 
trustee. The existence of a mere fiduciary relationship does not, in 
itself, make one a trustee for purposes of section 856(a)(1). The 
trustee will be considered to hold legal title to the property of the 
trust, for purposes of this subparagraph, whether the title is held in 
the name of the trust itself, in the name of one or more of the 
trustees, or in the name of a nominee for the exclusive benefit of the 
trust.
    (2) Beneficial ownership. Beneficial ownership shall be evidenced by 
transferable shares, or by transferable certificates of beneficial 
interest, and (subject to the provisions of paragraph (c) of this 
section) must be held by 100 or more persons, determined without 
reference to any rules of attribution. Provisions in the trust 
instrument or corporate charter or bylaws which permit the trustee or 
directors to redeem shares or to refuse to transfer shares in any case 
where the trustee or directors, in good faith, believe that a failure to 
redeem shares or that a transfer of shares would result in the loss of 
status as a real estate investment trust will not render the shares 
``nontransferable.'' For purposes of the regulations under part II of 
subchapter M, the terms ``stockholder,'' ``stockholders,'' 
``shareholder,'' and ``shareholders'' include holders of beneficial 
interest in a real estate investment trust, the terms ``stock,'' 
``shares,'' and ``shares of stock'' include certificates of beneficial 
interest, and the term ``shares'' includes shares of stock.
    (3) Unincorporated organization taxable as a domestic corporation. 
The determination of whether an unincorporated organization would be 
taxable as a domestic corporation, in the absence of the provisions of 
part II of subchapter M, shall be made in accordance with the provisions 
of section 7701(a) (3) and (4) and the regulations thereunder and for 
such purposes an otherwise qualified real estate investment trust is 
deemed to satisfy the ``objective to carry on business'' requirement of 
paragraph (a) of Sec. 301.7701-2 of this chapter. (Regulations on 
Procedure and Administration).
    (4) Property held for sale to customers. In the case of a taxable 
year beginning before October 5, 1976, a real estate investment trust 
may not hold any property (other than foreclosure property) primarily 
for sale to customers in the ordinary course of its trade or business. 
Whether property is held for sale to customers in the ordinary course of 
the trade or business of a real estate investment trust depends upon the 
facts and circumstances in each case.
    (5) Personal holding company. A corporation, trust, or association, 
even though it may otherwise meet the requirements of part II of 
subchapter M, will not be a real estate investment trust if, by 
considering all of its gross income as personal holding company income 
under section 543, it would be a personal holding company as defined in 
section 542. Thus, if at any time during the last half of the trust's 
taxable year more than 50 percent in value of its outstanding stock is 
owned (directly or indirectly under the provisions of section 544) by or 
for not more than 5 individuals, the stock ownership requirement in 
section 542(a)(2) will be met

[[Page 51]]

and the trust would be a personal holding company. See Sec. 1.857-8, 
relating to record requirements for purposes of determining whether the 
trust is a personal holding company.
    (e) Other rules applicable. To the extent that other provisions of 
chapter 1 of the Code are not inconsistent with those under part II of 
subchapter M there of and the regulations thereunder, such provisions 
will apply with respect to both the real estate investment trust and its 
shareholders in the same manner that they would apply to any other 
organization which would be taxable as a domestic corporation. For 
example:
    (1) Taxable income of a real estate investment trust is computed in 
the same manner as that of a domestic corporation;
    (2) Section 301, relating to distributions of property, applies to 
distributions by a real estate investment trust in the same manner as it 
would apply to a domestic corporation;
    (3) Sections 302, 303, 304, and 331 are applicable in determining 
whether distributions by a real estate investment trust are to be 
treated as in exchange for stock;
    (4) Section 305 applies to distributions by a real estate investment 
trust of its own stock;
    (5) Section 311 applies to distributions by a real estate investment 
trust;
    (6) Except as provided in section 857(d), earnings and profits of a 
real estate investment trust are computed in the same manner as in the 
case of a domestic corporation;
    (7) Section 316, relating to the definition of a dividend, applies 
to distributions by a real estate investment trust; and
    (8) Section 341, relating to collapsible corporations, applies to 
gain on the sale or exchange of, or a distribution which is in exchange 
for, stock in a real estate investment trust in the same manner that it 
would apply to a domestic corporation.
    (f) Unincorporated status required for certain taxable years. In the 
case of a taxable year beginning before October 5, 1976, a real estate 
investment trust must be an unincorporated trust or unincorporated 
association. Accordingly, in applying the regulations under part II of 
subchapter M of the Code with respect to such a taxable year, the term 
``an unincorporated trust or unincorporated association'' is to be 
substituted for the term ``a corporation, trust, or association'' each 
place it appears, and the references to ``directors'' and ``corporate 
charter or bylaws'' are to be disregarded.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. 856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917, 26 U.S.C. 7805), 
Internal Revenue Code of 1954)

[T.D. 6598, 27 FR 4082, Apr. 28, 1962, as amended by T.D. 6928, 32 FR 
13221, Sept. 19, 1967; T.D. 7767, 46 FR 11265, Feb. 6, 1981]



Sec. 1.856-2  Limitations.

    (a) Effective date. The provisions of part II, subchapter M, chapter 
1 of the Code, and the regulations thereunder apply only to taxable 
years of a real estate investment trust beginning after December 31, 
1960.
    (b) Election. Under the provisions of section 856(c)(1), a trust, 
even though it satisfies the other requirements of part II of subchapter 
M for the taxable year, will not be considered a ``real estate 
investment trust'' for such year, within the meaning of such part II, 
unless it elects to be a real estate investment trust for such taxable 
year, or has made such an election for a previous taxable year which has 
not been terminated or revoked under section 856(g)(1) or (2). The 
election shall be made by the trust by computing taxable income as a 
real estate investment trust in its return for the first taxable year 
for which it desires the election to apply, even though it may have 
otherwise qualified as a real estate investment trust for a prior year. 
No other method of making such election is permitted. An election cannot 
be revoked with respect to a taxable year beginning before October 5, 
1976. Thus, the failure of an organization to be a qualified real estate 
investment trust for a taxable year beginning before October 5, 1976,

[[Page 52]]

does not have the effect of revoking a prior election by the 
organization to be a real estate investment trust, even though the 
organization is not taxable under part II of subchapter M for such 
taxable year. See section 856(g) and Sec. 1.856-8 for rules under which 
an election may be revoked with respect to taxable years beginning after 
October 4, 1976.
    (c) Gross income requirements. Section 856(c) (2), (3), and (4), 
provides that a corporation, trust, or association is not a ``real 
estate investment trust'' for a taxable year unless it meets certain 
requirements with respect to the sources of its gross income for the 
taxable year. In determining whether the gross income of a real estate 
investment trust satisfies the percentage requirements of section 856(c) 
(2), (3), and (4), the following rules shall apply:
    (1) Gross income. For purposes of both the numerator and denominator 
in the computation of the specified percentages, the term ``gross 
income'' has the same meaning as that term has under section 61 and the 
regulations thereunder. Thus, in determining the gross income 
requirements under section 856(c) (2), (3), and (4), a loss from the 
sale or other disposition of stock, securities, real property, etc. does 
not enter into the computation.
    (2) Lapse of options. Under section 856(c)(6)(C), the term 
``interests in real property'' includes options to acquire land or 
improvements thereon, and options to acquire leaseholds of land and 
improvements thereon. However, where a corporation, trust, or 
association writes an option giving the holder the right to acquire land 
or improvements thereon, or writes an option giving the holder the right 
to acquire a leasehold of land or improvements thereon, any income that 
the corporation, trust, or association recognizes because the option 
expires unexercised is not considered to be gain from the sale or other 
disposition of real property (including interests in real property) for 
purposes of section 856(c) (2)(D) and (3)(C). The rule in the preceding 
sentence also applies for purposes of section 856(c)(4)(C) in 
determining gain from the sale or other disposition of real property for 
the 30-percent-of-gross-income limitation.
    (3) Commitment fees. For purposes of section 856(c) (2)(G) and 
(3)(G), if consideration is received or accrued for an agreement to make 
a loan secured by a mortgage covering both real property and other 
property, or for an agreement to purchase or lease both real property 
and other property, an apportionment of the consideration is required. 
The apportionment of consideration received or accrued for an agreement 
to make a loan secured by a mortgage covering both real property and 
other property shall be made under the principles of Sec. 1.856-5(c), 
relating to the apportionment of interest income.
    (4) Holding period of property. For purposes of the 30-percent 
limitation of section 856(c)(4), the determination of the period for 
which property described in such section has been held is governed by 
the provisions of section 1223 and the regulations thereunder.
    (5) Rents from real property and interest. See Secs. 1.856-4 and 
1.856-5 for rules relating to rents from real property and interest.
    (d) Diversification of investment requirements--(1) 75-percent test. 
Section 856(c)(5)(A) requires that at the close of each quarter of the 
taxable year at least 75 percent of the value of the total assets of the 
trust be represented by one or more of the following:
    (i) Real estate assets;
    (ii) Government securities; and
    (iii) Cash and cash items (including receivables).

For purposes of this subparagraph the term ``receivables'' means only 
those receivables which arise in the ordinary course of the trust's 
operation and does not include receivables purchased from another 
person. Subject to the limitations in section 856(c)(5)(B) and 
subparagraph (2) of this paragraph, the character of the remaining 25 
percent (or less) of the value of the total assets is not restricted.
    (2) Limitations on certain securities. Under section 856(c)(5)(B), 
not more than 25 percent of the value of the total assets of the trust 
may be represented by securities other than those described in section 
856(c)(5)(A). The ownership of securities under the 25-percent 
limitation in section 856(c)(5)(B) is further limited in respect of any 
one issuer to an amount not

[[Page 53]]

greater in value than 5 percent of the value of the total assets of the 
trust and to not more than 10 percent of the outstanding voting 
securities of such issuer. Thus, if the real estate investment trust 
meets the 75-percent asset diversification requirement in section 
856(c)(5)(A), it will also meet the first test under section 
856(c)(5)(B) since it will, of necessity, have not more than 25 percent 
of its total assets represented by securities other than those described 
in section 856(c)(5)(A). However, the trust must also meet two 
additional tests under section 856(c)(5)(B), i.e. it cannot own the 
securities of any one issuer in an amount (i) greater in value than 5 
percent of the value of the trust's total assets, or (ii) representing 
more than 10 percent of the outstanding voting securities of such 
issuer.
    (3) Determination of investment status. The term ``total assets'' 
means the gross assets of the trust determined in accordance with 
generally accepted accounting principles. In order to determine the 
effect, if any, which an acquisition of any security or other property 
may have with respect to the status of a trust as a real estate 
investment trust, section 856(c)(5) requires a revaluation of the 
trust's assets at the end of the quarter in which such acquisition was 
made. A revaluation of assets is not required at the end of any quarter 
during which there has been no acquisition of a security or other 
property since the mere change in market value of property held by the 
trust does not, of itself, affect the status of the trust as a real 
estate investment trust. A change in the nature of ``cash items'', for 
example, the prepayment of insurance or taxes, does not constitute the 
acquisition of ``other property'' for purposes of this subparagraph. A 
real estate investment trust shall keep sufficient records as to 
investments so as to be able to show that it has complied with the 
provisions of section 856(c)(5) during the taxable year. Such records 
shall be kept at all times available for inspection by any internal 
revenue officer or employee and shall be retained so long as the 
contents thereof may become material in the administration of any 
internal revenue law.
    (4) Illustrations. The application of section 856(c)(5) and this 
paragraph may be illustrated by the following examples:

    Example 1. Real Estate Investment Trust M, at the close of the first 
quarter of its taxable year, has its assets invested as follows:

 
                                                                Percent
 
Cash.........................................................          6
Government securities........................................          7
Real estate assets...........................................         63
Securities of various corporations (not exceeding, with               24
 respect to any one issuer, 5 percent of the value of the
 total assets of the trust nor 10 percent of the outstanding
 voting securities of such issuer)...........................
                                                              ----------
      Total..................................................        100
 


Trust M meets the requirements of section 856(c)(5) for that quarter of 
its taxable year.
    Example 2. Real Estate Investment Trust P, at the close of the first 
quarter of its taxable year, has its assets invested as follows:

 
                                                                Percent
 
Cash.........................................................          6
Government securities........................................          7
Real estate assets...........................................         63
Securities of Corporation Z..................................         20
Securities of Corporation X..................................          4
                                                              ----------
      Total..................................................        100
 


Trust P meets the requirement of section 856(c)(5)(A) since at least 75 
percent of the value of the total assets is represented by cash, 
Government securities, and real estate assets. However, Trust P does not 
meet the diversification requirements of section 856(c)(5)(B) because 
its investment in the voting securities of Corporation Z exceeds 5 
percent of the value of the trust's total assets.
    Example 3. Real Estate Investment Trust G, at the close of the first 
quarter of its taxable year, has its assets invested as follows:

 
                                                                Percent
 
Cash.........................................................          4
Government securities........................................          9
Real estate assets...........................................         70
Securities of Corporation S..................................          5
Securities of Corporation L..................................          4
Securities of Corporation U..................................          4
Securities of Corporation M (which equals 25 percent of                4
 Corporation M's outstanding voting securities)..............
                                                              ----------
      Total..................................................        100
 


Trust G meets the 75-percent requirement of section 856(c)(5)(A), but 
does not meet the requirements of section 856(c)(5)(B) because its 
investment in the voting securities of Corporation M exceeds 10 percent 
of Corporation M's outstanding voting securities.

[[Page 54]]

    Example 4. Real Estate Investment Trust R, at the close of the first 
quarter of its taxable year (i.e. calendar year), is a qualified real 
estate investment trust and has its assets invested as follows:

Cash..........................................................    $5,000
Government securities.........................................     4,000
Receivables...................................................     4,000
Real estate assets............................................    68,000
Securities of Corporation P...................................     4,000
Securities of Corporation O...................................     5,000
Securities of Corporation U...................................     5,000
Securities of Corporation T...................................     5,000
                                                               ---------
      Total assets............................................   100,000
 


During the second calendar quarter the stock in Corporation P increases 
in value to $50,000 while the value of the remaining assets has not 
changed. If Real Estate Investment Trust R has made no acquisition of 
stock or other property during such second quarter it will not lose its 
status as a real estate investment trust merely by reason of the 
appreciation in the value of P's stock. If, during the third quarter, 
Trust R acquires stock of Corporation S worth $2,000, such acquisition 
will necessitate a revaluation of all of the assets of Trust R as 
follows:

Cash..........................................................    $3,000
Government securities.........................................     4,000
Receivables...................................................     4,000
Real estate assets............................................    68,000
Securities in Corporation P...................................    50,000
Securities in Corporation O...................................     5,000
Securities in Corporation U...................................     5,000
Securities in Corporation T...................................     5,000
Securities in Corporation S...................................     2,000
                                                               ---------
      Total assets............................................   146,000
 

Because of the discrepancy between the value of its various investments 
and the 25-percent limitation in section 856(c)(5), resulting in part 
from the acquisition of the stock of Corporation S, Trust R, at the end 
of the third quarter, loses its status as a real estate investment 
trust. However, if Trust R, within 30 days after the close of such 
quarter, eliminates the discrepancy so that it meets the 25-percent 
limitation, the trust will be considered to have met the requirements of 
section 856(c)(5) at the close of the third quarter, even though the 
discrepancy between the value of its investment in Corporation P and the 
5-percent limitation in section 856(c)(5) (resulting solely from 
appreciation) may still exist. If instead of acquiring stock of 
Corporation S, Trust R had acquired additional stock of Corporation P, 
then because of the discrepancy between the value of its investments and 
both the 5-percent and the 25-percent limitations in section 856(c)(5) 
resulting in part from this acquisition, trust R, at the end of the 
third quarter, would lose its status as a real estate investment trust, 
unless within 30 days after the close of such quarter both of the 
discrepancies are eliminated.
    Example 5. If, in the previous example, the stock of Corporation P 
appreciates only to $10,000 during the second quarter and, in the third 
quarter, Trust R acquires stock of Corporation S worth $1,000, the 
assets as of the end of the third quarter would be as follows:

Cash..........................................................    $4,000
Government securities.........................................     4,000
Receivables...................................................     4,000
Real estate assets............................................    68,000
Securities in Corporation P...................................    10,000
Securities in Corporation O...................................     5,000
Securities in Corporation U...................................     5,000
Securities in Corporation T...................................     5,000
Securities in Corporation S...................................     1,000
                                                               ---------
      Total assets............................................   106,000
 


Because the discrepancy between the value of its investment in 
Corporation P and the 6-percent limitation in section 856(c)(5) results 
solely from appreciation, and because there is no discrepancy between 
the value of its various investments and the 25-percent limitation, 
Trust R, at the end of the third quarter, does not lose its status as a 
real estate investment trust. If, instead of acquiring stock of 
Corporation S, Trust R had acquired additional stock of Corporation P 
worth $1,000, then, because of the discrepancy between the value of its 
investment in Corporation P and the 5-percent limitation resulting in 
part from this acquisition, Trust R, at the end of the third quarter, 
would lose its status as a real estate investment trust, unless within 
30 days after the close of such quarter this discrepancy is eliminated.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. 856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001); (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 
26 U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 
(68A Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 
7805), Internal Revenue Code of 1954)

[T.D. 6598, 27 FR 4083, Apr. 28, 1962 as amended by T.D. 7767, 46 FR 
11265, Feb. 6, 1981]



Sec. 1.856-3  Definitions.

    For purposes of the regulations under part II, subchapter M, chapter 
1 of the Code, the following definitions shall apply.
    (a) Value. The term ``value'' means, with respect to securities for 
which market quotations are readily available, the market value of such 
securities; and with respect to other securities and assets, fair value 
as determined in good faith by the trustees of

[[Page 55]]

the real estate investment trust. In the case of securities of other 
qualified real estate investment trusts, fair value shall not exceed 
market value or asset value, whichever is higher.
    (b) Real estate assets--(1) In general. The term ``real estate 
assets'' means real property, interests in mortgages on real property 
(including interests in mortgages on leaseholds of land or improvements 
thereon), and shares in other qualified real estate investment trusts. 
The term ``mortgages on real property'' includes deeds of trust on real 
property.
    (2) Treatment of REMIC interests as real estate assets--(i) In 
general. If, for any calendar quarter, at least 95 percent of a REMIC's 
assets (as determined in accordance with Sec. 1.860F-4(e)(1)(ii) or 
Sec. 1.6049-7(f)(3)) are real estate assets (as defined in paragraph 
(b)(1) of this section), then, for that calendar quarter, all the 
regular and residual interests in that REMIC are treated as real estate 
assets and, except as provided in paragraph (b)(2)(iii) of this section, 
any amount includible in gross income with respect to those interests is 
treated as interest on obligations secured by mortgages on real 
property. If less than 95 percent of a REMIC's assets are real estate 
assets, then the real estate investment trust is treated as holding 
directly its proportionate share of the assets and as receiving directly 
its proportionate share of the income of the REMIC. See Secs. 1.860F-
4(e)(1)(ii)(B) and 1.6049-7(f)(3) for information required to be 
provided to regular and residual interest holders if the 95-percent test 
is not met.
    (ii) Treatment of REMIC assets for section 856 purposes--(A) 
Manufactured housing treated as real estate asset. For purposes of 
paragraphs (b) (1) and (2) of this section, the term ``real estate 
asset'' includes manufactured housing treated as a single family 
residence under section 25(e)(10).
    (B) Status of cash flow investments. For purposes of this paragraph 
(b)(2), cash flow investments (as defined in section 860G(a)(6) and 
Sec. 1.860G-2(g)(1)) are real estate assets.
    (iii) Certain contingent interest payment obligations held by a 
REIT. If a REIT holds a residual interest in a REMIC for a principal 
purpose of avoiding the limitation set out in section 856(f) (concerning 
interest based on mortgagor net profits) or section 856(j) (concerning 
shared appreciation provisions), then, even if the REMIC satisfies the 
95-percent test of paragraph (b)(i) of this section, the REIT is treated 
as receiving directly the REMIC's items of income for purposes of 
section 856.
    (c) Interests in real property. The term ``interests in real 
property'' includes fee ownership and co-ownership of land or 
improvements thereon, leaseholds of land or improvements thereon, 
options to acquire land or improvements thereon, and options to acquire 
leaseholds of land or improvements thereon. The term also includes 
timeshare interests that represent an undivided fractional fee interest, 
or undivided leasehold interest, in real property, and that entitle the 
holders of the interests to the use and enjoyment of the property for a 
specified period of time each year. The term also includes stock held by 
a person as a tenant-stockholder in a cooperative housing corporation 
(as those terms are defined in section 216). Such term does not, 
however, include mineral, oil, or gas royalty interests, such as a 
retained economic interest in coal or iron ore with respect to which the 
special provisions of section 631(c) apply.
    (d) Real property. The term ``real property'' means land or 
improvements thereon, such as buildings or other inherently permanent 
structures thereon (including items which are structural components of 
such buildings or structures). In addition, the term ``real property'' 
includes interests in real property. Local law definitions will not be 
controlling for purposes of determining the meaning of the term ``real 
property'' as used in section 856 and the regulations thereunder. The 
term includes, for example, the wiring in a building, plumbing systems, 
central heating, or central air-conditioning machinery, pipes or ducts, 
elevators or escalators installed in the building, or other items which 
are structural components of a building or other permanent structure. 
The term does not include assets accessory to the operation of a 
business, such as machinery, printing press, transportation equipment

[[Page 56]]

which is not a structural component of the building, office equipment, 
refrigerators, individual air-conditioning units, grocery counters, 
furnishings of a motel, hotel, or office building, etc., even though 
such items may be termed fixtures under local law.
    (e) Securities. The term ``securities'' does not include ``interests 
in real property'' or ``real estate assets'' as those terms are defined 
in section 856 and this section.
    (f) Qualified real estate investment trusts. The term ``qualified 
real estate investment trust'' means a real estate investment trust 
within the meaning of part II of subchapter M which is taxable under 
such part as a real estate investment trust. For purposes of the 75-
percent requirement in section 856(c)(5)(A), the trust whose stock has 
been included by another trust as ``real estate assets'' must be a 
``qualified real estate investment trust'' for its full taxable year in 
which falls the close of each quarter of the trust's taxable year for 
which the computation is made. For example, Real Estate Investment Trust 
Z for its taxable year ending December 31, 1963, holds as ``real estate 
assets'' stock in Real Estate Investment Trust Y, which is also on a 
calendar year. If Trust Y is not a qualified real estate investment 
trust for its full taxable year ending December 31, 1963, Trust Z may 
not include the stock of Trust Y as ``real estate assets'' in computing 
the 75-percent requirement as of the close of any quarter of its taxable 
year ending December 31, 1963.
    (g) Partnership interest. In the case of a real estate investment 
trust which is a partner in a partnership, as defined in section 
7701(a)(2) and the regulations thereunder, the trust will be deemed to 
own its proportionate share of each of the assets of the partnership and 
will be deemed to be entitled to the income of the partnership 
attributable to such share. For purposes of section 856, the interest of 
a partner in the partnership's assets shall be determined in accordance 
with his capital interest in the partnership. The character of the 
various assets in the hands of the partnerhsip and items of gross income 
of the partnership shall retain the same character in the hands of the 
partners for all purposes of section 856. Thus, for example, if the 
trust owns a 30-percent capital interest in a partnership which owns a 
piece of rental property the trust will be treated as owning 30 percent 
of such property and as being entitled to 30 percent of the rent derived 
from the property by the partnership. Similarly, if the partnership 
holds any property primarily for sale to customers in the ordinary 
course of its trade or business, the trust will be treated as holding 
its proportionate share of such property primarily for such purpose. 
Also, for example, where a partnership sells real property or a trust 
sells its interest in a partnership which owns real property, any gross 
income realized from such sale, to the extent that it is attributable to 
the real property, shall be deemed gross income from the sale or 
disposition of real property held for either the period that the 
partnership has held the real property of the period that the trust was 
a member of the partnership, whichever is the shorter.
    (h) Net capital gain. The term ``net capital gain'' means the excess 
of the net long-term capital gain for the taxable year over the net 
short-term capital loss for the taxable year.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. 856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954)

[T.D. 6598, 27 FR 4084, Apr. 28, 1962, as amended by T.D. 6841, 30 FR 
9308, July 27, 1965; T.D. 7767, 46 FR 11266, Feb. 6, 1981; T.D. 8458, 57 
FR 61298, Dec. 24, 1992]



Sec. 1.856-4  Rents from real property.

    (a) In general. Subject to the exceptions of section 856(d) and 
paragraph (b) of this section, the term ``rents from real property'' 
means, generally, the gross amounts received for the use of, or the 
right to use, real property of the real estate investment trust.
    (b) Amounts specifically included or excluded--(1) Charges for 
customary services. For taxable years beginning after

[[Page 57]]

October 4, 1976, the term ``rents from real property'', for purposes of 
paragraphs (2) and (3) of section 856(c), includes charges for services 
customarily furnished or rendered in connection with the rental of real 
property, whether or not the charges are separately stated. Services 
furnished to the tenants of a particular building will be considered as 
customary if, in the geographic market in which the building is located, 
tenants in buildings which are of a similar class (such as luxury 
apartment buildings) are customarily provided with the service. The 
furnishing of water, heat, light, and air-conditioning, the cleaning of 
windows, public entrances, exits, and lobbies, the performance of 
general maintenance and of janitorial and cleaning services, the 
collection of trash, and the furnishing of elevator services, telephone 
answering services, incidental storage space, laundry equipment, 
watchman or guard services, parking facilities, and swimming pool 
facilities are examples of services which are customarily furnished to 
the tenants of a particular class of buildings in many geographic 
marketing areas. Where it is customary, in a particular geographic 
marketing area, to furnish electricity or other utilities to tenants in 
buildings of a particular class, the submetering of such utilities to 
tenants in such buildings will be considered a customary service. To 
qualify as a service customarily furnished, the service must be 
furnished or rendered to the tenants of the real estate investment trust 
or, primarily for the convenience or benefit of the tenant, to the 
guests, customers, or subtenants of the tenant. The service must be 
furnished through an independent contractor from whom the trust does not 
derive or receive any income. See paragraph (b)(5) of this section. For 
taxable years beginning before October 5, 1976, the rules in paragraph 
(b)(3) of 26 CFR 1.856-4 (revised as of April 1, 1977), relating to the 
furnishing of services, shall continue to apply.
    (2) Amounts received with respect to certain personal property--(i) 
In general. In the case of taxable years beginning after October 4, 
1976, rent attributable to personal property that is leased under, or in 
connection with, the lease of real property is treated under section 
856(d)(1)(C) as ``rents from real property'' (and thus qualified for 
purposes of the income source requirements) if the rent attributable to 
the personal property is not more than 15 percent of the total rent 
received or accrued under the lease for the taxable year. If, however, 
the rent attributable to personal property is greater than 15 percent of 
the total rent received or accrued under the lease for the taxable year, 
then the portion of the rent from the lease that is attributable to 
personal property will not qualify as ``rents from real property''.
    (ii) Application. In general, the 15-percent test in section 
856(d)(1)(C) is applied separately to each lease of real property. 
However, where the real estate investment trust rents all (or a portion 
of all) the units in a multiple unit project under substantially similar 
leases (such as the leasing of apartments in an apartment building or 
complex to individual tenants), the 15-percent test may be applied with 
respect to the aggregate rent received or accrued for the taxable year 
under the similar leases of the property, by using the average of the 
trust's aggregate adjusted bases of all of the personal property subject 
to such leases, and the average of the trust's aggregate adjusted bases 
of all real and personal property subject to such leases. A lease of a 
furnished apartment is not considered to be substantially similar to a 
lease of an unfurnished apartment (including an apartment where the 
trust provides only personal property, such as major appliances, that is 
commonly provided by a landlord in connection with the rental of 
unfurnished living quarters).
    (iii) Taxable years beginning before October 5, 1976. In the case of 
taxable years beginning before October 5, 1976, any amount of rent that 
is attributable to personal property does not qualify as rent from real 
property.
    (3) Disqualification of rent which depends on income or profits of 
any person. Except as provided in paragraph (b)(6)(ii) of this section, 
no amount received or accrued, directly or indirectly, with respect to 
any real property (or personal property leased

[[Page 58]]

under, or in connection with, real property) qualifies as ``rents from 
real property'' where the determination of the amount depends in whole 
or in part on the income or profits derived by any person from the 
property. However, any amount so accured or received shall not be 
excluded from the term ``rents from real property'' solely by reason of 
being based on a fixed percentage or percentages of receipts or sales 
(whether or not receipts or sales are adjusted for returned merchandise, 
or Federal, State, or local sales taxes). Thus, for example, ``rents 
from real property'' would include rents where the lease provides for 
differing percentages or receipts or sales from different departments or 
from separate floors of a retail store so long as each percentage is 
fixed at the time of entering into the lease and a change in such 
percentage is not renegotiated during the term of the lease (including 
any renewal periods of the lease, in a manner which has the effect of 
basing the rent on income of profits. See paragraph (b)(6) of this 
section for rules relating to certain amounts received or accrued by a 
trust which are considered to be based on the income or profits of a 
sublessee of the prime tenant. The amount received or accrued as rent 
for the taxable year which is based on a fixed percentage or percentages 
of the lessee's receipts or sales reduced by escalation receipts 
(including those determined under a formula clause) will qualify as 
``rents from real property''. Escalation receipts include amounts 
received by a prime tenant from subtenants by reason of an agreement 
that rent shall be increased to reflect all or a portion of an increase 
in real estate taxes, property insurance, operating costs of the prime 
tenant, or similar items customarily included in lease escalation 
clauses. Where in accordance with the terms of an agreement an amount 
received or accrued as rent for the taxable year includes both a fixed 
rental and a percentage of all or a portion of the lessee's income or 
profits, neither the fixed rental nor the additional amount will qualify 
as ``rents from real property''. However, where the amount received or 
accrued for the taxable year under such an agreement includes only the 
fixed rental, the determination of which does not depend in whole or in 
part on the income or profits derived by the lessee, such amount may 
qualify as ``rents from real property''. An amount received or accrued 
as rent for the taxable year which consists, in whole or in part, of one 
or more percentages of the lessee's receipts or sales in excess of 
determinable dollar amounts may qualify as ``rents from real property'', 
but only if two conditions exist. First, the determinable amounts must 
not depend in whole or in part on the income or profits of the lessee. 
Second, the percentages and, in the case of leases entered into after 
July 7, 1978, the determinable amounts, must be fixed at the time the 
lease is entered into and a change in percentages and determinable 
amounts is not renegotiated during the term of the lease (including any 
renewal periods of the lease) in a manner which has the effect of basing 
rent on income or profits. In any event, an amount will not qualify as 
``rents from real property'' if, considering the lease and all the 
surrounding circumstances, the arrangement does not conform with normal 
business practice but is in reality used as a means of basing the rent 
on income or profits. The provisions of this subparagraph may be 
illustrated by the following example:

    Example. A real estate investment trust owns land underlying an 
office building. On January 1, 1975, the trust leases the land for 50 
years to a prime tenant for an annual rental of $100x plus 20 percent of 
the prime tenant's annual gross receipts from the office building in 
excess of a fixed base amount of $5,000x and 10 percent of such gross 
receipts in excess of $10,000x. For this purpose the lease defines gross 
receipts as all amounts received by the prime tenant from occupancy 
tenants pursuant to leases of space in the office building reduced by 
the amount by which real estate taxes, property insurance, and operating 
costs related to the office building for a particular year exceed the 
amount of such items for 1974. The exclusion from gross receipts of 
increases since 1974 in real estate taxes, property insurance, and other 
expenses relating to the office building reflects the fact that the 
prime tenant passes on to occupancy tenants by way of a customary lease 
escalation provision the risk that such expenses might increase during 
the term of an occupancy lease. The exclusion from gross receipts of 
these expense escalation items will not cause the rental received by the 
real estate investment trust

[[Page 59]]

from the prime tenant to fail to qualify as ``rents from real property'' 
for purposes of section 856(c).
    (4) Disqualification of amounts received from persons owned in whole 
or in part by the trust. ``Rents from real property'' does not include 
any amount received or accrued, directly or indirectly, from any person 
in which the real estate investment trust owns, at any time during the 
taxable year, the specified percentage or number of shares of stock (or 
interest in the assets or net profits) of that person. Any amount 
received from such person will not qualify as ``rents from real 
property'' if such person is a corporation and the trust owns 10 percent 
or more of the total combined voting power of all classes of its stock 
entitled to vote or 10 percent or more of the total number of shares of 
all classes of its outstanding stock, or if such person is not a 
corporation and the trust owns a 10-percent-or-more interest in its 
assets or net profits. For example, a trust leases an office building to 
a tenant for which it receives rent of $100,000 for the taxable year 
1962. The lessee of the building subleases space to various subtenants 
for which it receives gross rent of $500,000 for the year 1962. The 
trust owns 15 percent of the total assets of an unincorporated 
subtenant. The rent paid by this subtenant for the taxable year is 
$50,000. Therefore, $10,000 (50,000/500,000x$100,000) of the rent paid 
to the trust does not qualify as ``rents from real property''. Where the 
real estate investment trust receives, directly or indirectly, any 
amount of rent from any person in which it owns any proprietary 
interest, the trust shall submit, at the time it files its return for 
the taxable year (or before June 1, 1962, whichever is later), a 
schedule setting forth--
    (i) The name and address of such person and the amount received as 
rent from such person; and
    (ii) If such person is a corporation, the highest percentage of the 
total combined voting power of all classes of its stock entitled to 
vote, and the highest percentage of the total number of shares of all 
classes of its outstanding stock, owned by the trust at any time during 
the trust's taxable year; or
    (iii) If such person is not a corporation, the highest percentage of 
the trust's interest in the assets or net profits of such person, owned 
by the trust at any time during its taxable year.
    (5) Furnishing of services or management of property must be through 
an independent contractor--(i) In general. No amount received or 
accrued, directly or indirectly, with respect to any real property (or 
any personal property leased under, or in connection with, the real 
property) qualifies as ``rents from real property'' if the real estate 
investment trust furnishes or renders services to the tenants of the 
property or manages or operates the property, other than through an 
independent contractor from whom the trust itself does not derive or 
receive any income. The prohibition against the trust deriving or 
receiving any income from the independent contractor applies regardless 
of the source from which the income was derived by the independent 
contractor. Thus, for example, the trust may not receive any dividends 
from the independent contractor. The requirement that the trust not 
receive any income from an independent contractor requires that the 
relationship between the two be an arm's-length relationship. The 
independent contractor must be adequately compensated for any services 
which are performed for the trust. Compensation to an independent 
contractor determined by reference to an unadjusted percentage of gross 
rents will generally be considered to be adequate where the percentage 
is reasonable taking into account the going rate of compensation for 
managing similar property in the same locality, the services rendered, 
and other relevant factors. The independent contractor must not be an 
employee of the trust (i.e., the manner in which he carries out his 
duties as independent contractor must not be subject to the control of 
the trust). Although the cost of services which are customarily rendered 
or furnished in connection with the rental of real property may be borne 
by the trust, the services must be furnished or rendered through an 
independent contractor. Furthermore, the facilities through which the 
services are furnished must be maintained and operated by an independent 
contractor. For example, if a heating

[[Page 60]]

plant is located in the building, it must be maintained and operated by 
an independent contractor. To the extent that services (other than those 
customarily furnished or rendered in connection with the rental of real 
property) are rendered to the tenants of the property by the independent 
contractor, the cost of the services must be borne by the independent 
contractor, a separate charge must be made for the services, the amount 
of the separate charge must be received and retained by the independent 
contractor, and the independent contractor must be adequately 
compensated for the services.
    (ii) Trustee or director functions. The trustees or directors of the 
real estate investment trust are not required to delegate or contract 
out their fiduciary duty to manage the trust itself, as distinguished 
from rendering or furnishing services to the tenants of its property or 
managing or operating the property. Thus, the trustees or directors may 
do all those things necessary, in their fiduciary capacities, to manage 
and conduct the affairs of the trust itself. For example, the trustees 
or directors may establish rental terms, choose tenants, enter into and 
renew leases, and deal with taxes, interest, and insurance, relating to 
the trust's property. The trustees or directors may also make capital 
expenditures with respect to the trust's property (as defined in section 
263) and may make decisions as to repairs of the trust's property (of 
the type which would be deductible under section 162), the cost of which 
may be borne by the trust.
    (iii) Independent contractor defined. The term ``independent 
contractor'' means--
    (a) A person who does not own, directly or indirectly, at any time 
during the trust's taxable year more than 35 percent of the shares in 
the real estate investment trust, or
    (b) A person--
    (1) If a corporation, not more than 35 percent of the total combined 
voting power of whose stock (or 35 percent of the total shares of all 
classes of whose stock), or
    (2) If not a corporation, not more than 35 percent of the interest 
in whose assets or net profits is owned, directly or indirectly, at any 
time during the trust's taxable year by one or more persons owning at 
any time during such taxable year 35 percent or more of the shares in 
the trust.
    (iv) Information required. The real estate investment trust shall 
submit with its return for the taxable year (or before June 1, 1962, 
whichever is later) a statement setting forth the name and address of 
each independent contractor; and
    (a) The highest percentage of the outstanding shares in the trust 
owned at any time during its taxable year by such independent contractor 
and by any person owning at any time during such taxable year any shares 
of stock or interest in the independent contractor.
    (b) If the independent contractor is a corporation such statement 
shall set forth the highest percentage of the total combined voting 
power of its stock and the highest percentage of the total number of 
shares of all classes of its stock owned at any time during its taxable 
year by any person owning shares in the trust at any time during such 
taxable year.
    (c) If the independent contractor is not a corporation such 
statement shall set forth the highest percentage of any interest in its 
assets or net profits owned at any time during its taxable year by any 
person owning shares in the trust at any time during such taxable year.
    (6) Amounts based on income or profits of subtenants. (i) Except as 
provided in paragraph (b)(6)(ii) of this section, if a trust leases real 
property to a tenant under terms other than solely on a fixed sum rental 
(for example, a percentage of the tenant's gross receipts), and the 
tenant subleases all or a part of such property under an agreement which 
provides for a rental based in whole or in part on the income or profits 
of the sublessee, the entire amount of the rent received by the trust 
from the prime tenant with respect to such property is disqualified as 
``rents from real property''.
    (ii) Exception. For taxable years beginning after October 4, 1976, 
section 856(d)(4) provides an exception to the general rule that amounts 
received or accrued, directly or indirectly, by a real estate investment 
trust do not

[[Page 61]]

qualify as rents from real property if the determination of the amount 
depends in whole or in part on the income or profits derived by any 
person from the property. This exception applies where the trust rents 
property to a tenant (the prime tenant) for a rental which is based, in 
whole or in part, on a fixed percentage or percentages of the receipts 
or sales of the prime tenant, and the rent which the trust receives or 
accrues from the prime tenant pursuant to the lease would not qualify as 
``rents from real property'' solely because the prime tenant receives or 
accrues from subtenants (including concessionaires) rents or other 
amounts based on the income or profits derived by a person from the 
property. Under the exception, only a proportionate part of the rent 
received or accrued by the trust does not qualify as ``rents from real 
property''. The proportionate part of the rent received or accrued by 
the trust which is non-qualified is the lesser of the following two 
amounts:
    (A) The rent received or accrued by the trust from the prime tenant 
pursuant to the lease, that is based on a fixed percentage or 
percentages of receipts or sales, or
    (B) The product determined by multiplying the total rent which the 
trust receives or accrues from the prime tenant pursuant to the lease by 
a fraction, the numerator of which is the rent or other amount received 
by the prime tenant that is based, in whole or in part, on the income or 
profits derived by any person from the property, and the denominator of 
which is the total rent or other amount received by the prime tenant 
from the property. For example, assume that a real estate investment 
trust owns land underlying a shopping center. The trust rents the land 
to the owner of the shopping center for an annual rent of $10x plus 2 
percent of the gross receipts which the prime tenant receives from 
subtenants who lease space in the shopping center. Assume further that, 
for the year in question, the prime tenant derives total rent from the 
shopping center of $100x and, of that amount, $25x is received from 
subtenants whose rent is based, in whole or in part, on the income or 
profits derived from the property. Accordingly, the trust will receive a 
total rent of $12x, of which $2x is based on a percentage of the gross 
receipts of the prime tenant. The portion of the rent which is 
disqualified is the lesser of $2x (the rent received by the trust which 
is based on a percentage of gross receipts), or $3x, ($12x multiplied by 
$25x/$100x). Accordingly, $10x of the rent received by the trust 
qualifies as ``rents from real property'' and $2x does not qualify.
    (7) Attribution rules. Paragraphs (2) and (3) of section 856(d) 
relate to direct or indirect ownership of stock, assets, or net profits 
by the persons described therein. For purposes of determining such 
direct or indirect ownership, the rules prescribed by section 318(a) 
(for determining the ownership of stock) shall apply except that ``10 
percent'' shall be substituted for ``50 percent'' in section 318(a) 
(2)(C) and (3)(C).

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4085, Apr. 28, 1962, as amended by T.D. 6969, 33 FR 
12000, Aug. 23, 1968; T.D. 7767, 46 FR 11266, Feb. 6, 1981]



Sec. 1.856-5  Interest.

    (a) In general. In computing the percentage requirements in section 
856(c) (2)(B) and (3)(B), the term ``interest'' includes only an amount 
which constitutes compensation for the use or forbearance of money. For 
example, a fee received or accrued by a lender which is in fact a charge 
for services performed for a borrower rather than a charge for the use 
of borrowed money is not includable as interest.
    (b) Where amount depends on income or profits of any person. Except 
as provided in paragraph (d) of this section, any amount received or 
accrued, directly or indirectly, with respect to an obligation is not 
includable as interest for purposes of section 856(c) (2)(B) and (3)(B) 
if, under the principles set forth

[[Page 62]]

in paragraphs (b)(3) and (6)(i) of Sec. 1.856-4, the determination of 
the amount depends in whole or in part on the income or profits of any 
person (whether or not derived from property secured by the obligation). 
Thus, for example, if in accordance with a loan agreement an amount is 
received or accrued by the trust with respect to an obligation which 
includes both a fixed amount of interest and a percentage of the 
borrower's income or profits, neither the fixed interest nor the amount 
based upon the percentage will qualify as interest for purposes of 
section 856(c) (2)(B) and (3)(B). This paragraph and paragraph (d) of 
this section apply only to amounts received or accrued in taxable years 
beginning after October 4, 1976, pursuant to loans made after May 27, 
1976. For purposes of the preceding sentence, a loan is considered to be 
made before May 28, 1976, if it is made pursuant to a binding commitment 
entered into before May 28, 1976.
    (c) Apportionment of interest--(1) In general. Where a mortgage 
covers both real property and other property, an apportionment of the 
interest income must be made for purposes of the 75-percent requirement 
of section 856(c)(3). For purposes of the 75-percent requirement, the 
apportionment shall be made as follows:
    (i) If the loan value of the real property is equal to or exceeds 
the amount of the loan, then the entire interest income shall be 
apportioned to the real property.
    (ii) If the amount of the loan exceeds the loan value of the real 
property, then the interest income apportioned to the real property is 
an amount equal to the interest income multiplied by a fraction, the 
numerator of which is the loan value of the real property, and the 
denominator of which is the amount of the loan. The interest income 
apportioned to the other property is an amount equal to the excess of 
the total interest income over the interest income apportioned to the 
real property.
    (2) Loan value. For purposes of this paragraph, the loan value of 
the real property is the fair market value of the property, determined 
as of the date on which the commitment by the trust to make the loan 
becomes binding on the trust. In the case of a loan purchased by the 
trust, the loan value of the real property is the fair market value of 
the property, determined as of the date on which the commitment by the 
trust to purchase the loan becomes binding on the trust. However, in the 
case of a construction loan or other loan made for purposes of improving 
or developing real property, the loan value of the real property is the 
fair market value of the land plus the reasonably estimated cost of the 
improvements or developments (other than personal property) which will 
secure the loan and which are to be constructed from the proceeds of the 
loan. The fair market value of the land and the reasonably estimated 
cost of improvements or developments shall be determined as of the date 
on which a commitment to make the loan becomes binding on the trust. If 
the trust does not make the construction loan but commits itself to 
provide long-term financing following completion of construction, the 
loan value of the real property is determined by using the principles 
for determining the loan value for a construction loan. Moreover, if the 
mortgage on the real property is given as additional security (or as a 
substitute for other security) for the loan after the trust's commitment 
is binding, the real property loan value is its fair market value when 
it becomes security for the loan (or, if earlier, when the borrower 
makes a binding commitment to add or substitute the property as 
security).
    (3) Amount of loan. For purposes of this paragraph, the amount of 
the loan means the highest principal amount of the loan outstanding 
during the taxable year.
    (d) Exception. Section 856(f)(2) provides an exception to the 
general rule that amounts received, directly or indirectly, with respect 
to an obligation do not qualify as ``interest'' where the determination 
of the amounts depends in whole or in part on the income or profits of 
any person. The exception applies where the trust receives or accrues, 
with respect to the obligation of its debtor, an amount that is based in 
whole or in part on a fixed percentage or percentages of receipts or 
sales of the debtor, and the amount would not qualify as interest solely 
because the debtor has receipts or sale proceeds

[[Page 63]]

that are based on the income or profits of any person. Under this 
exception only a proportionate part of the amount received or accrued by 
the trust fails to qualify as interest for purposes of the percentage-
of-income requirements of section 856(c) (2) and (3). The proportionate 
part of the amount received or accrued by the trust that is non-
qualified is the lesser of the following two amounts:
    (1) The amount received or accrued by the trust from the debtor with 
respect to the obligation that is based on a fixed percentage or 
percentages of receipts or sales, or
    (2) The product determined by multiplying by a fraction the total 
amount received or accrued by the trust from the debtor with respect to 
the obligation. The numerator of the fraction is the amount of receipts 
or sales of the debtor that is based, in whole or in part, on the income 
or profits of any person and the denominator is the total amount of the 
receipts or sales of the debtor. For purposes of the preceding sentence, 
the only receipts or sales to be taken into account are those taken into 
account in determining the payment to the trust pursuant to the loan 
agreement.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954)

[T.D. 7767, 46 FR 11268, Feb. 6, 1981]



Sec. 1.856-6  Foreclosure property.

    (a) In general. Under section 856(e) a real estate investment trust 
may make an irrevocable election to treat as ``foreclosure property'' 
certain real property (including interests in real property), and any 
personal property incident to the real property, acquired by the trust 
after December 31, 1973. This section prescribes rules relating to the 
election, including rules relating to property eligible for the 
election. This section also prescribes rules relating to extensions of 
the general two-year period (hereinafter the ``grace period'') during 
which property retains its status as foreclosure property, as well as 
rules relating to early termination of the grace period under section 
856(e)(4). The election to treat property as foreclosure property does 
not alter the character of the income derived therefrom (other than for 
purposes of section 856(c)(2)(F) and (3)(F)). For example, if 
foreclosure property is sold, the determination of whether it is 
property described in section 1221(1) will not be affected by the fact 
that it is foreclosure property.
    (b) Property eligible for the election--(1) Rules relating to 
acquisitions. In general, the trust must acquire the property after 
December 31, 1973, as the result of having bid in the property at 
foreclosure, or having otherwise reduced the property to ownership or 
possession by agreement or process of law, after there was default (or 
default was imminent) on a lease of the property (where the trust was 
the lessor) or on an indebtedness owed to the trust which the property 
secured. Foreclosure property which secured an indebtedness owed to the 
trust is acquired for purposes of section 856(e) on the date on which 
the trust acquires ownership of the property for Federal income tax 
purposes. Foreclosure property which a trust owned and leased to another 
is acquired for purposes of section 856(e) on the date on which the 
trust acquires possession of the property from its lessee. A trust will 
not be considered to have acquired ownership of property for purposes of 
section 856(e) where it takes control of the property as a mortgagee-in-
possession and cannot receive any profit or sustain any loss with 
respect to the property except as a creditor of the mortgagor. A trust 
may be considered to have acquired ownership of property for purposes of 
section 856(e) even through legal title to the property is held by 
another person. For example, where, upon foreclosure of a mortgage held 
by the trust, legal title to the property is acquired in the name of a 
nominee for the exclusive benefit of the trust and the trust is the 
equitable owner of the property, the trust will be considered to have 
acquired ownership

[[Page 64]]

of the property for purposes of section 856(e). Generally, the fact that 
under local law the mortgagor has a right of redemption after 
foreclosure is not relevant in determining whether the trust has 
acquired ownership of the property for purposes of section 856(e). 
Property is not ineligible for the election solely because the property, 
in addition to securing an indebtedness owed to the trust, also secures 
debts owed to other creditors. Property eligible for the election 
includes a building or other improvement which has been constructed on 
land owned by the trust and which is acquired by the trust upon default 
of a lease of the land.
    (2) Personal property. Personal property (including personal 
property not subject to a mortgage or lease of the real property) will 
be considered incident to a particular item of real property if the 
personal property is used in a trade or business conducted on the 
property or the use of the personal property is otherwise an ordinary 
and necessary corollary of the use to which the real property is put. In 
the case of a hotel, such items as furniture, appliances, linens, china, 
food, etc. would be examples of incidental personal property. Personal 
property incident to the real property is eligible for the election even 
though it is acquired after the real property is acquired or is placed 
in the building or other improvement in the course of the completion of 
construction.
    (3) Property with respect to which default is anticipated. Property 
is not eligible for the election to be treated as foreclosure property 
if the loan or lease with respect to which the default occurs (or is 
imminent) was made or entered into (or the lease or indebtedness was 
acquired) by the trust with an intent to evict or foreclose, or when the 
trust knew or had reason to know that default would occur (``improper 
knowledge''). For purposes of the preceding sentence, a trust will not 
be considered to have improper knowledge with respect to a particular 
lease or loan, if the lease or loan was made pursuant to a binding 
commitment entered into by the trust at a time when it did not have 
improper knowledge. Moreover, if the trust, in an attempt to avoid 
default or foreclosure, advances additional amounts to the borrower in 
excess of amounts contemplated in the original loan commitment or 
modifies the lease or loan, such advance or modification will be 
considered not to have been made with an intent to evict or foreclose, 
or with improper knowledge, unless the original loan or lease was 
entered into with that intent or knowledge.
    (c) Election--(1) In general. (i) An election to treat property as 
foreclosure property applies to all of the eligible real property 
acquired in the same taxable year by the trust upon the default (or as a 
result of the imminence of default) on a particular lease (where the 
trust is the lessor) or on a particular indebtedness owed to the trust. 
For example, if a loan made by a trust is secured by two separate tracts 
of land located in different cities, and in the same taxable year the 
trust acquires both tracts on foreclosure upon the default (or imminence 
of default) of the loan, the trust must include both tracts in the 
election. For a further example, the trust may choose to make a separate 
election for only one of the tracts if they are acquired in different 
taxable years or were not security for the same loan. If real property 
subject to the same election is acquired at different times in the same 
taxable year, the grace period for a particular property begins when 
that property is acquired.
    (ii) If the trust acquires separate pieces of real property that 
secure the same indebtedness (or are under the same lease) in different 
taxable years because the trust delays acquiring one of them until a 
later taxable year, and the primary purpose for the delay is to include 
only one of them in an election, then if the trust makes an election for 
one piece it must also make an election for the other piece. A trust 
will not be considered to have delayed the acquisition of property for 
this purpose if there is a legitimate business reason for the delay 
(such as an attempt to avoid foreclosure by further negotiations with 
the debtor or lessee).
    (iii) All of the eligible personal property incident to the real 
property must also be included in the election.
    (2) Time for making election. The election to treat property as 
foreclosure

[[Page 65]]

property must be made on or before the due date (including extensions of 
time) for filing the trust's income tax return for the taxable year in 
which the trust acquires the property with respect to which the election 
is being made, or April 3, 1975, whichever is later.
    (3) Manner of making the election. An election made after February 
6, 1981, shall be made by a statement attached to the income tax return 
for the taxable year in which the trust acquired the property with 
respect to which the election is being made. The statement shall 
indicate that the election is made under section 856(e) and shall 
identify the property to which the election applies. The statement shall 
also set forth--
    (i) The name, address, and taxpayer identification number of the 
trust,
    (ii) The date the property was acquired by the trust, and
    (iii) A brief description of how the real property was acquired, 
including the name of the person or persons from whom the real property 
was acquired and a description of the lease or indebtedness with respect 
to which default occurred or was imminent.

An election made on or before February 6, 1981 shall be filed in the 
manner prescribed in 26 CFR 10.1(f) (revised as of April 1, 1977) 
(temporary regulations relating to the election to treat property as 
foreclosure property) as in effect when the election is made.
    (4) Status of taxpayer. In general, a taxpayer may make an election 
with respect to an acquisition of property only if the taxpayer is a 
qualified real estate investment trust for the taxable year in which the 
acquisition occurs. If, however, the taxpayer establishes, to the 
satisfaction of the district director for the internal revenue district 
in which the taxpayer maintains its principal place of business or 
principal office or agency, that its failure to be a qualified real 
estate investment trust for a taxable year was to due to reasonable 
cause and not due to willful neglect, the taxpayer may make the election 
with respect to property acquired in such taxable year. The principles 
of Secs. 1.856.7(c) and 1.856.8(d) (including the principles relating to 
expert advice) will apply in determining whether, for purposes of this 
subparagraph, the failure of the taxpayer to be a qualified real estate 
investment trust for the taxable year in which the property is acquired 
was due to reasonable cause and not due to willful neglect. If a 
taxpayer makes a valid election to treat property as foreclosure 
property, the property will not lose its status as foreclosure property 
solely because the taxpayer is not a qualified real estate investment 
trust for a subsequent taxable year (including a taxable year which 
encompasses an extension of the grace period). However, the rules 
relating to the termination of foreclosure property status in section 
856(e)(4) (but not the tax on income from foreclosure property imposed 
by section 857(b)(4)) apply to the year in which the property is 
acquired and all subsequent years, even though the taxpayer is not a 
qualified real estate investment trust for such year.
    (d) Termination of 2-year grace period; subsequent leases--(1) In 
general. Under section 856(e)(4)(A), all real property (and any 
incidental personal property) for which a particular election has been 
made (see paragraph (c)(1) of this section) shall cease to be 
foreclosure property on the first day (occurring on or after the day on 
which the trust acquired the property) on which the trust either--
    (i) Enters into a lease with respect to any of the property which, 
by its terms, will give rise to income of the trust which is not 
described in section 856(c)(3) (other than section 856(c)(3)(F)), or
    (ii) Receives or accrues, directly or indirectly, any amount which 
is not described in section 856(c)(3) (other than section 856(c)(3)(F)) 
pursuant to a lease with respect to any of the real property entered 
into by the trust on or after the day the trust acquired the property.

For example, assume the trust acquires, in a particular taxable year, a 
shopping center upon the default of an indebtedness owed to the trust. 
Also assume that the trust subsequently enters into a lease with respect 
to one of several stores in the shopping center that requires the lessee 
to pay rent to the trust which is not income described in section 
856(c)(3) (other than section 856(c)(3)(F)). In such case, the entire

[[Page 66]]

shopping center will cease to be foreclosure property on the day the 
trust enters into the lease.
    (2) Extensions or renewals of leases. Generally, the extension or 
renewal of a lease of foreclosure property will be treated as the 
entering into of a new lease only if the trust has a right to 
renegotiate the terms of the lease. If, however, by operation of law or 
by contract, the acquisition of the foreclosure property by the trust 
terminates a preexisting lease of the property, or gives the trust a 
right to terminate the lease, then for purposes of section 856(e)(4)(A), 
a trust, in such circumstances, will not be considered to have entered 
into a lease with respect to the property solely because the terms of 
the preexisting lease are continued in effect after foreclosure without 
substantial modification. The letting of rooms in a hotel or motel does 
not constitute the entering into a lease for purposes of section 
856(e)(4)(A).
    (3) Rent attributable to personal property. Solely for the purposes 
of section 856(e)(4)(A), if a trust enters into a lease with respect to 
real property on or after the day upon which the trust acquires such 
real property by foreclosure, and a portion of the rent from such lease 
is attributable to personal property which is foreclosure property 
incident to such real property, such rent attributable to the incidental 
personal property will not be considered to terminate the status of such 
real property (or such incidental personal property) as foreclosure 
property.
    (e) Termination of 2-year grace period; completion of construction--
(1) In general. Under section 856(e)(4)(B), all real property (and any 
incidental personal property) for which a particular election has been 
made (see paragraph (c)(1) of this section) shall cease to be 
foreclosure property on the first day (occurring on or after the day on 
which the trust acquired the property) on which any construction takes 
place on the property, other than completion of a building (or 
completion of any other improvement) where more than 10 percent of the 
construction of the building (or other improvement) was completed before 
default became imminent. If more than one default occurred with respect 
to an indebtedness or lease in respect of which there is an acquisition, 
the more-than-10-percent test (including the rule prescribed in this 
paragraph relating to the test) will not be applied at the time a 
particular default became imminent if it is clear that the acquisition 
did not occur as the result of such default. For example, if the debtor 
fails to make four consecutive payments of principal and interest on the 
due dates, and the trust takes action to acquire the property securing 
the debt only after the fourth default becomes imminent, the 10-percent 
test is applied at the time the fourth default became imminent (even 
though the trust would not have foreclosed on the property had not all 
four defaults occurred).
    (2) Determination of percentage of completion. The determination of 
whether the construction of a building or other improvement was more 
than 10 percent complete when default became imminent shall be made by 
comparing the total direct costs of construction incurred with respect 
to the building or other improvement as of the date default became 
imminent with the estimated total direct costs of construction as of 
such date. If the building or other improvement qualifies as more than 
10 percent complete under this method, the building or other improvement 
shall be considered to be more than 10 percent complete. For purposes of 
this subparagraph, direct costs of construction include the cost of 
labor and materials which are directly connected with the construction 
of the building or improvement.

Thus, for example, direct costs of construction incurred as of the date 
default became imminent would include amounts paid, or for which 
liability has been incurred, for labor which has been performed as of 
such date that is directly connected with the construction of the 
building or other improvement and for building materials and supplies 
used or consumed in connection with the construction as of such date. 
For purposes of applying the 10-percent test the trust may also take 
into account the cost of building materials and supplies which have been 
delivered to the construction site as of the date default became 
imminent and which are to be used or consumed in

[[Page 67]]

connection with the construction. On the other hand, architect's fees, 
administrative costs of the developer or builder, lawyers' fees, and 
expenses incurred in connection with obtaining zoning approval or 
building permits are not considerd to be direct costs of construction. 
Any construction by the trust as mortgagee-in-possession is considered 
to have taken place after default resulting in acquisition of the 
property became imminent. Generally, the trust's estimate of the total 
direct costs of completing construction as of the date the default 
became imminent will be accepted, provided that the estimate is 
reasonable, in good faith, and is based on all of the data reasonably 
available to the trust when the trust undertakes completion of 
construction of the building or other improvement. Appropriate 
documentation which shows that construction was more than 10 percent 
complete when default became imminent must be available at the principal 
place of business of the trust for inspection in connection with an 
examination of the income tax return. Construction includes the 
renovation of a building, such as the remodeling of apartments, or the 
renovation of an apartment building to convert rental units to a 
condominium. The renovation must be more than 10 percent complete 
(determined by comparing the total direct cost of the physical 
renovation which has been incurred when default became imminent with the 
estimated total direct cost of renovation as of such date) when default 
became immiment in order for the property not to lose its status as 
foreclosure property if the trust undertakes the renovation.
    (3) Modification of a building or improvement. Generally, the terms 
``building'' and ``improvement'' in section 856(e)(4)(B) mean the 
building or improvement (including any intergral part thereof) as 
planned by the mortgagor or lessee (or other person in possession of the 
property, if appropriate) as of the date default became imminent. The 
trust, however, may estimate the total direct costs of construction and 
complete the construction of the building or other improvement by 
modifying the building or other improvement as planned as of the date 
default became imminent so as to reduce the estimated direct cost of 
construction of the building or improvement. If the trust does so modify 
the planned construction of the building or improvement, the 10-percent 
test is to be applied by comparing the direct costs of construction 
incurred as of the date default became imminent that are attributable to 
the building or improvement as modified, with the estimated total direct 
costs (as of such date) of construction of the building or other 
improvement as modified. The trust, in order to meet the 10-percent 
test, may not, however, modify the planned building or improvement by 
reducing the estimated direct cost of construction to such an extent 
that the building or improvement is not functional.

Also, the trust may make subsequent modifications which increase the 
direct cost of construction of the building or improvement if such 
modifications--
    (i) Are required by a Federal, State, or local agency, or
    (ii) Are alterations that are either required by a prospective 
lessee or purchaser as a condition of leasing or buying the property or 
are necessary for the property to be used for the purpose planned at the 
time default became imminent.

Subdivision (ii) of the preceding sentence applies, however, only if the 
building or improvement, as modified, was more than 10 percent complete 
when default became imminent. A building completed by the trust will not 
cease to be foreclosure property solely because the building is used in 
a manner other than that planed by the defaulting mortgagor or lessee. 
Thus, for example, assume a trust acquired on foreclosure a planned 
apartment building which was 20 percent complete when default became 
imminent and that the trust completes the building without modifications 
which increase the direct cost of construction. The property will not 
cease to be foreclosure property by reason of section 856(e)(4)(B) 
solely because the trust sells the dwelling units in the building as 
condominium units, rather than holding them for rent as planned by the 
defaulting mortgagor. (See, however, section 856(e)(4)(C) and paragraph 
(f)(2) of this section for rules relating

[[Page 68]]

to the requirement that where foreclosure property is used in a trade or 
business (including a trade or business of selling the foreclosure 
property), the trade or business must be conducted through an 
independent contractor after 90 days after the property is acquired.)
    (4) Application on building-by-building basis. Generally the more 
than 10 percent test is to be applied on a building-by-building basis. 
Thus, for example, if a trust has foreclosed on land held by a developer 
building a housing subdivision, the trust may complete construction of 
the houses which were more than 10 percent complete when default became 
imminent. The trust, however, may not complete construction of houses 
which were only 10 percent (or less) complete, nor may the trust begin 
construction of other houses planned for the subdivision on which 
construction has not begun. The trust, however, may construct an 
additional building or improvement (whether or not the construction 
thereof has begun) which is an integral part of another building or 
other improvement that was more than 10 percent complete when default 
became imminent if the additional building or improvement and the other 
building or improvement, taken together as a unit, meet the more than 10 
percent test. For purposes of this paragraph, an additional building or 
other improvement will be considered to be an integral part of another 
building or improvement if--
    (i) It is ancillary to the other building or improvement and its 
principal intended use is to furnish services or facilities which either 
supplement the use of such other building or improvement or are 
necessary for such other building or improvement to be utilized in the 
manner or for the purpose for which it is intended, or
    (ii) The buildings or improvements are intended to comprise 
constituent parts of an interdependent group of buildings or other 
improvements.

However, a building or other improvement will not be considered to be an 
integral part of another building or improvement unless the buildings or 
improvements were planned as part of the same overall construction plan 
or project before default became imminent. An additional building or 
other improvement (such as, for example, an outdoor swimming pool or a 
parking garage) may be considered to be an integral part of another 
building or improvement, even though the additional building or 
improvement was also intended to be used to provide facilities or 
services for use in connection with several other buildings or 
improvements which will not be completed. If the trust chooses not to 
undertake the construction of an additional building or other 
improvement which qualifies as an integral part of another building or 
improvement, so much of the costs of construction (including both the 
direct costs of construction incurred before the default became imminent 
and the estimated costs of completion) as are attributable to that 
``integral part'' shall not be taken into account in determining whether 
any other building or improvement was more than 10 percent complete when 
default became imminent. For example, assume the trust acquires on 
foreclosure a property on which the defaulting mortgagor has begun 
construction of a motel. The motel, as planned by the mortgagor, was to 
consist of a two-story building containing 30 units, and two detached 
one-story wings, each of which was to contain 20 units. At the time 
default became imminent, the defaulting mortgagor had completed more 
than 10 percent of the construction of the two-story structure but the 
two wings, an access road, a parking lot, and an outdoor swimming pool 
planned for the motel were each less than 10 percent complete. The trust 
may construct the two wings of the motel, the access road, the parking 
lot, and the swimming pool: Provided, That the motel and the other 
improvements which the trust undertakes to construct, taken together as 
a unit, were more than 10 percent complete when default became imminent. 
If, however, the trust chooses not to undertake construction of the 
swimming pool, the cost of construction attributable to the swimming 
pool, whether incurred before default became imminent or estimated as 
the cost of completion, shall not be taken into account in determining 
whether the trust can complete construction of the other buildings and

[[Page 69]]

improvements. For another example, assume that the trust acquires a 
planned shopping center on foreclosure. At the time default became 
imminent several large buildings intended to house shops and stores in 
the shopping center were more than 10 percent complete. Less than 10 
percent of the construction, however, had been completed on a separate 
structure intended to house a bank. The bank was planned as a component 
of the shopping center in order to provide, in conjunction with the 
other shops and stores, a specific range and variety of goods and 
services with which to attract customers to the shopping center. The 
trust may complete construction of the bank: Provided, That the bank and 
the other buildings and improvements which the trust undertakes to 
complete, taken together as a unit, were more than 10 percent complete 
when default became imminent. If the trust chooses not to construct the 
bank, no actual or estimated construction costs attributable to the bank 
are to be taken into account in applying the 10-percent test with 
respect to the other buildings and improvements in the shopping center. 
For a third example, assume that a defaulting mortgagor had planned to 
construct two identical apartment buildings, A and B, on the same tract 
of land, that neither building is to provide substantial facilities or 
services to be used in connection with the other, and that only building 
A was more than 10 percent complete when default became imminent. The 
trust, in this case, may not complete building B. On the other hand, if 
the facts are the same except that pursuant to the plans of the 
defaulting mortgagor, one of the buildings is to contain the furnace and 
central air conditioning machinery for both buildings A and B, the trust 
may complete both buildings A and B: Provided, That, taken together as a 
unit, the two buildings meet the more-than-10-percent test.
    (5) Repair and maintenance. Under this paragraph (e), 
``construction'' does not include--
    (i) The repair or maintenance of a building or other improvement 
(such as the replacement of worn or obsolete furniture and appliances) 
to offset normal wear and tear or obsolescence, and the restoration of 
property required because of damage from fire, storm, vandalism or other 
casualty,
    (ii) The preparation of leased space for a new tenant which does not 
substantially extend the useful life of the building or other 
improvement or significantly increase its value, even though, in the 
case of commercial space, this preparation includes adapting the 
property to the conduct of a different business, or
    (iii) The performing of repair or maintenance described in paragraph 
(e)(5)(i) of this section after property is acquired that was deferred 
by the defaulting party and that does not constitute renovation under 
paragraph (e)(2) of this section.
    (6) Independent contractor required. If any construction takes place 
on the foreclosure property more than 90 days after the day on which 
such property was acquired by the trust, such construction must be 
performed by an independent contractor (as defined in section 856(d)(3) 
and Sec. 1.856-4(b)(5)(iii)) from whom the trust does not derive or 
receive any income. Otherwise, the property will cease to be foreclosure 
property.
    (7) Failure to complete construction. Property will not cease to be 
foreclosure property solely because a trust which undertakes the 
completion of construction of a building or other improvement on the 
property that was more than 10 percent complete when default became 
imminent does not complete the construction. Thus, for example, if a 
trust continues construction of a building that was 20 percent complete 
when default became imminent, and the trust constructs an additional 40 
percent of the building and then sells the property, the property will 
not lose its status as foreclosure property solely because the trust 
fails to complete construction of the building.
    (f) Termination of 2-year grace period; use of foreclosure property 
in a trade or business--(1) In general. Under section 856(e)(4)(C), all 
real property (and any incidental personal property) for which a 
particular election has been made (see paragraph (c)(1) of this section) 
shall cease to be foreclosure property on the first day (occurring more 
than

[[Page 70]]

90 days after the day on which the trust acquired the property) on which 
the property is used in a trade or business conducted by the trust, 
other than a trade or business conducted by the trust through an 
independent contractor from whom the trust itself does not derive or 
receive any income. (See section 856(d)(3) for the definition of 
independent contractor.)
    (2) Property held primarily for sale to customers. For the purposes 
of section 856(e)(4)(C), foreclosure property held by the trust 
primarily for sale to customers in the ordinary course of a trade or 
business is considered to be property used in a trade or business 
conducted by the trust. Thus, if a trust holds foreclosure property 
(whether real property or personal property incident to real property) 
for sale to customers in the ordinary course of a trade or business more 
than 90 days after the day on which the trust acquired the real 
property, the trade or business of selling the property must be 
conducted by the trust through an independent contractor from whom the 
trust does not derive or receive any income. Otherwise, after such 90th 
day the property will cease to be foreclosure property.
    (3) Change in use. Foreclosure property will not cease to be 
foreclosure property solely because the use of the property in a trade 
or business by the trust differs from the use to which the property was 
put by the person from whom it was acquired. Thus, for example, if a 
trust acquires a rental apartment building on foreclosure, the property 
will not cease to be foreclosure property solely because the trust 
converts the building to a condominium apartment building and, through 
an independent contractor from whom the trust derives no income, engages 
in the trade or business of selling the individual condominium units.
    (g) Extension of 2-year grace period--(1) In general. A real estate 
investment trust may apply to the district director of the internal 
revenue district in which is located the principal place of business (or 
principal office or agency) of the trust for an extension of the 2-year 
grace period. If the trust establishes to the satisfaction of the 
district director that an extension of the grace period is necessary for 
the orderly liquidation of the trust's interest in foreclosure property, 
or for an orderly renegotiation of a lease or leases of the property, 
the district director may extend the 2-year grace period. See section 
856(e)(3) (as in effect with respect to the particular extension) for 
rules relating to the maximum length of an extension, and the number of 
extensions which may be granted. An extension of the grace period may be 
granted by the district director either before or after the date on 
which the grace period, but for the extension, would expire. The 
extension shall be effective as of the date on which the grace period, 
but for the extension, would expire.
    (2) Showing required. Generally, in order to establish the necessity 
of an extension, the trust must demonstrate that it has made good faith 
efforts to renegotiate leases with respect to, or dispose of, the 
foreclosure property. In certain cases, however, the trust may establish 
the necessity of an extension even though it has not made such efforts. 
For example, if the trust demonstrates that, for valid business reasons, 
construction of the foreclosure property could not be completed before 
the expiration of the grace period, the necessity of the extension could 
be established even though the trust had made no effort to sell the 
property. For another example, if the trust demonstrates that due to a 
depressed real estate market, it could not sell the foreclosure property 
before the expiration of the grace period except at a distress price, 
the necessity of an extension could be established even though the trust 
had made no effort to sell the property. The fact that property was 
acquired as foreclosure property prior to January 3, 1975 (the date of 
enactment of section 856(e)), generally will be considered as a factor 
(but not a controlling factor) which tends to establish that an 
extension of the grace period is necessary.
    (3) Time for requesting an extension of the grace period. A request 
for an extension of the grace period must be filed with the appropriate 
district director more than 60 days before the day on which the grace 
period would otherwise expire. In the case of a grace period which would 
otherwise expire before

[[Page 71]]

August 6, 1976, a request for an extension will be considered to be 
timely filed if filed on or before June 7, 1976.
    (4) Information required. The request for an extension of the grace 
period shall identify the property with respect to which the request is 
being made and shall also include the following information:
    (i) The name, address, and taxpayer identification number of the 
trust,
    (ii) The date the property was acquired as foreclosure property by 
the trust,
    (iii) The taxable year of the trust in which the property was 
acquired,
    (iv) If the trust has been previously granted an extension of the 
grace period with respect to the property, a statement to that effect 
(which shall include the date on which the grace period, as extended, 
expires) and a copy of the information which accompanied the request for 
the previous extension,
    (v) A statement of the reasons why the grace period should be 
extended,
    (vi) A description of any efforts made by the trust after the 
acquisition of the property to dispose of the property or to renegotiate 
any lease with respect to the property, and
    (vii) A description of any other factors which tend to establish 
that an extension of the grace period is necessary for the orderly 
liquidation of the trust's interest in the property, or for an orderly 
renegotiation of a lease or leases of the property.

The trust shall also furnish any additional information requested by the 
district director after the request for extension is filed.
    (5) Automatic extension. If a real estate investment trust files a 
request for an extension with the district director more than 60 days 
before the expiration of the grace period, the grace period shall be 
considered to be extended until the end of the 30th day after the date 
on which the district director notifies the trust by certified mail sent 
to its last known address that the period of extension requested by the 
trust is not granted. For further guidance regarding the definition of 
last known address, see Sec. 301.6212-2 of this chapter. In no event, 
however, shall the rule in the preceding sentence extend the grace 
period beyond the expiration of (i) the period of extension requested by 
the trust, or (ii) the 1-year period following the date that the grace 
period (but for the automatic extension) would expire. The date of the 
postmark on the sender's receipt is considered to be the date of the 
certified mail for purposes of this subparagraph. This subparagraph does 
not apply, however, if the date of the notification by certified mail 
described in the first sentence is more than 30 days before the date 
that the grace period (determined without regard to this subparagraph) 
expires. Moreover, this subparagraph shall not operate to allow any 
period of extension that is prohibited by the last sentence of section 
856(e)(3) (as in effect with respect to the particular extension).
    (6) Extension of time for filing. If a real estate investment trust 
fails to file the request for an extension of the grace period within 
the time provided in paragraph (g)(3) of this section, then the district 
director shall grant a reasonable extension of time for filing such 
request, provided (i) it is established to the satisfaction of the 
district director that there was reasonable cause for failure to file 
the request within the prescribed time and (ii) a request for such 
extension is filed within such time as the district director considers 
reasonable under the circumstances.
    (7) Status of taxpayer. The reference to ``real estate investment 
trust'' or ``trust'' in this paragraph (g) shall be considered to 
include a taxpayer that is not a qualified real estate investment trust, 
if the taxpayer establishes to the satisfaction of the district director 
that its failure to be a qualified real estate investment trust for the 
taxable year was due to reasonable cause and not due to willful neglect. 
The principles of Sec. 1.856-7(c) and Sec. 1.856-8(d) (including the 
principles relating

[[Page 72]]

to expert advice) shall apply for determining reasonable cause (and 
absence of willful neglect) for this purpose.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11269, Feb. 6, 1981; 46 FR 15263, Mar. 5, 1981, as 
amended by T.D. 8939, 66 FR 2819, Jan. 12, 2001]



Sec. 1.856-7  Certain corporations, etc., that are considered to meet the gross income requirements.

    (a) In general. A corporation, trust, or association which fails to 
meet the requirements of paragraph (2) or (3) of section 856(c), or of 
both such paragraphs, for any taxable year nevertheless is considered to 
have satisfied these requirements if the corporation, trust, or 
association meets the requirements of subparagraphs (A), (B), and (C) of 
section 856(c)(7) (relating to a schedule attached to the return, the 
absence of fraud, and reasonable cause).
    (b) Contents of the schedule. The schedule required by subparagraph 
(A) of section 856(c)(7) must contain a breakdown, or listing, of the 
total amount of gross income falling under each of the separate 
subparagraphs of section 856(c) (2) and (3). Thus, for example, the real 
estate investment trust, for purposes of listing its income from the 
sources described in section 856(c)(2), would list separately the total 
amount of dividends, the total amount of interest, the total amount of 
rents from real property, etc. The listing is not required to be on a 
lease-by-lease, loan-by-loan, or project-by-project basis, but the real 
estate investment trust must maintain adequate records on such a basis 
with which to substantiate each total amount listed in the schedule.
    (c) Reasonable cause--(1) In general. The failure to meet the 
requirements of paragraph (2) or (3) of section 856(c) (or of both 
paragraphs) will be considered due to reasonable cause and not due to 
willful neglect if the real estate investment trust exercised ordinary 
business care and prudence in attempting to satisfy the requirements. 
Such care and prudence must be exercised at the time each transaction is 
entered into by the trust. However, even if the trust exercised ordinary 
business care and prudence in entering into a transaction, if the trust 
later determines that the transaction results in the receipt or accrual 
of nonqualified income and that the amounts of such nonqualified income, 
in the context of the trust's overall portfolio, reasonably can be 
expected to cause a source-of-income requirement to be failed, the trust 
must use ordinary business care and prudence in an effort to renegotiate 
the terms of the transaction, dispose of property acquired or leased in 
the transaction, or alter other elements of its portfolio. In any case, 
failure to meet an income source requirement will be considered due to 
willful neglect and not due to reasonable cause if the failure is 
willful and the trust could have avoided such failure by taking actions 
not inconsistent with ordinary business care and prudence. For example, 
if the trust enters into a lease knowing that it will produce 
nonqualified income which reasonably can be expected to cause a source-
of-income requirement to be failed, the failure is due to willful 
neglect even if the trust has a legitimate business purpose for entering 
into the lease.
    (2) Expert advice--(i) In general. The reasonable reliance on a 
reasoned, written opinion as to the characterization for purposes of 
section 856 of gross income to be derived (or being derived) from a 
transaction generally constitutes ``reasonable cause'' if income from 
that transaction causes the trust to fail to meet the requirements of 
paragraph (2) or (3) of section 856(c) (or of both paragraphs). The 
absence of such a reasoned, written opinion with respect to a 
transaction does not, by itself, give rise to any inference that

[[Page 73]]

the failure to meet a percentage of income requirement was without 
reasonable cause. An opinion as to the character of income from a 
transaction includes an opinion pertaining to the use of a standard form 
of transaction or standard operating procedure in a case where such 
standard form or procedure is in fact used or followed.
    (ii) If the opinion indicates that a portion of the income from a 
transaction will be nonqualifed income, the trust must still exercise 
ordinary business care and prudence with respect to the nonqualified 
income and determine that the amount of that income, in the context of 
its overall portfolio, reasonably cannot be expected to cause a source-
of-income requirement to be failed. Reliance on an opinion is not 
reasonable if the trust has reason to believe that the opinion is 
incorrect (for example, because the trust withholds facts from the 
person rendering the opinion).
    (iii) Reasoned written opinion. For purposes of this subparagraph 
(2), a written opinion means an opinion, in writing, rendered by a tax 
advisor (including house counsel) whose opinion would be relied on by a 
person exercising ordinary business care and prudence in the 
circumstances of the particular transaction. A written opinion is 
considered ``reasoned'' even if it reaches a conclusion which is 
subsequently determined to be incorrect, so long as the opinion is based 
on a full disclosure of the factual situation by the real estate 
investment trust and is addressed to the facts and law which the person 
rendering the opinion believes to be applicable. However, an opinion is 
not considered ``reasoned'' if it does nothing more than recite the 
facts and express a conclusion.
    (d) Application of section 856(c)(7) to taxable years beginning 
before October 5, 1976. Pursuant to section 1608(b) of the Tax Reform 
Act of 1976, paragraph (7) of section 856(c) and this section apply to a 
taxable year of a real estate investment trust which begins before 
October 5, 1976, only if as the result of a determination occurring 
after October 4, 1976, the trust does not meet the requirements of 
paragraph (2) or (3) of section 856(c), or both paragraphs, as in effect 
for the taxable year. The requirement that the schedule described in 
subparagraph (A) of section 856(c)(7) be attached to the income tax 
return of a real estate investment trust in order for section 856(c)(7) 
to apply is not applicable to taxable years beginning before October 5, 
1976. For purposes of section 1608(b) of the Tax Reform Act of 1976 and 
this paragraph, the rules relating to determinations prescribed in 
section 860(e) and Sec. 1.860-2(b)(1) (other than the second, third, and 
last sentences of Sec. 1.860-2(b)(1)(ii)) shall apply. However, a 
determination consisting of an agreement between the taxpayer and the 
district director (or other official to whom authority to sign the 
agreement is delegated) shall set forth the amount of gross income for 
the taxable year to which the determination applies, the amount of the 
90 percent and 75 percent source-of-income requirements for the taxable 
year to which the determination applies, and the amount by which the 
real estate investment trust failed to meet either or both of the 
requirements. The agreement shall also set forth the amount of tax for 
which the trust is liable pursuant to section 857(b)(5). The agreement 
shall also contain a finding as to whether the failure to meet the 
requirements of paragraph (2) or (3) of section 856(c) (or of both 
paragraphs) was due to reasonable cause and not due to willful neglect.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954); sec. 860(e) (92 Stat. 2849, 26 U.S.C. 
860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7767, 46 FR 11274, Feb. 6, 1981, as amended by T.D. 7936, 49 FR 
2106, Jan. 18, 1984]



Sec. 1.856-8  Revocation or termination of election.

    (a) Revocation of an election to be a real estate investment trust. 
A corporation, trust, or association that has made an election under 
section 856(c)(1)

[[Page 74]]

to be a real estate investment trust may revoke the election for any 
taxable year after the first taxable year for which the election is 
effective. The revocation must be made by filing a statement with the 
district director for the internal revenue district in which the 
taxpayer maintains its principal place of business or principal office 
or agency. The statement must be filed on or before the 90th day after 
the first day of the first taxable year for which the revocation is to 
be effective. The statement must be signed by an official authorized to 
sign the income tax return of the taxpayer and must--
    (1) Contain the name, address, and taxpayer identification number of 
the taxpayer,
    (2) Specify the taxable year for which the election was made, and
    (3) Include a statement that the taxpayer, pursuant to section 
856(g)(2), revokes its election under section 856(c)(1) to be a real 
estate investment trust.

The revocation may be made only with respect to a taxable year beginning 
after October 4, 1976, and is effective for the taxable year in which 
made and for all succeeding taxable years. A revocation with respect to 
a taxable year beginning after October 4, 1976, that is filed before 
February 6, 1981, in the time and manner prescribed in Sec. 7.856(g)-1 
of this chapter (as in effect when the revocation was filed) is 
considered to meet the requirements of this paragraph.
    (b) Termination of election to be a real estate investment trust. An 
election of a corporation, trust, or association under section 856(c)(1) 
to be a real estate investment trust shall terminate if the corporation, 
trust, or association is not a qualified real estate investment trust 
for any taxable year (including the taxable year with respect to which 
the election is made) beginning after October 4, 1976. (This election 
terminates whether the failure to be a qualified real estate investment 
trust is intentional or inadvertent.) The term ``taxable year'' includes 
a taxable year of less than 12 months for which a return is made under 
section 443. The termination of the election is effective for the first 
taxable year beginning after October 4, 1976, for which the corporation, 
trust, or association is not a qualified real estate investment trust 
and for all succeeding taxable years.
    (c) Restrictions on election after termination or revocation--(1) 
General rule. Except as provided in paragraph (d) of this section, if a 
corporation, trust, or association has made an election under section 
856(c)(1) to be a real estate investment trust and the election has been 
terminated or revoked under section 856(g)(1) or (2), the corporation, 
trust, or association (and any successor corporation, trust, or 
association) is not eligible to make a new election under section 
856(c)(1) for any taxable year prior to the fifth taxable year which 
begins after the first taxable year for which the termination or 
revocation is effective.
    (2) Successor corporation. The term ``successor corporation, trust, 
or association'', as used in section 856(g)(3), means a corporation, 
trust, or association which meets both a continuity of ownership 
requirement and a continuity of assets requirement with respect to the 
corporation, trust, or association whose election has been terminated 
under section 856(g)(1) or revoked under section 856(g)(2). A 
corporation, trust, or association meets the continuity of ownership 
requirement only if at any time during the taxable year the persons who 
own, directly or indirectly, 50 percent or more in value of its 
outstanding shares owned, at any time during the first taxable year for 
which the termination or revocation was effective, 50 percent or more in 
value of the outstanding shares of the corporation, trust, or 
association whose election has been terminated or revoked. A 
corporation, trust, or association meets the continuity of assets 
requirement only if either (i) a substantial portion of its assets were 
assets of the corporation, trust, or association whose election has been 
revoked or terminated, or (ii) it acquires a substantial portion of the 
assets of the corporation, trust, or association whose election has been 
terminated or revoked.
    (3) Effective date. Section 856(g)(3) does not apply to the 
termination of an election that was made by a taxpayer

[[Page 75]]

pursuant to section 856(c)(1) on or before October 4, 1976, unless the 
taxpayer is a qualified real estate investment trust for a taxable year 
ending after October 4, 1976, for which the pre-October 5, 1976, 
election is in effect. For example, assume that Trust X, a calendar year 
taxpayer, files a timely election under section 856(c)(1) with respect 
to its taxable year 1974, and is a qualified real estate investment 
trust for calendar years 1974 and 1975. Assume further that Trust X is 
not a qualified real estate investment trust for 1976 and 1977 because 
it willfully fails to meet the asset diversification requirements of 
section 856(c)(5) for both years. The failure (whether or not willful) 
to meet these requirements in 1977 terminates the election to be a real 
estate investment trust made with respect to 1974. (See paragraph (b) of 
this section.) The termination is effective for 1977 and all succeeding 
taxable years. However, under section 1608(d)(3) of the Tax Reform Act 
of 1976, Trust X is not prohibited by section 856(g)(3) from making a 
new election under section 856(c)(1) with respect to 1978.
    (d) Exceptions-- Section 856(g)(4) provides an exception to the 
general rule of section 856(g)(3) that the termination of an election to 
be a real estate investment trust disqualifies the corporation, trust, 
or association from making a new election for the 4 taxable years 
following the first taxable year for which the termination is effective. 
This exception applies where the corporation, trust, or association 
meets the requirements of section 856(g)(4)(A), (B) and (C) (relating to 
the timely filing of a return, the absence of fraud, and reasonable 
cause, respectively) for the taxable year with respect to which the 
termination of election occurs. In order to meet the requirements of 
section 856(g)(4)(C), the corporation, trust, or association must 
establish, to the satisfaction of the district director for the internal 
revenue district in which the corporation, trust, or association 
maintains its principal place of business or principal office or agency, 
that its failure to be a qualified real estate investment trust for the 
taxable year in question was due to reasonable cause and not due to 
willful neglect. The principles of Sec. 1.856-7(c) (including the 
principles relating to expert advice) will apply in determining whether, 
for purposes of section 856(g)(4), the failure of a corporation, trust, 
or association to be a qualified real estate investment trust for a 
taxable year was due to reasonable cause and not due to willful neglect. 
Thus, for example, the corporation, trust, or association must exercise 
ordinary business care and prudence in attempting to meet the status 
conditions of section 856(a) and the distribution and recordkeeping 
requirements of section 857(a), as well as the gross income requirements 
of section 856(c). The provisions of section 856(g)(4) do not apply to a 
taxable year in which the corporation, trust, or association makes a 
valid revocation, under section 856(g)(2), of an election to be a real 
estate investment trust.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11275, Feb. 6, 1981; 46 FR 15263, Mar. 5, 1981]



Sec. 1.857-1  Taxation of real estate investment trusts.

    (a) Requirements applicable thereto. Section 857(a) denies the 
application of the provisions of part II, subchapter M, chapter 1 of the 
Code (other than sections 856(g), relating to the revocation or 
termination of an election, and 857(d), relating to earnings and 
profits) to a real estate investment trust for a taxable year unless--
    (1) The deduction for dividends paid for the taxable year as defined 
in section 561 (computed without regard to capital gain dividends) 
equals or exceeds the amount specified in section 857(a)(1), as in 
effect for the taxable year; and
    (2) The trust complies for such taxable year with the provisions of 
Sec. 1.857-8 (relating to records required to be

[[Page 76]]

maintained by a real estate investment trust).

See section 858 and Sec. 1.858-1, relating to dividends paid after the 
close of the taxable year.
    (b) Failure to qualify. If a real estate investment trust does not 
meet the requirements of section 857(a) and paragraph (a) of this 
section for the taxable year, it will, even though it may otherwise be 
classified as a real estate investment trust, be taxed in such year as 
an ordinary corporation and not as a real estate investment trust. In 
such case, none of the provisions of part II of subchapter M (other than 
sections 856(g) and 857(d)) will be applicable to it. For the rules 
relating to the applicability of sections 856(g) and 857(d), see 
Sec. 1.857-7.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4087, Apr. 28, 1962, as amended by T.D. 7767, 46 FR 
11277, Feb. 6, 1981]



Sec. 1.857-2  Real estate investment trust taxable income and net capital gain.

    (a) Real estate investment trust taxable income. Section 857(b)(1) 
imposes a nominal tax and surtax, computed at the rates and in the 
manner prescribed in section 11, on the ``real estate investment trust 
taxable income'', as defined in section 857(b)(2). Section 857(b)(2) 
requires certain adjustments to be made to convert taxable income of the 
real estate investment trust to ``real estate investment trust taxable 
income''. The adjustments are as follows:
    (1) Net capital gain. In the case of taxable years ending before 
October 5, 1976, the net capital gain, if any, is excluded.
    (2) Special deductions disallowed. The special deductions provided 
in part VIII, subchapter B, chapter 1 of the Code (except the deduction 
under section 248) are not allowed.
    (3) Deduction for dividends paid--(i) General rule. The deduction 
for dividends paid (as defined in section 561) is allowed. In the case 
of taxable years ending before October 5, 1976, the deduction for 
dividends paid is computed without regard to capital gains dividends.
    (ii) Deduction for dividends paid if there is net income from 
foreclosure property. If for any taxable year the trust has net income 
from foreclosure property (as defined in section 857(b)(4)(B) and 
Sec. 1.857-3), the deduction for dividends paid is an amount equal to 
the amount which bears the same proportion to the total dividends paid 
or considered as paid during the taxable year that otherwise meet the 
requirements for the deduction for dividends paid (as defined in section 
561) as the real estate investment trust taxable income (determined 
without regard to the deduction for dividends paid) bears to the sum of-
-
    (A) The real estate investment trust taxable income (determined 
without regard to the deduction for dividends paid), and
    (B) The amount by which the net income from foreclosure property 
exceeds the tax imposed on such income by section 857(b)(4)(A).

For purposes of the preceding sentence, the term ``total dividends paid 
or considered as paid during the taxable year'' includes deficiency 
dividends paid with respect to the taxable year that are not otherwise 
excluded under this subdivision or section 857(b)(3)(A). The term, 
however, does not include either deficiency dividends paid during the 
taxable year with respect to a preceding taxable year ending before 
October 5, 1976, capital gains dividends.
    (iii) Deduction for dividends paid for purposes of the alternative 
tax. The rules in section 857(b)(3)(A) apply in determining the amount 
of the deduction for dividends paid that is taken into account in 
computing the alternative tax. Thus, for example, if a real estate 
investment trust has net income from foreclosure property for a taxable 
year ending after October 4, 1976, then for purposes of determining the 
partial tax described in section 857(b)(3)(A)(i), the

[[Page 77]]

amount of the deduction for dividends paid is computed pursuant to 
paragraph (a)(3)(ii) of this section, except that capital gains 
dividends are excluded from the dividends paid or considered as paid 
during the taxable year, and the net capital gain is excluded in 
computing real estate investment trust taxable income.
    (4) Section 443(b) disregarded. The taxable income is computed 
without regard to seciton 443(b). Thus, the taxable income for a period 
of less than 12 months is not placed on an annual basis even though the 
short taxable year results from a change of accounting period.
    (5) Net operating loss deduction. In the case of a taxable year 
ending before October 5, 1976, the net operating loss deduction provided 
in section 172 is not allowed.
    (6) Net income from foreclosure property. An amount equal to the net 
income from foreclosure property (as defined in section 857(b)(4)(B) and 
paragraph (a) of Sec. 1.857-3), if any, is excluded.
    (7) Tax imposed by section 857(b)(5). An amount equal to the tax (if 
any) imposed on the trust by section 857(b)(5) for the taxble year is 
excluded.
    (8) Net income or loss from prohibited transactions. An amount equal 
to the amount of any net income derived from prohibited transactions (as 
defined in section 857(b)(6)(B)(i)) is excluded. On the other hand, an 
amount equal to amount of any net loss derived from prohibited 
transactions (as defined in section 857(b)(6)(B)(ii)) is included. 
Because the amount of the net loss derived from prohibited transactions 
is taken into account in computing taxable income before the adjustments 
required by section 857(b)(2) and this section are made, the effect of 
including an amount equal to the amount of the loss is to disallow a 
deduction for the loss.
    (b) Net capital gain in taxable years ending October 5, 1976. The 
rules relating to the taxation of capital gains in 26 CFR 1.857-2(b) 
(revised as of April 1, 1977) apply to taxable years ending before 
October 5, 1976.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11277, Feb. 6, 1981]



Sec. 1.857-3  Net income from foreclosure property.

    (a) In general. For purposes of section 857(b)(40(B), net income 
from foreclosure property means the aggregate of--
    (1) All gains and losses from sales or other dispositions of 
foreclosure property described in section 1221(1), and,
    (2) The difference (hereinafter called ``net gain or loss from 
operations'') between (i) the gross income derived from foreclosure 
property (as defined in section 856(e)) to the extent such gross income 
is not described in subparagraph (A), (B), (C), (D), (E), or (G) of 
section 856(c)(3), and (ii) the deductions allowed by chapter 1 of the 
Code which are directly connected with the production of such gross 
income.

Thus, the sum of the gains and losses from sales or other dispositions 
of foreclosure property described in section 1221(1) is aggregated with 
the net gain or loss from operations in arriving at net income from 
foreclosure property. For example, if for a taxable year a real estate 
investment trust has gain of $100 from the sale of an item of 
foreclosure property described in section 1221(1), a loss of $50 from 
the sale of an item of foreclosure property described in section 
1221(1), gross income of $25 from the rental of foreclosure property 
that is not gross income described in subparagraph (A), (B), (C), (D), 
or (G) of section 856(c)(3), and deductions of $35 allowed by chapter 1 
of the Code which

[[Page 78]]

are directly connected with the production of the rental income, the net 
income from foreclosure property for the taxable years is $40 (($100-
$50)+($25-$35)).
    (b) Directly connected deductions. A deduction which is otherwise 
allowed by chapter 1 of the Code is ``directly connected'' with the 
production of gross income from the foreclosure property if it has a 
proximate and primary relationship to the earning of the income. Thus, 
in the case of gross income from real property that is foreclosure 
property, ``directly connected'' deductions would include depreciation 
on the property, interest paid or accrued on the indebtedness of the 
trust (whether or not secured by the property) to the extent 
attributable to the carrying of the property, real estate taxes, and 
fees paid to an independent contractor hired to manage the property. On 
the other hand, general overhead and administrative expenses of the 
trust are not ``directly connected'' deductions. Thus, salaries of 
officers and other administrative employees of the trust are not 
``directly connected'' deductions. The net operating loss deduction 
provided by section 172 is not allowed in computing net income from 
foreclosure property.
    (c) Net loss from foreclosure property. The tax imposed by section 
857(b)(4) applies only if there is net income from foreclosure property. 
If there is a net loss from foreclosure property (that is, if the 
aggregate computed under paragraph (a) of this section results in a 
negative amount) the loss is taken into account in computing real estate 
investment trust taxable income under section 857(b)(2).
    (d) Gross income not subject to tax on foreclosure property. If the 
gross income derived from foreclosure property consists of two classes, 
a deduction directly connected with the production of both classes 
(including interest attributable to the carrying of the property) must 
be apportioned between them. The two classes are:
    (1) Gross income which is taken into account in computing net income 
from foreclosure property and
    (2) Other income (such as income described in subparagraph (A), (B), 
(C), (D), or (G) of section 856(c)(3)).

The apportionment may be made on any reasonable basis.
    (e) Allocation and apportionment of interest. For purposes of 
determining the amount of interest attributable to the carrying of 
foreclosure property under paragraph (b) of this section, the following 
rules apply:
    (1) Deductible interest. Interest is taken into account under this 
paragraph (e) only if it is otherwise deductible under chapter 1 of the 
Code.
    (2) Interest specifically allocated to property. Interest that is 
specifically allocated to an item of property is attributable only to 
the carrying of that property. Interest is specifically allocated to an 
item of property if (i) the indebtedness on which the interest is paid 
or accrued is secured only by that property, (ii) such indebtedness was 
specifically incurred for the purpose of purchasing, constructing, 
maintaining, or improving that property, and (iii) the proceeds of the 
borrowing were applied for that purpose.
    (3) Other interest. Interest which is not specifically allocated to 
property is apportioned between foreclosure property and other property 
under the principles of Sec. 1.861-8(e)(2)(v).
    (4) Effective date. The rules in this paragraph (e) are mandatory 
for all taxable years ending after February 6, 1981.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11277, Feb. 6, 1981]



Sec. 1.857-4  Tax imposed by reason of the failure to meet certain source-of-income requirements.

    Section 857(b)(5) imposes a tax on a real estate investment trust 
that is considered, by reason of section 856(c)(7), as meeting the 
source-of-income requirements of paragraph (2) or

[[Page 79]]

(3) of section 856(c) (or both such paragraphs). The amount of the tax 
is determined in the manner prescribed in section 857(b)(5).

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11278, Feb. 2, 1981]



Sec. 1.857-5  Net income and loss from prohibited transactions.

    (a) In general. Section 857(b)(6) imposes, for each taxable year, a 
tax equal to 100 percent of the net income derived from prohibited 
transactions. A prohibited transaction is a sale or other disposition of 
property described in section 1221(1) that is not foreclosure property. 
The 100-percent tax is imposed to preclude a real estate investment 
trust from retaining any profit from ordinary retailing activities such 
as sales to customers of condominium units or subdivided lots in a 
development tract. In order to prevent a trust from receiving any tax 
benefit from such activities, a net loss from prohibited transactions 
effectively is disallowed in compting real estate investment trust 
taxable income. See Sec. 1.857-2(a)(8). Such loss, however, does reduce 
the amount which a trust is required to distribute as dividends. For 
purposes of applying the provisions of the Code, other than those 
provisions of part II of subchapter M which relate to prohibited 
transactions, no inference is to be drawn from the fact that a type of 
transaction does not constitute a prohibited transaction.
    (b) Special rules. In determining whether a particular transaction 
constitutes a prohibited transaction, the activities of a real estate 
investment trust with respect to foreclosure property and its sales of 
such property are disregarded. Also, if a real estate investment trust 
enters into a purchase and leaseback of real property with an option in 
the seller-lessee to repurchase the property at the end of the lease 
period, and the seller exercises the option pursuant to its terms, 
income from the sale generally will not be considered to be income from 
a prohibited transaction solely because the purchase and leaseback was 
entered into with an option in the seller to repurchase and because the 
option was exercised pursuant to its terms. Other facts and 
circumstances, however, may require a conclusion that the property is 
held primarily for sale to customers in the ordinary course of a trade 
or business. Gain from the sale or other disposition of property 
described in section 1221(1) (other than foreclosure property) that is 
included in gross income for a taxable year of a qualified real estate 
investment trust constitutes income from a prohibited transaction, even 
though the sale or other disposition from which the gain is derived 
occurred in a prior taxable year. For example, if a corporation that is 
a qualified real estate investment trust for the current taxable year 
elected to report the income from the sale of an item of section 1221(1) 
property (other than foreclosure property) on the installment method of 
reporting income, the gain from the sale that is taken into income by 
the real estate investment trust for the current taxable year is income 
from a prohibited transaction. This result follows even though the sale 
occurred in a prior taxable year for which the corporation did not 
qualify as a real estate investment trust. On the other hand, if the 
gain is taken into income in a taxable year for which the taxpayer is 
not a qualifed real estate investment trust, the 100-percent tax does 
not apply.
    (c) Net income or loss from prohibited transactions. Net income or 
net loss from prohibited transactions is determined by aggregating all 
gains from the sale or other disposition of property (other than 
foreclosure property) described in section 1221(1) with all losses from 
the sale or other disposition of such property. Thus, for example, if a 
real estate investment trust sells two items of property described in 
section 1221(1) (other than foreclosure property) and recognizes a gain 
of $100 on the sale of one item and a loss of $40 on the sale of the 
second item, the net

[[Page 80]]

income from prohibited transactions will be $60.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11278, Feb. 6, 1981]



Sec. 1.857-6  Method of taxation of shareholders of real estate investment trusts.

    (a) Ordinary income. Except as otherwise provided in paragraph (b) 
of this section (relating to capital gains), a shareholder receiving 
dividends from a real estate investment trust shall include such 
dividends in gross income for the taxable year in which they are 
received. See section 858(b) and paragraph (c) of Sec. 1.858-1 for 
treatment by shareholders of dividends paid by a real estate investment 
trust after the close of its taxable year in the case of an election 
under section 858(a).
    (b) Capital gains. Under section 857(b)(3)(B), shareholders of a 
real estate investment trust who receive capital gain dividends (as 
defined in paragraph (e) of this section), in respect of the capital 
gains of a corporation, trust, or association for a taxable year for 
which it is taxable under part II of subchapter M as a real estate 
investment trust, shall treat such capital gain dividends as gains from 
the sale or exchange of capital assets held for more than 1 year (6 
months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) and realized in the taxable year of the 
shareholder in which the dividend was received. In the case of dividends 
with respect to any taxable year of a real estate investment trust 
ending after December 31, 1969, and beginning before January 1, 1975, 
the portion of a shareholder's capital gain dividend which in his hands 
is gain to which section 1201(d) (1) or (2) applies is the portion so 
designated by the real estate investment trust pursuant to paragraph 
(e)(2) of this section.
    (c) Special treatment of loss on the sale or exchange of real estate 
investment trust stock held less than 31 days--(1) In general. Under 
section 857(b)(7), if any person with respect to a share of real estate 
investment trust stock held for a period of less than 31 days, is 
required by section 857(b)(3)(B) to include in gross income as a gain 
from the sale or exchange of a capital asset held for more than 1 year 
(6 months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) the amount of a capital gains dividend, then 
such person shall, to the extent of such amount, treat any loss on the 
sale or exchange of such share as a loss from the sale or exchange of a 
capital asset held for more than 1 year (6 months for taxable years 
beginning before 1977; 9 months for taxable years beginning in 1977).
    (2) Determination of holding period. The rules contained in section 
246(c)(3) (relating to the determination of holding periods for purposes 
of the deduction for dividends received) shall be applied in determining 
whether, for purposes of section 857(b)(7)(B) and this paragraph, a 
share of real estate investment trust stock has been held for a period 
of less than 31 days. In applying those rules, however, ``30 days'' 
shall be substituted for the number of days specified in subparagraph 
(B) of such section.
    (3) Illustration. The application of section 857(b)(7) and this 
paragraph may be illustrated by the following example:

    Example. On December 15, 1961, A purchased a share of stock in the S 
Real Estate Investment Trust for $20. The S trust declared a capital 
gains dividend of $2 per share to shareholders of record on December 31, 
1961. A, therefore, received a capital gain dividend of $2 which, 
pursuant to section 857(b)(3)(B), he must treat as a gain from the sale 
or exchange of a capital asset held for more than six months. On January 
5, 1962, A sold his share of stock in the S trust for $17.50, which sale 
resulted in a loss of $2.50. Under section 857(b)(4) and this paragraph, 
A must treat $2 of such loss (an amount equal to the capital gain 
dividend received with respect to such share of stock) as a loss from 
the sale or exchange of a capital asset held for more than six months.

[[Page 81]]

    (d) Dividend received credit, exclusion, and deduction not allowed. 
Any dividend received from a real estate investment trust which, for the 
taxable year to which the dividend relates, is a qualified real estate 
investment trust, shall not be eligible for the dividend received credit 
(for dividends received on or before December 31, 1964) under section 
34(a), the dividend received exclusion under section 116, or the 
dividend received deduction under section 243.
    (e) Definition of capital gain dividend. (1)(i) A capital gain 
dividend, as defined in section 857(b)(3)(C), is any dividend or part 
thereof which is designated by a real estate investment trust as a 
capital gain dividend in a written notice mailed to its shareholders 
within the period specified in section 857(b)(3)(C) and paragraph (f) of 
this section. If the aggregate amount so designated with respect to the 
taxable year (including capital gain dividends paid after the close of 
the taxable year pursuant to an election under section 858) is greater 
than the net capital gain of the taxable year, the portion of each 
distribution which shall be a capital gain dividend shall be only that 
proportion of the amount so designated which such excess of the net 
long-term capital gain over the net short-term capital loss bears to the 
aggregate of the amount so designated. For example, a real estate 
investment trust making its return on the calendar year basis advised 
its shareholders by written notice mailed December 30, 1961, that 
$200,000 of a distribution of $500,000 made December 15, 1961, 
constituted a capital gain dividend, amounting to $2 per share. It was 
later discovered that an error had been made in determining the net 
capital gain of the taxable year and the net capital gain was $100,000 
instead of $200,000. In such case, each shareholder would have received 
a capital gain dividend of $1 per share instead of $2 per share.
    (ii) For purposes of section 857(b)(3)(C) and this paragraph, the 
net capital gain for a taxable year ending after October 4, 1976, is 
deemed not to exceed the real estate investment trust taxable income 
determined by taking into account the net operating loss deduction for 
the taxable year but not the deduction for dividends paid. See example 2 
in Sec. 1.172-5(a)(4).
    (2) In the case of capital gain dividends designated with respect to 
any taxable year of a real estate investment trust ending after December 
31, 1969, and beginning before January 1, 1975 (including capital gain 
dividends paid after the close of the taxable year pursuant to an 
election under section 858), the real estate investment trust must 
include in its written notice designating the capital gain dividend a 
statement showing the shareholder's proportionate share of such dividend 
which is gain described in section 1201(d)(1) and his proportionate 
share of such dividend which is gain described in section 1201(d)(2). In 
determining the portion of the capital gain dividend which, in the hands 
of a shareholder, is gain described in section 1201(d) (1) or (2), the 
real estate investment trust shall consider that capital gain dividends 
for a taxable year are first made from its long-term capital gains which 
are not described in section 1201(d) (1) or (2), to the extent thereof, 
and then from its long-term capital gains for such year which are 
described in section 1201(d) (1) or (2). A shareholder's proportionate 
share of gains which are described in section 1201(d)(1) is the amount 
which bears the same ratio to the amount paid to him as a capital gain 
dividend in respect of such year as (i) the aggregate amount of the 
trust's gains which are described in section 1201(d)(1) and paid to all 
shareholders bears to (ii) the aggregate amount of the capital gain 
dividend paid to all shareholders in respect of such year. A 
shareholder's proportionate share of gains which are described in 
section 1201(d)(2) shall be determined in a similar manner. Every real 
estate investment trust shall keep a record of the proportion of each 
capital gain divided (to which this subparagraph applies) which is gain 
described in section 1201(d) (1) or (2).
    (f) Mailing of written notice to shareholders--(1) General rule. 
Except as provided in paragraph (f)(2) of this section, the written 
notice designating a dividend or part thereof as a capital gain dividend 
must be mailed to the shareholders not later than 30 days

[[Page 82]]

after the close of the taxable year of the real estate investment trust.
    (2) Net capital gain resulting from a determination. If, as a result 
of a determination (as defined in section 860(e)), occurring after 
October 4, 1976, there is an increase in the amount by which the net 
capital gain exceeds the deduction for dividends paid (determined with 
reference to capital gains dividends only) for the taxable year, then a 
real estate investment trust may designate a dividend (or part thereof) 
as a capital gain dividend in a written notice mailed to its 
shareholders at any time during the 120-day period immediately following 
the date of the determination. The designation may be made with respect 
to a dividend (or part thereof) paid during the taxable year to which 
the determination applies (including a dividend considered as paid 
during the taxable year pursuant to section 858). A deficiency dividend 
(as defined in section 860(f)), or a part thereof, that is paid with 
respect to the taxable year also may be designated as a capital gain 
dividend by the real estate investment trust (or by the acquiring 
corporation to which section 381(c)(25) applies) before the expiration 
of the 120-day period immediately following the determination. However, 
the aggregate amount of the dividends (or parts thereof) that may be 
designated as capital gain dividends after the date of the determination 
shall not exceed the amount of the increase in the excess of the net 
capital gain over the deduction for dividends paid (determined with 
reference to capital gains dividends only) that results from the 
determination. The date of a determination shall be established in 
accordance with Sec. 1.860-2(b)(1).

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C.(856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954); sec. 860(e) (92 Stat. 2849, 26 U.S.C. 
860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 6598, 27 FR 4088, Apr. 28, 1962, as amended by T.D. 6777, 29 FR 
17809, Dec. 16, 1964; T.D. 7337, 39 FR 44974, Dec. 30, 1974; T.D. 7728, 
45 FR 72650, Nov. 3, 1980. Redesignated and amended by T.D. 7767, 46 FR 
11277, 11279, and 11283, Feb. 6, 1981; T.D. 7936, 49 FR 2107, Jan. 18, 
1984; T.D. 8107, 51 FR 43347, Dec. 2, 1986]



Sec. 1.857-7  Earnings and profits of a real estate investment trust.

    (a) Any real estate investment trust whether or not such trust meets 
the requirements of section 857(a) and paragraph (a) of Sec. 1.857-1 for 
any taxable year beginning after December 31, 1960 shall apply paragraph 
(b) of this section in computing its earnings and profits for such 
taxable year.
    (b) In the determination of the earnings and profits of a real 
estate investment trust, section 857(d) provides that such earnings and 
profits for any taxable year (but not the accumulated earnings and 
profits) shall not be reduced by any amount which is not allowable as a 
deduction in computing its taxable income for the taxable year. Thus, if 
a trust would have had earnings and profits of $500,000 for the taxable 
year except for the fact that it had a net capital loss of $100,000, 
which amount was not deductible in determining its taxable income, its 
earnings and profits for that year if it is a real estate investment 
trust would be $500,000. If the real estate investment trust had no 
accumulated earnings and profits at the beginning of the taxable

[[Page 83]]

year, in determining its accumulated earnings and profits as of the 
beginning of the following taxable year, the earnings and profits for 
the taxable year to be considered in such computation would amount to 
$400,000 assuming that there had been no distribution from such earnings 
and profits. If distributions had been made in the taxable year in the 
amount of the earnings and profits then available for distribution, 
$500,000, the trust would have as of the beginning of the following 
taxable year neither accumulated earnings and profits nor a deficit in 
accumulated earnings and profits, and would begin such year with its 
paid-in capital reduced by $100,000, an amount equal to the excess of 
the $500,000 distributed over the $400,000 accumulated earnings and 
profits which would otherwise have been carried into the following 
taxable year. For purposes of section 857(d) and this section, if an 
amount equal to any net loss derived from prohibited transactions is 
included in real estate investment trust taxable income pursuant to 
section 857(b)(2)(F), that amount shall be considered to be an amount 
which is not allowable as a deduction in computing taxable income for 
the taxable year. The earnings and profits for the taxable year (but not 
the accumulated earnings and profits) shall not be considered to be less 
than (i) in the case of a taxable year ending before October 5, 1976, 
the amount (if any) of the net capital gain for the taxable year, or 
(ii) in the case of a taxable year ending after December 31, 1973, the 
amount (if any), of the excess of the net income from foreclosure 
property for the taxable year over the tax imposed thereon by section 
857(b)(4)(A).

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C.(856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4088, Apr. 28, 1962. Redesignated and amended by T.D. 
7767, 46 FR 11277 and 11279, Feb. 6, 1981]



Sec. 1.857-8  Records to be kept by a real estate investment trust.

    (a) In general. Under section 857(a)(2) a real estate investment 
trust is required to keep such records as will disclose the actual 
ownership of its outstanding stock. Thus, every real estate investment 
trust shall maintain in the internal revenue district in which it is 
required to file its income tax return permanent records showing the 
information relative to the actual owners of its stock contained in the 
written statements required by this section to be demanded from its 
shareholders. Such records shall be kept at all times available for 
inspection by any internal revenue officer or employee, and shall be 
retained so long as the contents thereof may become material in the 
administration of any internal revenue law.
    (b) Actual owner of stock. The actual owner of stock of a real 
estate investment trust is the person who is required to include in 
gross income in his return the dividends received on the stock. 
Generally, such person is the shareholder of record of the real estate 
investment trust. However, where the shareholder of record is not the 
actual owner of the stock, the stockholding record of the real estate 
investment trust may not disclose the actual ownership of such stock. 
Accordingly, the

[[Page 84]]

real estate investment trust shall demand written statements from 
shareholders of record disclosing the actual owners of stock as required 
in paragraph (d) of this section.
    (c) Stock ownership for personal holding company determination. For 
the purpose of determining under section 856(a)(6) whether a trust, 
claiming to be a real estate investment trust, is a personal holding 
company, the permanent records of the trust shall show the maximum 
number of shares of the trust (including the number and face value of 
securities convertible into stock of the trust) to be considered as 
actually or constructively owned by each of the actual owners of any of 
its stock at any time during the last half of the trust's taxable year, 
as provided in section 544.
    (d) Statements to be demanded from shareholders. The information 
required by paragraphs (b) and (c) of this section shall be set forth in 
written statements which shall be demanded from shareholders of record 
as follows:
    (1) In the case of a trust having 2,000 or more shareholders of 
record of its stock on any dividend record date, from each record holder 
of 5 percent or more of its stock; or
    (2) In the case of a trust having less than 2,000 and more than 200 
shareholders of record of its stock on any dividend record date, from 
each record holder of 1 percent or more of its stock; or
    (3) In the case of a trust having 200 or less shareholders of record 
of its stock on any dividend record date, from each record holder of 
one-half of 1 percent or more of its stock.
    (e) Demands for statements. The written statements from shareholders 
of record shall be demanded by the real estate investment trust in 
accordance with paragraph (d) of this section within 30 days after the 
close of the real estate investment trust's taxable year (or before June 
1, 1962, whichever is later). When making demand for such written 
statements, the trust shall inform each such shareholder of his duty to 
submit at the time he files his income tax return (or before July 1, 
1962, whichever is later) the statements which are required by 
Sec. 1.857-9 if he fails or refuses to comply with such demand. A list 
of the persons failing or refusing to comply in whole or in part with 
the trust's demand for statements under this section shall be maintained 
as a part of the trust's records required by this section. A trust which 
fails to keep such records to show, to the extent required by this 
section, the actual ownership of its outstanding stock shall be taxable 
as an ordinary corporation and not as a real estate investment trust.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4088, Apr. 28, 1962. Redesignated and amended by T.D. 
7767, 46 FR 11277 and 11279, Feb. 6, 1981]



Sec. 1.857-9  Information required in returns of shareholders.

    (a) In general. Any person who fails or refuses to submit to a real 
estate investment trust the written statements required under 
Sec. 1.857-8 to be demanded by such trust from its shareholders of 
record shall submit at the time he files his income tax return for his 
taxable year which ends with, or includes, the last day of the trust's 
taxable year (or before July 1, 1962, whichever is later) a statement 
setting forth the information required by this section.
    (b) Information required--(1) Shareholder of record not actual 
owner. In the case of any person holding shares of stock in any trust 
claiming to be a real estate investment trust who is not the actual 
owner of such stock, the name and address of each actual owner, the 
number of shares owned by each actual owner at any time during such 
person's taxable year, and the amount of dividends belonging to each 
actual owner.
    (2) Actual owner of shares. In the case of an actual owner of shares 
of stock in any trust claiming to be a real estate investment trust--
    (i) The name and address of each such trust, the number of shares 
actually

[[Page 85]]

owned by him at any and all times during his taxable year, and the 
amount of dividends from each such trust received during his taxable 
year;
    (ii) If shares of any such trust were acquired or disposed of during 
such person's taxable year, the name and address of the trust, the 
number of shares acquired or disposed of, the dates of acquisition or 
disposition, and the names and addresses of the persons from whom such 
shares were acquired or to whom they were transferred;
    (iii) If any shares of stock (including securities convertible into 
stock) of any such trust are also owned by any member of such person's 
family (as defined in section 544(a)(2)), or by any of his partners, the 
name and address of the trust, the names and addresses of such members 
of his family and his partners, and the number of shares owned by each 
such member of his family or partner at any and all times during such 
person's taxable year; and
    (iv) The names and addresses of any corporation, partnership, 
association, or trust, in which such person had a beneficial interest of 
10 percent or more at any time during his taxable year.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4089, Apr. 28, 1962, as amended by T.D. 6628, 27 FR 
12794, Dec. 28, 1962. Redesignated and amended by T.D. 7767, 46 FR 11277 
and 11279, Feb. 6, 1981]



Sec. 1.857-10  Information returns.

    Nothing in Secs. 1.857-8 and 1.857-9 shall be construed to relieve a 
real estate investment trust or its shareholders from the duty of filing 
information returns required by regulations prescribed under the 
provisions of subchapter A, chapter 61 of the Code.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4089, Apr. 28, 1962. Redesignated and amended by T.D. 
7767, 46 FR 11277 and 11279, Feb. 6, 1981]



Sec. 1.857-11  Non-REIT earnings and profits.

    (a) Applicability of section 857(a)(3)(A). A real estate investment 
trust does not satisfy section 857(a)(3)(A) unless--
    (1) Part II of subchapter M applied to the trust for all its taxable 
years beginning after February 28, 1986; and
    (2) For each corporation to whose earnings and profits the trust 
succeeded by the operation of section 381, part II of subchapter M 
applied for all the corporation's taxable years beginning after February 
28, 1986.
    (b) Applicability of section 857(a)(3)(B); in general. A real estate 
investment trust does not satisfy section 857(a)(3)(B) unless, as of the 
close of the taxable year, it has no earnings and profits other than 
earnings and profits that--
    (1) Were earned by a corporation in a year for which part II of 
subchapter M applied to the corporation and, at all times thereafter, 
were the earnings and profits of a corporation to which part II of 
subchapter M applied; or
    (2) By the operation of section 381 pursuant to a transaction that 
occurred before December 22, 1992, became the earnings and profits of a 
corporation to which part II of subchapter M applied and, at all times 
thereafter, were the earnings and profits of a corporation to which part 
II of subchapter M applied.
    (c) Distribution procedures similar to those for regulated 
investment companies

[[Page 86]]

to apply. Distribution procedures similar to those in section 852(e) for 
regulated investment companies apply to non-REIT earnings and profits of 
real estate investment trusts.
    (d) Effective date. This regulation is effective for taxable years 
ending on or after December 22, 1992.
    (e) For treatment of net built-in gain assets of a C corporation 
that become assets of a REIT, see Sec. 1.337(d)-5T.

[T.D. 8483, 58 FR 43798, Aug. 18, 1993; as amended by T.D. 8872, 65 FR 
5777, Feb. 7, 2000]



Sec. 1.858-1  Dividends paid by a real estate investment trust after close of taxable year.

    (a) General rule. Under section 858, a real estate investment trust 
may elect to treat certain dividends that are distributed within a 
specified period after the close of a taxable year as having been paid 
during the taxable year. The dividend is taken into account in 
determining the deduction for dividends paid for the taxable year in 
which it is treated as paid. The dividend may be an ordinary dividend 
or, subject to the requirements of sections 857(b)(3)(C) and 858(c), a 
capital gain dividend. The trust may make the dividend declaration 
required by section 858(a)(1) either before or after the close of the 
taxable year as long as the declaration is made before the time 
prescribed by law for filing its return for the taxable year (including 
the period of any extension of time granted for filing the return).
    (b) Election--(1) Method of making election. The election must be 
made in the return filed by the trust for the taxable year. The election 
shall be made by treating the dividend (or portion thereof) to which the 
election applies as a dividend paid during the taxable year of the trust 
in computing its real estate investment trust taxable income and, if 
applicable, the alternative tax imposed by section 857(b)(3)(A). (In the 
case of an election with respect to a taxable year ending before October 
5, 1976, if the dividend (or portion thereof) to which the election is 
to apply is a capital gain dividend, the trust shall treat the dividend 
as paid during such taxable year in computing the amount of capital 
gains dividends paid during the taxable year.) In the case of an 
election with respect to a taxable year beginning after October 4, 1976, 
the trust must also specify in its return (or in a statement attached to 
its return) the exact dollar amount that is to be treated as having been 
paid during the taxable year.
    (2) Limitation based on earnings and profits. The election provided 
in section 858(a) may be made only to the extent that the earnings and 
profits of the taxable year (computed with the application of sections 
857(d) and Sec. 1.857-7) exceed the total amount of distributions out of 
such earnings and profits actually made during the taxable year. For 
purposes of the preceding sentence, deficiency dividends and 
distributions with respect to which an election has been made for a 
prior year under section 858(a) are disregarded in determining the total 
amount of distributions out of earnings and profits actually made during 
the taxable year. The dividend or portion thereof, with respect to which 
the real estate investment trust has made a valid election under section 
858(a), shall be considered as paid out of the earnings and profits of 
the taxable year for which such election is made, and not out of the 
earnings and profits of the taxable year in which the distribution is 
actually made.
    (3) Additional limitation based on amount specified. The amount 
treated under section 858(a) as having been paid in a taxable year 
beginning after October 4, 1976, cannot exceed the lesser of (i) the 
dollar amount specified by the trust in its return (or a statement 
attached thereto) in making the election or (ii) the amount allowable 
under the limitation prescribed in paragraph (b)(2) of this section.
    (4) Irrevocability of the election. After the expiration of the time 
for filing the return for the taxable year for which an election is made 
under section 858(a), such election shall be irrevocable with respect to 
the dividend or portion thereof to which it applies.
    (c) Receipt by shareholders. Under section 858(b), the dividend or 
portion thereof, with respect to which a valid election has been made, 
will be includable in the gross income of the shareholders of the real 
estate investment trust for the taxable year in which the dividend is 
received by them.

[[Page 87]]

    (d) Illustrations. The application of paragraphs (a), (b), and (c) 
of this section may be illustrated by the following examples:
    Example 1. The X Trust, a real estate investment trust, had taxable 
income (and earnings and profits) for the calendar year 1961 of 
$100,000. During that year the trust distributed to shareholders taxable 
dividends aggregating $88,000. On March 10, 1962, the trust declared a 
dividend of $37,000 payable to shareholders on March 20, 1962. Such 
dividend consisted of the first regular quarterly dividend for 1962 of 
$25,000 plus an additional $12,000 representing that part of the taxable 
income for 1961 which was not distributed in 1961. On March 15, 1962, 
the X Trust filed its Federal income tax return and elected therein to 
treat $12,000 of the total dividend of $37,000 to be paid to 
shareholders on March 20, 1962, as having been paid during the taxable 
year 1961. Assuming that the X Trust actually distributed the entire 
amount of the dividend of $37,000 on March 20, 1962, an amount equal to 
$12,000 thereof will be treated for the purposes of section 857(a) as 
having been paid during the taxable year 1961. Upon distribution of such 
dividend the trust becomes a qualified real estate investment trust for 
the taxable year 1961. Such amount ($12,000) will be considered by the X 
Trust as a distribution out of the earnings and profits for the taxable 
year 1961, and will be treated by the shareholders as a taxable dividend 
for the taxable year in which such distribution is received by them. 
However, assuming that the X Trust is not a qualified real estate 
investment trust for the calendar year 1962, nevertheless, the $12,000 
portion of the dividend (paid on March 20, 1962) which the trust elected 
to relate to the calendar year 1961, will not qualify as a dividend for 
purposes of section 34, 116, or 243.
    Example 2. The Y Trust, a real estate investment trust, had taxable 
income (and earnings and profits) for the calendar year 1964 of 
$100,000, and for 1965 taxable income (and earnings and profits) of 
$125,000. On January 1, 1964, the trust had a deficit in its earnings 
and profits accumulated since February 28, 1913, of $115,000. During the 
year 1964 the trust distributed to shareholders taxable dividends 
aggregating $85,000. On March 5, 1965, the trust declared a dividend of 
$65,000 payable to shareholders on March 31, 1965. On March 15, 1965, 
the Y Trust filed its Federal income tax return in which it included 
$40,000 of the total dividend of $65,000 payable to shareholders on 
March 31, 1965, as a dividend paid by it during the taxable year 1964. 
On March 31, 1965, the Y Trust distributed the entire amount of the 
dividend of $65,000 declared on March 5, 1965. The election under 
section 858(a) is valid only to the extent of $15,000, the amount of the 
undistributed earnings and profits for 1964 ($100,000 earnings and 
profits less $85,000 distributed during 1964). The remainder ($50,000) 
of the $65,000 dividend paid on March 31, 1965, could not be the subject 
of an election, and such amount will be regarded as a distribution by 
the Y Trust out of earnings and profits for the taxable year 1965. 
Assuming that the only other distribution by the Y Trust during 1965 was 
a distribution of $75,000 paid as a dividend on October 31, 1965, the 
total amount of the distribution of $65,000 paid on March 31, 1965, is 
to be treated by the shareholders as taxable dividends for the taxable 
year in which such dividend is received. The Y Trust will treat the 
amount of $15,000 as a distribution of the earnings or profits of the 
trust for the taxable year 1964, and the remaining $50,000 as a 
distribution of the earnings or profits for the year 1965. The 
distribution of $75,000 on October 31, 1966, is, of course, a taxable 
dividend out of the earnings and profits for the year 1965.
    Example 3. Assume the facts are the same as in example 2, except 
that the taxable years involved are calendar years 1977 and 1978, and Y 
Trust specified in its Federal income tax return for 1977 that the 
dollar amount of $40,000 of the $65,000 distribution payable to 
shareholders on March 31, 1978, is to be treated as having been paid in 
1977. The result will be the same as in example 2, since the amount of 
the undistributed earnings and profits for 1977 is less than the $40,000 
amount specified by Y Trust in making its election. Accordingly, the 
election is valid only to the extent of $15,000. Y Trust will treat the 
amount of $15,000 as a distribution, in 1977, of earnings and profits of 
the trust for the taxable year 1977 and the remaining $50,000 as a 
distribution, in 1978, of the earnings and profits for 1978.

    (e) Notice to shareholders. Section 858(c) provides that, in the 
case of dividends with respect to which a real estate investment trust 
has made an election under section 858(a), any notice to shareholders 
required under part II, subchapter M, chapter 1 of the Code, with 
respect to such amounts, shall be made not later than 30 days after the 
close of the taxable year in which the distribution is made. Thus, the 
notice requirement of section 857(b)(3)(C) and paragraph (f) of 
Sec. 1.857-6 with respect to capital gains dividends may be satisfied 
with respect to amounts to which section 858(a) and this section apply 
if the notice relating to such amounts is mailed to the shareholders not 
later than 30 days after the close of the taxable year in which the 
distribution is made. If the notice

[[Page 88]]

under section 858(c) reltes to an election with respect to any capital 
gains dividends, such capital gains dividends shall be aggregated by the 
real estate investment trust with the designated capital gains dividends 
actually paid during the taxable year to which the election applies (not 
including deficiency dividends or dividends with respect to which an 
election has been made for a prior taxable year under section 858) to 
determine whether the aggregate of the designated capital gains 
dividends with respect to such taxable year exceeds the net capital gain 
of the trust. See section 857(b)(3)(C) and paragraph (f) of Sec. 1.857-
6.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4089, Apr. 28, 1962, as amended by T.D. 7767, 46 FR 
11279, Feb. 6, 1981]



Sec. 1.860-1  Deficiency dividends.

    Section 860 allows a qualified investment entity to be relieved from 
the payment of a deficiency in (or to be allowed a credit or refund of) 
certain taxes. ``Qualified investment entity'' is defined in section 
860(b). The taxes referred to are those imposed by sections 852(b) (1) 
and (3), 857(b) (1) or (3), the minimum tax on tax preferences imposed 
by section 56 and, if the entity fails the distribution requirements of 
section 852(a)(1)(A) or 857(a)(1) (as applicable), the corporate income 
tax imposed by section 11(a) or 1201(a). The method provided by section 
860 is to allow an additional deduction for a dividend distribution 
(that meets the requirements of section 860 and Sec. 1.860-2) in 
computing the deduction for dividends paid for the taxable year for 
which the deficiency is determined. A deficiency divided may be an 
ordinary dividend or, subject to the limitations of sections 
852(b)(3)(C), 857(b)(3)(C), and 860(f)(2)(B), may be a capital gain 
dividend.

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; sec. 860(e) (92 Stat. 2849, 
26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7936, 49 FR 2107, Jan. 18, 1984]



Sec. 1.860-2  Requirements for deficiency dividends.

    (a) In general--(1) Determination, etc. A qualified investment 
entity is allowed a deduction for a deficiency dividend only if there is 
a determination (as defined in section 860(e) and paragraph (b)(1) of 
this section) that results in an adjustment (as defined in section 
860(d) (1) or (2)) for the taxable year for which the deficiency 
dividend is paid. An adjustment does not include an increase in the 
excess of (i) the taxpayer's interest income excludable from gross 
income under section 103(a) over (ii) its deductions disallowed under 
sections 265 and 171(a)(2).
    (2) Payment date and claim. The deficiency dividend must be paid on, 
or within 90 days after, the date of the determination and before the 
filing of a claim under section 860(g) and paragraph (b)(2) of this 
section. This claim must be filed within 120 days after the date of the 
determination.
    (3) Nature and amount of distribution. (i) The deficiency dividend 
must be a distribution of property (including money) that would have 
been properly taken into account in computing the dividends paid 
deduction under section 561 for the taxable year for which tax liability 
resulting from the determination exists if the property had been 
distributed during that year. Thus, if the distribution would have been 
a dividend under section 316(a) if it had been made during the taxable 
year for which the determination applies, and the distribution may 
qualify under sections 316(b)(3), 562(a), and 860(f)(1), even though the 
distributing corporation, trust, or association has no current or 
accumulated earnings and profits for the taxable year in which the 
distribution is actually made. The amount of the distribution is 
determined under section 301 as of the date of the distribution.

[[Page 89]]


The amount of the deduction is subject to the applicable limitations 
under sections 562 and 860(f)(2). Thus, if the entity distributes to an 
individual shareholder property (other than money) which on the date of 
the distribution has a fair market value in excess of its adjusted basis 
in the hands of the entity, the amount of the deficiency dividend in the 
individual's hands for purposes of section 316(b)(3) is determined by 
using the property's fair market value on that date. Nevertheless, the 
amount of the deficiency dividend the entity may deduct is limited, 
under Sec. 1.562-1(a), to the adjusted basis of the property and the 
amount taxable to the individual as a dividend is determined by 
reference to the current and accumulated earnings and profits for the 
year to which the determination applies.
    (ii) The qualified investment entity does not have to distribute the 
full amount of the adjustment in order to pay a deficiency dividend. For 
example, assume that in 1983 a determination with respect to a calendar 
year regulated investment company results in an increase of $100 in 
investment company taxable income (computed without the dividends paid 
deduction) for 1981 and no other change. The regulated investment 
company may choose to pay a deficiency dividend of $100 or of any lesser 
amount and be allowed a dividends paid deduction for 1981 for the amount 
of that deficiency dividend.
    (4) Status of distributor. The corporation, trust, or association 
that pays the deficiency dividend does not have to be a qualified 
investment entity at the time of payment.
    (5) Certain definitions to apply. For purposes of sections 860(d) 
(defining adjustment) and (f)(2) (limitations) the definitions of the 
terms ``investment company taxable income,'' ``real estate investment 
trust taxable income,'' and ``capital gains dividends'' in sections 
852(b)(2), 857(b)(2), 852(b)(3)(C), and 857(b)(3)(C) apply, as 
appropriate to the particular entity.
    (b) Determination and claim for deduction--(1) Determination. For 
purposes of applying section 860(e), the following rules apply:
    (i) The date of determination by a decision of the United States Tax 
Court, the date upon which a judgment of a court becomes final, and the 
date of determination by a closing agreement shall be determined under 
the rules in Sec. 1.547-2(b)(1) (ii), (iii), and (iv).
    (ii) A determination under section 860(e)(3) may be made by an 
agreement signed by the district director or another official to whom 
authority to sign the agreement is delegated, and by or on behalf of the 
taxpayer. The agreement shall set forth the amount, if any, of each 
adjustment described in subparagraphs (A), (B), and (C) of section 
860(d) (1) or (2) (as appropriate) for the taxable year and the amount 
of the liability for any tax imposed by section 11(a), 56(a), 852(b)(1), 
852(b)(3)(A), 857(b)(1), 857(b)(3)(A), or 1201(a) for the taxable year. 
The agreement shall also set forth the amount of the limitation 
(determined under section 860(f)(2)) on the amount of deficiency 
dividends that can qualify as capital gain dividends and ordinary 
dividends, respectively, for the taxable year. An agreement under this 
subdivision (ii) which is signed by the district director (or other 
delegate) shall be sent to the taxpayer at its last known address by 
either registered or certified mail. For further guidance regarding the 
definition of last known address, see Sec. 301.6212-2 of this chapter. 
If registered mail is used, the date of registration is the date of 
determination. If certified mail is used, the date of the postmark on 
the sender's receipt is the date of determination. However, if a 
dividend is paid by the taxpayer before the registration or postmark 
date, but on or after the date the agreement is signed by the district 
director (or other delegate), the date of determination is the date of 
signing.
    (2) Claim for deduction. A claim for deduction for a deficiency 
dividend shall be made, with the requisite declaration, on Form 976 and 
shall contain the following information and have the following 
attachments:
    (i) The name, address, and taxpayer identification number of the 
corporation, trust, or association;
    (ii) The amount of the deficiency and the taxable year or years 
involved;
    (iii) The amount of the unpaid deficiency or, if the deficiency has 
been

[[Page 90]]

paid in whole or in part, the date of payment and the amount thereof;
    (iv) A statement as to how the deficiency was established (i.e., by 
an agreement under section 860(e)(3), by a closing agreement under 
section 7121, or by a decision of the Tax Court or court judgment);
    (v) Any date or other information with respect to the determination 
that is required by Form 976;
    (vi) The amount and date of payment of the dividend with respect to 
which the claim for the deduction for deficiency dividends is filed;
    (vii) The amount claimed as a deduction for deficiency dividends;
    (viii) If the amount claimed as a deduction for deficiency dividends 
includes any amount designated (or to be designated) as capital gain 
dividends, the amount of capital gain dividends for which a deficiency 
dividend deduction is claimed;
    (ix) Any other information required by the claim form;
    (x) A certified copy of the resolution of the trustees, directors, 
or other authority authorizing the payment of the dividend with respect 
to which the claim is filed; and
    (xi) A copy of any court decision, judgment, agreement, or other 
document required by Form 976.
    (3) Filing claim. The claim, together with the accompanying 
documents, shall be filed with the district director, or director of the 
internal revenue service center, with whom the income tax return for the 
taxable year for which the determination applies was filed. In the event 
that the determination is an agreement with the district director (or 
other delegate) described in section 860(e)(3) and paragraph (b)(1)(ii) 
of this section, the claim may be filed with the district director with 
whom (or pursuant to whose delegation) the agreement was made.

(The reporting requirements of this section were approved by the Office 
of Management and Budget under control number 1545-0045)

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; sec. 860(e) (92 Stat. 2849, 
26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7936, 49 FR 2107, Jan. 18, 1984; 49 FR 3177, Jan. 26, 1984, as 
amended by T.D. 8939, 66 FR 2819, Jan. 12, 2001]



Sec. 1.860-3  Interest and additions to tax.

    (a) In general. If a qualified investment entity is allowed a 
deduction for deficiency dividends with respect to a taxable year, under 
section 860(c)(1) the tax imposed on the entity by chapter 1 of the Code 
(computed by taking into account the deduction) for that year is deemed 
to be increased by the amount of the deduction. This deemed increase in 
tax, however, applies solely for purposes of determining the liability 
of the entity for interest under subchapter A of chapter 67 of the Code 
and for additions to tax and additional amounts under chapter 68 of the 
Code. For purposes of applying subchapter A of chapter 67 and 68, the 
last date prescribed for payment of the deemed increase in tax is 
considered to be the last date prescribed for the payment of tax 
(determined in the manner provided in section 6601(b)) for the taxable 
year for which the deduction for deficiency dividends is allowed. The 
deemed increase in tax is considered to be paid as of the date that the 
claim for the deficiency dividend deduction described in section 860(g) 
is filed.
    (b) Overpayments of tax. If a qualified investment entity is 
entitled to a credit or refund of an overpayment of the tax imposed by 
chapter 1 of the Code for the taxable year for which the deficiency 
dividend deduction is allowed, then, for purposes of computing interest, 
additions to tax, and additional amounts, the payment (or payments) that 
result in the overpayment and that precede the filing of the claim 
described in section 860(g) will be applied against and reduce the 
increase in tax that is deemed to occur under section 860(c)(1).
    (c) Examples. This section is illustrated by the following examples:

    Example 1. Corporation X is a real estate investment trust that 
files its income tax return on a calendar year basis. X receives an 
extension of time until June 15, 1978, to file its 1977 income tax 
return and files the return on May 15, 1978. X does not elect to pay any 
tax due in installments. For 1977, X reports real estate investment 
trust taxable income (computed without the dividends paid deduction) of 
$100, a dividends paid deduction of $100, and no tax liability. 
Following an examination of X's 1977 return, the district director and X 
enter into an agreement which is a determination under section

[[Page 91]]

860(e)(3). The determination is dated November 1, 1979, and increases 
X's real estate investment trust taxable income (computed without the 
dividends paid deduction) by $20 to $120. Thus, taking into account the 
$100 of dividends paid in 1977, X has undistributed real estate 
investment trust taxable income of $20 as a result of the determination. 
X pays a dividend of $20 on November 10, 1979, files a claim for a 
deficiency dividend deduction of this $20 pursuant to section 860(g) on 
November 15, 1979, and is allowed a deficiency dividend deduction of $20 
for 1977. After taking into account this deduction, X has no real estate 
investment trust taxable income and meets the distribution requirements 
of section 857(a)(1). However, for purposes of section 6601 (relating to 
interest on underpayment of tax), the tax imposed by chapter 1 of the 
Code on X for 1977 is deemed increased by this $20, and the last date 
prescribed for payment of the tax is March 15, 1978 (the due date of the 
1977 return determined without any extension of time). The tax of $20 is 
deemed paid on November 15, 1979, the date the claim for the deficiency 
dividend deduction is filed. Thus, X is liable for interest on $20, at 
the rate established under section 6621, for the period from March 15, 
1978, to November 15, 1979. Also, for purposes of determining whether X 
is liable for any addition to tax or additional amount imposed by 
chapter 68 of the Code (including the penalty prescribed by section 
6697), the amount of tax imposed on X by chapter 1 of the Code is deemed 
to be increased by $20 (the amount of the deficiency dividend deduction 
allowed), the last date prescribed for payment of such tax is March 15, 
1978, and the tax of $20 is deemed to be paid on November 15, 1979. X, 
however, is not subject to interest and penalties for the amount of any 
tax for which it would have been liable under section 11(a), 56(a), 
1201(a), or 857(b) had it not been allowed the $20 deduction for 
deficiency dividends.
    Example 2. Assume the facts are the same as in example (1) except 
that the district director, upon examining X's income tax return, 
asserts an income tax deficiency of $4, based on an asserted increase of 
$10 in real estate investment trust taxable income, and no agreement is 
entered into between the parties. X pays the $4 on June 1, 1979, and 
files suit for refund in the United States District Court. The District 
Court, in a decision which becomes final on November 1, 1980, holds that 
X did fail to report $10 of real estate investment trust taxable income 
and is not entitled to any refund. (No other item of income or deduction 
is in issue.) X pays a dividend of $10 on November 10, 1980, files a 
claim for a deficiency dividend deduction of this $10 on November 15, 
1980, and is allowed a deficiency dividend deduction of $10 for 1977. 
Assume further that $4 is refunded to X on December 31, 1980, as the 
result of the $10 deficiency dividend deduction being allowed. Also 
assume that any assessable penalties, additional amounts, and additions 
to tax (including the penalty imposed by section 6697) for which X is 
liable are paid within 10 days of notice and demand, so that no interest 
is imposed on such penalties, etc. X's liability for interest for the 
period March 15, 1978, to June 1, 1979, is determined with respect to 
$10 (the amount of the deficiency dividend deduction allowed). X's 
liability for interest for the period June 1, 1979, to November 15, 
1980, is determined with respect to $6, i.e., $10 minus the $4 payment. 
X is entitled to interest on the $4 overpayment for the period described 
in section 6611(b)(2), beginning on November 15, 1980.

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; sec. 860(e) (92 Stat. 2849, 
26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7936, 49 FR 2108, Jan. 18, 1984]



Sec. 1.860-4  Claim for credit or refund.

    If the allowance of a deduction for a deficiency dividend results in 
an overpayment of tax, the taxpayer, in order to secure credit or refund 
of the overpayment, must file a claim on Form 1120X in addition to the 
claim for the deficiency dividend deduction required under section 
860(g). The credit or refund will be allowed as if on the date of the 
determination (as defined in section 860(e)) two years remained before 
the expiration of the period of limitations on the filing of claim for 
refund for the taxable year to which the overpayment relates.

(The reporting requirements of this section were approved by the Office 
of Management and Budget under control number 1545-0045)

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; sec. 860(e) (92 Stat. 2849, 
26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7936, 49 FR 2109, Jan. 18, 1984]



Sec. 1.860-5  Effective date.

    (a) In general. Section 860 and Secs. 1.860-1 through 1.860-4 apply 
with respect to determinations after November 6, 1978.
    (b) Prior determination of real estate investments trusts. Section 
859 (as in effect before the enactment of the Revenue Act of 1978) 
applies to determinations with respect to real estate investment trusts 
occurring after October 4, 1976, and before November 7, 1978. In the 
case of such a determination, the rules in Secs. 1.860-1 through 1.860-4 
apply, a reference in this chapter 1 to section 860

[[Page 92]]

(or to a particular provision of section 860) shall be considered to be 
a reference to section 859 (or to the corresponding substantive 
provision of section 859), as in effect before enactment of the Revenue 
Act of 1978, and ``qualified investment entity'' in Secs. 1.381(c)25-
1(a) and 1.860-1 through 1.860-3 means a real estate investment trust.

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; sec. 860(e) (92 Stat. 2849, 
26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7936, 49 FR 2109, Jan. 18, 1984]



Sec. 1.860A-0  Outline of REMIC provisions.

    This section lists the paragraphs contained in Secs. 1.860A-1 
through 1.860G-3.

         Section 1.860A-1  Effective dates and transition rules.

    (a) In general.
    (b) Exceptions.
    (1) Reporting regulations.
    (2) Tax avoidance rules.
    (i) Transfers of certain residual interests.
    (ii) Transfers to foreign holders.
    (iii) Residual interests that lack significant value.
    (3) Excise taxes.
    (4) Rate based on current interest rate.
    (i) In general.
    (ii) Rate based on index.
    (iii) Transition obligations.

      Section 1.860C-1  Taxation of holders of residual interests.

    (a) Pass-thru of income or loss.
    (b) Adjustments to basis of residual interests.
    (1) Increase in basis.
    (2) Decrease in basis.
    (3) Adjustments made before disposition.
    (c) Counting conventions.

  Section 1.860C-2  Determination of REMIC taxable income or net loss.

    (a) Treatment of gain or loss.
    (b) Deductions allowable to a REMIC.
    (1) In general.
    (2) Deduction allowable under section 163.
    (3) Deduction allowable under section 166.
    (4) Deduction allowable under section 212.
    (5) Expenses and interest relating to tax-exempt income.

                Section 1.860D-1  Definition of a REMIC.

    (a) In general.
    (b) Specific requirements.
    (1) Interests in a REMIC.
    (i) In general.
    (ii) De minimis interests.
    (2) Certain rights not treated as interests.
    (i) Payments for services.
    (ii) Stripped interests.
    (iii) Reimbursement rights under credit enhancement contracts.
    (iv) Rights to acquire mortgages.
    (3) Asset test.
    (i) In general.
    (ii) Safe harbor.
    (4) Arrangements test.
    (5) Reasonable arrangements.
    (i) Arrangements to prevent disqualified organizations from holding 
residual interests.
    (ii) Arrangements to ensure that information will be provided.
    (6) Calendar year requirement.
    (c) Segregated pool of assets.
    (1) Formation of REMIC.
    (2) Identification of assets.
    (3) Qualified entity defined.
    (d) Election to be treated as a real estate mortgage investment 
conduit.
    (1) In general.
    (2) Information required to be reported in the REMIC's first taxable 
year.
    (3) Requirement to keep sufficient records.

  Section 1.860E-1  Treatment of taxable income of a residual interest 
                   holder in excess of daily accruals.

    (a) Excess inclusion cannot be offset by otherwise allowable 
deductions.
    (1) In general.
    (2) Affiliated groups.
    (3) Special rule for certain financial institutions.
    (i) In general.
    (ii) Ordering rule.
    (A) In general.
    (B) Example.
    (iii) Significant value.
    (iv) Determining anticipated weighted average life.
    (A) Anticipated weighted average life of the REMIC.
    (B) Regular interests that have a specified principal amount.
    (C) Regular interests that have no specified principal amount or 
that have only a nominal principal amount, and all residual interests.
    (D) Anticipated payments.
    (b) Treatment of a residual interest held by REITs, RICs, common 
trust funds, and subchapter T cooperatives. [Reserved]
    (c) Transfers of noneconomic residual interests.
    (1) In general.
    (2) Noneconomic residual interest.
    (3) Computations.
    (4) Safe harbor for establishing lack of improper knowledge.
    (5) Asset test.
    (6) Definitions for asset test.
    (7) Formula test.

[[Page 93]]

    (8) Conditions and limitations on formula test.
    (9) Examples.
    (10) Effective dates.
    (d) Transfers to foreign persons.

   Section 1.860E-2  Tax on transfers of residual interest to certain 
                             organizations.

    (a) Transfers to disqualified organizations.
    (1) Payment of tax.
    (2) Transitory ownership.
    (3) Anticipated excess inclusions.
    (4) Present value computation.
    (5) Obligation of REMIC to furnish information.
    (6) Agent.
    (7) Relief from liability.
    (i) Transferee furnishes information under penalties of perjury.
    (ii) Amount required to be paid.
    (b) Tax on pass-thru entities.
    (1) Tax on excess inclusions.
    (2) Record holder furnishes information under penalties of perjury.
    (3) Deductibility of tax.
    (4) Allocation of tax.

                Section 1.860F-1  Qualified liquidations.

                 Section 1.860F-2  Transfers to a REMIC.

    (a) Formation of a REMIC.
    (1) In general.
    (2) Tiered arrangements.
    (i) Two or more REMICs formed pursuant to a single set of 
organizational documents.
    (ii) A REMIC and one or more investment trusts formed pursuant to a 
single set of documents.
    (b) Treatment of sponsor.
    (1) Sponsor defined.
    (2) Nonrecognition of gain or loss.
    (3) Basis of contributed assets allocated among interests.
    (i) In general.
    (ii) Organizational expenses.
    (A) Organizational expense defined.
    (B) Syndication expenses.
    (iii) Pricing date.
    (4) Treatment of unrecognized gain or loss.
    (i) Unrecognized gain on regular interests.
    (ii) Unrecognized loss on regular interests.
    (iii) Unrecognized gain on residual interests.
    (iv) Unrecognized loss on residual interests.
    (5) Additions to or reductions of the sponsor's basis.
    (6) Transferred basis property.
    (c) REMIC's basis in contributed assets.

Section 1.860F-4  REMIC reporting requirements and other administrative 
                                 rules.

    (a) In general.
    (b) REMIC tax return.
    (1) In general.
    (2) Income tax return.
    (c) Signing of REMIC return.
    (1) In general.
    (2) REMIC whose startup day is before November 10, 1988.
    (i) In general.
    (ii) Startup day.
    (iii) Exception.
    (d) Designation of tax matters person.
    (e) Notice to holders of residual interests.
    (1) Information required.
    (i) In general.
    (ii) Information with respect to REMIC assets.
    (A) 95 percent asset test.
    (B) Additional information required if the 95 percent test not met.
    (C) For calendar quarters in 1987.
    (D) For calendar quarters in 1988 and 1989.
    (iii) Special provisions.
    (2) Quarterly notice required.
    (i) In general.
    (ii) Special rule for 1987.
    (3) Nominee reporting.
    (i) In general.
    (ii) Time for furnishing statement.
    (4) Reports to the Internal Revenue Service.
    (f) Information returns for persons engaged in a trade or business.

     Section 1.860G-1  Definition of regular and residual interests.

    (a) Regular interest.
    (1) Designation as a regular interest.
    (2) Specified portion of the interest payments on qualified 
mortgages.
    (i) In general.
    (ii) Specified portion cannot vary.
    (iii) Defaulted or delinquent mortgages.
    (iv) No minimum specified principal amount is required.
    (v) Specified portion includes portion of interest payable on 
regular interest.
    (vi) Examples.
    (3) Variable rate.
    (i) Rate based on current interest rate.
    (ii) Weighted average rate.
    (A) In general.
    (B) Reduction in underlying rate.
    (iii) Additions, subtractions, and multiplications.
    (iv) Caps and floors.
    (v) Funds-available caps.
    (A) In general.
    (B) Facts and circumstances test.
    (C) Examples.
    (vi) Combination of rates.
    (4) Fixed terms on the startup day.
    (5) Contingencies prohibited.
    (b) Special rules for regular interests.
    (1) Call premium.
    (2) Customary prepayment penalties received with respect to 
qualified mortgages.
    (3) Certain contingencies disregarded.
    (i) Prepayments, income, and expenses.
    (ii) Credit losses.
    (iii) Subordinated interests.

[[Page 94]]

    (iv) Deferral of interest.
    (v) Prepayment interest shortfalls.
    (vi) Remote and incidental contingencies.
    (4) Form of regular interest.
    (5) Interest disproportionate to principal.
    (i) In general.
    (ii) Exception.
    (6) Regular interest treated as a debt instrument for all Federal 
income tax purposes.
    (c) Residual interest.
    (d) Issue price of regular and residual interests.
    (1) In general.
    (2) The public.

                     Section 1.860G-2  Other rules.

    (a) Obligations principally secured by an interest in real property.
    (1) Tests for determining whether an obligation is principally 
secured.
    (i) The 80-percent test.
    (ii) Alternative test.
    (2) Treatment of liens.
    (3) Safe harbor.
    (i) Reasonable belief that an obligation is principally secured.
    (ii) Basis for reasonable belief.
    (iii) Later discovery that an obligation is not principally secured.
    (4) Interests in real property; real property.
    (5) Obligations secured by an interest in real property.
    (6) Obligations secured by other obligations; residual interests.
    (7) Certain instruments that call for contingent payments are 
obligations.
    (8) Defeasance.
    (9) Stripped bonds and coupons.
    (b) Assumptions and modifications.
    (1) Significant modifications are treated as exchanges of 
obligations.
    (2) Significant modification defined.
    (3) Exceptions.
    (4) Modifications that are not significant modifications.
    (5) Assumption defined.
    (6) Pass-thru certificates.
    (c) Treatment of certain credit enhancement contracts.
    (1) In general.
    (2) Credit enhancement contracts.
    (3) Arrangements to make certain advances.
    (i) Advances of delinquent principal and interest.
    (ii) Advances of taxes, insurance payments, and expenses.
    (iii) Advances to ease REMIC administration.
    (4) Deferred payment under a guarantee arrangement.
    (d) Treatment of certain purchase agreements with respect to 
convertible mortgages.
    (1) In general.
    (2) Treatment of amounts received under purchase agreements.
    (3) Purchase agreement.
    (4) Default by the person obligated to purchase a convertible 
mortgage.
    (5) Convertible mortgage.
    (e) Prepayment interest shortfalls.
    (f) Defective obligations.
    (1) Defective obligation defined.
    (2) Effect of discovery of defect.
    (g) Permitted investments.
    (1) Cash flow investment.
    (i) In general.
    (ii) Payments received on qualified mortgages.
    (iii) Temporary period.
    (2) Qualified reserve funds.
    (3) Qualified reserve asset.
    (i) In general.
    (ii) Reasonably required reserve.
    (A) In general.
    (B) Presumption that a reserve is reasonably required.
    (C) Presumption may be rebutted.
    (h) Outside reserve funds.
    (i) Contractual rights coupled with regular interests in tiered 
arrangements.
    (1) In general.
    (2) Example.
    (j) Clean-up call.
    (1) In general.
    (2) Interest rate changes.
    (3) Safe harbor.
    (k) Startup day.

             Section 1.860G-3  Treatment of foreign persons.

    (a) Transfer of a residual interest with tax avoidance potential.
    (1) In general.
    (2) Tax avoidance potential.
    (i) Defined.
    (ii) Safe harbor.
    (3) Effectively connected income.
    (4) Transfer by a foreign holder.
    (b) [Reserved]

[T.D. 8458, 57 FR 61299, Dec. 24, 1992; 58 FR 15089, Mar. 19, 1993, as 
amended by T.D. 8614, 60 FR 42787, Aug. 17, 1995; T.D. 9004, 67 FR 
47453, July 19, 2002]



Sec. 1.860A-1  Effective dates and transition rules.

    (a) In general. Except as otherwise provided in paragraph (b) of 
this section, the regulations under sections 860A through 860G are 
effective only for a qualified entity (as defined in Sec. 1.860D-
1(c)(3)) whose startup day (as defined in section 860G(a)(9) and 
Sec. 1.860G-2(k)) is on or after November 12, 1991.
    (b) Exceptions--(1) Reporting regulations--(i) Sections 1.860D-1(c) 
(1)

[[Page 95]]

and (3), and Sec. 1.860D-1(d) (1) through (3) are effective after 
December 31, 1986.
    (ii) Sections 1.860F-4 (a) through (e) are effective after December 
31, 1986 and are applicable after that date except as follows:
    (A) Section 1.860F-4(c)(1) is effective for REMICs with a startup 
day on or after November 10, 1988.
    (B) Sections 1.860F-4(e)(1)(ii) (A) and (B) are effective for 
calendar quarters and calendar years beginning after December 31, 1988.
    (C) Section 1.860F-4(e)(1)(ii)(C) is effective for calendar quarters 
and calendar years beginning after December 31, 1986 and ending before 
January 1, 1988.
    (D) Section 1.860F-4(e)(1)(ii)(D) is effective for calendar quarters 
and calendar years beginning after December 31, 1987 and ending before 
January 1, 1990.
    (2) Tax avoidance rules--(i) Transfers of certain residual 
interests. Section 1.860E-1(c) (concerning transfers of noneconomic 
residual interests) and Sec. 1.860G-3(a)(4) (concerning transfers by a 
foreign holder to a United States person) are effective for transfers of 
residual interests on or after September 27, 1991.
    (ii) Transfers to foreign holders. Generally, Sec. 1.860G-3(a) 
(concerning transfers of residual interests to foreign holders) is 
effective for transfers of residual interests after April 20, 1992. 
However, Sec. 1.860G-3(a) does not apply to a transfer of a residual 
interest in a REMIC by the REMIC's sponsor (or by another transferor 
contemporaneously with formation of the REMIC) on or before June 30, 
1992, if--
    (A) The terms of the regular interests and the prices at which 
regular interests were offered had been fixed on or before April 20, 
1992;
    (B) On or before June 30, 1992, a substantial portion of the regular 
interests in the REMIC were transferred, with the terms and at the 
prices that were fixed on or before April 20, 1992, to investors who 
were unrelated to the REMIC's sponsor at the time of the transfer; and
    (C) At the time of the transfer of the residual interest, the 
expected future distributions on the residual interest were equal to at 
least 30 percent of the anticipated excess inclusions (as defined in 
Sec. 1.860E-2(a)(3)), and the transferor reasonably expected that the 
transferee would receive sufficient distributions from the REMIC at or 
after the time at which the excess inclusions accrue in an amount 
sufficient to satisfy the taxes on the excess inclusions.
    (iii) Residual interests that lack significant value. The 
significant value requirement in Sec. 1.860E-1(a) (1) and (3) 
(concerning excess inclusions accruing to organizations to which section 
593 applies) generally is effective for residual interests acquired on 
or after September 27, 1991. The significant value requirement in 
Sec. 1.860E-1(a) (1) and (3) does not apply, however, to residual 
interests acquired by an organization to which section 593 applies as a 
sponsor at formation of a REMIC in a transaction described in 
Sec. 1.860F-2(a)(1) if more than 50 percent of the interests in the 
REMIC (determined by reference to issue price) were sold to unrelated 
investors before November 12, 1991. The exception from the significant 
value requirement provided by the preceding sentence applies only so 
long as the sponsor owns the residual interests.
    (3) Excise taxes. Section 1.860E-2(a)(1) is effective for transfers 
of residual interests to disqualified organizations after March 31, 
1988. Section 1.860E-2(b)(1) is effective for excess inclusions accruing 
to pass-thru entities after March 31, 1988.
    (4) Rate based on current interest rate--(i) In general. Section 
1.860G-1(a)(3)(i) applies to obligations (other than transition 
obligations described in paragraph (b)(4)(iii) of this section) intended 
to qualify as regular interests that are issued on or after April 4, 
1994.
    (ii) Rate based on index. Section 1.860G-1(a)(3)(i) (as contained in 
26 CFR part 1 revised as of April 1, 1994) applies to obligations 
intended to qualify as regular interests that--
    (A) Are issued by a qualified entity (as defined in Sec. 1.860D-
1(c)(3)) whose startup date (as defined in section 860G(a)(9) and 
Sec. 1.860G-2(k)) is on or after November 12, 1991; and
    (B) Are either--
    (1) Issued before April 4, 1994; or
    (2) Transition obligations described in paragraph (b)(4)(iii) of 
this section.

[[Page 96]]

    (iii) Transition obligations. Obligations are described in this 
paragraph (b)(4)(iii) if--
    (A) The terms of the obligations and the prices at which the 
obligations are offered are fixed before April 4, 1994; and
    (B) On or before June 1, 1994, a substantial portion of the 
obligations are transferred, with the terms and at the prices that are 
fixed before April 4, 1994, to investors who are unrelated to the 
REMIC's sponsor at the time of the transfer.

[T.D. 8458, 57 FR 61300, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; 58 FR 
15089, Mar. 19, 1993; T.D. 8614, 60 FR 42787, Aug. 17, 1995]



Sec. 1.860C-1  Taxation of holders of residual interests.

    (a) Pass-thru of income or loss. Any holder of a residual interest 
in a REMIC must take into account the holder's daily portion of the 
taxable income or net loss of the REMIC for each day during the taxable 
year on which the holder owned the residual interest.
    (b) Adjustments to basis of residual interests--(1) Increase in 
basis. A holder's basis in a residual interest is increased by--
    (i) The daily portions of taxable income taken into account by that 
holder under section 860C(a) with respect to that interest; and
    (ii) The amount of any contribution described in section 860G(d)(2) 
made by that holder.
    (2) Decrease in basis. A holder's basis in a residual interest is 
reduced (but not below zero) by--
    (i) First, the amount of any cash or the fair market value of any 
property distributed to that holder with respect to that interest; and
    (ii) Second, the daily portions of net loss of the REMIC taken into 
account under section 860C(a) by that holder with respect to that 
interest.
    (3) Adjustments made before disposition. If any person disposes of a 
residual interest, the adjustments to basis prescribed in paragraph (b) 
(1) and (2) of this section are deemed to occur immediately before the 
disposition.
    (c) Counting conventions. For purposes of determining the daily 
portion of REMIC taxable income or net loss under section 860C(a)(2), 
any reasonable convention may be used. An example of a reasonable 
convention is ``30 days per month/90 days per quarter/360 days per 
year.''

[T.D. 8458, 57 FR 61301, Dec. 24, 1992]



Sec. 1.860C-2  Determination of REMIC taxable income or net loss.

    (a) Treatment of gain or loss. For purposes of determining the 
taxable income or net loss of a REMIC under section 860C(b), any gain or 
loss from the disposition of any asset, including a qualified mortgage 
(as defined in section 860G(a)(3)) or a permitted investment (as defined 
in section 860G(a)(5) and Sec. 1.860G-2(g)), is treated as gain or loss 
from the sale or exchange of property that is not a capital asset.
    (b) Deductions allowable to a REMIC--(1) In general. Except as 
otherwise provided in section 860C(b) and in paragraph (b) (2) through 
(5) of this section, the deductions allowable to a REMIC for purposes of 
determining its taxable income or net loss are those deductions that 
would be allowable to an individual, determined by taking into account 
the same limitations that apply to an individual.
    (2) Deduction allowable under section 163. A REMIC is allowed a 
deduction, determined without regard to section 163(d), for any interest 
expense accrued during the taxable year.
    (3) Deduction allowable under section 166. For purposes of 
determining a REMIC's bad debt deduction under section 166, debt owed to 
the REMIC is not treated as nonbusiness debt under section 166(d).
    (4) Deduction allowable under section 212. A REMIC is not treated as 
carrying on a trade or business for purposes of section 162. Ordinary 
and necessary operating expenses paid or incurred by the REMIC during 
the taxable year are deductible under section 212, without regard to 
section 67. Any expenses that are incurred in connection with the 
formation of the REMIC and that relate to the organization of the REMIC 
and the issuance of regular and residual interests are not treated as 
expenses of the REMIC for which a deduction is allowable under section 
212. See Sec. 1.860F-2(b)(3)(ii) for treatment of those expenses.

[[Page 97]]

    (5) Expenses and interest relating to tax-exempt income. Pursuant to 
section 265(a), a REMIC is not allowed a deduction for expenses and 
interest allocable to tax-exempt income. The portion of a REMIC's 
interest expense that is allocable to tax-exempt interest is determined 
in the manner prescribed in section 265(b)(2), without regard to section 
265(b)(3).

[T.D. 8458, 57 FR 61301, Dec. 24, 1992]



Sec. 1.860D-1  Definition of a REMIC.

    (a) In general. A real estate mortgage investment conduit (or REMIC) 
is a qualified entity, as defined in paragraph (c)(3) of this section, 
that satisfies the requirements of section 860D(a). See paragraph (d)(1) 
of this section for the manner of electing REMIC status.
    (b) Specific requirements--(1) Interests in a REMIC--(i) In general. 
A REMIC must have one class, and only one class, of residual interests. 
Except as provided in paragraph (b)(1)(ii) of this section, every 
interest in a REMIC must be either a regular interest (as defined in 
section 860G(a)(1) and Sec. 1.860G-1(a)) or a residual interest (as 
defined in section 860G(a)(2) and Sec. 1.860G-1(c)).
    (ii) De minimis interests. If, to facilitate the creation of an 
entity that elects REMIC status, an interest in the entity is created 
and, as of the startup day (as defined in section 860G(a)(9) and 
Sec. 1.860G-2(k)), the fair market value of that interest is less than 
the lesser of $1,000 or 1/1,000 of one percent of the aggregate fair 
market value of all the regular and residual interests in the REMIC, 
then, unless that interest is specifically designated as an interest in 
the REMIC, the interest is not treated as an interest in the REMIC for 
purposes of section 860D(a) (2) and (3) and paragraph (B)(1)(i) of this 
section.
    (2) Certain rights not treated as interests. Certain rights are not 
treated as interests in a REMIC. Although not an exclusive list, the 
following rights are not interests in a REMIC.
    (i) Payments for services. The right to receive from the REMIC 
payments that represent reasonable compensation for services provided to 
the REMIC in the ordinary course of its operation is not an interest in 
the REMIC. Payments made by the REMIC in exchange for services may be 
expressed as a specified percentage of interest payments due on 
qualified mortgages or as a specified percentage of earnings from 
permitted investments. For example, a mortgage servicer's right to 
receive reasonable compensation for servicing the mortgages owned by the 
REMIC is not an interest in the REMIC.
    (ii) Stripped interests. Stripped bonds or stripped coupons not held 
by the REMIC are not interests in the REMIC even if, in a transaction 
preceding or contemporaneous with the formation of the REMIC, they and 
the REMIC's qualified mortgages were created from the same mortgage 
obligation. For example, the right of a mortgage servicer to receive a 
servicing fee in excess of reasonable compensation from payments it 
receives on mortgages held by a REMIC is not an interest in the REMIC. 
Further, if an obligation with a fixed principal amount provides for 
interest at a fixed or variable rate and for certain contingent payment 
rights (e.g., a shared appreciation provision or a percentage of 
mortgagor profits provision), and the owner of the obligation 
contributes the fixed payment rights to a REMIC and retains the 
contingent payment rights, the retained contingent payment rights are 
not an interest in the REMIC.
    (iii) Reimbursement rights under credit enhancement contracts. A 
credit enhancer's right to be reimbursed for amounts advanced to a REMIC 
pursuant to the terms of a credit enhancement contract (as defined in 
Sec. 1.860G-2 (c)(2)) is not an interest in the REMIC even if the credit 
enhancer is entitled to receive interest on the amounts advanced.
    (iv) Rights to acquire mortgages. The right to acquire or the 
obligation to purchase mortgages and other assets from a REMIC pursuant 
to a clean-up call (as defined in Sec. 1.860G-2(j)) or a qualified 
liquidation (as defined in section 860F(a)(4)), or on conversion of a 
convertible mortgage (as defined in Sec. 1.860G-2(d)(5)), is not an 
interest in the REMIC.
    (3) Asset test--(i) In general. For purposes of the asset test of 
section

[[Page 98]]

860D(a)(4), substantially all of a qualified entity's assets are 
qualified mortgages and permitted investments if the qualified entity 
owns no more than a de minimis amount of other assets.
    (ii) Safe harbor. The amount of assets other than qualified 
mortgages and permitted investments is de minimis if the aggregate of 
the adjusted bases of those assets is less than one percent of the 
aggregate of the adjusted bases of all of the REMIC's assets. 
Nonetheless, a qualified entity that does not meet this safe harbor may 
demonstrate that it owns no more than a de minimis amount of other 
assets.
    (4) Arrangements test. Generally, a qualified entity must adopt 
reasonable arrangements designed to ensure that--
    (i) Disqualified organizations (as defined in section 860E(e)(5)) do 
not hold residual interests in the qualified entity; and
    (ii) If a residual interest is acquired by a disqualified 
organization, the qualified entity will provide to the Internal Revenue 
Service, and to the persons specified in section 860E(e)(3), information 
needed to compute the tax imposed under section 860E(e) on transfers of 
residual interests to disqualified organizations.
    (5) Reasonable arrangements--(i) Arrangements to prevent 
disqualified organizations from holding residual interests. A qualified 
entity is considered to have adopted reasonable arrangements to ensure 
that a disqualified organization (as defined in section 860E(e)(5)) will 
not hold a residual interest if--
    (A) The residual interest is in registered form (as defined in 
Sec. 5f.103-1(c) of this chapter); and
    (B) The qualified entity's organizational documents clearly and 
expressly prohibit a disqualified organization from acquiring beneficial 
ownership of a residual interest, and notice of the prohibition is 
provided through a legend on the document that evidences ownership of 
the residual interest or through a conspicuous statement in a prospectus 
or private offering document used to offer the residual interest for 
sale.
    (ii) Arrangements to ensure that information will be provided. A 
qualified entity is considered to have made reasonable arrangements to 
ensure that the Internal Revenue Service and persons specified in 
section 860E(e)(3) as liable for the tax imposed under section 860E(e) 
receive the information needed to compute the tax if the qualified 
entity's organizational documents require that it provide to the 
Internal Revenue Service and those persons a computation showing the 
present value of the total anticipated excess inclusions with respect to 
the residual interest for periods after the transfer. See Sec. 1.860E-
2(a)(5) for the obligation to furnish information on request.
    (6) Calendar year requirement. A REMIC's taxable year is the 
calendar year. The first taxable year of a REMIC begins on the startup 
day and ends on December 31 of the same year. If the startup day is 
other than January 1, the REMIC has a short first taxable year.
    (c) Segregated pool of assets--(1) Formation of REMIC. A REMIC may 
be formed as a segregated pool of assets rather than as a separate 
entity. To constitute a REMIC, the assets identified as part of the 
segregated pool must be treated for all Federal income tax purposes as 
assets of the REMIC and interests in the REMIC must be based solely on 
assets of the REMIC.
    (2) Identification of assets. Formation of the REMIC does not occur 
until--
    (i) The sponsor identifies the assets of the REMIC, such as through 
execution of an indenture with respect to the assets; and
    (ii) The REMIC issues the regular and residual interests in the 
REMIC.
    (3) Qualified entity defined. For purposes of this section, the term 
``qualified entity'' includes an entity or a segregated pool of assets 
within an entity.
    (d) Election to be treated as a real estate mortgage investment 
conduit--(1) In general. A qualified entity, as defined in paragraph 
(c)(3) of this section, elects to be treated as a REMIC by timely 
filing, for the first taxable year of its existence, a Form 1066, U.S. 
Real Estate Mortgage Investment Conduit Income Tax Return, signed by a 
person authorized to sign that return under Sec. 1.860F-4(c). See 
Sec. 1.9100-1 for rules regarding

[[Page 99]]

extensions of time for making elections. Once made, this election is 
irrevocable for that taxable year and all succeeding taxable years.
    (2) Information required to be reported in the REMIC's first taxable 
year. For the first taxable year of the REMIC's existence, the qualified 
entity, as defined in paragraph (c)(3) of this section, must provide 
either on its return or in a separate statement attached to its return--
    (i) The REMIC's employer identification number, which must not be 
the same as the identification number of any other entity,
    (ii) Information concerning the terms and conditions of the regular 
interests and the residual interest of the REMIC, or a copy of the 
offering circular or prospectus containing such information,
    (iii) A description of the prepayment and reinvestment assumptions 
that are made pursuant to section 1272(a)(6) and the regulations 
thereunder, including a statement supporting the selection of the 
prepayment assumption,
    (iv) The form of the electing qualified entity under State law or, 
if an election is being made with respect to a segregated pool of assets 
within an entity, the form of the entity that holds the segregated pool 
of assets, and
    (v) Any other information required by the form.
    (3) Requirement to keep sufficient records. A qualified entity, as 
defined in paragraph (c)(3) of this section, that elects to be a REMIC 
must keep sufficient records concerning its investments to show that it 
has complied with the provisions of sections 860A through 860G and the 
regulations thereunder during each taxable year.

[T.D. 8366, 56 FR 49516, Sept. 30, 1991; T.D. 8458, 57 FR 61301, Dec. 
24, 1992]



Sec. 1.860E-1  Treatment of taxable income of a residual interest holder in excess of daily accruals.

    (a) Excess inclusion cannot be offset by otherwise allowable 
deductions--(1) In general. Except as provided in paragraph (a)(3) of 
this section, the taxable income of any holder of a residual interest 
for any taxable year is in no event less than the sum of the excess 
inclusions attributable to that holder's residual interests for that 
taxable year. In computing the amount of a net operating loss (as 
defined in section 172(c)) or the amount of any net operating loss 
carryover (as defined in section 172(b)(2)), the amount of any excess 
inclusion is not included in gross income or taxable income. Thus, for 
example, if a residual interest holder has $100 of gross income, $25 of 
which is an excess inclusion, and $90 of business deductions, the holder 
has taxable income of $25, the amount of the excess inclusion, and a net 
operating loss of $15 ($75 of other income - $90 of business 
deductions).
    (2) Affiliated groups. If a holder of a REMIC residual interest is a 
member of an affiliated group filing a consolidated income tax return, 
the taxable income of the affiliated group cannot be less than the sum 
of the excess inclusions attributable to all residual interests held by 
members of the affiliated group.
    (3) Special rule for certain financial institutions--(i) In general. 
If an organization to which section 593 applies holds a residual 
interest that has significant value (as defined in paragraph (a)(3)(iii) 
of this section), section 860E(a)(1) and paragraph (a)(1) of this 
section do not apply to that organization with respect to that interest. 
Consequently, an organization to which section 593 applies may use its 
allowable deductions to offset an excess inclusion attributable to a 
residual interest that has significant value, but, except as provided in 
section 860E(a)(4)(A), may not use its allowable deductions to offset an 
excess inclusion attributable to a residual interest held by any other 
member of an affiliated group, if any, of which the organization is a 
member. Further, a net operating loss of any other member of an 
affiliated group of which the organization is a member may not be used 
to offset an excess inclusion attributable to a residual interest held 
by that organization.
    (ii) Ordering rule--(A) In general. In computing taxable income for 
any year, an organization to which section 593 applies is treated as 
having applied its allowable deductions for the year first to offset 
that portion of its gross income that is not an excess inclusion

[[Page 100]]

and then to offset that portion of its income that is an excess 
inclusion.
    (B) Example. The following example illustrates the provisions of 
paragraph (a)(3)(ii) of this section:

    Example. Corp. X, a corporation to which section 593 applies, is a 
member of an affiliated group that files a consolidated return. For a 
particular taxable year, Corp. X has gross income of $1,000, and of this 
amount, $150 is an excess inclusion attributable to a residual interest 
that has significant value. Corp. X has $975 of allowable deductions for 
the taxable year. Corp. X must apply its allowable deductions first to 
offset the $850 of gross income that is not an excess inclusion, and 
then to offset the portion of its gross income that is an excess 
inclusion. Thus, Corp. X has $25 of taxable income ($1,000-$975), and 
that $25 is an excess inclusion that may not be offset by losses 
sustained by other members of the affiliated group.

    (iii) Significant value. A residual interest has significant value 
if--
    (A) The aggregate of the issue prices of the residual interests in 
the REMIC is at least 2 percent of the aggregate of the issue prices of 
all residual and regular interests in the REMIC; and
    (B) The anticipated weighted average life of the residual interests 
is at least 20 percent of the anticipated weighted average life of the 
REMIC.
    (iv) Determining anticipated weighted average life--(A) Anticipated 
weighted average life of the REMIC. The anticipated weighted average 
life of a REMIC is the weighted average of the anticipated weighted 
average lives of all classes of interests in the REMIC. This weighted 
average is determined under the formula in paragraph (a)(3)(iv)(B) of 
this section, applied by treating all payments taken into account in 
computing the anticipated weighted average lives of regular and residual 
interests in the REMIC as principal payments on a single regular 
interest.
    (B) Regular interests that have a specified principal amount. 
Generally, the anticipated weighted average life of a regular interest 
is determined by--
    (1) Multiplying the amount of each anticipated principal payment to 
be made on the interest by the number of years (including fractions 
thereof) from the startup day (as defined in section 860G(a)(9) and 
Sec. 1.860G-2(k)) to the related principal payment date;
    (2) Adding the results; and
    (3) Dividing the sum by the total principal paid on the regular 
interest.
    (C) Regular interests that have no specified principal amount or 
that have only a nominal principal amount, and all residual interests. 
If a regular interest has no specified principal amount, or if the 
interest payments to be made on a regular interest are 
disproportionately high relative to its specified principal amount (as 
determined by reference to Sec. 1.860G-1(b)(5)(i)), then, for purposes 
of computing the anticipated weighted average life of the interest, all 
anticipated payments on that interest, regardless of their designation 
as principal or interest, must be taken into account in applying the 
formula set out in paragraph (a)(3)(iv)(B) of this section. Moreover, 
for purposes of computing the weighted average life of a residual 
interest, all anticipated payments on that interest, regardless of their 
designation as principal or interest, must be taken into account in 
applying the formula set out in paragraph (a)(3)(iv)(B) of this section.
    (D) Anticipated payments. The anticipated principal payments to be 
made on a regular interest subject to paragraph (a)(3)(iv)(B) of this 
section, and the anticipated payments to be made on a regular interest 
subject to paragraph (a)(3)(iv)(C) of this section or on a residual 
interest, must be determined based on--
    (1) The prepayment and reinvestment assumptions adopted under 
section 1272(a)(6), or that would have been adopted had the REMIC's 
regular interests been issued with original issue discount; and
    (2) Any required or permitted clean up calls or any required 
qualified liquidation provided for in the REMIC's organizational 
documents.
    (b) Treatment of residual interests held by REITs, RICs, common 
trust funds, and subchapter T cooperatives. [Reserved]
    (c) Transfers of noneconomic residual interests--(1) In general. A 
transfer of a noneconomic residual interest is disregarded for all 
Federal tax purposes if a significant purpose of the transfer was to 
enable the transferor to impede the assessment or collection of tax. A 
significant purpose to impede the assessment or collection of tax exists 
if

[[Page 101]]

the transferor, at the time of the transfer, either knew or should have 
known (had ``improper knowledge'') that the transferee would be 
unwilling or unable to pay taxes due on its share of the taxable income 
of the REMIC.
    (2) Noneconomic residual interest. A residual interest is a 
noneconomic residual interest unless, at the time of the transfer--
    (i) The present value of the expected future distributions on the 
residual interest at least equals the product of the present value of 
the anticipated excess inclusions and the highest rate of tax specified 
in section 11(b)(1) for the year in which the transfer occurs; and
    (ii) The transferor reasonably expects that, for each anticipated 
excess inclusion, the transferee will receive distributions from the 
REMIC at or after the time at which the taxes accrue on the anticipated 
excess inclusion in an amount sufficient to satisfy the accrued taxes.
    (3) Computations. The present value of the expected future 
distributions and the present value of the anticipated excess inclusions 
must be computed under the procedure specified in Sec. 1.860E-2(a)(4) 
for determining the present value of anticipated excess inclusions in 
connection with the transfer of a residual interest to a disqualified 
organization.
    (4) Safe harbor for establishing lack of improper knowledge. A 
transferor is presumed not to have improper knowledge if--
    (i) The transferor conducted, at the time of the transfer, a 
reasonable investigation of the financial condition of the transferee 
and, as a result of the investigation, the transferor found that the 
transferee had historically paid its debts as they came due and found no 
significant evidence to indicate that the transferee will not continue 
to pay its debts as they come due in the future;
    (ii) The transferee represents to the transferor that it understands 
that, as the holder of the noneconomic residual interest, the transferee 
may incur tax liabilities in excess of any cash flows generated by the 
interest and that the transferee intends to pay taxes associated with 
holding the residual interest as they become due;
    (iii) The transferee represents that it will not cause income from 
the noneconomic residual interest to be attributable to a foreign 
permanent establishment or fixed base (within the meaning of an 
applicable income tax treaty) of the transferee or another U.S. 
taxpayer; and
    (iv) The transfer satisfies either the asset test in paragraph 
(c)(5) of this section or the formula test in paragraph (c)(7) of this 
section.
    (5) Asset test. The transfer satisfies the asset test if it meets 
the requirements of paragraphs (c)(5)(i), (ii) and (iii) of this 
section.
    (i) At the time of the transfer, and at the close of each of the 
transferee's two fiscal years preceding the transferee's fiscal year of 
transfer, the transferee's gross assets for financial reporting purposes 
exceed $100 million and its net assets for financial reporting purposes 
exceed $10 million. For purposes of the preceding sentence, the gross 
assets and net assets of a transferee do not include any obligation of 
any related person (as defined in paragraph (c)(6)(ii) of this section) 
or any other asset if a principal purpose for holding or acquiring the 
other asset is to permit the transferee to satisfy the conditions of 
this paragraph (c)(5)(i).
    (ii) The transferee must be an eligible corporation (defined in 
paragraph (c)(6)(i) of this section) and must agree in writing that any 
subsequent transfer of the interest will be to another eligible 
corporation in a transaction that satisfies paragraphs (c)(4)(i), (ii), 
and (iii) and this paragraph (c)(5). The direct or indirect transfer of 
the residual interest to a foreign permanent establishment (within the 
meaning of an applicable income tax treaty) of a domestic corporation is 
a transfer that is not a transfer to an eligible corporation. A transfer 
also fails to meet the requirements of this paragraph (c)(5)(ii) if the 
transferor knows, or has reason to know, that the transferee will not 
honor the restrictions on subsequent transfers of the residual interest.
    (iii) A reasonable person would not conclude, based on the facts and 
circumstances known to the transferor on or before the date of the 
transfer, that the taxes associated with the residual

[[Page 102]]

interest will not be paid. The consideration given to the transferee to 
acquire the noneconomic residual interest in the REMIC is only one 
factor to be considered, but the transferor will be deemed to know that 
the transferee cannot or will not pay if the amount of consideration is 
so low compared to the liabilities assumed that a reasonable person 
would conclude that the taxes associated with holding the residual 
interest will not be paid. In determining whether the amount of 
consideration is too low, the specific terms of the formula test in 
paragraph (c)(7) of this section need not be used.
    (6) Definitions for asset test. The following definitions apply for 
purposes of paragraph (c)(5) of this section:
    (i) Eligible corporation means any domestic C corporation (as 
defined in section 1361(a)(2)) other than--
    (A) A corporation which is exempt from, or is not subject to, tax 
under section 11;
    (B) An entity described in section 851(a) or 856(a);
    (C) A REMIC; or
    (D) An organization to which part I of subchapter T of chapter 1 of 
subtitle A of the Internal Revenue Code applies.
    (ii) Related person is any person that--
    (A) Bears a relationship to the transferee enumerated in section 
267(b) or 707(b)(1), using ``20 percent'' instead of ``50 percent'' 
where it appears under the provisions; or
    (B) Is under common control (within the meaning of section 52(a) and 
(b)) with the transferee.
    (7) Formula test. The transfer satisfies the formula test if the 
present value of the anticipated tax liabilities associated with holding 
the residual interest does not exceed the sum of--
    (i) The present value of any consideration given to the transferee 
to acquire the interest;
    (ii) The present value of the expected future distributions on the 
interest; and
    (iii) The present value of the anticipated tax savings associated 
with holding the interest as the REMIC generates losses.
    (8) Conditions and limitations on formula test. The following rules 
apply for purposes of the formula test in paragraph (c)(7) of this 
section.
    (i) The transferee is assumed to pay tax at a rate equal to the 
highest rate of tax specified in section 11(b)(1). If the transferee has 
been subject to the alternative minimum tax under section 55 in the 
preceding two years and will compute its taxable income in the current 
taxable year using the alternative minimum tax rate, then the tax rate 
specified in section 55(b)(1)(B) may be used in lieu of the highest rate 
specified in section 11(b)(1).
    (ii) The direct or indirect transfer of the residual interest to a 
foreign permanent establishment or fixed base (within the meaning of an 
applicable income tax treaty) of a domestic transferee is not eligible 
for the formula test.
    (iii) Present values are computed using a discount rate equal to the 
Federal short-term rate prescribed by section 1274(d) for the month of 
the transfer and the compounding period used by the taxpayer.
    (9) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Transfer to partnership. X transfers a noneconomic 
residual interest in a REMIC to Partnership P in a transaction that does 
not satisfy the formula test of paragraph (c)(7) of this section. Y and 
Z are the partners of P. Even if Y and Z are eligible corporations that 
satisfy the requirements of paragraph (c)(5)(i) of this section, the 
transfer fails to satisfy the asset test requirements found in paragraph 
(c)(5)(ii) of this section because P is a partnership rather than an 
eligible corporation within the meaning of (c)(6)(i) of this section.
    Example 2. Transfer to a corporation without capacity to carry 
additional residual interests. During the first ten months of a year, 
Bank transfers five residual interests to Corporation U under 
circumstances meeting the requirements of the asset test in paragraph 
(c)(5) of this section. Bank is the major creditor of U and consequently 
has access to U's financial records and has knowledge of U's financial 
circumstances. During the last month of the year, Bank transfers three 
additional residual interests to U in a transaction that does not meet 
the formula test of paragraph (c)(7) of this section. At the time of 
this transfer, U's financial records indicate it has retained the 
previously transferred residual interests. U's financial circumstances, 
including the aggregate tax liabilities it has assumed with respect to

[[Page 103]]

REMIC residual interests, would cause a reasonable person to conclude 
that U will be unable to meet its tax liabilities when due. The 
transfers in the last month of the year fail to satisfy the 
investigation requirement in paragraph (c)(4)(i) of this section and the 
asset test requirement of paragraph (c)(5)(iii) of this section because 
Bank has reason to know that U will not be able to pay the tax due on 
those interests.
    Example 3. Transfer to a foreign permanent establishment of an 
eligible corporation. R transfers a noneconomic residual interest in a 
REMIC to the foreign permanent establishment of Corporation T. Solely 
because of paragraph (c)(8)(ii) of this section, the transfer does not 
satisfy the formula test of paragraph (c)(7) of this section. In 
addition, even if T is an eligible corporation, the transfer does not 
satisfy the asset test because the transfer fails the requirements of 
paragraph (c)(5)(ii) of this section.

    (10) Effective dates. Paragraphs (c)(4) through (c)(9) of this 
section are applicable to transfers occurring on or after February 4, 
2000, except for paragraphs (c)(4)(iii) and (c)(8)(iii) of this section, 
which are applicable for transfers occurring on or after August 19, 
2002. For the dates of applicability of paragraphs (a) through (c)(3) 
and (d) of this section, see Sec. 1.860A-1.
    (d) Transfers to foreign persons. Paragraph (c) of this section does 
not apply to transfers of residual interests to which Sec. 1.860G-
3(a)(1), concerning transfers to certain foreign persons, applies.

[T.D. 8458, 57 FR 61302, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; T.D. 
9004, 67 FR 47453, July 19, 2002]



Sec. 1.860E-2  Tax on transfers of residual interests to certain organizations.

    (a) Transfers to disqualified organizations--(1) Payment of tax. Any 
excise tax due under section 860E(e)(1) must be paid by the later of 
March 24, 1993, or April 15th of the year following the calendar year in 
which the residual interest is transferred to a disqualified 
organization. The Commissioner may prescribe rules for the manner and 
method of collecting the tax.
    (2) Transitory ownership. For purposes of section 860E (e) and this 
section, a transfer of a residual interest to a disqualified 
organization in connection with the formation of a REMIC is disregarded 
if the disqualified organization has a binding contract to sell the 
interest and the sale occurs within 7 days of the startup day (as 
defined in section 860G(a)(9) and Sec. 1.860G-2(k)).
    (3) Anticipated excess inclusions. The anticipated excess inclusions 
are the excess inclusions that are expected to accrue in each calendar 
quarter (or portion thereof) following the transfer of the residual 
interest. The anticipated excess inclusions must be determined as of the 
date the residual interest is transferred and must be based on--
    (i) Events that have occurred up to the time of the transfer;
    (ii) The prepayment and reinvestment assumptions adopted under 
section 1272(a)(6), or that would have been adopted had the REMIC's 
regular interests been issued with original issue discount; and
    (iii) Any required or permitted clean up calls, or required 
qualified liquidation provided for in the REMIC's organizational 
documents.
    (4) Present value computation. The present value of the anticipated 
excess inclusions is determined by discounting the anticipated excess 
inclusions from the end of each remaining calendar quarter in which 
those excess inclusions are expected to accrue to the date the 
disqualified organization acquires the residual interest. The discount 
rate to be used for this present value computation is the applicable 
Federal rate (as specified in section 1274(d)(1)) that would apply to a 
debt instrument that was issued on the date the disqualified 
organization acquired the residual interest and whose term ended on the 
close of the last quarter in which excess inclusions were expected to 
accrue with respect to the residual interest.
    (5) Obligation of REMIC to furnish information. A REMIC is not 
obligated to determine if its residual interests have been transferred 
to a disqualified organization. However, upon request of a person 
designated in section 860E(e)(3), the REMIC must furnish information 
sufficient to compute the present value of the anticipated excess 
inclusions. The information must be furnished to the requesting party 
and to the Internal Revenue Service within 60 days of the request. A 
reasonable fee charged to the requestor is not income derived

[[Page 104]]

from a prohibited transaction within the meaning of section 860F(a).
    (6) Agent. For purposes of section 860E(e)(3), the term ``agent'' 
includes a broker (as defined in section 6045(c) and Sec. 1.6045-
1(a)(1)), nominee, or other middleman.
    (7) Relief from liability--(i) Transferee furnishes information 
under penalties of perjury. For purposes of section 860E(e)(4), a 
transferee is treated as having furnished an affidavit if the transferee 
furnishes--
    (A) A social security number, and states under penalties of perjury 
that the social security number is that of the transferee; or
    (B) A statement under penalties of perjury that it is not a 
disqualified organization.
    (ii) Amount required to be paid. The amount required to be paid 
under section 860E(e)(7)(B) is equal to the product of the highest rate 
specified in section 11(b)(1) for the taxable year in which the transfer 
described in section 860E(e)(1) occurs and the amount of excess 
inclusions that accrued and were allocable to the residual interest 
during the period that the disqualified organization held the interest.
    (b) Tax on pass-thru entities--(1) Tax on excess inclusions. Any tax 
due under section 860E(e)(6) must be paid by the later of March 24, 
1993, or by the fifteenth day of the fourth month following the close of 
the taxable year of the pass-thru entity in which the disqualified 
person is a record holder. The Commissioner may prescribe rules for the 
manner and method of collecting the tax.
    (2) Record holder furnishes information under penalties of perjury. 
For purposes of section 860E(e)(6)(D), a record holder is treated as 
having furnished an affidavit if the record holder furnishes--
    (i) A social security number and states, under penalties of perjury, 
that the social security number is that of the record holder; or
    (ii) A statement under penalties of perjury that it is not a 
disqualified organization.
    (3) Deductibility of tax. Any tax imposed on a pass-thru entity 
pursuant to section 860E(e)(6)(A) is deductible against the gross amount 
of ordinary income of the pass-thru entity. For example, in the case of 
a REIT, the tax is deductible in determining real estate investment 
trust taxable income under section 857(b)(2).
    (4) Allocation of tax. Dividends paid by a RIC or by a REIT are not 
preferential dividends within the meaning of section 562(c) solely 
because the tax expense incurred by the RIC or REIT under section 
860E(e)(6) is allocated solely to the shares held by disqualified 
organizations.

[T.D. 8458, 57 FR 61304, Dec. 24, 1992]



Sec. 1.860F-1  Qualified liquidations.

    A plan of liquidation need not be in any special form. If a REMIC 
specifies the first day in the 90-day liquidation period in a statement 
attached to its final return, then the REMIC will be considered to have 
adopted a plan of liquidation on the specified date.

[T.D. 8458, 57 FR 61304, Dec. 24, 1992]



Sec. 1.860F-2  Transfers to a REMIC.

    (a) Formation of a REMIC--(1) In general. For Federal income tax 
purposes, a REMIC formation is characterized as the contribution of 
assets by a sponsor (as defined in paragraph (b)(1) of this section) to 
a REMIC in exchange for REMIC regular and residual interests. If, 
instead of exchanging its interest in mortgages and related assets for 
regular and residual interests, the sponsor arranges to have the REMIC 
issue some or all of the regular and residual interests for cash, after 
which the sponsor sells its interests in mortgages and related assets to 
the REMIC, the transaction is, nevertheless, viewed for Federal income 
tax purposes as the sponsor's exchange of mortgages and related assets 
for regular and residual interests, followed by a sale of some or all of 
those interests. The purpose of this rule is to ensure that the tax 
consequences associated with the formation of a REMIC are not affected 
by the actual sequence of steps taken by the sponsor.
    (2) Tiered arrangements--(i) Two or more REMICs formed pursuant to a 
single set of organizational documents. Two or more REMICs can be 
created pursuant to a single set of organizational documents even if for 
state law purposes or for Federal securities law purposes

[[Page 105]]

those documents create only one organization. The organizational 
documents must, however, clearly and expressly identify the assets of, 
and the interests in, each REMIC, and each REMIC must satisfy all of the 
requirements of section 860D and the related regulations.
    (ii) A REMIC and one or more investment trusts formed pursuant to a 
single set of documents. A REMIC (or two or more REMICs) and one or more 
investment trusts can be created pursuant to a single set of 
organizational documents and the separate existence of the REMIC(s) and 
the investment trust(s) will be respected for Federal income tax 
purposes even if for state law purposes or for Federal securities law 
purposes those documents create only one organization. The 
organizational documents for the REMIC(s) and the investment trust(s) 
must, however, require both the REMIC(s) and the investment trust(s) to 
account for items of income and ownership of assets for Federal tax 
purposes in a manner that respects the separate existence of the 
multiple entities. See Sec. 1.860G-2(i) concerning issuance of regular 
interests coupled with other contractual rights for an illustration of 
the provisions of this paragraph.
    (b) Treatment of sponsor--(1) Sponsor defined. A sponsor is a person 
who directly or indirectly exchanges qualified mortgages and related 
assets for regular and residual interests in a REMIC. A person 
indirectly exchanges interests in qualified mortgages and related assets 
for regular and residual interests in a REMIC if the person transfers, 
other than in a nonrecognition transaction, the mortgages and related 
assets to another person who acquires a transitory ownership interest in 
those assets before exchanging them for interests in the REMIC, after 
which the transitory owner then transfers some or all of the interests 
in the REMIC to the first person.
    (2) Nonrecognition of gain or loss. The sponsor does not recognize 
gain or loss on the direct or indirect transfer of any property to a 
REMIC in exchange for regular or residual interests in the REMIC. 
However, the sponsor, upon a subsequent sale of the REMIC regular or 
residual interests, may recognize gain or loss with respect to those 
interests.
    (3) Basis of contributed assets allocated among interests--(i) In 
general. The aggregate of the adjusted bases of the regular and residual 
interests received by the sponsor in the exchange described in paragraph 
(a) of this section is equal to the aggregate of the adjusted bases of 
the property transferred by the sponsor in the exchange, increased by 
the amount of organizational expenses (as described in paragraph 
(b)(3)(ii) of this section). That total is allocated among all the 
interests received in proportion to their fair market values on the 
pricing date (as defined in paragraph (b)(3)(iii) of this section) if 
any, or, if none, the startup day (as defined in section 860G(a)(9) and 
Sec. 1.860G-2(k)).
    (ii) Organizational expenses--(A) Organizational expense defined. An 
organizational expense is an expense that is incurred by the sponsor or 
by the REMIC and that is directly related to the creation of the REMIC. 
Further, the organizational expense must be incurred during a period 
beginning a reasonable time before the startup day and ending before the 
date prescribed by law for filing the first REMIC tax return (determined 
without regard to any extensions of time to file). The following are 
examples of organizational expenses: legal fees for services related to 
the formation of the REMIC, such as preparation of a pooling and 
servicing agreement and trust indenture; accounting fees related to the 
formation of the REMIC; and other administrative costs related to the 
formation of the REMIC.
    (B) Syndication expenses. Syndication expenses are not 
organizational expenses. Syndication expenses are those expenses 
incurred by the sponsor or other person to market the interests in a 
REMIC, and, thus, are applied to reduce the amount realized on the sale 
of the interests. Examples of syndication expenses are brokerage fees, 
registration fees, fees of an underwriter or placement agent, and 
printing costs of the prospectus or placement memorandum and other 
selling or promotional material.
    (iii) Pricing date. The term ``pricing date'' means the date on 
which the

[[Page 106]]

terms of the regular and residual interests are fixed and the prices at 
which a substantial portion of the regular interests will be sold are 
fixed.
    (4) Treatment of unrecognized gain or loss--(i) Unrecognized gain on 
regular interests. For purposes of section 860F(b)(1)(C)(i), the sponsor 
must include in gross income the excess of the issue price of a regular 
interest over the sponsor's basis in the interest as if the excess were 
market discount (as defined in section 1278(a)(2)) on a bond and the 
sponsor had made an election under section 1278(b) to include this 
market discount currently in gross income. The sponsor is not, however, 
by reason of this paragraph (b)(4)(i), deemed to have made an election 
under section 1278(b) with respect to any other bonds.
    (ii) Unrecognized loss on regular interests. For purposes of section 
860F(b)(1)(D)(i), the sponsor treats the excess of the sponsor's basis 
in a regular interest over the issue price of the interest as if that 
excess were amortizable bond premium (as defined in section 171(b)) on a 
taxable bond and the sponsor had made an election under section 171(c). 
The sponsor is not, however, by reason of this paragraph (b)(4)(ii), 
deemed to have made an election under section 171(c) with respect to any 
other bonds.
    (iii) Unrecognized gain on residual interests. For purposes of 
section 860F(b)(1)(C)(ii), the sponsor must include in gross income the 
excess of the issue price of a residual interest over the sponsor's 
basis in the interest ratably over the anticipated weighted average life 
of the REMIC (as defined in Sec. 1.860E-1(a)(3)(iv)).
    (iv) Unrecognized loss on residual interests. For purposes of 
section 860F(b)(1)(D)(ii), the sponsor deducts the excess of the 
sponsor's basis in a residual interest over the issue price of the 
interest ratably over the anticipated weighted average life of the 
REMIC.
    (5) Additions to or reductions of the sponsor's basis. The sponsor's 
basis in a regular or residual interest is increased by any amount 
included in the sponsor's gross income under paragraph (b)(4) of this 
section. The sponsor's basis in a regular or residual interest is 
decreased by any amount allowed as a deduction and by any amount applied 
to reduce interest payments to the sponsor under paragraph (b)(4)(ii) of 
this section.
    (6) Transferred basis property. For purposes of paragraph (b)(4) of 
this section, a transferee of a regular or residual interest is treated 
in the same manner as the sponsor to the extent that the basis of the 
transferee in the interest is determined in whole or in part by 
reference to the basis of the interest in the hands of the sponsor.
    (c) REMIC's basis in contributed assets. For purposes of section 
860F(b)(2), the aggregate of the REMIC's bases in the assets contributed 
by the sponsor to the REMIC in a transaction described in paragraph (a) 
of this section is equal to the aggregate of the issue prices 
(determined under section 860G(a)(10) and Sec. 1.86G-1(d)) of all 
regular and residual interests in the REMIC.

[T.D. 8458, 57 FR 61304, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993]



Sec. 1.860F-4  REMIC reporting requirements and other administrative rules.

    (a) In general. Except as provided in paragraph (c) of this section, 
for purposes of subtitle F of the Internal Revenue Code, a REMIC is 
treated as a partnership and any holder of a residual interest in the 
REMIC is treated as a partner. A REMIC is not subject, however, to the 
rules of subchapter C of chapter 63 of the Internal Revenue Code, 
relating to the treatment of partnership items, for a taxable year if 
there is at no time during the taxable year more than one holder of a 
residual interest in the REMIC.
    (b) REMIC tax return--(1) In general. To satisfy the requirement 
under section 6031 to make a return of income for each taxable year, a 
REMIC must file the return required by paragraph (b)(2) of this section. 
The due date and any extensions for filing the REMIC's annual return are 
determined as if the REMIC were a partnership.
    (2) Income tax return. The REMIC must make a return, as required by 
section 6011(a), for each taxable year on Form 1066, U.S. Real Estate 
Mortgage Investment Conduit Income Tax Return. The return must include--

[[Page 107]]

    (i) The amount of principal outstanding on each class of regular 
interests as of the close of the taxable year,
    (ii) The amount of the daily accruals determined under section 
860E(c), and
    (iii) The information specified in Sec. 1.860D-1(d)(2) (i), (iv), 
and (v).
    (c) Signing of REMIC return--(1) In general. Although a REMIC is 
generally treated as a partnership for purposes of subtitle F, for 
purposes of determining who is authorized to sign a REMIC's income tax 
return for any taxable year, the REMIC is not treated as a partnership 
and the holders of residual interests in the REMIC are not treated as 
partners. Rather, the REMIC return must be signed by a person who could 
sign the return of the entity absent the REMIC election. Thus, the 
return of a REMIC that is a corporation or trust under applicable State 
law must be signed by a corporate officer or a trustee, respectively. 
The return of a REMIC that consists of a segregated pool of assets must 
be signed by a person who could sign the return of the entity that owns 
the assets of the REMIC under applicable State law.
    (2) REMIC whose startup day is before November 10, 1988--(i) In 
general. The income tax return of a REMIC whose startup day is before 
November 10, 1988, may be signed by any person who held a residual 
interest during the taxable year to which the return relates, or, as 
provided in section 6903, by a fiduciary, as defined in section 
7701(a)(6), who is acting for the REMIC and who has furnished adequate 
notice in the manner prescribed in Sec. 301.6903-1(b) of this chapter.
    (ii) Startup day. For purposes of paragraph (c)(2) of this section, 
startup day means any day selected by a REMIC that is on or before the 
first day on which interests in such REMIC are issued.
    (iii) Exception. A REMIC whose startup day is before November 10, 
1988, may elect to have paragraph (c)(1) of this section apply, instead 
of paragraph (c)(2) of this section, in determining who is authorized to 
sign the REMIC return. See section 1006(t)(18)(B) of the Technical and 
Miscellaneous Revenue Act of 1988 (102 Stat. 3426) and Sec. 5h.6(a)(1) 
of this chapter for the time and manner for making this election.
    (d) Designation of tax matters person. A REMIC may designate a tax 
matters person in the same manner in which a partnership may designate a 
tax matters partner under Sec. 301.6231(a)(7)-1T of this chapter. For 
purposes of applying that section, all holders of residual interests in 
the REMIC are treated as general partners.
    (e) Notice to holders of residual interests--(1) Information 
required. As of the close of each calendar quarter, a REMIC must provide 
to each person who held a residual interest in the REMIC during that 
quarter notice on Schedule Q (Form 1066) of information specified in 
paragraphs (e)(1) (i) and (ii) of this section.
    (i) In general. Each REMIC must provide to each of its residual 
interest holders the following information--
    (A) That person's share of the taxable income or net loss of the 
REMIC for the calendar quarter;
    (B) The amount of the excess inclusion (as defined in section 860E 
and the regulations thereunder), if any, with respect to that person's 
residual interest for the calendar quarter;
    (C) If the holder of a residual interest is also a pass-through 
interest holder (as defined in Sec. 1.67-3T(a)(2)), the allocable 
investment expenses (as defined in Sec. 1.67-3T(a)(4)) for the calendar 
quarter, and
    (D) Any other information required by Schedule Q (Form 1066).
    (ii) Information with respect to REMIC assets--(A) 95 percent asset 
test. For calendar quarters after 1988, each REMIC must provide to each 
of its residual interest holders the following information--
    (1) The percentage of REMIC assets that are qualifying real property 
loans under section 593,
    (2) The percentage of REMIC assets that are assets described in 
section 7701(a)(19), and
    (3) The percentage of REMIC assets that are real estate assets 
defined in section 856(c)(6)(B), computed by reference to the average 
adjusted basis (as defined in section 1011) of the REMIC assets during 
the calendar quarter (as described in paragraph (e)(1)(iii) of this 
section). If the percentage of REMIC assets represented by a category is 
at least 95 percent, then the REMIC need

[[Page 108]]

only specify that the percentage for that category was at least 95 
percent.
    (B) Additional information required if the 95 percent test not met. 
If, for any calendar quarter after 1988, less than 95 percent of the 
assets of the REMIC are real estate assets defined in section 
856(c)(6)(B), then, for that calendar quarter, the REMIC must also 
provide to any real estate investment trust (REIT) that holds a residual 
interest the following information--
    (1) The percentage of REMIC assets described in section 
856(c)(5)(A), computed by reference to the average adjusted basis of the 
REMIC assets during the calendar quarter (as described in paragraph 
(e)(1)(iii) of this section),
    (2) The percentage of REMIC gross income (other than gross income 
from prohibited transactions defined in section 860F(a)(2)) described in 
section 856(c)(3)(A) through (E), computed as of the close of the 
calendar quarter, and
    (3) The percentage of REMIC gross income (other than gross income 
from prohibited transactions defined in section 860F(a)(2)) described in 
section 856(c)(3)(F), computed as of the close of the calendar quarter. 
For purposes of this paragraph (e)(1)(ii)(B)(3), the term ``foreclosure 
property'' contained in section 856(c)(3)(F) has the meaning specified 
in section 860G(a)(8).

In determining whether a REIT satisfies the limitations of section 
856(c)(2), all REMIC gross income is deemed to be derived from a source 
specified in section 856(c)(2).

    (C) For calendar quarters in 1987. For calendar quarters in 1987, 
the percentages of assets required in paragraphs (e)(1)(ii) (A) and (B) 
of this section may be computed by reference to the fair market value of 
the assets of the REMIC as of the close of the calendar quarter (as 
described in paragraph (e)(1)(iii) of this section), instead of by 
reference to the average adjusted basis during the calendar quarter.
    (D) For calendar quarters in 1988 and 1989. For calendar quarters in 
1988 and 1989, the percentages of assets required in paragraphs 
(e)(1)(ii) (A) and (B) of this section may be computed by reference to 
the average fair market value of the assets of the REMIC during the 
calendar quarter (as described in paragraph (e)(1)(iii) of this 
section), instead of by reference to the average adjusted basis of the 
assets of the REMIC during the calendar quarter.
    (iii) Special provisions. For purposes of paragraph (e)(1)(ii) of 
this section, the percentage of REMIC assets represented by a specified 
category computed by reference to average adjusted basis (or fair market 
value) of the assets during a calendar quarter is determined by dividing 
the average adjusted bases (or for calendar quarters before 1990, fair 
market value) of the assets in the specified category by the average 
adjusted basis (or, for calendar quarters before 1990, fair market 
value) of all the assets of the REMIC as of the close of each month, 
week, or day during that calendar quarter. The monthly, weekly, or daily 
computation period must be applied uniformly during the calendar quarter 
to all categories of assets and may not be changed in succeeding 
calendar quarters without the consent of the Commissioner.
    (2) Quarterly notice required--(i) In general. Schedule Q must be 
mailed (or otherwise delivered) to each holder of a residual interest 
during a calendar quarter no later than the last day of the month 
following the close of the calendar quarter.
    (ii) Special rule for 1987. Notice to any holder of a REMIC residual 
interest of the information required in paragraph (e)(1) of this section 
for any of the four calendar quarters of 1987 must be mailed (or 
otherwise delivered) to each holder no later than March 28, 1988.
    (3) Nominee reporting--(i) In general. If a REMIC is required under 
paragraphs (e) (1) and (2) of this section to provide notice to an 
interest holder who is a nominee of another person with respect to an 
interest in the REMIC, the nominee must furnish that notice to the 
person for whom it is a nominee.
    (ii) Time for furnishing statement. The nominee must furnish the 
notice required under paragraph (e)(3)(i) of this section to the person 
for whom it is a nominee no later than 30 days after receiving this 
information.
    (4) Reports to the Internal Revenue Service. For each person who was 
a residual interest holder at any time during a REMIC's taxable year, 
the REMIC must attach a copy of Schedule Q to its income tax return for 
that

[[Page 109]]

year for each quarter in which that person was a residual interest 
holder. Quarterly notice to the Internal Revenue Service is not 
required.
    (f) Information returns for persons engaged in a trade or business. 
See Sec. 1.6041-1(b)(2) for the treatment of a REMIC under sections 6041 
and 6041A.

[T.D. 8366, 56 FR 49516, Sept. 30, 1991, as amended by T.D. 8458, 57 FR 
61306, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993]



Sec. 1.860G-1  Definition of regular and residual interests.

    (a) Regular interest--(1) Designation as a regular interest. For 
purposes of section 860G(a)(1), a REMIC designates an interest as a 
regular interest by providing to the Internal Revenue Service the 
information specified in Sec. 1.860D-1(d)(2)(ii) in the time and manner 
specified in Sec. 1.860D-1(d)(2).
    (2) Specified portion of the interest payments on qualified 
mortgages--(i) In general. For purposes of section 860G(a)(1)(B)(ii), a 
specified portion of the interest payments on qualified mortgages means 
a portion of the interest payable on qualified mortgages, but only if 
the portion can be expressed as--
    (A) A fixed percentage of the interest that is payable at either a 
fixed rate or at a variable rate described in paragraph (a)(3) of this 
section on some or all of the qualified mortgages;
    (B) A fixed number of basis points of the interest payable on some 
or all of the qualified mortgages; or
    (C) The interest payable at either a fixed rate or at a variable 
rate described in paragraph (a)(3) of this section on some or all of the 
qualified mortgages in excess of a fixed number of basis points or in 
excess of a variable rate described in paragraph (a)(3) of this section.
    (ii) Specified portion cannot vary. The portion must be established 
as of the startup day (as defined in section 860G(a)(9) and Sec. 1.860G-
2(k)) and, except as provided in paragraph (a)(2)(iii) of this section, 
it cannot vary over the period that begins on the startup day and ends 
on the day that the interest holder is no longer entitled to receive 
payments.
    (iii) Defaulted or delinquent mortgages. A portion is not treated as 
varying over time if an interest holder's entitlement to a portion of 
the interest on some or all of the qualified mortgages is dependent on 
the absence of defaults or delinquencies on those mortgages.
    (iv) No minimum specified principal amount is required. If an 
interest in a REMIC consists of a specified portion of the interest 
payments on the REMIC's qualified mortgages, no minimum specified 
principal amount need be assigned to that interest. The specified 
principal amount can be zero.
    (v) Specified portion includes portion of interest payable on 
regular interest. (A) The specified portions that meet the requirements 
of paragraph (a)(2)(i) of this section include a specified portion that 
can be expressed as a fixed percentage of the interest that is payable 
on some or all of the qualified mortgages where--
    (1) Each of those qualified mortgages is a regular interest issued 
by another REMIC; and
    (2) With respect to that REMIC in which it is a regular interest, 
each of those regular interests bears interest that can be expressed as 
a specified portion as described in paragraph (a)(2)(i)(A), (B), or (C) 
of this section.
    (B) See Sec. 1.860A-1(a) for the effective date of this paragraph 
(a)(2)(v).
    (vi) Examples. The following examples, each of which describes a 
pass-thru trust that is intended to qualify as a REMIC, illustrate the 
provisions of this paragraph (a)(2).

    Example 1. (i) A sponsor transferred a pool of fixed rate mortgages 
to a trustee in exchange for two classes of certificates. The Class A 
certificate holders are entitled to all principal payments on the 
mortgages and to interest on outstanding principal at a variable rate 
based on the current value of One-Month LIBOR, subject to a lifetime cap 
equal to the weighted average rate payable on the mortgages. The Class B 
certificate holders are entitled to all interest payable on the 
mortgages in excess of the interest paid on the Class A certificates. 
The Class B certificates are subordinate to the Class A certificates so 
that cash flow shortfalls due to defaults or delinquencies on the 
mortgages will be borne first by the Class B certificate holders.
    (ii) The Class B certificate holders are entitled to all interest 
payable on the pooled mortgages in excess of a variable rate described 
in paragraph (a)(3)(vi) of this section. Moreover, the portion of the 
interest payable

[[Page 110]]

to the Class B certificate holders is not treated as varying over time 
solely because payments on the Class B certificates may be reduced as a 
result of defaults or delinquencies on the pooled mortgages. Thus, the 
Class B certificates provide for interest payments that consist of a 
specified portion of the interest payable on the pooled mortgages under 
paragraph (a)(2)(i)(C) of this section.
    Example 2. (i) A sponsor transferred a pool of variable rate 
mortgages to a trustee in exchange for two classes of certificates. The 
mortgages call for interest payments at a variable rate based on the 
current value of the One-Year Constant Maturity Treasury Index 
(hereinafter ``CMTI'') plus 200 basis points, subject to a lifetime cap 
of 12 percent. Class C certificate holders are entitled to all principal 
payments on the mortgages and interest on the outstanding principal at a 
variable rate based on the One-Year CMTI plus 100 basis points, subject 
to a lifetime cap of 12 percent. The interest rate on the Class C 
certificates is reset at the same time the rate is reset on the pooled 
mortgages.
    (ii) The Class D certificate holders are entitled to all interest 
payments on the mortgages in excess of the interest paid on the Class C 
certificates. So long as the One-Year CMTI is at 10 percent or lower, 
the Class D certificate holders are entitled to 100 basis points of 
interest on the pooled mortgages. If, however, the index exceeds 10 
percent on a reset date, the Class D certificate holders' entitlement 
shrinks, and it disappears if the index is at 11 percent or higher.
    (iii) The Class D certificate holders are entitled to all interest 
payable on the pooled mortgages in excess of a qualified variable rate 
described in paragraph (a)(3) of this section. Thus, the Class D 
certificates provide for interest payments that consist of a specified 
portion of the interest payable on the qualified mortgages under 
paragraph (a)(2)(i)(C) of this section.
    Example 3. (i) A sponsor transferred a pool of fixed rate mortgages 
to a trustee in exchange for two classes of certificates. The fixed 
interest rate payable on the mortgages varies from mortgage to mortgage, 
but all rates are between 8 and 10 percent. The Class E certificate 
holders are entitled to receive all principal payments on the mortgages 
and interest on outstanding principal at 7 percent. The Class F 
certificate holders are entitled to receive all interest on the 
mortgages in excess of the interest paid on the Class E certificates.
    (ii) The Class F certificates provide for interest payments that 
consist of a specified portion of the interest payable on the mortgages 
under paragraph (a)(2)(i) of this section. Although the portion of the 
interest payable to the Class F certificate holders varies from mortgage 
to mortgage, the interest payable can be expressed as a fixed percentage 
of the interest payable on each particular mortgage.

    (3) Variable rate. A regular interest may bear interest at a 
variable rate. For purposes of section 860G(a)(1)(B)(i), a variable rate 
of interest is a rate described in this paragraph (a)(3).
    (i) Rate based on current interest rate. A qualified floating rate 
as defined in Sec. 1.1275-5(b)(1) (but without the application of 
paragraph (b)(2) or (3) of that section) set at a current value, as 
defined in Sec. 1.1275-5(a)(4), is a variable rate. In addition, a rate 
equal to the highest, lowest, or average of two or more qualified 
floating rates is a variable rate. For example, a rate based on the 
average cost of funds of one or more financial institutions is a 
variable rate.
    (ii) Weighted average rate--(A) In general. A rate based on a 
weighted average of the interest rates on some or all of the qualified 
mortgages held by a REMIC is a variable rate. The qualified mortgages 
taken into account must, however, bear interest at a fixed rate or at a 
rate described in this paragraph (a)(3). Generally, a weighted average 
interest rate is a rate that, if applied to the aggregate outstanding 
principal balance of a pool of mortgage loans for an accrual period, 
produces an amount of interest that equals the sum of the interest 
payable on the pooled loans for that accrual period. Thus, for an 
accrual period in which a pool of mortgage loans comprises $300,000 of 
loans bearing a 7 percent interest rate and $700,000 of loans bearing a 
9.5 percent interest rate, the weighted average rate for the pool of 
loans is 8.75 percent.
    (B) Reduction in underlying rate. For purposes of paragraph 
(a)(3)(ii)(A) of this section, an interest rate is considered to be 
based on a weighted average rate even if, in determining that rate, the 
interest rate on some or all of the qualified mortgages is first subject 
to a cap or a floor, or is first reduced by a number of basis points or 
a fixed percentage. A rate determined by taking a weighted average of 
the interest rates on the qualified mortgage loans net of any servicing 
spread, credit enhancement fees, or other expenses of the REMIC is a 
rate based on a weighted

[[Page 111]]

average rate for the qualified mortgages. Further, the amount of any 
rate reduction described above may vary from mortgage to mortgage.
    (iii) Additions, subtractions, and multiplications. A rate is a 
variable rate if it is--
    (A) Expressed as the product of a rate described in paragraph 
(a)(3)(i) or (ii) of this section and a fixed multiplier;
    (B) Expressed as a constant number of basis points more or less than 
a rate described in paragraph (a)(3)(i) or (ii) of this section; or
    (C) Expressed as the product, plus or minus a constant number of 
basis points, of a rate described in paragraph (a)(3)(i) or (ii) of this 
section and a fixed multiplier (which may be either a positive or a 
negative number).
    (iv) Caps and floors. A rate is a variable rate if it is a rate that 
would be described in paragraph (a)(3)(i) through (iii) of this section 
except that it is--
    (A) Limited by a cap or ceiling that establishes either a maximum 
rate or a maximum number of basis points by which the rate may increase 
from one accrual or payment period to another or over the term of the 
interest; or
    (B) Limited by a floor that establishes either a minimum rate or a 
maximum number of basis points by which the rate may decrease from one 
accrual or payment period to another or over the term of the interest.
    (v) Funds-available caps--(A) In general. A rate is a variable rate 
if it is a rate that would be described in paragraph (a)(3)(i) through 
(iv) of this section except that it is subject to a ``funds-available'' 
cap. A funds-available cap is a limit on the amount of interest to be 
paid on an instrument in any accrual or payment period that is based on 
the total amount available for the distribution, including both 
principal and interest received by an issuing entity on some or all of 
its qualified mortgages as well as amounts held in a reserve fund. The 
term ``funds-available cap'' does not, however, include any cap or limit 
on interest payments used as a device to avoid the standards of 
paragraph (a)(3)(i) through (iv) of this section.
    (B) Facts and circumstances test. In determining whether a cap or 
limit on interest payments is a funds-available cap within the meaning 
of this section and not a device used to avoid the standards of 
paragraph (a)(3)(i) through (iv) of this section, one must consider all 
of the facts and circumstances. Facts and circumstances that must be 
taken into consideration are--
    (1) Whether the rate of the interest payable to the regular interest 
holders is below the rate payable on the REMIC's qualified mortgages on 
the start-up day; and
    (2) Whether, historically, the rate of interest payable to the 
regular interest holders has been consistently below that payable on the 
qualified mortgages.
    (C) Examples. The following examples, both of which describe a pass-
thru trust that is intended to qualify as a REMIC, illustrate the 
provisions of this paragraph (a)(3)(v).

    Example 1. (i) A sponsor transferred a pool of mortgages to a 
trustee in exchange for two classes of certificates. The pool of 
mortgages has an aggregate principal balance of $100x. Each mortgage in 
the pool provides for interest payments based on the eleventh district 
cost of funds index (hereinafter COFI) plus a margin. The initial 
weighted average rate for the pool is COFI plus 200 basis points. The 
trust issued a Class X certificate that has a principal amount of $100x 
and that provides for interest payments at a rate equal to One-Year 
LIBOR plus 100 basis points, subject to a cap described below. The Class 
R certificate, which the sponsor designated as the residual interest, 
entitles its holder to all funds left in the trust after the Class X 
certificates have been retired. The Class R certificate holder is not 
entitled to current distributions.
    (ii) At the time the certificates were issued, COFI equalled 4.874 
percent and One-Year LIBOR equalled 3.375 percent. Thus, the initial 
weighted average pool rate was 6.874 percent and the Class X certificate 
rate was 4.375 percent. Based on historical data, the sponsor does not 
expect the rate paid on the Class X certificate to exceed the weighted 
average rate on the pool.
    (iii) Initially, under the terms of the trust instrument, the excess 
of COFI plus 200 over One-Year LIBOR plus 100 (excess interest) will be 
applied to pay expenses of the trust, to fund any required reserves, and 
then to reduce the principal balance on the Class X certificate. 
Consequently, although the aggregate principal balance of the mortgages 
initially matched the principal balance of the Class X certificate, the 
principal balance

[[Page 112]]

on the Class X certificate will pay down faster than the principal 
balance on the mortgages as long as the weighted average rate on the 
mortgages is greater than One-Year LIBOR plus 100. If, however, the rate 
on the Class X certificate (One-Year LIBOR plus 100) ever exceeds the 
weighted average rate on the mortgages, then the Class X certificate 
holders will receive One-Year LIBOR plus 100 subject to a cap based on 
the current funds that are available for distribution.
    (iv) The funds available cap here is not a device used to avoid the 
standards of paragraph (a)(3) (i) through (iv) of this section. First, 
on the date the Class X certificates were issued, a significant spread 
existed between the weighted average rate payable on the mortgages and 
the rate payable on the Class X certificate. Second, historical data 
suggest that the weighted average rate payable on the mortgages will 
continue to exceed the rate payable on the Class X certificate. Finally, 
because the excess interest will be applied to reduce the outstanding 
principal balance of the Class X certificate more rapidly than the 
outstanding principal balance on the mortgages is reduced, One-Year 
LIBOR plus 100 basis points would have to exceed the weighted average 
rate on the mortgages by an increasingly larger amount before the funds 
available cap would be triggered. Accordingly, the rate paid on the 
Class X certificates is a variable rate.
    Example 2. (i) The facts are the same as those in Example 1, except 
that the pooled mortgages are commercial mortgages that provide for 
interest payments based on the gross profits of the mortgagors, and the 
rate on the Class X certificates is 400 percent on One-Year LIBOR (a 
variable rate under paragraph (a)(3)(iii) of this section), subject to a 
cap equal to current funds available to the trustee for distribution.
    (ii) Initially, 400 percent of One-Year LIBOR exceeds the weighted 
average rate payable on the mortgages. Furthermore, historical data 
suggest that there is a significant possibility that, in the future, 400 
percent of One-Year LIBOR will exceed the weighted average rate on the 
mortgages.
    (iii) The facts and circumstances here indicate that the use of 400 
percent of One-Year LIBOR with the above-described cap is a device to 
pass through to the Class X certificate holder contingent interest based 
on mortgagor profits. Consequently, the rate paid on the Class X 
certificate here is not a variable rate.

    (vi) Combination of rates. A rate is a variable rate if it is based 
on--
    (A) One fixed rate during one or more accrual or payment periods and 
a different fixed rate or rates, or a rate or rates described in 
paragraph (a)(3) (i) through (v) of this section, during other accrual 
or payment periods; or
    (B) A rate described in paragraph (a)(3) (i) through (v) of this 
section during one or more accrual or payment periods and a fixed rate 
or rates, or a different rate or rates described in paragraph (a)(3) (i) 
through (v) of this section in other periods.
    (4) Fixed terms on the startup day. For purposes of section 
860G(a)(1), a regular interest in a REMIC has fixed terms on the startup 
day if, on the startup day, the REMIC's organizational documents 
irrevocably specify--
    (i) The principal amount (or other similar amount) of the regular 
interest;
    (ii) The interest rate or rates used to compute any interest 
payments (or other similar amounts) on the regular interest; and
    (iii) The latest possible maturity date of the interest.
    (5) Contingencies prohibited. Except for the contingencies specified 
in paragraph (b)(3) of this section, the principal amount (or other 
similar amount) and the latest possible maturity date of the interest 
must not be contingent.
    (b) Special rules for regular interests--(1) Call premium. An 
interest in a REMIC does not qualify as a regular interest if the terms 
of the interest entitle the holder of that interest to the payment of 
any premium that is determined with reference to the length of time that 
the regular interest is outstanding and is not described in paragraph 
(b)(2) of this section.
    (2) Customary prepayment penalties received with respect to 
qualified mortgages. An interest in a REMIC does not fail to qualify as 
a regular interest solely because the REMIC's organizational documents 
provide that the REMIC must allocate among and pay to its regular 
interest holders any customary prepayment penalties that the REMIC 
receives with respect to its qualified mortgages. Moreover, a REMIC may 
allocate prepayment penalties among its classes of interests in any 
manner specified in the REMIC's organizational documents. For example, a 
REMIC could allocate all or substantially all of a prepayment penalty 
that it receives to holders of an interest-only class of interests 
because that class

[[Page 113]]

would be most significantly affected by prepayments.
    (3) Certain contingencies disregarded. An interest in a REMIC does 
not fail to qualify as a regular interest solely because it is issued 
subject to some or all of the contingencies described in paragraph 
(b)(3) (i) through (vi) of this section.
    (i) Prepayments, income, and expenses. An interest does not fail to 
qualify as a regular interest solely because--
    (A) The timing of (but not the right to or amount of) principal 
payments (or other similar amounts) is affected by the extent of 
prepayments on some or all of the qualified mortgages held by the REMIC 
or the amount of income from permitted investments (as defined in 
Sec. 1.860G-2(g)); or
    (B) The timing of interest and principal payments is affected by the 
payment of expenses incurred by the REMIC.
    (ii) Credit losses. An interest does not fail to qualify as a 
regular interest solely because the amount or the timing of payments of 
principal or interest (or other similar amounts) with respect to a 
regular interest is affected by defaults on qualified mortgages and 
permitted investments, unanticipated expenses incurred by the REMIC, or 
lower than expected returns on permitted investments.
    (iii) Subordinated interests. An interest does not fail to qualify 
as a regular interest solely because that interest bears all, or a 
disproportionate share, of the losses stemming from cash flow shortfalls 
due to defaults or delinquencies on qualified mortgages or permitted 
investments, unanticipated expenses incurred by the REMIC, lower than 
expected returns on permitted investments, or prepayment interest 
shortfalls before other regular interests or the residual interest bear 
losses occasioned by those shortfalls.
    (iv) Deferral of interest. An interest does not fail to qualify as a 
regular interest solely because that interest, by its terms, provides 
for deferral of interest payments.
    (v) Prepayment interest shortfalls. An interest does not fail to 
qualify as a regular interest solely because the amount of interest 
payments is affected by prepayments of the underlying mortgages.
    (vi) Remote and incidental contingencies. An interest does not fail 
to qualify as a regular interest solely because the amount or timing of 
payments of principal or interest (or other similar amounts) with 
respect to the interest is subject to a contingency if there is only a 
remote likelihood that the contingency will occur. For example, an 
interest could qualify as a regular interest even though full payment of 
principal and interest on that interest is contingent upon the absence 
of significant cash flow shortfalls due to the operation of the Soldiers 
and Sailors Civil Relief Act, 50 U.S.C. app. 526 (1988).
    (4) Form of regular interest. A regular interest in a REMIC may be 
issued in the form of debt, stock, an interest in a partnership or 
trust, or any other form permitted by state law. If a regular interest 
in a REMIC is not in the form of debt, it must, except as provided in 
paragraph (a)(2)(iv) of this section, entitle the holder to a specified 
amount that would, were the interest issued in debt form, be identified 
as the principal amount of the debt.
    (5) Interest disproportionate to principal--(i) In general. An 
interest in a REMIC does not qualify as a regular interest if the amount 
of interest (or other similar amount) payable to the holder is 
disproportionately high relative to the principal amount or other 
specified amount described in paragraph (b)(4) of this section 
(specified principal amount). Interest payments (or other similar 
amounts) are considered disproportionately high if the issue price (as 
determined under paragraph (d) of this section) of the interest in the 
REMIC exceeds 125 percent of its specified principal amount.
    (ii) Exception. A regular interest in a REMIC that entitles the 
holder to interest payments consisting of a specified portion of 
interest payments on qualified mortgages qualifies as a regular interest 
even if the amount of interest is disproportionately high relative to 
the specified principal amount.
    (6) Regular interest treated as a debt instrument for all Federal 
income tax purposes. In determining the tax under chapter 1 of the 
Internal Revenue Code,

[[Page 114]]

a REMIC regular interest (as defined in section 860G(a)(1)) is treated 
as a debt instrument that is an obligation of the REMIC. Thus, sections 
1271 through 1288, relating to bonds and other debt instruments, apply 
to a regular interest. For special rules relating to the accrual of 
original issue discount on regular interests, see section 1272(a)(6).
    (c) Residual interest. A residual interest is an interest in a REMIC 
that is issued on the startup day and that is designated as a residual 
interest by providing the information specified in Sec. 1.860D-
1(d)(2)(ii) at the time and in the manner provided in Sec. 1.860D-
1(d)(2). A residual interest need not entitle the holder to any 
distributions from the REMIC.
    (d) Issue price of regular and residual interests--(1) In general. 
The issue price of any REMIC regular or residual interest is determined 
under section 1273(b) as if the interest were a debt instrument and, if 
issued for property, as if the requirements of section 1273(b)(3) were 
met. Thus, if a class of interests is publicly offered, then the issue 
price of an interest in that class is the initial offering price to the 
public at which a substantial amount of the class is sold. If the 
interest is in a class that is not publicly offered, the issue price is 
the price paid by the first buyer of that interest regardless of the 
price paid for the remainder of the class. If the interest is in a class 
that is retained by the sponsor, the issue price is its fair market 
value on the pricing date (as defined in Sec. 1.860F-2(b)(3)(iii)), if 
any, or, if none, the startup day, regardless of whether the property 
exchanged therefor is publicly traded.
    (2) The public. The term ``the public'' for purposes of this section 
does not include brokers or other middlemen, nor does it include the 
sponsor who acquires all of the regular and residual interests from the 
REMIC on the startup day in a transaction described in Sec. 1.860F-2(a).

[T.D. 8458, 57 FR 61306, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; 58 FR 
15089, Mar. 19, 1993; T.D. 8614, 60 FR 42787, Aug. 17, 1995]



Sec. 1.860G-2  Other rules.

    (a) Obligations principally secured by an interest in real property-
-(1) Tests for determining whether an obligation is principally secured. 
For purposes of section 860G(a)(3)(A), an obligation is principally 
secured by an interest in real property only if it satisfies either the 
test set out in paragraph (a)(1)(i) or the test set out in paragraph 
(a)(1)(ii) of this section.
    (i) The 80-percent test. An obligation is principally secured by an 
interest in real property if the fair market value of the interest in 
real property securing the obligation--
    (A) Was at least equal to 80 percent of the adjusted issue price of 
the obligation at the time the obligation was originated (see paragraph 
(b)(1) of this section concerning the origination date for obligations 
that have been significantly modified); or
    (B) Is at least equal to 80 percent of the adjusted issue price of 
the obligation at the time the sponsor contributes the obligation to the 
REMIC.
    (ii) Alternative test. For purposes of section 860G(a)(3)(A), an 
obligation is principally secured by an interest in real property if 
substantially all of the proceeds of the obligation were used to acquire 
or to improve or protect an interest in real property that, at the 
origination date, is the only security for the obligation. For purposes 
of this test, loan guarantees made by the United States or any state (or 
any political subdivision, agency, or instrumentality of the United 
States or of any state), or other third party credit enhancement are not 
viewed as additional security for a loan. An obligation is not 
considered to be secured by property other than real property solely 
because the obligor is personally liable on the obligation.
    (2) Treatment of liens. For purposes of paragraph (a)(1)(i) of this 
section, the fair market value of the real property interest must be 
first reduced by the amount of any lien on the real property interest 
that is senior to the obligation being tested, and must be further 
reduced by a proportionate amount of any lien that is in parity with the 
obligation being tested.
    (3) Safe harbor--(i) Reasonable belief that an obligation is 
principally secured. If, at the time the sponsor contributes an 
obligation to a REMIC, the sponsor reasonably believes that the 
obligation

[[Page 115]]

is principally secured by an interest in real property within the 
meaning of paragraph (a)(1) of this section, then the obligation is 
deemed to be so secured for purposes of section 860G(a)(3). A sponsor 
cannot avail itself of this safe harbor with respect to an obligation if 
the sponsor actually knows or has reason to know that the obligation 
fails both of the tests set out in paragraph (a)(1) of this section.
    (ii) Basis for reasonable belief. For purposes of paragraph 
(a)(3)(i) of this section, a sponsor may base a reasonable belief 
concerning any obligation on--
    (A) Representations and warranties made by the originator of the 
obligation; or
    (B) Evidence indicating that the originator of the obligation 
typically made mortgage loans in accordance with an established set of 
parameters, and that any mortgage loan originated in accordance with 
those parameters would satisfy at least one of the tests set out in 
paragraph (a)(1) of this section.
    (iii) Later discovery that an obligation is not principally secured. 
If, despite the sponsor's reasonable belief concerning an obligation at 
the time it contributed the obligation to the REMIC, the REMIC later 
discovers that the obligation is not principally secured by an interest 
in real property, the obligation is a defective obligation and loses its 
status as a qualified mortgage 90 days after the date of discovery. See 
paragraph (f) of this section, relating to defective obligations.
    (4) Interests in real property; real property. The definition of 
``interests in real property'' set out in Sec. 1.856-3(c), and the 
definition of ``real property'' set out in Sec. 1.856-3(d), apply to 
define those terms for purposes of section 860G(a)(3) and paragraph (a) 
of this section.
    (5) Obligations secured by an interest in real property. Obligations 
secured by interests in real property include the following: mortgages, 
deeds of trust, and installment land contracts; mortgage pass-thru 
certificates guaranteed by GNMA, FNMA, FHLMC, or CMHC (Canada Mortgage 
and Housing Corporation); other investment trust interests that 
represent undivided beneficial ownership in a pool of obligations 
principally secured by interests in real property and related assets 
that would be considered to be permitted investments if the investment 
trust were a REMIC, and provided the investment trust is classified as a 
trust under Sec. 301.7701-4(c) of this chapter; and obligations secured 
by manufactured housing treated as single family residences under 
section 25(e)(10) (without regard to the treatment of the obligations or 
the properties under state law).
    (6) Obligations secured by other obligations; residual interests. 
Obligations (other than regular interests in a REMIC) that are secured 
by other obligations are not principally secured by interests in real 
property even if the underlying obligations are secured by interests in 
real property. Thus, for example, a collateralized mortgage obligation 
issued by an issuer that is not a REMIC is not an obligation principally 
secured by an interest in real property. A residual interest (as defined 
in section 860G(a)(2)) is not an obligation principally secured by an 
interest in real property.
    (7) Certain instruments that call for contingent payments are 
obligations. For purposes of section 860G(a)(3) and (4), the term 
``obligation'' includes any instrument that provides for total 
noncontingent principal payments that at least equal the instrument's 
issue price even if that instrument also provides for contingent 
payments. Thus, for example, an instrument that was issued for $100x and 
that provides for noncontingent principal payments of $100x, interest 
payments at a fixed rate, and contingent payments based on a percentage 
of the mortgagor's gross receipts, is an obligation.
    (8) Defeasance. If a REMIC releases its lien on real property that 
secures a qualified mortgage, that mortgage ceases to be a qualified 
mortgage on the date the lien is released unless--
    (i) The mortgagor pledges substitute collateral that consists solely 
of government securities (as defined in section 2(a)(16) of the 
Investment Company Act of 1940 as amended (15 U.S.C. 80a-1));
    (ii) The mortgage documents allow such a substitution;
    (iii) The lien is released to facilitate the disposition of the 
property or any

[[Page 116]]

other customary commercial transaction, and not as part of an 
arrangement to collateralize a REMIC offering with obligations that are 
not real estate mortgages; and
    (iv) The release is not within 2 years of the startup day.
    (9) Stripped bonds and coupons. The term ``qualified mortgage'' 
includes stripped bonds and stripped coupons (as defined in section 
1286(e) (2) and (3)) if the bonds (as defined in section 1286(e)(1)) 
from which such stripped bonds or stripped coupons arose would have been 
qualified mortgages.
    (b) Assumptions and modifications--(1) Significant modifications are 
treated as exchanges of obligations. If an obligation is significantly 
modified in a manner or under circumstances other than those described 
in paragraph (b)(3) of this section, then the modified obligation is 
treated as one that was newly issued in exchange for the unmodified 
obligation that it replaced. Consequently--
    (i) If such a significant modification occurs after the obligation 
has been contributed to the REMIC and the modified obligation is not a 
qualified replacement mortgage, the modified obligation will not be a 
qualified mortgage and the deemed disposition of the unmodified 
obligation will be a prohibited transaction under section 860F(a)(2); 
and
    (ii) If such a significant modification occurs before the obligation 
is contributed to the REMIC, the modified obligation will be viewed as 
having been originated on the date the modification occurs for purposes 
of the tests set out in paragraph (a)(1) of this section.
    (2) Significant modification defined. For purposes of paragraph 
(b)(1) of this section, a ``significant modification'' is any change in 
the terms of an obligation that would be treated as an exchange of 
obligations under section 1001 and the related regulations.
    (3) Exceptions. For purposes of paragraph (b)(1) of this section, 
the following changes in the terms of an obligation are not significant 
modifications regardless of whether they would be significant 
modifications under paragraph (b)(2) of this section--
    (i) Changes in the terms of the obligation occasioned by default or 
a reasonably foreseeable default;
    (ii) Assumption of the obligation;
    (iii) Waiver of a due-on-sale clause or a due on encumbrance clause; 
and
    (iv) Conversion of an interest rate by a mortgagor pursuant to the 
terms of a convertible mortgage.
    (4) Modifications that are not significant modifications. If an 
obligation is modified and the modification is not a significant 
modification for purposes of paragraph (b)(1) of this section, then the 
modified obligation is not treated as one that was newly originated on 
the date of modification.
    (5) Assumption defined. For purposes of paragraph (b)(3) of this 
section, a mortgage has been assumed if--
    (i) The buyer of the mortgaged property acquires the property 
subject to the mortgage, without assuming any personal liability;
    (ii) The buyer becomes liable for the debt but the seller also 
remains liable; or
    (iii) The buyer becomes liable for the debt and the seller is 
released by the lender.
    (6) Pass-thru certificates. If a REMIC holds as a qualified mortgage 
a pass-thru certificate or other investment trust interest of the type 
described in paragraph (a)(5) of this section, the modification of a 
mortgage loan that backs the pass-thru certificate or other interest is 
not a modification of the pass-thru certificate or other interest unless 
the investment trust structure was created to avoid the prohibited 
transaction rules of section 860F(a).
    (c) Treatment of certain credit enhancement contracts--(1) In 
general. A credit enhancement contract (as defined in paragraph (c) (2) 
and (3) of this section) is not treated as a separate asset of the REMIC 
for purposes of the asset test set out in section 860D(a)(4) and 
Sec. 1.860D-1(b)(3), but instead is treated as part of the mortgage or 
pool of mortgages to which it relates. Furthermore, any collateral 
supporting a credit enhancement contract is not treated as an asset of 
the REMIC solely because it supports the guarantee represented by that 
contract. See paragraph (g)(1)(ii) of this section for the treatment of

[[Page 117]]

payments made pursuant to credit enhancement contracts as payments 
received under a qualified mortgage.
    (2) Credit enhancement contracts. For purposes of this section, a 
credit enhancement contract is any arrangement whereby a person agrees 
to guarantee full or partial payment of the principal or interest 
payable on a qualified mortgage or on a pool of such mortgages, or full 
or partial payment on one or more classes of regular interests or on the 
class of residual interests, in the event of defaults or delinquencies 
on qualified mortgages, unanticipated losses or expenses incurred by the 
REMIC, or lower than expected returns on cash flow investments. Types of 
credit enhancement contracts may include, but are not limited to, pool 
insurance contracts, certificate guarantee insurance contracts, letters 
of credit, guarantees, or agreements whereby the REMIC sponsor, a 
mortgage servicer, or other third party agrees to make advances 
described in paragraph (c)(3) of this section.
    (3) Arrangements to make certain advances. The arrangements 
described in this paragraph (c)(3) are credit enhancement contracts 
regardless of whether, under the terms of the arrangement, the payor is 
obligated, or merely permitted, to advance funds to the REMIC.
    (i) Advances of delinquent principal and interest. An arrangement by 
a REMIC sponsor, mortgage servicer, or other third party to advance to 
the REMIC out of its own funds an amount to make up for delinquent 
payments on qualified mortgages is a credit enhancement contract.
    (ii) Advances of taxes, insurance payments, and expenses. An 
arrangement by a REMIC sponsor, mortgage servicer, or other third party 
to pay taxes and hazard insurance premiums on, or other expenses 
incurred to protect the REMIC's security interest in, property securing 
a qualified mortgage in the event that the mortgagor fails to pay such 
taxes, insurance premiums, or other expenses is a credit enhancement 
contract.
    (iii) Advances to ease REMIC administration. An agreement by a REMIC 
sponsor, mortgage servicer, or other third party to advance temporarily 
to a REMIC amounts payable on qualified mortgages before such amounts 
are actually due to level out the stream of cash flows to the REMIC or 
to provide for orderly administration of the REMIC is a credit 
enhancement contract. For example, if two mortgages in a pool have 
payment due dates on the twentieth of the month, and all the other 
mortgages have payment due dates on the first of each month, an 
agreement by the mortgage servicer to advance to the REMIC on the 
fifteenth of each month the payments not yet received on the two 
mortgages together with the amounts received on the other mortgages is a 
credit enhancement contract.
    (4) Deferred payment under a guarantee arrangement. A guarantee 
arrangement does not fail to qualify as a credit enhancement contract 
solely because the guarantor, in the event of a default on a qualified 
mortgage, has the option of immediately paying to the REMIC the full 
amount of mortgage principal due on acceleration of the defaulted 
mortgage, or paying principal and interest to the REMIC according to the 
original payment schedule for the defaulted mortgage, or according to 
some other deferred payment schedule. Any deferred payments are payments 
pursuant to a credit enhancement contract even if the mortgage is 
foreclosed upon and the guarantor, pursuant to subrogation rights set 
out in the guarantee arrangement, is entitled to receive immediately the 
proceeds of foreclosure.
    (d) Treatment of certain purchase agreements with respect to 
convertible mortgages--(1) In general. For purposes of sections 
860D(a)(4) and 860G(a)(3), a purchase agreement (as described in 
paragraph (d)(3) of this section) with respect to a convertible mortgage 
(as described in paragraph (d)(5) of this section) is treated as 
incidental to the convertible mortgage to which it relates. 
Consequently, the purchase agreement is part of the mortgage or pool of 
mortgages and is not a separate asset of the REMIC.
    (2) Treatment of amounts received under purchase agreements. For 
purposes of sections 860A through 860G and for purposes of determining 
the accrual of

[[Page 118]]

original issue discount and market discount under sections 1272(a)(6) 
and 1276, respectively, a payment under a purchase agreement described 
in paragraph (d)(3) of this section is treated as a prepayment in full 
of the mortgage to which it relates. Thus, for example, a payment under 
a purchase agreement with respect to a qualified mortgage is considered 
a payment received under a qualified mortgage within the meaning of 
section 860G(a)(6) and the transfer of the mortgage is not a disposition 
of the mortgage within the meaning of section 860F(a)(2)(A).
    (3) Purchase agreement. A purchase agreement is a contract between 
the holder of a convertible mortgage and a third party under which the 
holder agrees to sell and the third party agrees to buy the mortgage for 
an amount equal to its current principal balance plus accrued but unpaid 
interest if and when the mortgagor elects to convert the terms of the 
mortgage.
    (4) Default by the person obligated to purchase a convertible 
mortgage. If the person required to purchase a convertible mortgage 
defaults on its obligation to purchase the mortgage upon conversion, the 
REMIC may sell the mortgage in a market transaction and the proceeds of 
the sale will be treated as amounts paid pursuant to a purchase 
agreement.
    (5) Convertible mortgage. A convertible mortgage is a mortgage that 
gives the obligor the right at one or more times during the term of the 
mortgage to elect to convert from one interest rate to another. The new 
rate of interest must be determined pursuant to the terms of the 
instrument and must be intended to approximate a market rate of interest 
for newly originated mortgages at the time of the conversion.
    (e) Prepayment interest shortfalls. An agreement by a mortgage 
servicer or other third party to make payments to the REMIC to make up 
prepayment interest shortfalls is not treated as a separate asset of the 
REMIC and payments made pursuant to such an agreement are treated as 
payments on the qualified mortgages. With respect to any mortgage that 
prepays, the prepayment interest shortfall for the accrual period in 
which the mortgage prepays is an amount equal to the excess of the 
interest that would have accrued on the mortgage during that accrual 
period had it not prepaid, over the interest that accrued from the 
beginning of that accrual period up to the date of the prepayment.
    (f) Defective obligations--(1) Defective obligation defined. For 
purposes of sections 860G(a)(4)(B)(ii) and 860F(a)(2), a defective 
obligation is a mortgage subject to any of the following defects.
    (i) The mortgage is in default, or a default with respect to the 
mortgage is reasonably foreseeable.
    (ii) The mortgage was fraudulently procured by the mortgagor.
    (iii) The mortgage was not in fact principally secured by an 
interest in real property within the meaning of paragraph (a)(1) of this 
section.
    (iv) The mortgage does not conform to a customary representation or 
warranty given by the sponsor or prior owner of the mortgage regarding 
the characteristics of the mortgage, or the characteristics of the pool 
of mortgages of which the mortgage is a part. A representation that 
payments on a qualified mortgage will be received at a rate no less than 
a specified minimum or no greater than a specified maximum is not 
customary for this purpose.
    (2) Effect of discovery of defect. If a REMIC discovers that an 
obligation is a defective obligation, and if the defect is one that, had 
it been discovered before the startup day, would have prevented the 
obligation from being a qualified mortgage, then, unless the REMIC 
either causes the defect to be cured or disposes of the defective 
obligation within 90 days of discovering the defect, the obligation 
ceases to be a qualified mortgage at the end of that 90 day period. Even 
if the defect is not cured, the defective obligation is, nevertheless, a 
qualified mortgage from the startup day through the end of the 90 day 
period. Moreover, even if the REMIC holds the defective obligation 
beyond the 90 day period, the REMIC may, nevertheless, exchange the 
defective obligation for a qualified replacement mortgage so long as the 
requirements of section 860G(a)(4)(B) are satisfied. If the defect is 
one that does not affect the status of an obligation as a qualified 
mortgage, then the obligation

[[Page 119]]

is always a qualified mortgage regardless of whether the defect is or 
can be cured. For example, if a sponsor represented that all mortgages 
transferred to a REMIC had a 10 percent interest rate, but it was later 
discovered that one mortgage had a 9 percent interest rate, the 9 
percent mortgage is defective, but the defect does not affect the status 
of that obligation as a qualified mortgage.
    (g) Permitted investments--(1) Cash flow investment--(i) In general. 
For purposes of section 860G(a)(6) and this section, a cash flow 
investment is an investment of payments received on qualified mortgages 
for a temporary period between receipt of those payments and the 
regularly scheduled date for distribution of those payments to REMIC 
interest holders. Cash flow investments must be passive investments 
earning a return in the nature of interest.
    (ii) Payments received on qualified mortgages. For purposes of 
paragraph (g)(1) of this section, the term ``payments received on 
qualified mortgages'' includes--
    (A) Payments of interest and principal on qualified mortgages, 
including prepayments of principal and payments under credit enhancement 
contracts described in paragraph (c)(2) of this section;
    (B) Proceeds from the disposition of qualified mortgages;
    (C) Cash flows from foreclosure property and proceeds from the 
disposition of such property;
    (D) A payment by a sponsor or prior owner in lieu of the sponsor's 
or prior owner's repurchase of a defective obligation, as defined in 
paragraph (f) of this section, that was transferred to the REMIC in 
breach of a customary warranty; and
    (E) Prepayment penalties required to be paid under the terms of a 
qualified mortgage when the mortgagor prepays the obligation.
    (iii) Temporary period. For purposes of section 860G(a)(6) and this 
paragraph (g)(1), a temporary period generally is that period from the 
time a REMIC receives payments on qualified mortgages and permitted 
investments to the time the REMIC distributes the payments to interest 
holders. A temporary period may not exceed 13 months. Thus, an 
investment held by a REMIC for more than 13 months is not a cash flow 
investment. In determining the length of time that a REMIC has held an 
investment that is part of a commingled fund or account, the REMIC may 
employ any reasonable method of accounting. For example, if a REMIC 
holds mortgage cash flows in a commingled account pending distribution, 
the first-in, first-out method of accounting is a reasonable method for 
determining whether all or part of the account satisfies the 13 month 
limitation.
    (2) Qualified reserve funds. The term qualified reserve fund means 
any reasonably required reserve to provide for full payment of expenses 
of the REMIC or amounts due on regular or residual interests in the 
event of defaults on qualified mortgages, prepayment interest shortfalls 
(as defined in paragraph (e) of this section), lower than expected 
returns on cash flow investments, or any other contingency that could be 
provided for under a credit enhancement contract (as defined in 
paragraph (c) (2) and (3) of this section).
    (3) Qualified reserve asset--(i) In general. The term ``qualified 
reserve asset'' means any intangible property (other than a REMIC 
residual interest) that is held both for investment and as part of a 
qualified reserve fund. An asset need not generate any income to be a 
qualified reserve asset.
    (ii) Reasonably required reserve--(A) In general. In determining 
whether the amount of a reserve is reasonable, it is appropriate to 
consider the credit quality of the qualified mortgages, the extent and 
nature of any guarantees relating to either the qualified mortgages or 
the regular and residual interests, the expected amount of expenses of 
the REMIC, and the expected availability of proceeds from qualified 
mortgages to pay the expenses. To the extent that a reserve exceeds a 
reasonably required amount, the amount of the reserve must be promptly 
and appropriately reduced. If at any time, however, the amount of the 
reserve fund is less than is reasonably required, the amount of the 
reserve fund may be increased by the addition of

[[Page 120]]

payments received on qualified mortgages or by contributions from 
holders of residual interests.
    (B) Presumption that a reserve is reasonably required. The amount of 
a reserve fund is presumed to be reasonable (and an excessive reserve is 
presumed to have been promptly and appropriately reduced) if it does not 
exceed--
    (1) The amount required by a nationally recognized independent 
rating agency as a condition of providing the rating for REMIC interests 
desired by the sponsor; or
    (2) The amount required by a third party insurer or guarantor, who 
does not own directly or indirectly (within the meaning of section 
267(c)) an interest in the REMIC (as defined in Sec. 1.860D-1(b)(1)), as 
a condition of providing credit enhancement.
    (C) Presumption may be rebutted. The presumption in paragraph 
(g)(3)(ii)(B) of this section may be rebutted if the amounts required by 
the rating agency or by the third party insurer are not commercially 
reasonable considering the factors described in paragraph (g)(3)(ii)(A) 
of this section.
    (h) Outside reserve funds. A reserve fund that is maintained to pay 
expenses of the REMIC, or to make payments to REMIC interest holders is 
an outside reserve fund and not an asset of the REMIC only if the 
REMIC's organizational documents clearly and expressly--
    (1) Provide that the reserve fund is an outside reserve fund and not 
an asset of the REMIC;
    (2) Identify the owner(s) of the reserve fund, either by name, or by 
description of the class (e.g., subordinated regular interest holders) 
whose membership comprises the owners of the fund; and
    (3) Provide that, for all Federal tax purposes, amounts transferred 
by the REMIC to the fund are treated as amounts distributed by the REMIC 
to the designated owner(s) or transferees of the designated owner(s).
    (i) Contractual rights coupled with regular interests in tiered 
arrangements--(1) In general. If a REMIC issues a regular interest to a 
trustee of an investment trust for the benefit of the trust certificate 
holders and the trustee also holds for the benefit of those certificate 
holders certain other contractual rights, those other rights are not 
treated as assets of the REMIC even if the investment trust and the 
REMIC were created contemporaneously pursuant to a single set of 
organizational documents. The organizational documents must, however, 
require that the trustee account for the contractual rights as property 
that the trustee holds separate and apart from the regular interest.
    (2) Example. The following example, which describes a tiered 
arrangement involving a pass-thru trust that is intended to qualify as a 
REMIC and a pass-thru trust that is intended to be classified as a trust 
under Sec. 301.7701-4(c) of this chapter, illustrates the provisions of 
paragraph (i)(1) of this section.

    Example. (i) A sponsor transferred a pool of mortgages to a trustee 
in exchange for two classes of certificates. The pool of mortgages has 
an aggregate principal balance of $100x. Each mortgage in the pool 
provides for interest payments based on the eleventh district cost of 
funds index (hereinafter COFI) plus a margin. The trust (hereinafter 
REMIC trust) issued a Class N bond, which the sponsor designates as a 
regular interest, that has a principal amount of $100x and that provides 
for interest payments at a rate equal to One-Year LIBOR plus 100 basis 
points, subject to a cap equal to the weighted average pool rate. The 
Class R interest, which the sponsor designated as the residual interest, 
entitles its holder to all funds left in the trust after the Class N 
bond has been retired. The Class R interest holder is not entitled to 
current distributions.
    (ii) On the same day, and under the same set of documents, the 
sponsor also created an investment trust. The sponsor contributed to the 
investment trust the Class N bond together with an interest rate cap 
contract. Under the interest rate cap contract, the issuer of the cap 
contract agrees to pay to the trustee for the benefit of the investment 
trust certificate holders the excess of One-Year LIBOR plus 100 basis 
points over the weighted average pool rate (COFI plus a margin) times 
the outstanding principal balance of the Class N bond in the event One-
Year LIBOR plus 100 basis points ever exceeds the weighted average pool 
rate. The trustee (the same institution that serves as REMIC trust 
trustee), in exchange for the contributed assets, gave the sponsor 
certificates representing undivided beneficial ownership interests in 
the Class N bond and the interest rate cap contract. The organizational 
documents require the trustee to account for the regular interest and 
the cap contract as discrete property rights.

[[Page 121]]

    (iii) The separate existence of the REMIC trust and the investment 
trust are respected for all Federal income tax purposes. Thus, the 
interest rate cap contract is an asset beneficially owned by the several 
certificate holders and is not an asset of the REMIC trust. 
Consequently, each certificate holder must allocate its purchase price 
for the certificate between its undivided interest in the Class N bond 
and its undivided interest in the interest rate cap contract in 
accordance with the relative fair market values of those two property 
rights.

    (j) Clean-up call--(1) In general. For purposes of section 
860F(a)(5)(B), a clean-up call is the redemption of a class of regular 
interests when, by reason of prior payments with respect to those 
interests, the administrative costs associated with servicing that class 
outweigh the benefits of maintaining the class. Factors to consider in 
making this determination include--
    (i) The number of holders of that class of regular interests;
    (ii) The frequency of payments to holders of that class;
    (iii) The effect the redemption will have on the yield of that class 
of regular interests;
    (iv) The outstanding principal balance of that class; and
    (v) The percentage of the original principal balance of that class 
still outstanding.
    (2) Interest rate changes. The redemption of a class of regular 
interests undertaken to profit from a change in interest rates is not a 
clean-up call.
    (3) Safe harbor. Although the outstanding principal balance is only 
one factor to consider, the redemption of a class of regular interests 
with an outstanding principal balance of no more than 10 percent of its 
original principal balance is always a clean-up call.
    (k) Startup day. The term ``startup day'' means the day on which the 
REMIC issues all of its regular and residual interests. A sponsor may, 
however, contribute property to a REMIC in exchange for regular and 
residual interests over any period of 10 consecutive days and the REMIC 
may designate any one of those 10 days as its startup day. The day so 
designated is then the startup day, and all interests are treated as 
issued on that day.

[T.D. 8458, 57 FR 61309, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993]



Sec. 1.860G-3  Treatment of foreign persons.

    (a) Transfer of a residual interest with tax avoidance potential--
(1) In general. A transfer of a residual interest that has tax avoidance 
potential is disregarded for all Federal tax purposes if the transferee 
is a foreign person. Thus, if a residual interest with tax avoidance 
potential is transferred to a foreign holder at formation of the REMIC, 
the sponsor is liable for the tax on any excess inclusion that accrues 
with respect to that residual interest.
    (2) Tax avoidance potential--(i) Defined. A residual interest has 
tax avoidance potential for purposes of this section unless, at the time 
of the transfer, the transferor reasonably expects that, for each excess 
inclusion, the REMIC will distribute to the transferee residual interest 
holder an amount that will equal at least 30 percent of the excess 
inclusion, and that each such amount will be distributed at or after the 
time at which the excess inclusion accrues and not later than the close 
of the calendar year following the calendar year of accrual.
    (ii) Safe harbor. For purposes of paragraph (a)(2)(i) of this 
section, a transferor has a reasonable expectation if the 30-percent 
test would be satisfied were the REMIC's qualified mortgages to prepay 
at each rate within a range of rates from 50 percent to 200 percent of 
the rate assumed under section 1272(a)(6) with respect to the qualified 
mortgages (or the rate that would have been assumed had the mortgages 
been issued with original issue discount).
    (3) Effectively connected income. Paragraph (a)(1) of this section 
will not apply if the transferee's income from the residual interest is 
subject to tax under section 871(b) or section 882.
    (4) Transfer by a foreign holder. If a foreign person transfers a 
residual interest to a United States person or a foreign holder in whose 
hands the income from a residual interest would be effectively connected 
income, and if the transfer has the effect of allowing the transferor to 
avoid tax on accrued excess inclusions, then the transfer is disregarded 
and the transferor continues to be treated as the owner of the residual 
interest for purposes of section 871(a), 881, 1441, or 1442.

[[Page 122]]

    (b) [Reserved]

[T.D. 8458, 57 FR 61313, Dec. 24, 1992]

  TAX BASED ON INCOME FROM SOURCES WITHIN OR WITHOUT THE UNITED STATES

                   Determination of Sources of Income



Sec. 1.861-1  Income from sources within the United States.

    (a) Categories of income. Part I (section 861 and following), 
subchapter N, chapter 1 of the Code, and the regulations thereunder 
determine the sources of income for purposes of the income tax. These 
sections explicitly allocate certain important sources of income to the 
United States or to areas outside the United States, as the case may be; 
and, with respect to the remaining income (particularly that derived 
partly from sources within and partly from sources without the United 
States), authorize the Secretary or his delegate to determine the income 
derived from sources within the United States, either by rules of 
separate allocation or by processes or formulas of general 
apportionment. The statute provides for the following three categories 
of income:
    (1) Within the United States. The gross income from sources within 
the United States, consisting of the items of gross income specified in 
section 861(a) plus the items of gross income allocated or apportioned 
to such sources in accordance with section 863(a). See Secs. 1.861-2 to 
1.861-7, inclusive, and Sec. 1.863-1. The taxable income from sources 
within the United States, in the case of such income, shall be 
determined by deducting therefrom, in accordance with sections 861(b) 
and 863(a), the expenses, losses, and other deductions properly 
apportioned or allocated thereto and a ratable part of any other 
expenses, losses, or deductions which cannot definitely be allocated to 
some item or class of gross income. See Secs. 1.861-8 and 1.863-1.
    (2) Without the United States. The gross income from sources without 
the United States, consisting of the items of gross income specified in 
section 862(a) plus the items of gross income allocated or apportioned 
to such sources in accordance with section 863(a). See Secs. 1.862-1 and 
1.863-1. The taxable income from sources without the United States, in 
the case of such income, shall be determined by deducting therefrom, in 
accordance with sections 862(b) and 863(a), the expenses, losses, and 
other deductions properly apportioned or allocated thereto and a ratable 
part of any other expenses, losses, or deductions which cannot 
definitely be allocated to some item or class of gross income. See 
Secs. 1.862-1 and 1.863-1.
    (3) Partly within and partly without the United States. The gross 
income derived from sources partly within and partly without the United 
States, consisting of the items specified in section 863(b) (1), (2), 
and (3). The taxable income allocated or apportioned to sources within 
the United States, in the case of such income, shall be determined in 
accordance with section 863 (a) or (b). See Secs. 1.863-2 to 1.863-5, 
inclusive.
    (4) Exceptions. An owner of certain aircraft or vessels first leased 
on or before December 28, 1980, may elect to treat income in respect of 
these aircraft or vessels as income from sources within the United 
States for purposes of sections 861(a) and 862(a). See Sec. 1.861-9. An 
owner of certain aircraft, vessels, or spacecraft first leased after 
December 28, 1980, must treat income in respect of these craft as income 
from sources within the United States for purposes of sections 861(a) 
and 862(a). See Sec. 1.861-9A.
    (b) Taxable income from sources within the United States. The 
taxable income from sources within the United States shall consist of 
the taxable income described in paragraph (a)(1) of this section plus 
the taxable income allocated or apportioned to such sources, as 
indicated in paragraph (a)(3) of this section.
    (c) Computation of income. If a taxpayer has gross income from 
sources within or without the United States, together with gross income 
derived partly from sources within and partly from sources without the 
United States, the amounts thereof, together with the expenses and 
investment applicable thereto, shall be segregated; and the taxable 
income from sources

[[Page 123]]

within the United States shall be separately computed therefrom.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7928, 48 FR 
55845, Dec. 16, 1983]



Sec. 1.861-2  Interest.

    (a) In general. (1) Gross income consisting of interest from the 
United States or any agency or instrumentality thereof (other than a 
possession of the United States or an agency or instrumentality of a 
possession), a State or any political subdivision thereof, or the 
District of Columbia, and interest from a resident of the United States 
on a bond, note, or other interest-bearing obligation issued, assumed or 
incurred by such person shall be treated as income from sources within 
the United States. Thus, for example, income from sources within the 
United States includes interest received on any refund of income tax 
imposed by the United States, a State or any political subdivision 
thereof, or the District of Columbia. Interest other than that described 
in this paragraph is not to be treated as income from sources within the 
United States. See paragraph (a)(7) of this section for special rules 
concerning substitute interest paid or accrued pursuant to a securities 
lending transaction.
    (2) The term ``resident of the United States'', as used in this 
paragraph, includes (i) an individual who at the time of payment of the 
interest is a resident of the United States, (ii) a domestic 
corporation, (iii) a domestic partnership which at any time during its 
taxable year is engaged in trade or business in the United States, or 
(iv) a foreign corporation or a foreign partnership, which at any time 
during its taxable year is engaged in trade or business in the United 
States.
    (3) The method by which, or the place where, payment of the interest 
is made is immaterial in determining whether interest is derived from 
sources within the United States.
    (4) For purposes of this section, the term ``interest'' includes all 
amounts treated as interest under section 483, and the regulations 
thereunder. It also includes original issue discount, as defined in 
section 1232(b)(1), whether or not the underlying bond, debenture, note, 
certificate, or other evidence of indebtedness is a capital asset in the 
hands of the taxpayer within the meaning of section 1221.
    (5) If interest is paid on an obligation of a resident of the United 
States by a nonresident of the United States acting in the nonresident's 
capacity as a guarantor of the obligation of the resident, the interest 
will be treated as income from sources within the United States.
    (6) In the case of interest received by a nonresident alien 
individual or foreign corporation this paragraph (a) applies whether or 
not the interest is effectively connected for the taxable year with the 
conduct of a trade or business in the United States by such individual 
or corporation.
    (7) A substitute interest payment is a payment, made to the 
transferor of a security in a securities lending transaction or a sale-
repurchase transaction, of an amount equivalent to an interest payment 
which the owner of the transferred security is entitled to receive 
during the term of the transaction. A securities lending transaction is 
a transfer of one or more securities that is described in section 
1058(a) or a substantially similar transaction. A sale-repurchase 
transaction is an agreement under which a person transfers a security in 
exchange for cash and simultaneously agrees to receive a substantially 
identical securities from the transferee in the future in exchange for 
cash. A substitute interest payment shall be sourced in the same manner 
as the interest accruing on the transferred security for purposes of 
this section and Sec. 1.862-1. See also Secs. 1.864-5(b)(2)(iii), 1.871-
7(b)(2), 1.881-2(b)(2) and for the character of such payments and 
Sec. 1.894-1(c) for the application tax treaties to these transactions.
    (b) Interest not derived from U.S. sources. Notwithstanding 
paragraph (a) of this section, interest shall be treated as income from 
sources without the United States to the extent provided by 
subparagraphs (A) through (H), of section 861(a)(1) and by the following 
subparagraphs of this paragraph.
    (1) Interest on bank deposits and on similar amounts. (i) Interest 
paid or credited before January 1, 1977, to a

[[Page 124]]

nonresident alien individual or foreign corporation on--
    (a) Deposits with persons, including citizens of the United States 
or alien individuals and foreign or domestic partnerships or 
corporations, carrying on the banking business in the United States,
    (b) Deposits or withdrawable accounts with savings institutions 
chartered and supervised as savings and loan or similar associations 
under Federal or State law, or
    (c) Amounts held by an insurance company under an agreement to pay 
interest thereon, shall be treated as income from sources without the 
United States if such interest is not effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by such nonresident alien individual or foreign corporation. If 
such interest is effectively connected for the taxable year with the 
conduct of a trade or business in the United States by such nonresident 
alien individual or foreign corporation, it shall be treated as income 
from sources within the United States under paragraph (a) of this 
section unless it is treated as income from sources without the United 
States under another subparagraph of this paragraph. For a special rule 
for determining whether such interest is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States, see paragraph (c)(1)(ii) or Sec. 1.864-4.
    (ii) Paragraph (b)(1)(i)(b) of this section applies to interest on 
deposits or withdrawable accounts described therein only to the extent 
that the interest paid or credited by the savings institution described 
therein is deductible under section 591 in determining the taxable 
income of such institution; and, for this purpose, whether an amount is 
deductible under section 591 shall be determined without regard to 
section 265, relating to deductions allocable to tax-exempt income. 
Thus, for example, such subdivision does not apply to amounts paid by a 
savings and loan or similar association on or with respect to its 
nonwithdrawable capital stock or on or with respect to funds held in 
restricted accounts which represent a proprietary interest in such 
association. Paragraph (b)(1)(i)(b) of this section also applies to so-
called dividends paid or credited on deposits or withdrawable accounts 
if such dividends are deductible under section 591 without reference to 
section 265.
    (iii) For purposes of paragraph (b)(1)(i)(c) of this section, 
amounts held by an insurance company under an agreement to pay interest 
thereon include policyholder dividends left with the company to 
accumulate, prepaid insurance premiums, proceeds of policies left on 
deposit with the company, and overcharges of premiums. Such subdivision 
does not apply to (a) the so-called ``interest element'' in the case of 
annuity or installment payments under life insurance or endowment 
contracts or (b) interest paid by an insurance company to its creditors 
on notes, bonds, or similar evidences of indebtedness, if the debtor-
creditor relationship does not arise by virtue of a contract of 
insurance with the insurance company.
    (iv) For purposes of paragraph (b)(1)(i) of this section, interest 
received by a partnership shall be treated as received by each partner 
of such partnership to the extent of his distributive share of such 
item.
    (2) Interest from a resident alien individual or domestic 
corporation deriving substantial income from sources without the United 
States. Interest received from a resident alien individual or a domestic 
corporation shall be treated as income from sources without the United 
States when it is shown to the satisfaction of the district director 
(or, if applicable, the Director of International Operations) that less 
than 20 percent of the gross income from all sources of such individual 
or corporation has been derived from sources within the United States, 
as determined under the provisions of sections 861 to 863, inclusive, 
and the regulations thereunder, for the 3-year period ending with the 
close of the taxable year of such individual or corporation preceding 
its taxable year in which such interest is paid or credited, or for such 
part of such period as may be applicable. If 20 percent or more of the 
gross income from all sources of such individual or corporation has been 
derived from sources

[[Page 125]]

within the United States, as so determined, for such 3-year period (or 
part thereof), the entire amount of the interest from such individual or 
corporation shall be treated as income from sources within the United 
States.
    (3) Interest from a foreign corporation not deriving major portion 
of its income from a U.S. business. (i) Interest from a foreign 
corporation which, at any time during the taxable year, is engaged in 
trade or business in the United States shall be treated as income from 
sources without the United States when it is shown to the satisfaction 
of the district director (or, if applicable, the Director of 
International Operations) that (a) less than 50 percent of the gross 
income from all sources of such foreign corporation for the 3-year 
period ending with the close of its taxable year preceding its taxable 
year in which such interest is paid or credited (or for such part of 
such period as the corporation has been in existence) was effectively 
connected with the conduct by such corporation of a trade or business in 
the United States, as determined under section 864(c) and Sec. 1.864-3, 
or (b) such foreign corporation had gross income for such 3-year period 
(or part thereof) but none was effectively connected with the conduct of 
a trade or business in the United States.
    (ii) If 50 percent or more of the gross income from all sources of 
such foreign corporation for such 3-year period (or part thereof) was 
effectively connected with the conduct by such corporation of a trade or 
business in the United States, see section 861(a)(1)(D) and paragraph 
(c)(1) of this section for determining the portion of interest from such 
corporation which is treated as income from sources within the United 
States.
    (iii) For purposes of this paragraph the gross income which is 
effectively connected with the conduct of a trade or business in the 
United States includes the gross income which, pursuant to section 882 
(d) or (e) and the regulations thereunder, is treated as income which is 
effectively connected with the conduct of a trade or business in the 
United States.
    (iv) This paragraph does not apply to interest paid or credited 
after December 31, 1969, by a branch in the United States of a foreign 
corporation if, at the time of payment or crediting, such branch is 
engaged in the commercial banking business in the United States; 
furthermore, such interest is treated under paragraph (a) of this 
section as income from sources within the United States unless it is 
treated as income from sources without the United States under paragraph 
(b) (1) or (4) of this section.
    (4) Bankers' acceptances. Interest derived by a foreign central bank 
of issue from bankers' acceptances shall be treated as income from 
sources without the United States. For this purpose, a foreign central 
bank of issue is a bank which is by law or government sanction the 
principal authority, other than the government itself, issuing 
instruments intended to circulate as currency. Such a bank is generally 
the custodian of the banking reserves of the country under whose laws it 
is organized.
    (5) Foreign banking branch of a domestic corporation or partnership. 
Interest paid or credited on deposits with a branch outside the United 
States (as defined in section 7701(a)(9)) of a domestic corporation or 
of a domestic partnership shall be treated as income from sources 
without the United States, if, at the time of payment or crediting, such 
branch is engaged in the commercial banking business. For purposes of 
applying this paragraph, it is immaterial (i) whether the domestic 
corporation or domestic partnership is carrying on a banking business in 
the United States, (ii) whether the recipient of the interest is a 
citizen or resident of the United States, a foreign corporation, or a 
foreign partnership, (iii) whether the interest is effectively connected 
with the conduct of a trade or business in the United States by the 
recipient, or (iv) whether the deposits with the branch located outside 
the United States are payable in the currency of a foreign country. 
Notwithstanding the provisions of Sec. 1.863-6, interest to which this 
paragraph applies shall be treated as income from sources within the 
foreign country, possession of the United States, or other territory in 
which the branch is located.
    (6) Section 4912(c) debt obligations-- (i) In general. Under section 
861(a)(1)(G),

[[Page 126]]

interest on a debt obligation shall not be treated as income from 
sources within the United States if--
    (a) The debt obligation was part of an issue of debt obligations 
with respect to which an election has been made under section 4912(c) 
(relating to the treatment of such debt obligations as debt obligations 
of a foreign obligor for purposes of the interest equalization tax),
    (b) The debt obligation had a maturity not exceeding 15 years 
(within the meaning of paragraph (b)(6)(ii) of this section) on the date 
it is originally issued or on the date it is treated under section 
4912(c)(2) as issued by reason of being assumed by a certain domestic 
corporation,
    (c) The debt obligation, when originally issued, was purchased by 
one or more underwriters (within the meaning of paragraph (b)(6)(iii) of 
this section) with a view to distribution through resale (within the 
meaning of paragraph (b)(6)(iv) of this section), and
    (d) The interest on the debt obligation is attributable to periods 
after the effective date of an election under section 4912(c) to treat 
such debt obligations as debt obligations of a foreign obligor for 
purposes of the interest equalization tax.
    (ii) Maturity not exceeding 15 years. The date the debt obligation 
is issued or treated as issued is not included in the 15 year 
computation, but the date of maturity of the debt, obligation is 
included in such computation.
    (iii) Purchased by one or more underwriters. For purposes of this 
paragraph, the debt obligation when originally issued will not be 
treated as purchased by one or more underwriters unless the underwriter 
purchases the debt obligation for his own account and bears the risk of 
gain or loss on resale. Thus, for example, a debt obligation, when 
originally issued, will not be treated as purchased by one or more 
underwriters if the underwriter acts only in the capacity of an agent of 
the issuer. Neither will a debt obligation, when originally issued, be 
treated as purchased by one or more underwriters if the agreement 
between the underwriter and issuer is merely for a ``best efforts'' 
underwriting, for the purchase by the underwriter of all or a portion of 
the debt obligations remaining unsold at the expiration of a fixed 
period of time, or for any other arrangement under the terms of which 
the debt obligations are not purchased by the underwriter with a view to 
distribution through resale. The fact that an underwriter is related to 
the issuer will not prevent the underwriter from meeting the 
requirements of this paragraph. In determining whether a related 
underwriter meets the requirements of this paragraph consideration shall 
be given to whether the purchase by the underwriter of the debt 
obligation from the issuer for resale was effected by a transaction 
subject to conditions similar to those which would have been imposed 
between independent persons.
    (iv) With a view to distribution through resale. (a) An underwriter 
who purchased a debt obligation shall be deemed to have purchased it 
with a view to distribution through resale if the requirements of 
paragraph (b)(6)(iv) (b) or (c) of this section are met.
    (b) The requirements of this paragraph (b) is that--
    (1) The debt obligation is registered, approved, or listed for 
trading on one or more foreign securities exchanges or foreign 
established securities markets within 4 months after the date on which 
the underwriter purchases the debt obligation, or by the date of the 
first interest payment on the debt obligation, whichever is later, or
    (2) The debt obligation, or any substantial portion of the issue of 
which the debt obligation is a part, is actually traded on one or more 
foreign securities markets on or within 15 calendar days after the date 
on which the underwriter purchases the debt obligation.

For purposes of this paragraph (b)(6)(iv), a foreign established 
securities market includes any foreign over-the-counter market as 
reflected by the existence of an inter-dealer quotation system for 
regularly disseminating to brokers and dealers quotations of obligations 
by identified brokers or dealers, other than quotations prepared and 
distributed by a broker or dealer in the regular course of his business 
and containing only quotations of such broker or dealer.

[[Page 127]]

    (c) The requirements of this paragraph (c) are that, except as 
provided in paragraph (b)(6)(iv)(d) of this section, the underwriter is 
under no written or implied restriction imposed by the issuer with 
respect to whom he may resell the debt obligation and either--
    (1) Within 30 calendar days after he purchased the debt obligation 
the underwriter or underwriters either (i) sold it or (ii) sold at least 
95 percent of the face amount of the issue of which the debt obligation 
is a part, or
    (2)(i) The debt obligation is evidenced by an instrument which, 
under the laws of the jurisdiction in which it is issued, is either 
negotiable or transferable by assignment (whether or not it is 
registered for trading), and (ii) it appears from all the relevant facts 
and circumstances, including any written statements or assurances made 
by the purchasing underwriter or underwriters, that such debt obligation 
was purchased with a view to distribution through resale.
    (d) The requirements of paragraph (b)(6)(iv)(c) of this paragraph 
may be met whether or not the underwriter is restricted from reselling 
the debt obligations--
    (1) To a United States person (as defined in section 7701(a)(30)) or
    (2) To any particular person or persons pursuant to a restriction 
imposed by, or required to be met in order to comply with, United States 
or foreign securities or other law.
    (v) Statement with return. Any taxpayer who is required to file a 
tax return and who excludes from gross income interest of the type 
specified in this subparagraph must comply with the requirements of 
paragraph (d) of this section.
    (vi) Effect of termination of IET. If the interest equalization tax 
expires, the provisions of section 861(a)(1)(G) and this subparagraph 
shall apply to interest paid on debt obligations only with respect to 
which a section 4912(c) election was made.
    (vii) Definition of term underwriter. For purposes of section 
861(a)(1)(G) and this paragraph, the term ``underwriter'' shall mean any 
underwriter as defined in section 4919(c)(1).
    (c) Special rules--(1) Proration of interest from a foreign 
corporation deriving major portion of its income from a U.S. business. 
If, after applying the first sentence of paragraph (b)(3) of this 
section to interest to which that paragraph applies, it is determined 
that the interest may not be treated as income from sources without the 
United States, the amount of the interest from the foreign corporation 
which at some time during the taxable year is engaged in trade or 
business in the United States which is to be treated as income from 
sources within the United States shall be the amount that bears the same 
ratio to such interest as the gross income of such foreign corporation 
for the 3-year period ending with the close of its taxable year 
preceding its taxable year in which such interest is paid or credited 
(or for such part of such period as the corporation has been in 
existence) which was effectively connected with the conduct by such 
corporation of a trade or business in the United States bears to its 
gross income from all sources for such period.
    (2) Payors having no gross income for period preceding taxable year 
of payment. If the resident alien individual, domestic corporation, or 
foreign corporation, as the case may be, paying interest has no gross 
income from any source for the 3-year period (or part thereof) specified 
in paragraph (b) (2) or (3) of this section, or paragraph (c)(1) of this 
section, the 20-percent test or the 50-percent test, or the 
apportionment formula, as the case may be, described in such paragraph 
shall be applied solely with respect to the taxable year of the payor in 
which the interest is paid or credited. This paragraph applies whether 
the lack of gross income for the 3-year period (or part thereof) stems 
from the business inactivity of the payor, from the fact that the payor 
is a corporation which is newly created or organized, or from any other 
cause.
    (3) Transitional rule. For purposes of applying paragraph (b)(3) of 
this section, and paragraph (c)(1) of this section, the gross income of 
the foreign corporation for any period before the first taxable year 
beginning after December 31, 1966, which is from sources within the 
United States (determined as provided by sections 861 through 863,

[[Page 128]]

and the regulations thereunder, as in effect immediately before 
amendment by section 102 of the Foreign Investors Tax Act of 1966 (Pub. 
L. 89-809, 80 Stat. 1541)) shall be treated as gross income for such 
period which is effectively connected with the conduct of a trade or 
business in the United States by such foreign corporation.
    (4) Gross income determinations. In making determinations under 
paragraph (b) (2) or (3) of this section, or paragraph (c) (1) or (3) of 
this section--
    (i) The gross income of a domestic corporation or a resident alien 
individual is to be determined by excluding any items specifically 
excluded from gross income under chapter 1 of the Code, and
    (ii) The gross income of a foreign corporation which is effectively 
connected with the conduct of a trade or business in the United States 
is to be determined under section 882(b)(2) and by excluding any items 
specifically excluded from gross income under chapter 1 of the Code, and
    (iii) The gross income from all sources of a foreign corporation is 
to be determined without regard to section 882(b) and without excluding 
any items otherwise specifically excluded from gross income under 
chapter 1 of the Code.
    (d) Statement with return. Any taxpayer who is required to file a 
return and applies any provision of this section to exclude an amount of 
interest from his gross income must file with his return a statement 
setting forth the amount so excluded, the date of its receipt, the name 
and address of the obligor of the interest, and, if known, the location 
of the records which substantiate the amount of the exclusion. A 
statement from the obligor setting forth such information and indicating 
the amount of interest to be treated as income from sources without the 
United States may be used for this purpose. See Secs. 1.6012-1(b)(1)(i) 
and 1.6012-2(g)(1)(i).
    (e) Effective dates. Except as otherwise provided, this section 
applies with respect to taxable years beginning after December 31, 1966. 
For corresponding rules applicable to taxable years beginning before 
January 1, 1967, (see 26 CFR part 1 revised April 1, 1971). Paragraph 
(a)(7) of this section is applicable to payments made after November 13, 
1997.

[T.D. 7378, 40 FR 45429, Oct. 2, 1975; 40 FR 48508, Oct. 16, 1975, as 
amended by T.D. 8257, 54 FR 31819, Aug. 2, 1989; T.D. 8735, 62 FR 53500, 
Oct. 14, 1997]



Sec. 1.861-3  Dividends.

    (a) General--(1) Dividends included in gross income. Gross income 
from sources within the United States includes a dividend described in 
subparagraph (2), (3), (4), or (5) of this paragraph. For purposes of 
subparagraphs (2), (3), and (4) of this paragraph, the term ``dividend'' 
shall have the same meaning as set forth in section 316 and the 
regulations thereunder. See subparagraph (5) of this paragraph for 
special rules with respect to certain dividends from a DISC or former 
DISC. See also paragraph (a)(6) of this section for special rules 
concerning substitute dividend payments received pursuant to a 
securities lending transaction.
    (2) Dividend from a domestic corporation. A dividend described in 
this subparagraph is a dividend from a domestic corporation other than a 
domestic corporation entitled to the benefits of section 931, and other 
than a domestic corporation less than 20 percent of the gross income of 
which is shown to the satisfaction of the district director (or, if 
applicable, the Director of International Operations) to have been 
derived from sources within the United States, as determined under the 
provisions of sections 861 to 864, inclusive, and the regulations 
thereunder, for the 3-year period ending with the close of the taxable 
year of such corporation preceding the declaration of such dividend, or 
for such part of such period as the corporation has been in existence. 
See subparagraph (5) of this paragraph for the treatment of certain 
dividends from a DISC or former DISC.
    (3) Dividend from a foreign corporation--(i) In general. (a) A 
dividend described in this subparagraph is a dividend from a foreign 
corporation (other than a dividend to which subparagraph (4) of this 
paragraph applies) unless less than 50 percent of the gross income from 
all sources of such foreign corporation for the 3-year period ending 
with the close of its taxable year

[[Page 129]]

preceding the taxable year in which occurs the declaration of such 
dividend (or for such part of such period as the corporation has been in 
existence) was effectively connected with the conduct by such 
corporation of a trade or business in the United States, as determined 
under section 864(c) and Sec. 1.864-3. Thus, no portion of a dividend 
from a foreign corporation shall be treated as income from sources 
within the United States under section 861(a)(2)(B) if less than 50 
percent of the gross income of such foreign corporation from all sources 
for such 3-year period (or part thereof) was effectively connected with 
the conduct by such corporation of a trade or business in the United 
States or if such foreign corporation had gross income for such 3-year 
period (or part thereof) but none was effectively connected with the 
conduct by such corporation of a trade or business in the United States.
    (b) If 50 percent or more of the gross income from all sources of 
such foreign corporation for such 3-year period (or part thereof) was 
effectively connected with the conduct by such corporation of a trade or 
business in the United States, the amount of the dividend which is to be 
treated as income from sources within the United States under section 
861(a)(2)(B) shall be the amount that bears the same ratio to such 
dividend as the gross income of such foreign corporation for such 3-year 
period (or part thereof) which was effectively connected with the 
conduct by such corporation of a trade or business in the United States 
bears to its gross income from all sources for such period.
    (c) For purposes of this subdivision (i), the gross income which is 
effectively connected with the conduct of a trade or business in the 
United States includes the gross income which, pursuant to section 882 
(d) or (e), is treated as income which is effectively connected with the 
conduct of a trade or business in the United States.
    (ii) Rule applicable in applying limitation on amount of foreign tax 
credit. For purposes of determining under section 904 the limitation 
upon the amount of the foreign tax credit--
    (a) So much of a dividend from a foreign corporation as exceeds (and 
only to the extent it so exceeds) the amount which is 100/85ths of the 
amount of the deduction allowable under section 245(a) in respect of 
such dividend, plus
    (b) An amount which bears the same proportion to any section 78 
dividend to which the dividend from the foreign corporation gives rise 
as the amount of the excess determined under (a) of this subdivision 
bears to the total amount of the dividend from the foreign corporation, 
shall, notwithstanding subdivision (i) of this subparagraph, be treated 
as income from sources without the United States. This subdivision 
applies to a dividend for which no dividends-received deduction is 
allowed under section 245 or for which the 85 percent dividends-received 
deduction is allowed under section 245(a) but does not apply to a 
dividend for which a deduction is allowable under section 245(b). All of 
a dividend for which the 100 percent dividends-received deduction is 
allowed under section 245(b) shall be treated as income from sources 
within the United States for purposes of determining under section 904 
the limitation upon the amount of the foreign tax credit. If the amount 
of a distribution of property other than money (constituting a dividend 
under section 316) is determined by applying section 301(b)(1)(C), such 
amount must be used as the dividend for purposes of applying (a) of this 
subdivision even though the amount used for purposes of section 245(a) 
is determined by applying section 301(b)(1)(D). In making determinations 
under this subdivision, a dividend (other than a section 78 dividend 
referred to in (b) of this subdivision) shall be determined without 
regard to section 78.
    (iii) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. D, a domestic corporation, owns 80 percent of the 
outstanding stock of M, a foreign manufacturing corporation. M, which 
makes its returns on the basis of the calendar year, has earnings and 
profits of $200,000 for 1971 and 60 percent of its gross income for that 
year is effectively connected for 1971 with the conduct of a trade or 
business in the United States. For an uninterrupted period of 36 months 
ending on December 31, 1970, M has been engaged in trade or business in 
the United States and has received gross income effectively connected 
with the conduct of a trade or business in the

[[Page 130]]

United States amounting to 60 percent of its gross income from all 
sources for such period. The only distribution by M to D for 1971 is a 
cash dividend of $100,000; of this amount, $60,000 ($100,000x60%) is 
treated under subdivision (i) of this subparagraph as income from 
sources within the United States, and $40,000 ($100,000-$60,000) is 
treated under Sec. 1.862-1(a)(2) as income from sources without the 
United States. Accordingly, under section 245(a), D is entitled to a 
dividends-received deduction of $51,000 ($60,000x85%), and under 
subdivision (ii) of this subparagraph $40,000 ($100,000-[$51,000x100/
85]) is treated as income from sources without the United States for 
purposes of determining under section 904(a) (1) or (2) the limitation 
upon the amount of the foreign tax credit.
    Example 2. (a) The facts are the same as in example (1) except that 
the distribution for 1971 consists of property which has a fair market 
value of $100,000 and an adjusted basis of $30,000 in M's hands 
immediately before the distribution. The amount of the dividend under 
section 316 is $58,000, determined by applying secton 301(b)(1)(C) as 
follows:

Portion of adjusted basis of property attributable to gross      $18,000
 income of M effectively connected for 1971 with conduct of
 trade or business in United States ($30,000x60%).............
Portion of fair market value of property attributable to gross    40,000
 income of M not effectively connected for 1971 with conduct
 of trade or business in United States ($100,000x40%).........
                                                               ---------
      Total dividend..........................................    58,000
 

    (b) Of the total dividend, $34,800 ($58,000x60% (percentage 
applicable to 3-year period)) is treated under subdivision (i) of this 
subparagraph as income from sources within the United States, and 
$23,200 ($58,000x40%) is treated under Sec. 1.862-1(a)(2) as income from 
sources without the United States. However, by reason of section 245(c) 
the adjusted basis of the property ($30,000) is used under section 
245(a) in determining the dividends-received deduction. Thus, under 
section 245(a), D is entitled to a dividends-received deduction of 
$15,300 ($30,000x60%x85%).
    (c) Under subdivision (ii) of this subparagraph, the amount of the 
dividend for purposes of applying (a) of that subdivision is the amount 
($58,000) determined by applying section 301(b)(1)(C) rather than the 
amount ($30,000) determined by applying section 301(b)(1)(B). 
Accordingly, under subdivision (ii) of this subparagraph $40,000 
($58,000-[$15,300x100/85]) is treated as income from sources without the 
United States for purposes of determining under section 904(a) (1) or 
(2) the limitation upon the amount of the foreign tax credit.
    Example 3. (a) D, a domestic corporation which makes its returns on 
the basis of the calendar year, owns 100 percent of the outstanding 
stock of N, a foreign corporation which is not a less developed country 
corporation under section 902(d). N, which makes its returns on the 
basis of the calendar year, has total gross income for 1971 of $100,000, 
of which $80,000 (including $60,000 from sources within foreign country 
X) is effectively connected for that year with the conduct of a trade or 
business in the United States. For 1971 N is assumed to have paid 
$27,000 of income taxes to country X and to have accumulated profits of 
$81,000 for purposes of section 902(c)(1)(A). N's accumulated profits in 
excess of foreign income taxes amount to $54,000. For 1971 D receives a 
cash dividend of $42,000 from N, which is D's only income for that year.
    (b) For 1971 D chooses the benefits of the foreign tax credit under 
section 901, and as a result is required under section 78 to include in 
gross income an amount equal to the foreign income taxes of $21,000 
($27,000x$42,000/$54,000) it is deemed to have paid under section 
902(a)(1). Thus, assuming no other deductions for the taxable year, D 
has gross income of $63,000 ($42,000+$21,000) for 1971 less a dividends-
received deduction under section 245(a) of $28,560 ([$42,000x$80,000/
$100,000]x85%), or taxable income for 1971 of $34,440.
    (c) Under subdivision (ii) of this subparagraph, for purposes of 
determining under section 904(a) (1) or (2) the limitation upon the 
amount of the foreign tax credit, $12,600 is treated as income from 
sources without the United States, determined as follows:

Excess of dividend from N over amount which is 100/85ths of       $8,400
 amount of sec. 245(a) deduction ($42,000-[$28,560x 100/85])..
Proportionate part of sec. 78 dividend ($21,000x$8,400/            4,200
 $42,000).....................................................
                                                               ---------
      Taxable income from sources without the United States...    12,600
 

    Example 4. A, an individual citizen of the United States who makes 
his return on the basis of the calendar year, receives in 1971 a cash 
dividend of $10,000 from M, a foreign corporation, which makes its 
return on the basis of the calendar year. For the 3-year period ending 
with 1970 M has been engaged in trade or business in the United States 
and has received gross income effectively connected with the conduct of 
a trade or business in the United States amounting to 80 percent of its 
gross income from all sources for such period. Of the total dividend, 
$8,000 ($10,000x80%) is treated under subdivision (i) of this 
subparagraph as income from sources within the United States and $2,000 
($10,000-$8,000) is treated under Sec. 1.862-1(a)(2) as income from 
sources without the United States. Since under section 245 no dividends 
received-deduction is allowable to an individual, A is entitled under 
subdivision (ii) of this subparagraph to treat the entire dividend of 
$10,000 ($10,000-[$0x100/85]) as income from sources without the United 
States for purposes of determining under section 904(a)

[[Page 131]]

(1) or (2) the limitation upon the amount of the foreign tax credit.

    (4) Dividend from a foreign corporation succeeding to earnings of a 
domestic corporation. A dividend described in this subparagraph is a 
dividend from a foreign corporation, if such dividend is received by a 
corporation after December 31, 1959, but only to the extent that such 
dividend is treated by such recipient corporation under the provisions 
of Sec. 1.243-3 as a dividend from a domestic corporation subject to 
taxation under chapter 1 of the Code. To the extent that this 
subparagraph applies to a dividend received from a foreign corporation, 
subparagraph (3) of this paragraph shall not apply to such dividend.
    (5) Certain dividends from a DISC or former DISC--(i) General rule. 
A dividend described in this subparagraph is a dividend from a 
corporation that is a DISC or former DISC (as defined in section 992(a)) 
other than a dividend that--
    (a) Is deemed paid by a DISC, for taxable years beginning before 
January 1, 1976, under section 995(b)(1)(D) as in effect for taxable 
years beginning before January 1, 1976, and for taxable years beginning 
after December 31, 1975, under section 995(b)(1) (D), (E), and (F) to 
the extent provided in subdivision (iii) of this subparagraph or
    (b) Reduces under Sec. 1.996-3(b)(3) accumulated DISC income (as 
defined in subdivision (ii)(b) of this subparagraph) to the extend 
provided in subdivision (iv) of this subparagraph.

Thus, a dividend deemed paid under section 995(b)(1) (A), (B), or (C) 
(relating to certain deemed distributions in qualified years) will be 
treated in full as gross income from sources within the United States. 
To the extent that a dividend from a DISC or former DISC is paid out of 
other earnings and profits (as defined in Sec. 1.996-3(d)), subparagraph 
(2) of this paragraph shall apply. To the extent that a dividend from a 
DISC or former DISC is paid out of previously taxed income (as defined 
in Sec. 1.996-3(c)), see section 996(a)(3) (relating to the exclusion 
from gross income of amounts distributed out of previously taxed 
income). In determining the source of income of certain dividends from a 
DISC or former DISC, the source of income from any transaction which 
gives rise to gross receipts (as defined in Sec. 1.993-6), in the hands 
of the DISC or former DISC, is immaterial.
    (ii) Definitions. For purposes of this subparagraph, the term--
    (a) ``Dividend from'' means any amount actually distributed which is 
a dividend within the meaning of section 316 (including distributions to 
meet qualification requirements under section 992(c)) and any amount 
treated as a distribution taxable as a dividend pursuant to section 
995(b) (relating to deemed distributions in qualified years or upon 
disqualification) or included in gross income as a dividend pursuant to 
section 995(c) (relating to gain on certain dispositions of stock in a 
DISC or former DISC), and
    (b) ``Accumulated DISC income'' means the amount of accumulated DISC 
income as of the close of the taxable year immediately preceding the 
taxable year in which the dividend was made increased by the amount of 
DISC income for the taxable year in which the dividend was made (as 
determined under Sec. 1.996-3(b)(2)).
    (c) ``Nonqualified export taxable income'' means the taxable income 
of a DISC from any transaction which gives rise to gross receipts (as 
defined in Sec. 1.993-6) which are not qualified export receipts (as 
defined in Sec. 1.993-1) other than a transaction giving rise to gain 
described in section 995(b)(1) (B) or (C).

For purposes of subdivisions (i)(b) and (iv) of this subparagraph, if by 
reason of section 995(c), gain is included in the shareholder's gross 
income as a dividend, accumulated DISC income shall be treated as if it 
were reduced under Sec. 1.996-3(b)(3).
    (iii) Determination of source of income for deemed distributions, 
for taxable years beginning before January 1, 1976, under section 
995(b)(1)(D) as in effect for taxable years beginning before January 1, 
1976, and for taxable years beginning after December 31, 1975, under 
section 995(b)(1) (D), (E), and (F). (a) If for its taxable year a DISC 
does not have any nonqualified export taxable income, then for such year 
the entire amount treated, for taxable years beginning before January 1, 
1976, under section 995(b)(1)(D) as in effect for taxable years 
beginning before January 1, 1976, and for taxable years beginning after

[[Page 132]]

December 31, 1975, under section 995(b)(1) (D), (E), and (F) as a deemed 
distribution taxable as a dividend will be treated as gross income from 
sources without the United States.
    (b) If for its taxable year a DISC has any nonqualified export 
taxable income, then for such year the portion of the amount treated, 
for taxable years beginning before January 1, 1976, under section 
995(b)(1)(D) as in effect for taxable years beginning before January 1, 
1976, and for taxable years beginning after December 31, 1975, under 
section 995(b)(1) (D), (E), and (F) as a deemed distribution taxable as 
a dividend that will be treated as income from sources within the United 
States shall be equal to the amount of such nonqualified export taxable 
income multiplied by the following fraction. The numerator of the 
fraction is the sum of the amounts treated, for taxable years beginning 
before January 1, 1976, under section 995(b)(1)(D) as in effect for 
taxable years beginning before January 1, 1976, and for taxable years 
beginning after December 31, 1975, under section 995(b)(1) (D), (E), and 
(F) as deemed distributions taxable as dividends. The denominator of the 
fraction is the taxable income of the DISC for the taxable year, reduced 
by the amounts treated under section 995(b)(1) (A), (B), and (C) as 
deemed distributions taxable as dividends. However, in no event shall 
the numerator exceed the denominator. The remainder of such dividend 
will be treated as gross income from sources without the United States.
    (iv) Determination of source of income for dividends that reduce 
accumulated DISC income. (a) If no portion of the accumulated DISC 
income of a DISC or former DISC is attributable to nonqualified export 
taxable income from any transaction during a year for which it is (or is 
treated as) a DISC, then the entire amount of any dividend that reduces 
under Sec. 1.996-3(b)(3) accumulated DISC income will be treated as 
income from sources without the United States.
    (b) If any portion of the accumulated DISC income of a DISC or 
former DISC is attributable to nonqualified export taxable income from 
any transaction during a year for which it is (or is treated as) a DISC, 
then the portion of any dividend during its taxable year that reduces 
under Sec. 1.996-3(b)(3) accumulated DISC income that will be treated as 
income from sources within the United States shall be equal to the 
amount of such dividend multiplied by a fraction (determined as of the 
close of such year) the numerator of which is the amount of accumulated 
DISC income attributable to nonqualified export taxable income, and the 
denominator of which is the total amount of accumulated DISC income. The 
remainder of such dividend will be treated as gross income from sources 
without the United States.
    (v) Special rules. For purposes of subdivisions (iii) and (iv) of 
this subparagraph--
    (a) Taxable income shall be determined under Sec. 1.992-3(b)(2)(i) 
(relating to the computation of deficiency distribution), and
    (b) The portion of any deemed distribution taxable as a dividend, 
for taxable years beginning before January 1, 1976, under section 
995(b)(1)(D) as in effect for taxable years beginning before January 1, 
1976, and for taxable years beginning after December 31, 1975, under 
section 995(b)(1)(D), (E), and (F) or amount under Sec. 1.996-3(b)(3) 
(i) through (iv) that is treated as gross income from sources within the 
United States during the taxable year shall be considered to reduce the 
amount of nonqualified export taxable income as of the close of such 
year.
    (vi) Illustrations. This subparagraph may be illustrated by the 
following examples:

    Example 1. (a) Y is a corporation which uses the calendar year as 
its taxable year and which elects to be treated as a DISC beginning with 
1972. X is its sole shareholder. In 1973, Y has $18,000 of taxable 
income from qualified export receipts (none of which are interest and 
gains described in section 995(b)(1)(A), (B), and (C)) and $1,000 of 
nonqualified export taxable income. Under these facts, X is deemed to 
have received a distribution under section 995(b)(1)(D) as in effect for 
taxable years beginning before January 1, 1976, of $9,500, i.e., $19,000 
X \1/2\. X is treated under subdivision (iii)(b) of this subparagraph as 
having $500, i.e., $1,000 X $9,500/$19,000, from sources within the 
United States and $9,000 from sources without the United States.
    (b) For 1972, assume that Y did not have any nonqualified export 
taxable income.

[[Page 133]]

Pursuant to subdivision (v)(b) of this subparagraph, at the beginning of 
1974, $500 of Y's accumulated DISC income is attributable to 
nonqualified export taxable income (iii)(a) of this subparagraph), i.e., 
$1,000--$500.

    Example 2. The facts are the same as in example (1) except that in 
1973, in addition to the taxable income described in such example, Y has 
$450 of taxable income from gross interest from producer's loans 
described in section 995(b)(1)(A). Under these facts, the deemed 
distribution of $450 under section 995(b)(1)(A) is treated in full under 
subdivision (i) of this subparagraph as gross income from sources within 
the United States. The deemed distribution under section 995(b)(1)(D) as 
in effect for taxable years beginning before January 1, 1976, of $9,500 
will be treated in the same manner as in example (1), i.e., $1,000 X 
$9,500/($19,450-$450).
    Example 3. (a) The facts are the same as in example (1) except that 
in 1973, in addition to the distribution described in such example, Y 
makes a deemed distribution taxable as a dividend of $100 under section 
995(b)(1)(G) (relating to foreign investment attributable to producer's 
loans) and actual distributions of all of its previously taxed income 
and of $2,000 taxable as a dividend which reduces accumulated DISC 
income (as defined in subdivision (ii)(b) of this subparagraph). Under 
Sec. 1.996-3(b)(3), accumulated DISC income is first reduced by the 
deemed distribution of $100 and then by the actual distribution taxable 
as a dividend of $2,000. As indicated in example (1), for 1972 Y did not 
have any nonqualified export taxable income. Assume that Y had 
accumulated DISC income of $12,000 at the end of 1973, $500 of which 
under example (1) is attributable to nonqualified export taxable income.
    (b) The distribution from previously taxed income is excluded from 
gross income pursuant to section 996(a)(3).
    (c) Of the deemed distribution of $100, X is treated under 
subdivision (iv)(b) as having $4.17, i.e., $100x500/12,000, from sources 
within the United States and $95.83, i.e., $100--$4.17, from sources 
without the United States.
    (d) Of the actual distribution taxable as a dividend of $2,000, X is 
treated under subdivision (iv)(b) as having $83.33, i.e., $2,000x500/
12,000, from sources within the United States and $1,916.67, i.e., 
$2,000--$83.33, from sources without the United States.
    (e) The sum of the amounts deemed and actually distributed as 
dividends for 1973 that are treated as gross income from sources within 
the United States is as follows:

------------------------------------------------------------------------
                                                               Amount of
                                                                dividend
                                                                  from
                                                      Total     sources
                                                     dividend    within
                                                                  the
                                                                 United
                                                                 States
------------------------------------------------------------------------
Deemed distribution under sec. 995(b)(1)(D) as in      $9,500    $500.00
 effect for taxable years beginning before January
 1, 1976..........................................
Deemed distribution under section 995(b)(1)(G)....        100       4.17
Actual distribution that reduces accumulated DISC       2,000      83.33
 income...........................................
                                                   ---------------------
      Totals......................................    $11,600    $587.50
------------------------------------------------------------------------


Thus, pursuant to subdivision (v)(b) of this subparagraph, at the 
beginning of 1974 Y has $412.50, i.e., $1,000--$587.50, of nonqualified 
export taxable income.
    (f) The result would be the same if Y made an actual distribution 
taxable as a dividend of $1,500 on March 30, 1973, and another 
distribution of $500 on December 31, 1973.
    Example 4. (a) Z is a corporation which uses the calendar year as 
its taxable year and which elects to be treated as a DISC beginning with 
1972. W is its sole shareholder. At the end of the 1976 Z has previously 
taxed income of $12,000 and accumulated DISC income of $4,000, $900 of 
which is attributable to nonqualified export taxable income. In 1977, Z 
has $20,050 of taxable income from qualified export receipts, of which 
$550 is from gross income from producer's loans described in section 
995(b)(1)(A); Z has $950 of taxable income giving rise to gross receipts 
which are not qualified export receipts, of which $450 is gain described 
in section 995(b)(1)(B). Of its total taxable income of $21,000 (which 
is equal to its earnings and profits for 1977), $1,000 is attributable 
to sales of military property. Z has an international boycott factor 
(determined under section 999) of .10, and made an illegal bribe (within 
the meaning of section 162(c)) of $1,265. The proportion which the 
amount of Z's adjusted base period export receipts bears to Z's export 
gross receipts for 1977 is .40 (see section 995(e)(1)). Z makes a deemed 
distribution taxable as a dividend of $1,000 under section 995(b)(1)(G) 
(relating to foreign investment attributable to producer's loans) and 
actual distributions of $32,000.
    (b) The deemed distributions of $550 under section 995(b)(1)(A) and 
$450 under section 995(b)(1)(B) are treated in full under subdivision 
(i) of this subparagraph as gross income from sources within the United 
States.
    (c) Under these facts, Z has also made the following deemed 
distributions taxable as dividends to W under the following subdivisions 
of section 995(b)(1):

[[Page 134]]



(D).........................    $500,  i.e., \1/2\x$1,000.
(E).........................   7,800,  i.e.,.40x[$21,000-
                                        $(550+450+[hairsp][hairsp]500)].
(F)(i)......................   5,850,  i.e., \1/
                                        2\x[hairsp][hairsp][$21,000-
                                        [hairsp][hairsp]$550+[hairsp][ha
                                        irsp]450+[hairsp][hairsp]500+
                                        7,800)].
  (ii)......................     585,  i.e., $5,850x.10
  (iii).....................    1,265
                             ---------
    Total...................   16,000
 

    (d) The portion of the total amount of these deemed distributions 
($16,000 that is treated under the subdivision (iii)(b) as gross income 
from sources within the United States is computed as follows:
    (1) The amount of nonqualified export taxable income is $500, i.e., 
taxable income giving rise to gross receipts which are not qualified 
export receipts ($950) minus gain described in section 995(b)(1) (B) or 
(C) ($450).
    (2) $500x($16,000/$[21,000-(550+450)]) =$400.

The remainder of these distributions, $15,600 ($16,000 minus $400), is 
treated under subdivision (iii)(b) of this subparagraph as gross income 
from sources without the United States.
    (e) The earnings and profits accounts of Z at the end of 1977 are 
computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                             Accumulated DISC
                                                                                          income attributable to
                                                                                            taxable income from
                                                                                            translations which
                                                                     Total    Previously    give rise to gross
                                                                   earnings      taxed       receipts which--
                                                                      and       income   -----------------------
                                                                    profits                   Are       Are not
                                                                                           qualified   qualified
                                                                                            export      export
                                                                                           receipts    receipts
----------------------------------------------------------------------------------------------------------------
(1) Balance: January 1, 1977....................................    $16,000     $12,000      $3,100        $900
(2) Earnings and profits for 1977, before actual and section         21,000      17,000       3,900     \1\ 100
 955(b)(1)(G) distributions.....................................
(3) Balance: December 31, 1977..................................     37,000      29,000       7,000       1,000
(4) Distribution under section 995(b)(1)(G).....................  ..........      1,000        (875)   \2\ (125)
(5) Balance.....................................................     37,000      30,000       6,125         875
(6) Actual distribution.........................................    (32,000)    (30,000)     (1,750)   \3\ (250)
(7) Balance: January 1, 1978....................................      5,000   ..........      4,375         625
----------------------------------------------------------------------------------------------------------------
\1\ The total of nonqualified export taxable income ($500) minus the portion of such income, under subdivision
  (iii)(b) of this subparagraph, deemed distributed pursuant to section 995(b)(1)(D), (E), and (F) ($400), as
  computed under (d)(2) of this example.
\2\ Under subdivision (iv)(b) of this subparagraph, $1,000/$8,000x$1,000.
\3\ Under subdivision (iv)(b) of this subparagraph, $1,000/$8,000x$2,000 (amount of actual distribution that
  reduces accumulated DISC income).

    (6) Substitute dividend payments. A substitute dividend payment is a 
payment, made to the transferor of a security in a securities lending 
transaction or a sale-repurchase transaction, of an amount equivalent to 
a dividend distribution which the owner of the transferred security is 
entitled to receive during the term of the transaction. A securities 
lending transaction is a transfer of one or more securities that is 
described in section 1058(a) or a substantially similar transaction. A 
sale-repurchase transaction is an agreement under which a person 
transfers a security in exchange for cash and simultaneously agrees to 
receive substantially identical securities from the transferee in the 
future in exchange for cash. A substitute dividend payment shall be 
sourced in the same manner as the distributions with respect to the 
transferred security for purposes of this section and Sec. 1.862-1. See 
also Secs. 1.864-5(b)(2)(iii), 1.871-7(b)(2) and 1.881-2(b)(2) for the 
character of such payments and Sec. 1.894-1(c) for the application of 
tax treaties to these transactions.

    (b) Special rules--(1) Foreign corporation having no gross income 
for period preceding declaration of dividend. If the foreign corporation 
has no gross income from any source for the 3-year period (or part 
thereof) specified in paragraph (a)(3)(i) of this section, the 50-
percent test, or the apportionment formula, as the case may be, 
described in such paragraph shall be applied solely with respect to the 
taxable year of such corporation in which the declaration of the 
dividend occurs. This subparagraph applies whether the lack of gross 
income for the 3-year period (or part thereof) stems from the business 
inactivity of the foreign corporation, from the fact that such 
corporation is newly created or organized, or from any other cause.

    (2) Transitional rule. For purposes of applying paragraph (a)(3)(i) 
of this section, the gross income of the foreign

[[Page 135]]

corporation for any period before the first taxable year beginning after 
December 31, 1966, which is from sources within the United States 
(determined as provided by sections 861 through 863, and the regulations 
thereunder, as in effect immediately before amendment by section 102 of 
the Foreign Investors Tax Act of 1966 (Pub. L. 89-809, 80 Stat. 1541)) 
shall be treated as gross income for such period which is effectively 
connected with the conduct of a trade or business within the United 
States by such foreign corporation.

    (3) Gross income determinations. In making determinations under 
subparagraph (2) or (3) of paragraph (a) of this section, or 
subparagraph (2) of this paragraph--

    (i) The gross income of a domestic corporation is to be determined 
by excluding any items specifically excluded from gross income under 
chapter 1 of the Code.

    (ii) The gross income of a foreign corporation which is effectively 
connected with the conduct of a trade or business in the United States 
is to be determined under section 882(b)(2) and by excluding any items 
specifically excluded from gross income under chapter 1 of the Code, and

    (iii) The gross income from all sources of a foreign corporation is 
to be determined without regard to section 882(b) and without excluding 
any items otherwise specifically excluded from gross income under 
chapter 1 of the Code.

    (c) Statement with return. Any taxpayer who is required to file a 
return and applies any provision of this section to exclude any dividend 
from his gross income must file with his return a statement setting 
forth the amount so excluded, the date of its receipt, the name and 
address of the corporation paying the dividend, and, if known, the 
location of the records which substantiate the amount of the exclusion. 
A statement from the paying corporation setting forth such information 
and indicating the amount of the dividend to be treated as income from 
sources within the United States may be used for this purpose. See 
Secs. 1.6012-1(b)(1)(i) and 1.6012-2 (g)(1)(i).

    (d) Effective date. Except as otherwise provided in this paragraph 
this section applies with respect to dividends received or accrued after 
December 31, 1966. Paragraph (a)(5) of this section applies to certain 
dividends from a DISC or former DISC in taxable years ending after 
December 31, 1971. Paragraph (a)(6) of this section is applicable to 
payments made after November 13, 1997. For purposes of paragraph (a)(5) 
of this section, any reference to a distribution taxable as a dividend 
under section 995(b)(1)(F) (ii) and (iii) for taxable years beginning 
after December 31, 1975, shall also constitute a reference to any 
distribution taxable as a dividend under section 995(b)(1)(F) (ii) and 
(iii) for taxable years beginning after November 30, 1975, but before 
January 1, 1976. For corresponding rules applicable with respect to 
dividends received or accrued before January 1, 1967, see 26 CFR 1.861-3 
(Revised as of January 1, 1972).

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6830, 30 FR 
8046, June 23, 1965; T.D. 7378, 40 FR 45432, Oct. 2, 1975; 40 FR 48508, 
Oct. 16, 1975; T.D. 7472, 42 FR 12179, Mar. 3, 1977; T.D. 7591, 44 FR 
5116, Jan. 25, 1979; T.D. 7854, 47 FR 51738, Nov. 17, 1982; T.D. 8735, 
62 FR 53501, Oct. 14, 1997]



Sec. 1.861-4  Compensation for labor or personal services.

    (a) In general. (1) Gross income from sources within the United 
States includes compensation for labor or personal services performed in 
the United States irrespective of the residence of the payer, the place 
in which the contract for service was made, or the place or time of 
payment; except that such compensation shall be deemed not to be income 
from sources within the United States, if--
    (i) The labor or services are performed by a nonresident alien 
individual temporarily present in the United States for a period or 
periods not exceeding a total of 90 days during his taxable year,
    (ii) The compensation for such labor or services does not exceed in 
the aggregate a gross amount of $3,000, and
    (iii) The compensation is for labor or services performed as an 
employee of, or under any form of contract with--

[[Page 136]]

    (a) A nonresident alien individual, foreign partnership, or foreign 
corporation, not engaged in trade or business within the United States, 
or
    (b) An individual who is a citizen or resident of the United States, 
a domestic partnership, or a domestic corporation, if such labor or 
services are performed for an office or place of business maintained in 
a foreign country or in a possession of the United States by such 
individual, partnership, or corporation.
    (2) As a general rule, the term ``day'', as used in subparagraph 
(1)(i) of this paragraph, means a calendar day during any portion of 
which the nonresident alien individual is physically present in the 
United States.
    (3) Solely for purposes of applying this paragraph, the nonresident 
alien individual, foreign partnership, or foreign corporation for which 
the nonresident alien individual is performing personal services in the 
United States shall not be considered to be engaged in trade or business 
in the United States by reason of the performance of such services by 
such individual.
    (4) In determining for purposes of subparagraph (1)(ii) of this 
paragraph whether compensation received by the nonresident alien 
individual exceeds in the aggregate a gross amount of $3,000, any 
amounts received by the individual from an employer as advances or 
reimbursements for travel expenses incurred on behalf of the employer 
shall be omitted from the compensation received by the individual, to 
the extent of expenses incurred, where he was required to account and 
did account to his employer for such expenses and has met the tests for 
such accounting provided in Sec. 1.162-17 and paragraph (e)(4) of 
Sec. 1.274-5. If advances or reimbursements exceed such expenses, the 
amount of the excess shall be included as compensation for personal 
services for purposes of such subparagraph. Pensions and retirement pay 
attributable to labor or personal services performed in the United 
States are not to be taken into account for purposes of subparagraph 
(1)(ii) of this paragraph. (5) For definition of the term ``United 
States'', when used in a geographical sense, see sections 638 and 
7701(a)(9).
    (b) Amount includible in gross income--(1) Taxable years beginning 
after December 31, 1975. (i) If a specific amount is paid for labor or 
personal services performed in the United States, that amount (if income 
from sources within the United States) shall be included in the gross 
income. If no accurate allocation or segregation of compensation for 
labor or personal services performed in the United States can be made, 
or when such labor or service is performed partly within and partly 
without the United States, the amount to be included in the gross income 
shall be determined on the basis that most correctly reflects the proper 
source of income under the facts and circumstances of the particular 
case. In many cases the facts and circumstances will be such that an 
apportionment on the time basis will be acceptable, that is, the amount 
to be included in gross income will be that amount which bears the same 
relation to the total compensation as the number of days of performance 
of the labor or services within the United States bears to the total 
number of days of performance of labor or services for which the payment 
is made. In other cases, the facts and circumstances will be such that 
another method of apportionment will be acceptable.
    (ii) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. B, a nonresident alien individual, was employed by M from 
March 1, 1976, to June 12, 1976, a total of 104 days, for which he 
received compensation in the amount of $12,240. During that period B was 
present in the United States 59 days. Under his contract B was subject 
to call at all times by his employer and was in a payment status on a 7-
day week basis. There was no specific agreement as to the amount of pay 
for services performed within the United States; moreover, he received 
his stipulated salary payments regardless of the number of days per week 
he actually performed services. Under these circumstances the amount of 
compensation to be included in gross income as income from sources 
within the United States will be $6,943.85 ($12,240x59/104).
    Example 2. C, a citizen of the United States, was a resident of a 
foreign country during his entire taxable year. He is employed by N, a 
domestic corporation, and paid a salary of $17,600 per annum. Under his 
contract C is required to work only on a 5-day week basis,

[[Page 137]]

Monday through Friday. During 1976 he was in the United States for 6 
weeks, performing services therein for N for 30 work days. During the 
year he worked 240 days for N for which payment was made, determined by 
eliminating his vacation period for which no payment was made. Under 
these circumstances the amount of compensation for personal services 
performed in the United States is $2,200 ($17,600x30/240).

    (2) Taxable years beginning before January 1, 1976. If a specific 
amount is paid for labor or personal services performed in the United 
States, that amount (if income from sources within the United States) 
shall be included in the gross income. If no accurate allocation or 
segregation of compensation for labor or personal services performed in 
the United States can be made, or when such labor or service is 
performed partly within and partly without the United States, the amount 
to be included in the gross income shall be determined by an 
apportionment on the time basis; that is, there shall be included in the 
gross income an amount which bears the same relation to the total 
compensation as the number of days of performance of the labor or 
services within the United States bears to the total number of days of 
performance of labor or services for which the payment is made.
    (c) Coastwise travel. Except as to income excluded by paragraph (a) 
of this section, wages received for services rendered inside the 
territorial limits of the United States and wages of an alien seaman 
earned on a coastwise vessel are to be regarded as from sources within 
the United States.
    (d) Effective date. This section applies with respect to taxable 
years beginning after December 31, 1966. For corresponding rules 
applicable to taxable years beginning before January 1, 1967, see 26 CFR 
1.861-4 (Revised as of January 1, 1972).

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7378, 40 FR 45433, Oct. 2, 1975; 40 FR 48508, Oct. 16, 
1975]



Sec. 1.861-5  Rentals and royalties.

    Gross income from sources within the United States includes rentals 
or royalties from property located in the United States or from any 
interest in such property, including rentals or royalties for the use 
of, or for the privilege of using, in the United States, patents, 
copyrights, secret processes and formulas, good will, trademarks, trade 
brands, franchises, and other like property. The income arising from the 
rental of property, whether tangible or intangible, located within the 
United States, or from the use of property, whether tangible or 
intangible, within the United States, is from sources within the United 
States. For taxable years beginning after December 31, 1966, gains 
described in section 871(a)(1)(D) and section 881(a)(4) from the sale or 
exchange after October 4, 1966, of patents, copyrights, and other like 
property shall be treated, as provided in section 871(e)(2), as rentals 
or royalties for the use of, or privilege of using, property or an 
interest in property. See paragraph (e) of Sec. 1.871-11.

[T.D. 7378, 40 FR 45434, Oct. 2, 1975]



Sec. 1.861-6  Sale of real property.

    Gross income from sources within the United States includes gain, 
computed under the provisions of section 1001 and the regulations 
thereunder, derived from the sale or other disposition of real property 
located in the United States. For the treatment of capital gains and 
losses, see subchapter P (section 1201 and following), chapter 1 of the 
Code, and the regulations thereunder.



Sec. 1.861-7  Sale of personal property.

    (a) General. Gains, profits, and income derived from the purchase 
and sale of personal property shall be treated as derived entirely from 
the country in which the property is sold. Thus, gross income from 
sources within the United States includes gains, profits, and income 
derived from the purchase of personal property without the United States 
and its sale within the United States.
    (b) Purchase within a possession. Notwithstanding paragraph (a) of 
this section, income derived from the purchase of personal property 
within a possession of the United States and its sale within the United 
States shall be treated as derived partly from sources within and partly 
from sources without the United States. See section 863(b)(3) and 
Sec. 1.863-2.

[[Page 138]]

    (c) Country in which sold. For the purposes of part I (section 861 
and following), subchapter N, chapter 1 of the Code, and the regulations 
thereunder, a sale of personal property is consummated at the time when, 
and the place where, the rights, title, and interest of the seller in 
the property are transferred to the buyer. Where bare legal title is 
retained by the seller, the sale shall be deemed to have occurred at the 
time and place of passage to the buyer of beneficial ownership and the 
risk of loss. However, in any case in which the sales transaction is 
arranged in a particular manner for the primary purpose of tax 
avoidance, the foregoing rules will not be applied. In such cases, all 
factors of the transaction, such as negotiations, the execution of the 
agreement, the location of the property, and the place of payment, will 
be considered, and the sale will be treated as having been consummated 
at the place where the substance of the sale occurred.
    (d) Production and sale. For provisions respecting the source of 
income derived from the sale of personal property produced by the 
taxpayer, see section 863(b)(2) and paragraphs (b) of Secs. 1.863-1 and 
1.863-2.
    (e) Section 306 stock. For determining the source of gain on the 
disposition of section 306 stock, see section 306(f) and the regulations 
thereunder.



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

    (a) In general--(1) Scope. Sections 861(b) and 863(a) state in 
general terms how to determine taxable income of a taxpayer from sources 
within the United States after gross income from sources within the 
United States has been determined. Sections 862(b) and 863(a) state in 
general terms how to determine taxable income of a taxpayer from sources 
without the United States after gross income from sources without the 
United States has been determined. This section provides specific 
guidance for applying the cited Code sections by prescribing rules for 
the allocation and apportionment of expenses, losses, and other 
deductions (referred to collectively in this section as ``deductions'') 
of the taxpayer. The rules contained in this section apply in 
determining taxable income of the taxpayer from specific sources and 
activities under other sections of the Code, referred to in this section 
as operative sections. See paragraph (f)(1) of this section for a list 
and description of operative sections. The operative sections include, 
among others, sections 871(b) and 882 (relating to taxable income of a 
nonresident alien individual or a foreign corporation which is 
effectively connected with the conduct of a trade or business in the 
United States), section 904(a)(1) (as in effect before enactment of the 
Tax Reform Act of 1976, relating to taxable income from sources within 
specific foreign countries), and section 904(a)(2) (as in effect before 
enactment of the Tax Reform Act of 1976, or section 904(a) after such 
enactment, relating to taxable income from all sources without the 
United States).
    (2) Allocation and apportionment of deductions in general. A 
taxpayer to which this section applies is required to allocate 
deductions to a class of gross income and, then, if necessary to make 
the determination required by the operative section of the Code, to 
apportion deductions within the class of gross income between the 
statutory grouping of gross income (or among the statutory groupings) 
and the residual grouping of gross income. Except for deductions, if 
any, which are not definitely related to gross income (see paragraphs 
(c)(2) and (e)(9) of this section) and which, therefore, are ratably 
apportioned to all gross income, all deductions of the taxpayer (except 
the deductions for personal exemptions enumerated in paragraph (e)(11) 
of this section) must be so allocated and apportioned. As further 
detailed below, allocations and apportionments are made on the basis of 
the factual relationship of deductions to gross income.
    (3) Class of gross income. For purposes of this section, the gross 
income to which a specific deduction is definitely related is referred 
to as a ``class of gross income'' and may consist of one or more items 
(or subdivisions of these items) of gross income enumerated in section 
61, namely:

[[Page 139]]

    (i) Compensation for services, including fees, commissions, and 
similar items;
    (ii) Gross income derived from business;
    (iii) Gains derived from dealings in property;
    (iv) Interest;
    (v) Rents;
    (vi) Royalties;
    (vii) Dividends;
    (viii) Alimony and separate maintenance payments;
    (ix) Annuities;
    (x) Income from life insurance and endowment contracts;
    (xi) Pensions;
    (xii) Income from discharge of indebtedness;
    (xiii) Distributive share of partnership gross income;
    (xiv) Income in respect of a decedent;
    (xv) Income from an interest in an estate or trust.
    (4) Statutory grouping of gross income and residual grouping of 
gross income. For purposes of this section, the term ``statutory 
grouping of gross income'' or ``statutory grouping'' means the gross 
income from a specific source or activity which must first be determined 
in order to arrive at ``taxable income'' from which specific source or 
activity under an operative section. (See paragraph (f)(1) of this 
section.) Gross income from other sources or activities is referred to 
as the ``residual grouping of gross income'' or ``residual grouping.'' 
For example, for purposes of determining taxable income from sources 
within specific foreign countries and possessions of the United States, 
in order to apply the per-country limitation to the foreign tax credit 
(as in effect before enactment of the Tax Reform Act of 1976), the 
statutory groupings are the separate gross incomes from sources within 
each country and possession. Moreover, if the taxpayer has income 
subject to section 904(d) (as in effect after enactment of the Tax 
Reform Act of 1976), such income constitutes one or more separate 
statutory groupings. In the case of the per-country limitation, the 
residual grouping is the aggregate of gross income from sources within 
the United States. In some instances, where the operative section so 
requires, the statutory grouping or the residual grouping may include, 
or consist entirely of, excluded income. See paragraph (d)(2) of this 
section with respect to the allocation and apportionment of deductions 
to excluded income.
    (5) Effective date--(i) Taxable years beginning after December 31, 
1976. The provisions of this section apply to taxable years beginning 
after December 31, 1976.
    (ii) Taxable years beginning before January 1, 1977. For taxable 
years beginning before January 1, 1977, Sec. 1.861-8 applies as in 
effect on October 23, 1957 (T.D. 6258), as amended on August 22, 1966 
(T.D. 6892) and on September 29, 1975 (T.D. 7378). The specific rules 
for allocation and apportionment of deductions set forth in this section 
may, at the option of the taxpayer, apply to those taxable years on a 
deduction-by-deduction basis if the rules are applied consistently to 
all taxable years with respect to which action by the Internal Revenue 
Service is not barred by any statute of limitations. Thus, for example, 
a calendar year taxpayer may choose to have the rules of paragraph 
(e)(2) of this section apply for the allocation and apportionment of all 
interest expenses for the two taxable years ending December 31, 1975 and 
1976, which are open years under examination, and may justify the 
allocation and apportionment of all research and development expenses 
for those years on a basis supportable under Sec. 1.861-8 as in effect 
for 1975 and 1976 without regard to the rules of paragraph (e)(3) of 
this section.
    (b) Allocation--(1) In general. For purposes of this section, the 
gross income to which a specific deduction is definitely related is 
referred to as a ``class of gross income'' and may consist of one or 
more items of gross income. The rules emphasize the factual relationship 
between the deduction and a class of gross income. See paragraph (d)(1) 
of this section which provides that in a taxable year there may be no 
item of gross income in a class or less gross income than deductions 
allocated to the class, and paragraph (d)(2) of this section which 
provides that a class of gross income may include excluded income. 
Allocation is accomplished by

[[Page 140]]

determining, with respect to each deduction, the class of gross income 
to which the deduction is definitely related and then allocating the 
deduction to such class of gross income (without regard to the 
taxpayable year in which such gross income is received or accrued or is 
expected to be received or accrued). The classes of gross income are not 
predetermined but must be determined on the basis of the deductions to 
be allocated. Although most deductions will be definitely related to 
some class of a taxpayer's total gross income, some deductions are 
related to all gross income. In addition, some deductions are treated as 
not definitely related to any gross income and are ratably apportioned 
to all gross income. (See paragraph (e)(9) of this section.) In 
allocating deductions it is not necessary to differentiate between 
deductions related to one item of gross income and deductions related to 
another item of gross income where both items of gross income are 
exclusively within the same statutory grouping or exclusively within the 
residual grouping.
    (2) Relationship to activity or property. A deduction shall be 
considered definitely related to a class of gross income and therefore 
allocable to such class if it is incurred as a result of, or incident 
to, an activity or in connection with property from which such class of 
gross income is derived. Where a deduction is incurred as a result of, 
or incident to, an activity or in connection with property, which 
activity or property generates, has generated, or could reasonably have 
been expected to generate gross income, such deduction shall be 
considered definitely related to such gross income as a class whether or 
not there is any item of gross income in such class which is received or 
accrued during the taxable year and whether or not the amount of 
deductions exceeds the amount of the gross income in such class. See 
paragraph (d)(1) of this section and example 17 of paragraph (g) of this 
section with respect to cases in which there is an excess of deductions. 
In some cases, it will be found that this subparagraph can most readily 
be applied by determining, with respect to a deduction, the categories 
of gross income to which it is not related and concluding that it is 
definitely related to a class consisting of all other gross income.
    (3) Supportive functions. [Reserved] For guidance, see Sec. 1.861-
8T(b)(3).
    (4) Deductions related to a class of gross income. See paragraph (e) 
of this section for rules relating to the allocation and apportionment 
of certain specific deductions definitely related to a class of gross 
income. See paragraph (c)(1) of this section for rules relating to the 
apportionment of deductions.
    (5) Deductions related to all gross income. If a deduction does not 
bear a definite relationship to a class of gross income constituting 
less than all of gross income, it shall ordinarily be treated as 
definitely related and allocable to all of the taxpayer's gross income 
except where provided to the contrary under paragraph (e) of this 
section. Paragraph (e)(9) of this section lists various deductions which 
generally are not definitely related to any gross income and are ratably 
apportioned to all gross income.
    (c) Apportionment of deductions--(1) Deductions definitely related 
to a class of gross income. [Reserved] For guidance, see Sec. 1.861-
8T(c)(1).
    (2) Apportionment based on assets. [Reserved] For guidance, see 
Sec. 1.861-8T(c)(2).
    (3) Deductions not definitely related to any gross income. If a 
deduction is not definitely related to any gross income (see paragraph 
(e)(9) of this section), the deduction must be apportioned ratably 
between the statutory grouping (or among the statutory groupings) of 
gross income and the residual grouping. Thus, the amount apportioned to 
each statutory grouping shall be equal to the same proportion of the 
deduction which the amount of gross income in the statutory grouping 
bears to the total amount of gross income. The amount apportioned to the 
residual grouping shall be equal to the same proportion of the deduction 
which the amount of the gross income in the residual grouping bears to 
the total amount of gross income.
    (d) Excess of deductions and excluded and eliminated income--(1) 
Excess of deductions. Each deduction which bears a definite relationship 
to a class of gross income shall be allocated to that class

[[Page 141]]

in accordance with paragraph (b)(1) of this section even though, for the 
taxable year, no gross income in such class is received or accrued or 
the amount of the deduction exceeds the amount of such class of gross 
income. In apportioning deductions, it may be that, for the taxable 
year, there is no gross income in the statutory grouping (or residual 
grouping), or that deductions exceed the amount of gross income in the 
statutory grouping (or residual grouping). If there is no gross income 
in a statutory grouping or the amount of deductions allocated and 
apportioned to a statutory grouping exceeds the amount of gross income 
in the statutory grouping, the effects are determined under the 
operative section. If the taxpayer is a member of a group filing a 
consolidated return, such excess of deductions allocated or apportioned 
to a statutory grouping of income of such member is taken into account 
in determining the consolidated taxable income from such statutory 
grouping, and such excess of deductions allocated or apportioned to the 
residual grouping of income is taken into account in determining the 
consolidated taxable income from the residual grouping. See Sec. 1.1502-
4(d)(1) and the last sentence of Sec. 1.1502-12. For an illustration of 
the principles of this paragraph (d)(1), see example 17 of paragraph (g) 
of this section.
    (2) Allocation and apportionment to exempt, excluded, or eliminated 
income. [Reserved] For guidance, see Sec. 1.861-8T(d)(2).
    (e) Allocation and apportionment of certain deductions--(1) In 
general. Subparagraphs (2) and (3) of this paragraph contain rules with 
respect to the allocation and apportionment of interest expense and 
research and development expenditures, respectively. Subparagraphs (4) 
through (8) of this paragraph contain rules with respect to the 
allocation of certain other deductions. Subparagraph (9) of this 
paragraph lists those deductions which are ordinarily considered as not 
being definitely related to any class of gross income. Subparagraph (10) 
of this paragraph lists special deductions of corporations which must be 
allocated and apportioned. Subparagraph (11) of this paragraph lists 
personal exemptions which are neither allocated nor apportioned. 
Examples of allocation and apportionment are contained in paragraph (g) 
of this section.
    (2) Interest. [Reserved] For guidance, see Sec. 1.861-8T(e)(2).
    (3) Research and experimental expenditures. For rules regarding the 
allocation and apportionment of research and experimental expenditures, 
see Sec. 1.861-17.
    (4) Stewardship expenses attributable to dividends received. If a 
corporation renders services for the benefit of a related corporation 
and the corporation charges the related corporation for such services 
(see section 482 and the regulations thereunder which provide for an 
allocation where the charge is not on an arm's length basis as 
determined therein), the deductions for expenses of the corporation 
attributable to the rendering of such services are considered definitely 
related to the amounts so charged and are to be allocated to such 
amounts. However, the regulations under section 482 (Sec. 1.482-
2(b)(2)(ii) recognize a type of activity which is not considered to be 
for the benefit of a related corporation but is considered to constitute 
``stewardship'' or ``overseeing'' functions undertaken for the 
corporation's own benefit as an investor in the related corporation, and 
therefore, a charge to the related corporation for such stewardship or 
overseeing functions is not provided for. Services undertaken by a 
corporation of a stewardship or overseeing character generally represent 
a duplication of services which the related corporation has 
independently performed for itself. For example, assume that a related 
corporation, which has a qualified financial staff, makes an analysis to 
determine the amount and source of its borrowing needs and submits a 
report of its findings and a plan of borrowing to the parent 
corporation, and the parent corporation's financial staff reviews the 
findings and plans to determine whether to advise the related 
corporation to reconsider its plan. The services of review performed by 
the parent corporation for its own benefit are of a stewardship or 
overseeing character. The deductions resulting

[[Page 142]]

from stewardship or overseeing functions are incurred as a result of, or 
incident to, the ownership of the related corporation and, thus, shall 
be considered definitely related and allocable to dividends received or 
to be received from the related corporation. If a corporation has a 
foreign or international department which exercises stewardship or 
overseeing functions with respect to related foreign corporations and, 
in addition, the department has other functions which are attributable 
to other foreign-source income (such as fees for services rendered 
outside of the United States for the benefit of foreign related 
corporations, foreign royalties, and gross income of foreign branches) 
to which its deductions are also to be allocated, some part of the 
deductions with respect to that department are considered definitely 
related to the other foreign-source income. In some instances, the 
operations of a foreign or international department will also be 
attributable to United States source income (such as fees for services 
performed in the United States) to which its deductions are to be 
allocated. Methods of apportionment which could possibly be utilized 
with respect to stewardship expenses include comparisons of time spent 
by employees weighted to take into account differences in compensation, 
or comparisons of each related corporation's gross receipts, gross 
income, or unit sales volume, assuming that stewardship activities are 
not substantially disproportionate to such factors. See paragraph (f)(5) 
of this section for the type of verification that may be required in 
this respect. See examples 17 and (18) of paragraph (g) of this section 
for the allocation and apportionment of stewardship expenses. See 
paragraph (b)(3) of this section for the allocation and apportionment of 
deductions attributable to supportive functions other than stewardship 
activities.
    (5) Legal and accounting fees and expenses. Fees and other expenses 
for legal and accounting services are ordinarily definitely related and 
allocable to specific classes of gross income or to all the taxpayer's 
gross income, depending on the nature of the services rendered (and are 
apportioned as provided in paragraph (c)(1) of this section). For 
example, accounting fees for the preparation of a study of the costs 
involved in manufacturing a specific product will ordinarily be 
definitely related to the class of gross income derived from (or which 
could reasonably have been expected to be derived from) that specific 
product. The taxpayer is not relieved from his responsibility to make a 
proper allocation and apportionment of fees on the grounds that the 
statement of services rendered does not identify the services performed 
beyond a generalized designation such as ``professional,'' or does not 
provide any type of allocation, or does not properly allocate the fees 
involved.
    (6) Income taxes--(i) In general. The deduction for state, local, 
and foreign income, war profits and excess profits taxes (``state income 
taxes'') allowed by section 164 shall be considered definitely related 
and allocable to the gross income with respect to which such state 
income taxes are imposed. For example, if a domestic corporation is 
subject to state income taxation and the state income tax is imposed in 
part on an amount of foreign source income, then that part of the 
taxpayer's deduction for state income tax that is attributable to 
foreign source income is definitely related and allocable to foreign 
source income. In allocating and apportioning the deduction for state 
income tax for purposes including (but not limited to) the computation 
of the foreign tax credit limitation under section 904 of the Code and 
the consolidated foreign tax credit under Sec. 1.1502-4 of the 
regulations, the income upon which the state income tax is imposed is 
determined by reference to the law of the jurisdiction imposing the tax. 
Thus, if a state attributes taxable income to a corporate taxpayer by 
applying an apportionment formula that takes into consideration the 
income and factors of one or more corporations related by ownership to 
the corporate taxpayer and engaging in activities related to the 
business of the corporate taxpayer, then the income so attributed is the 
income upon which the state income tax is imposed. If the income so 
attributed to the corporate taxpayer includes foreign source income, 
then, in computing the taxpayer's foreign tax credit limitation under 
section 904, for example,

[[Page 143]]

the taxpayer's deduction for state income tax will be considered 
definitely related and allocable to a class of gross income that 
includes the statutory grouping of foreign source income. When the law 
of the state includes dividends that are treated under section 862(a)(2) 
as income from sources without the United States in taxable income 
apportionable to the state, but does not include factors of the 
corporation paying such dividends in the apportionment formula used to 
determine state taxable income, an appropriate portion of the deduction 
for state income tax will be considered definitely related and allocable 
to a class of gross income consisting solely of foreign source dividend 
income. A deduction for state income tax will not be considered 
definitely related to a hypothetical amount of income calculated under 
federal tax principles when the jurisdiction imposing the tax computes 
taxable income under different principles. A corporate taxpayer's 
deduction for a state franchise tax that is computed on the basis of 
income attributable to business activities conducted within the state 
must be allocated and apportioned in the same manner as the deduction 
for state income taxes. In determining, for example, both the foreign 
tax credit under section 904 of the Code and the consolidated foreign 
tax credit limitation under Sec. 1.1502-4 of the regulations, the 
deduction for state income tax may be allocable and apportionable to 
foreign source income in a statutory grouping described in section 
904(d) in a taxable year in which the taxpayer has no foreign source 
income in such statutory grouping. Alternatively, such an allocation or 
apportionment may be appropriate if a taxpayer corporation has no 
foreign source income in a statutory grouping, but its deduction is 
attributable to foreign source income in such grouping that is 
attributed to the taxpayer corporation under the law of a state which 
attributes taxable income to a corporation by applying an apportionment 
formula that takes into consideration the income and factors of one or 
more corporations related by ownership to the taxpayer corporation and 
engaging in activities related to the business of the taxpayer 
corporation. Example 30 of paragraph (g) of this section illustrates the 
application of this last rule.
    (ii) Methods of allocation and apportionment--(A) In general. A 
taxpayer's deduction for a state income tax is to be allocated (and then 
apportioned, if necessary, subject to the rules of Sec. 1.861-8(d)) by 
reference to the taxable income that the law of the taxing jurisdiction 
attributes to the taxpayer (``state taxable income'').
    (B) Effect of subsequent recomputations of state income tax. 
[Reserved]
    (C) Illustrations--(1) In general. Examples 25 through 32 of 
paragraph (g) of Sec. 1.861-8 illustrate, in the given factual 
situations, the application of this paragraph (e)(6) and the general 
rule of paragraph (b)(1) of this section that a deduction must be 
allocated to the class of gross income to which the deduction is 
factually related. In general, these examples employ a presumption that 
state income taxes are allocable to a class of gross income that 
includes the statutory grouping of income from sources without the 
United States when the total amount of taxable income determined under 
state law exceeds the amount of taxable income determined under the Code 
(without taking into account the deduction for state income taxes) in 
the residual grouping of income from sources within the United States. A 
taxpayer that allocates and apportions the deduction for state income 
tax in accordance with the methodology of Example 25 of paragraph (g) of 
this section must also apply the modifications illustrated in Examples 
26 and 27 of paragraph (g) of this section, when applicable. The 
modification illustrated in Example 26 is applicable when the deduction 
for state income tax is attributable in part to taxes imposed by a state 
which factually excludes foreign source income (as determined for 
federal income tax purposes) from state taxable income. The modification 
illustrated in Example 27 is applicable when the taxpayer has income-
producing activities in a state which does not impose a corporate income 
tax. The specific allocation of state income tax illustrated in Example 
28 follows the rule in paragraph (e)(6)(i) of this section, and must be 
applied whenever a taxpayer's state

[[Page 144]]

taxable income includes dividends apportioned to the state under a 
formula that does not take into account the factors of the corporations 
paying those dividends, regardless of whether the taxpayer uses the 
methodology of Example 25 with respect to the remainder of the deduction 
for state income taxes.
    (2) Modifications. Before applying a method of allocation and 
apportionment illustrated in the examples, the computation of state 
taxable income under state law may be modified, subject to the approval 
of the District Director, to reflect more accurately the income with 
respect to which the state income tax is imposed. Any modification to 
the state law computation of state taxable income must yield an 
allocation and apportionment of the deduction for state income taxes 
that is consistent with the rules contained in this paragraph (e)(6), 
and that accurately reflects the factual relationship between the state 
income tax and the income on which that tax is imposed. For example, a 
modification to the computation of taxable income under state law might 
be appropriate to compensate for differences between the state law 
definition of taxable income and the federal definition of taxable 
income, due to a difference in the rate of allowable depreciation or the 
amount of another deduction that is allowable under both systems. This 
rule is illustrated in Example 31 of paragraph (g) of this section. 
However, a modification to the computation of taxable income under state 
law will not be appropriate, and will not more accurately reflect the 
factual relationship between the state tax and the income on which the 
tax is imposed, to the extent such modification reflects the fact that 
the state does not follow federal tax principles in attributing income 
to the taxpayer's activities in the state. This rule is illustrated in 
Example 32 of paragraph (g) of this section. A taxpayer may not modify 
the methods illustrated in the examples, or use an alternative method of 
allocation and apportionment of the deduction for state income taxes, if 
the modification or alternative method would be inconsistent with the 
rules of paragraph (e)(6)(i) of this section. A taxpayer that uses a 
method of allocation and apportionment other than one illustrated in 
Example 25 (as modified by Examples 26 and 27), or 29 with respect to a 
factual situation similar to those of the examples, must describe the 
alternative method on an attachment to its federal income tax return and 
establish to the satisfaction of the District Director, upon 
examination, that the result of the alternative method more accurately 
reflects the factual relationship between the state income tax and the 
income on which the tax is imposed.
    (D) Elective safe harbor methods. (1) In general. In lieu of 
applying the rules set forth in paragraphs (e)(6)(ii) (A) through (C) of 
this section, a taxpayer may elect to allocate and apportion the 
deduction for state income tax in accordance with one of the two safe 
harbor methods described in paragraph (e)(6)(ii)(D) (2) and (3) of this 
section. A taxpayer shall make this election for a taxable year by 
filing a timely tax return for that year that reflects an allocation and 
apportionment of the deduction for state income tax under one of the 
safe harbor methods and attaching to such return a statement that the 
taxpayer has elected to use the safe harbor method provided in either 
paragraph (e)(6)(ii)(D) (2) or (3) of this section, as appropriate. Once 
made, this election is effective for the taxable year for which made and 
all subsequent taxable years, and may be revoked only with the consent 
of the Commissioner. Example 33 of paragraph (g) of this section 
illustrates the application of these safe harbor methods.
    (2) Method One. (i) Step One--Specific allocation to foreign source 
portfolio dividends and other income. If any portion of the deduction 
for state income tax is attributable to tax imposed by a state which 
includes in a corporate taxpayer's taxable income apportionable to the 
state, portfolio dividends (as defined in paragraph (i) of Example 28 of 
paragraph (g) of this section) that are treated under section 862(a)(2) 
as income from sources without the United States, but does not include 
factors of the corporations paying the portfolio dividends in the 
apportionment formula used to determine state taxable income, the 
taxpayer shall allocate an

[[Page 145]]

appropriate portion of the deduction to a class of gross income 
consisting solely of foreign source portfolio dividends. The portion of 
the deduction so allocated, and the amount of foreign source portfolio 
dividends included in such class, shall be determined in accordance with 
the methodology illustrated in paragraph (ii) of Example 28 of paragraph 
(g). If a state income tax is determined based upon formulary 
apportionment of the total taxable income attributable to the taxpayer's 
unitary business, the taxpayer must also apply the methodology 
illustrated in paragraph (ii) (C) through (G) of Example 29 of paragraph 
(g) of this section to make specific allocations of appropriate portions 
of the deduction for state income tax on the basis of income that, under 
separate accounting, would have been attributed to other members of the 
unitary group. The taxpayer shall reduce its aggregate state taxable 
income by the amount of foreign source portfolio dividends and other 
income to which a specific allocation is made (the reduced amount being 
referred to hereinafter as ``adjusted state taxable income'').
    (ii) Step Two--Adjustment of U.S. source federal taxable income. If 
the taxpayer has significant income-producing activities in a state 
which does not impose a corporate income tax or other state tax measured 
by income derived from business activities in the state, the taxpayer 
shall reduce its U.S. source federal taxable income (solely for purposes 
of this safe harbor method) by the amount of federal taxable income 
attributable to its activities in such state. This amount shall be 
determined in accordance with the methodology illustrated in paragraph 
(ii) of Example 27 of paragraph (g) of this section, provided that the 
taxpayer shall be required to use the rules of the Uniform Division of 
Income for Tax Purposes Act to attribute income to the relevant state. 
The taxpayer's U.S. source federal taxable income, as so reduced, is 
referred to hereinafter as ``adjusted U.S. source federal taxable 
income.''
    (iii) Step Three--Allocation. The taxpayer shall allocate the 
remainder of the deduction for state income tax (after reduction by the 
portion allocated to foreign source portfolio dividends and other income 
under Step One) in accordance with the methodology illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section. However, 
the taxpayer shall substitute for the comparison of aggregate state 
taxable income to U.S. source federal taxable income, illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section, a 
comparison of its adjusted state taxable income to an amount equal to 
110% of its adjusted U.S. source federal taxable income.
    (iv) Step Four--Apportionment. In the event that apportionment of 
the remainder of the deduction for state income tax is required, the 
taxpayer shall apportion that remaining deduction to U.S. source income 
in accordance with the methodology illustrated in paragraph (iii) of 
Example 25 of paragraph (g) of this section, substituting for domestic 
source income in that paragraph an amount equal to 110% of the 
taxpayer's adjusted U.S. source federal taxable income. The remaining 
portion of the deduction shall be apportioned to the statutory groupings 
of foreign source income described in section 904(d) of the Code in 
accordance with the proportion of the income in each statutory grouping 
of foreign source income described in section 904(d) to the taxpayer's 
total foreign source federal taxable income (after reduction by the 
amount of foreign source portfolio dividends to which tax has been 
specifically allocated under Step One, above).
    (3) Method Two. (i) Step One--Specific allocation to foreign source 
portfolio dividends and other income. Step One of this method is the 
same as Step One of Method One (as described in paragraph 
(e)(6)(ii)(D)(2)(i) of this section).
    (ii) Step Two--Adjustment of U.S. source federal taxable income. 
Step Two of this method is the same as Step Two of Method One (as 
described in paragraph (e)(6)(ii)(D)(2)(ii) of this section).
    (iii) Step Three--Allocation. The taxpayer shall allocate the 
remainder of the deduction for state income tax (after reduction by the 
portion allocated to foreign source portfolio dividends and other income 
under Step

[[Page 146]]

One) in accordance with the methodology illustrated in paragraph (ii) of 
Example 25 of paragraph (g) of this section. However, the taxpayer shall 
substitute for the comparison of aggregate state taxable income to U.S. 
source federal taxable income, illustrated in paragraph (ii) of Example 
25 of paragraph (g) of this section, a comparison of its adjusted state 
taxable income to its adjusted U.S. source federal taxable income.
    (iv) Step Four--Apportionment. In the event that apportionment of 
the deduction is required, the taxpayer shall apportion to U.S. source 
income that portion of the deduction that is attributable to state 
income taxes imposed upon an amount of state taxable income equal to 
adjusted U.S. source federal taxable income. The taxpayer shall 
apportion the remaining amount of the deduction to U.S. and foreign 
source income in the same proportions that the taxpayer's adjusted U.S. 
source federal taxable income and foreign source federal taxable income 
(after reduction by the amount of foreign source portfolio dividends to 
which tax has been specifically allocated under Step One, above) bear to 
its total federal taxable income (taking into account the adjustment of 
U.S. source federal taxable income under Step Two and after reduction by 
the amount of foreign source portfolio dividends to which tax has been 
specifically allocated under Step One). The portion of the deduction 
apportioned to foreign source income shall be apportioned among the 
statutory groupings described in section 904(d) of the Code in 
accordance with the proportions of the taxpayer's total foreign source 
federal taxable income (after reduction by the amount of foreign source 
portfolio dividends to which tax has been specifically allocated under 
Step One, above) in each grouping.
    (iii) Effective dates. The rules of Sec. 1.861-8(e)(6)(i) and the 
language preceding the examples in Sec. 1.861-8(g) are effective for 
taxable years beginning after December 31, 1976. The rules of 
Sec. 1.861-8(e)(6)(ii) (other than Sec. 1.861-8(e)(6)(ii)(D)) and 
Examples 25 through 32 of Sec. 1.861-8(g) are effective for taxable 
years beginning on or after January 1, 1988. The rules of Sec. 1.861-
8(e)(6)(ii)(D) and Example 33 of Sec. 1.861-8(g) are effective for 
taxable years ending after March 12, 1991. At the option of the 
taxpayer, however, the rules of Sec. 1.861-8(e)(6)(ii) (other than 
Sec. 1.861-8(e)(6)(ii)(D)) and Examples 25 through 32 of Sec. 1.861-8(g) 
may be applied with respect to deductions for state taxes incurred in 
taxable years beginning before January 1, 1988.
    (7) Losses on the sale, exchange, or other disposition of property--
(i) Allocation. The deduction allowed for loss recognized on the sale, 
exchange, or other disposition of a capital asset or property described 
in section 1231(b) shall be considered a deduction which is definitely 
related and allocable to the class of gross income to which such asset 
or property ordinarily gives rise in the hands of the taxpayer. Where 
the nature of gross income generated from the asset or property has 
varied significantly over several taxable years of the taxpayer, such 
class of gross income shall generally be determined by reference to 
gross income generated from the asset or property during the taxable 
year or years immediately preceding the sale, exchange, or other 
dispostion of such asset or property. Thus, for example, where an asset 
generates primarily sales income from domestic sources in the early 
years of its operation and then is leased by the taxpayer to a foreign 
subsidiary in later years, the class of gross income to which the asset 
gives rise will be considered to be the rental income derived from the 
lease and will not include sales income from domestic sources.
    (ii) Apportionment of losses. Where in the unusual circumstances 
that an apportionment of a deduction for losses on the sale, exchange, 
or other disposition of a capital asset or property described in section 
1231(b) is necessary, the amount of such deduction shall be apportioned 
between the statutory grouping (or among the statutory groupings) of 
gross income (within the class of gross income) and the residual 
grouping (within the class of gross income) in the same proportion that 
the amount of gross income within such statutory grouping (or statutory 
groupings) and such residual grouping bear, respectively, to the total 
amount of gross income within the class of

[[Page 147]]

gross income. Apportionment will be necessary where, for example, the 
class of gross income to which the deduction is allocated consists of 
gross income (such as royalties) attributable to an intangible asset 
used both within and without the United States, or gross income (such as 
from sales or services) attributable to a tangible asset used both 
within and without the United States.
    (iii) Allocation of loss recognized in taxable years after 1986. See 
Secs. 1.865-1 and 1.865-2 for rules regarding the allocation of certain 
loss recognized in taxable years beginning after December 31, 1986.
    (8) Net operating loss deduction. A net operating loss deduction 
allowed under section 172 shall be allocated and apportioned in the same 
manner as the deductions giving rise to the net operating loss 
deduction.
    (9) Deductions which are not definitely related. Deductions which 
shall generally be considered as not definitely related to any gross 
income, and therefore are ratably apportioned as provided in paragraph 
(c)(2) of this section, are--
    (i) The deduction allowed by section 163 for interest described in 
subparagraph (2)(iii) of this paragraph (e);
    (ii) The deduction allowed by section 164 for real estate taxes on a 
personal residence or for sales tax on the purchase of items for 
personal use;
    (iii) The deduction for medical expenses allowed by section 213;
    (iv) The deduction for charitable contributions allowed by sections 
170, 873(b)(2), and 882(c)(1)(B); and
    (v) The deduction for alimony payments allowed by section 215.
    (10) Special deductions. The special deductions allowed in the case 
of a corporation by section 241 (relating to the deductions for 
partially tax exempt interest, dividends received, etc.), section 922 
(relating to Western Hemisphere trade corporations), and section 941 
(relating to China Trade Act corporations) shall be allocated and 
apportioned consistent with the principles of this section.
    (11) Personal exemptions. The deductions for the personal exemptions 
allowed by section 151, 642(b), or 873(b)(3) shall not be taken into 
account for purpose of allocation and apportionment under this section.
    (f) Miscellaneous matters--(1) Operative sections. The operative 
sections of the Code which require the determination of taxable income 
of the taxpayer from specific sources or activities and which give rise 
to statutory groupings to which this section is applicable include the 
sections described below.
    (i) Overall limitation to the foreign tax credit. Under the overall 
limitation to the foreign tax credit, as provided in section 904(a)(2) 
(as in effect before enactment of the Tax Reform Act of 1976, or section 
904(a) after such enactment) the amount of the foreign tax credit may 
not exceed the tentative U.S. tax (i.e., the U.S. tax before application 
of the foreign tax credit) multiplied by a fraction, the numerator of 
which is the taxable income from sources without the United States and 
the denominator of which is the entire taxable income. Accordingly, in 
this case, the statutory grouping is foreign source income (including, 
for example, interest received from a domestic corporation which meets 
the tests of section 861(a)(1)(B), dividends received from a domestic 
corporation which has an election in effect under section 936, and other 
types of income specified in section 862). Pursuant to sections 862(b) 
and 863(a) and Secs. 1.862-1 and 1.863-1, this section provides rules 
for identifying the deductions to be taken into account in determining 
taxable income from sources without the United States. See section 
904(d) (as in effect after enactment of the Tax Reform Act of 1976) and 
the regulations thereunder which require separate treatment of certain 
types of income. See example 3 of paragraph (g) of this section for one 
example of the application of this section to the overall limitation.
    (ii)  [Reserved]
    (iii) DISC and FSC taxable income. Sections 925 and 994 provide 
rules for determining the taxable income of a FSC and DISC, 
respectively, with respect to qualified sales and leases of export 
property and qualified services. The combined taxable income method 
available for determining a DISC's taxable income provides, without 
consideration of export promotion expenses, that the taxable income of 
the DISC

[[Page 148]]

shall be 50 percent of the combined taxable income of the DISC and the 
related supplier derived from sales and leases of export property and 
from services. In the FSC context, the taxable income of the FSC equals 
23 percent of the combined taxable income of the FSC and the related 
supplier. Pursuant to regulations under section 925 and 994, this 
section provides rules for determining the deductions to be taken into 
account in determining combined taxable income, except to the extent 
modified by the marginal costing rules set forth in the regulations 
under sections 925(b)(2) and 994(b)(2) if used by the taxpayer. See 
Examples (22) and (23) of paragraph (g) of this section. In addition, 
the computation of combined taxable income is necessary to determine the 
applicability of the section 925(d) limitation and the ``no loss'' rules 
of the regulations under sections 925 and 994.
    (iv) Effectively connected taxable income. Nonresident alien 
individuals and foreign corporations engaged in trade or business within 
the United States, under sections 871(b)(1) and 882(a)(1), on taxable 
income which is effectively connected with the conduct of a trade or 
business within the United States. Such taxable income is determined in 
most instances by initially determining, under section 864(c), the 
amount of gross income which is effectively connected with the conduct 
of a trade or business within the United States. Pursuant to sections 
873 and 882(c), this section is applicable for purposes of determining 
the deductions from such gross income (other than the deduction for 
interest expense allowed to foreign corporations (see Sec. 1.882-5)) 
which are to be taken into account in determining taxable income. See 
example 21 of paragraph (g) of this section.
    (v) Foreign base company income. Section 954 defines the term 
``foreign base company income'' with respect to controlled foreign 
corporations. Section 954(b)(5) provides that in determining foreign 
base company income the gross income shall be reduced by the deductions 
of the controlled foreign corporation ``properly allocable to such 
income''. This section provides rules for identifying which deductions 
are properly allocable to foreign base company income.
    (vi) Other operative sections. The rules provided in this section 
also apply in determining--
    (A) The amount of foreign source items of tax preference under 
section 58(g) determined for purposes of the minimum tax;
    (B) The amount of foreign mineral income under section 901(e);
    (C)  [Reserved]
    (D) The amount of foreign oil and gas extraction income and the 
amount of foreign oil related income under section 907;
    (E) The tax base for citizens entitled to the benefits of section 
931 and the section 936 tax credit of a domestic corporation which has 
an election in effect under section 936;
    (F) The exclusion for income from Puerto Rico for residents of 
Puerto Rico under section 933;
    (G) The limitation under section 934 on the maximum reduction in 
income tax liability incurred to the Virgin Islands;
    (H) The income derived from Guam by an individual who is subject to 
section 935;
    (I) The special deduction granted to China Trade Act corporations 
under section 941;
    (J) The amount of certain U.S. source income excluded from the 
subpart F income of a controlled foreign corporation under section 
952(b);
    (K) The amount of income from the insurance of U.S. risks under 
section 953(b)(5);
    (L) The international boycott factor and the specifically 
attributable taxes and income under section 999; and
    (M) The taxable income attributable to the operation of an agreement 
vessel under section 607 of the Merchant Marine Act of 1936, as amended, 
and the Capital Construction Fund Regulations thereunder (26 CFR, part 
3). See 26 CFR 3.2(b)(3).
    (2) Application to more than one operative section. (i) Where more 
than one operative section applies, it may be necessary for the taxpayer 
to apply this section separately for each applicable operative section. 
In such a case, the taxpayer is required to use the same method of 
allocation and the same

[[Page 149]]

principles of apportionment for all operative sections.
    (ii) When expenses, losses, and other deductions that have been 
properly allocated and apportioned between combined gross income of a 
related supplier and a DISC or former DISC and residual gross income, 
regardless of which of the administrative pricing methods of section 994 
has been applied, such deductions are not also allocated and apportioned 
to gross income consisting of distributions from the DISC or former DISC 
attributable to income of the DISC or former DISC as determined under 
the administrative pricing methods with respect to DISC or former DISC 
taxable years beginning after December 31, 1986. Accordingly, Example 
(22) of paragraph (g) of this section does not apply to distributions 
from a DISC or former DISC with respect to DISC or former DISC taxable 
years beginning after December 31, 1986. This rule does not apply to the 
extent that the taxable income of the DISC or former DISC is determined 
under the section 994(a)(3) transfer pricing method. In addition, for 
taxable years beginning after December 31, 1986, in the case of 
expenses, losses, and other deductions that have been properly allocated 
and apportioned between combined gross income of a related supplier and 
a FSC and residual gross income, regardless of which of the 
administrative pricing methods of section 925 has been applied, such 
deductions are not also allocated and apportioned to gross income 
consisting of distributions from the FSC or former FSC which are 
attributable to the foreign trade income of the FSC or former FSC as 
determined under the administrative pricing methods. This rule does not 
apply to the extent that the foreign trade income of the FSC or former 
FSC is determined under the section 925(a)(3) transfer pricing method. 
See Example (23) of paragraph (g) of this section.
    (3) Special rules of section 863(b)--(i) In general. Special rules 
under section 863(b) provide for the application of rules of general 
apportionment provided in Secs. 1.863-3 to 1.863-5, to worldwide taxable 
income in order to attribute part of such worldwide taxable income to 
U.S. sources and the remainder of such worldwide taxable income to 
foreign sources. The activities specified in section 863(b) are--
    (A) Transportation or other services rendered partly within and 
partly without the United States,
    (B) Sales of personal property produced by the taxpayer within and 
sold without the United States, or produced by the taxpayer without and 
sold within the United States, and
    (C) Sales within the United States of personal property purchased 
within a possession of the United States.

In the instances provided in Secs. 1.863-3 and 1.863-4 with respect to 
the activities described in (A), (B), and (C) of this subdivision, this 
section is applicable only in determining worldwide taxable income 
attributable to these activities.
    (ii) Relationship of sections 861, 862, 863(a), and 863(b). Sections 
861, 862, 863(a), and 863(b) are the four provisions applicable in 
determining taxable income from specific sources. Each of these four 
provisions applies independently. Where a deduction has been allocated 
and apportioned to income under one of these four provisions, the 
deduction shall not again be allocated and apportioned to gross income 
under any of the other three provisions. However, two or more of these 
provisions may have to be applied at the same time to determine the 
proper allocation and apportionment of a deduction. The special rules 
under section 863(b) take precedence over the general rules of Code 
sections 861, 862 and 863(a). For example, where a deduction is 
allocable in whole or in part to gross income to which section 863(b) 
applies, such deduction or part thereof shall not otherwise be allocated 
under section 861, 862, or 863(a). However, where the gross income to 
which the deduction is allocable includes both gross income to which 
section 863(b) applies and gross income to which section 861, 862, or 
863(a) applies, more than one section must be applied at the same time 
in order to determine the proper allocation and apportionment of the 
deduction.
    (4) Adjustments made under other provisions of the Code--(i) In 
general. If an adjustment which affects the taxpayer is made under 
section 482 or any other

[[Page 150]]

provision of the Code, it may be necessary to recompute the allocations 
and apportionments required by this section in order to reflect changes 
resulting from the adjustment. The recomputation made by the District 
Director shall be made using the same method of allocation and 
apportionment as was originally used by the taxpayer, provided such 
method as originally used conformed with paragraph (a)(5) of this 
section and, in light of the adjustment, such method does not result in 
a material distortion. In addition to adjustments which would be made 
aside from this section, adjustments to the taxpayer's income and 
deductions which would not otherwise be made may be required before 
applying this section in order to prevent a distortion in determining 
taxable income from a particular source of activity. For example, if an 
item included as a part of the cost of goods sold has been improperly 
attributed to specific sales, and, as a result, gross income under one 
of the operative sections referred to in paragraph (f)(1) of this 
section is improperly determined, it may be necessary for the District 
Director to make an adjustment to the cost of goods sold, consistent 
with the principles of this section, before applying this section. 
Similarly, if a domestic corporation transfers the stock in its foreign 
subsidiaries to a domestic subsidiary and the parent continues to incur 
expenses in connection with the supervision of the foreign subsidiaries 
(see paragraph (e)(4) of this section), it may be necessary for the 
District Director to make an allocation under section 482 with respect 
to such expenses before making allocations and apportionments required 
by this section, even though the section 482 allocation might not 
otherwise be made.
    (ii) Example. X, a domestic corporation, purchases and sells 
consumer items in the United States and foreign markets. Its sales in 
foreign markets are made to related foreign subsidiaries. X reported 
$1,500,000 as sales during the taxable year of which $1,000,000 was 
domestic sales and $500,000 was foreign sales. X took a deduction for 
expenses incurred by its marketing department during the taxable year in 
the amount of $150,000. These expenses were determined to be allocable 
to both domestic and foreign sales and are apportionable between such 
sales. Thus, X allocated and apportioned the marketing department 
deduction as follows:

To gross income from domestic sales: $150,000x($1,000,000/      $100,000
 $1,500,000).................................................
To gross income from foreign sales: $150,000x($500,000/           50,000
 $1,500,000).................................................
                                                              ----------
      Total..................................................    150,000
 

    On audit of X's return for the taxable year, the District Director 
adjusted, under section 482, X's sales to related foreign subsidiaries 
by increasing the sales price by a total of $100,000, thereby increasing 
X's foreign sales and total sales by the same amount. As a result of the 
section 482 adjustment, the apportionment of the deduction for the 
marketing department expenses is redetermined as follows:

To gross income from domestic sales: $150,000x($1,000,000/       $93,750
 $1,600,000)..................................................
To gross income from foreign sales: $150,000x($600,000/           56,250
 $1,600,000)
                                                               ---------
      Total...................................................   150,000
 

    (5) Verification of allocations and apportionments. Since, under 
this section, allocations and apportionments are made on the basis of 
the factual relationship between deductions and gross income, the 
taxpayer is required to furnish, at the request of the District 
Director, information from which such factual relationships can be 
determined. In reviewing the overall limitation to the foreign tax 
credit of a domestic corporation, for example, the District Director 
should consider information which would enable him to determine the 
extent to which deductions attributable to functions performed in the 
United States are related to earning foreign source income, United 
States source income, or income from both sources. In addition to 
functions with a specific international purpose, consideration should be 
given to the functions of management, the direction and results of an 
acquisition program, the functions of operating units and personnel 
located at the head office, the functions of support units (including 
but not limited to engineering, legal, budget, accounting, and 
industrial relations), the functions of selling and advertising units 
and personnel, the direction and uses of research and development and 
the direction and uses of services furnished by independent

[[Page 151]]

contractors. Thus, for example when requested by the District Director, 
the taxpayer shall make available any of its organization charts, 
manuals, and other writings which relate to the manner in which its 
gross income arises and to the functions of organizational units, 
employees, and assets of the taxpayer and arrange for the interview of 
such of its employees as the District Director deems desirable in order 
to determine the gross income to which deductions relate. See section 
7602 and the regulations thereunder which generally provide for the 
examination of books and witnesses. See also section 905(b) and the 
regulations thereunder which require proof of foreign tax credits to the 
satisfaction of the Secretary or his delegate.
    (g) General examples. The following examples illustrate the 
principles of this section. In each example, unless otherwise specified, 
the operative section which is applied and gives rise to the statutory 
grouping of gross income is the overall limitation to the foreign tax 
credit under section 904(a). In addition, in each example, where a 
method of allocation or apportionment is illustrated as an acceptable 
method, it is assumed that such method is used by the taxpayer on a 
consistent basis from year to year (except in the case of the optional 
method for apportioning research and development expense under paragraph 
(e)(3)(iii) of Sec. 1.861-8). Further, it is assumed that each party 
named in each example operates on a calendar year accounting basis and, 
where the party is a U.S. taxpayer, files returns on a calendar year 
basis.

    Examples 1--16 --[Reserved]
    Example 17-- Stewardship Expenses (Consolidation)--(i) Facts. X, a 
domestic corporation, wholly owns M, N, and O, also domestic 
corporations. X, M, N, and O file a consolidated income tax return. All 
the income of X and O is from sources within the United States, all of 
M's income is from sources within South America, and all of N's income 
is from sources within Africa. X receives no dividends from M, N, or O. 
During the taxable year, the consolidated group of corporations earned 
consolidated gross income of $550,000 and incurred total deductions of 
$370,000 as follows:

------------------------------------------------------------------------
                                              Gross income    Deductions
------------------------------------------------------------------------
Corporations:
  X........................................        $100,000      $50,000
  M........................................         250,000      100,000
  N........................................         150,000      200,000
  O........................................          50,000       20,000
                                            ----------------------------
    Total..................................         550,000      370,000
------------------------------------------------------------------------


Of the $50,000 of deductions incurred by X, $15,000 relates to X's 
ownership of M; $10,000 relates to X's ownership of N; $5,000 relates to 
X's ownership of O; and the entire $30,000 constitute stewardship 
expenses. The remainder of X's deductions ($20,000) relates to 
production of income from its plant in the United States.
    (ii) Allocation. In accordance with Sec. 1.1502-4, each corporation 
must first compute its separate taxable income for purposes of computing 
the limitation on the foreign tax credit. X's deductions of $50,000 are 
definitely related and thus allocable to the types of gross income to 
which they give rise, namely $25,000 wholly to income from sources 
outside the United States ($15,000 for stewardship of M and $10,000 for 
stewardship of N) and the remainder ($25,000) wholly to gross income 
from sources within the United States. Expenses incurred by M and N are 
entirely related and thus wholly allocable to income earned from sources 
without the United States and expenses incurred by O are entirely 
related and thus wholly allocable to income earned within the United 
States. Hence, no apportionment of expenses of X, M, N, or O is 
necessary. For purposes of applying the overall limitation, the 
statutory grouping is gross income from sources without the United 
States and the residual grouping is gross income from sources within the 
United States. As a result of the allocation of deductions, X, M, and N 
have separate taxable income (losses) from sources without the United 
States in the amounts of ($25,000), $150,000, and ($50,000), 
respectively, computed as follows:

------------------------------------------------------------------------
                                             X         M           N
------------------------------------------------------------------------
Foreign gross income...................  ........   $250,000    $150,000
Less: Deductions allocable to foreign     $25,000    100,000     200,000
 gross income..........................
                                        --------------------------------
    Total, taxable income (loss).......  (25,000)    150,000    (50,000)
------------------------------------------------------------------------

Thus, in the combined computation of the overall limitation, the 
numerator of the limiting fraction (taxable income from sources outside 
the United States) is $75,000 ($150,000 of separate taxable income of M 
less $50,000 of losses of N and less $25,000 of losses of X).
    Example 18-- Stewardship and Supportive Expenses--(i) Facts. X, a 
domestic corporation, manufactures and sells pharmaceuticals in the 
United States. X's domestic

[[Page 152]]

subsidiary S, and X's foreign subsidiaries T, U, and V perform similar 
functions in the United States and foreign countries T, U, and V, 
respectively. Each corporation derives substantial net income during the 
taxable year. X's gross income for the taxable year consists of:

Domestic sales income......................................  $32,000,000
Dividends from S (before dividends received deduction).....    3,000,000
Dividends from T...........................................    2,000,000
Dividends from U...........................................    1,000,000
Dividends from V...........................................            0
Royalties from T and U.....................................    1,000,000
Fees from U for services performed in the United States....    1,000,000
                                                            ------------
    Total gross income.....................................   40,000,000
Among other deductions, X incurs the following:
  Expenses of supervision department.......................    1,600,000
  Charitable contributions.................................      100,000
 


X's Supervision Department (the Department) is responsible for the 
supervision of its four subsidiaries and for rendering certain services 
to the subsidiaries, and this Department provides all the supportive 
functions necessary for X's foreign activities. The Department performs 
three principal types of activities. The first type consists of services 
for the direct benefit of U for which a fee is paid by U to X. The cost 
of the services for U is $1,000,000. The second type consists of 
stewardship activities which are in the nature of a management review 
and generally duplicate functions performed by the subsidiaries' own 
employees (and are, therefore, of a type described in Sec. 1.482-
2(b)(2)(ii) which would not be subject to an allocation under section 
482). For example, a team of auditors from X's accounting department 
periodically audits the subsidiaries' books and prepares internal 
reports for use by X's management. Similarly, X's treasurer periodically 
reviews for the board of directors of X the subsidiaries' financial 
policies. The cost of the duplicative services and related supportive 
expenses is $540,000. The third type of activity consists of providing 
services which are ancillary to the license agreements which X maintains 
with subsidiaries T and U. The cost of the ancillary services is 
$60,000.
    (ii) Allocation. The Department's outlay of $1,000,000 is the basis 
for the charge to U for services rendered, and therefore $1,000,000 is 
allocated to the fees paid by U. The remaining $600,000 in the 
Department's deductions are definitely related to the types of gross 
income to which they give rise, namely dividends from subsidiaries S, T, 
U and V and royalties from t and U. However, $60,000 of the $600,000 in 
deductions are found to be attributable to the ancillary serivces and 
are definitely related (and therefore allocable) solely to royalties 
received from T and U, while the remaining $540,000 in deductions are 
definitely related (and therefore allocable) to dividends received from 
all the subsidiaries.
    (iii) Apportionment. For purposes of applying the overall 
limitation, the statutory grouping is gross income from sources outside 
the United States and the residual grouping is gross income from sources 
within the United States. X's deduction of $540,000 for the Supervision 
Department expenses and related supportive expenses which is allocable 
to dividends received from the subsidiaries must be apportioned between 
the statutory and residual groupings before the overall limitation may 
be applied. In determining an appropriate method for apportioning the 
$540,000, a basis other than X's gross income must be used since the 
dividend payment policies of the subsidiaries bear no relationship 
either to the activities of the Department or to the amount of income 
earned by each subsidiary. This is evidenced by the fact that V paid no 
dividends during the year, whereas S, T, and U paid dividends of $1 
million or more each. In the absence of facts that would indicate a 
material distortion resulting from the use of such method, the 
stewardship expenses ($540,000) may be apportioned on the basis of the 
gross receipts of each subsidiary.

The gross receipts of the subsidiaries were as follows:
  S........................................................   $4,000,000
  T........................................................    3,000,000
  U........................................................      500,000
  V........................................................    1,500,000
                                                            ------------
    Total..................................................    9,000,000
 

    Thus, the expenses of the Department are apportioned for purposes of 
the overall limitation as follows:

Apportionment of stewardship expenses to the statutory          $300,000
 grouping of gross income: 540,000x[($3,000,000+$500,000+
 $1,500,000)/ $9,000,000]...................................
Apportionment of supervisory expenses to the residual            240,000
 grouping of gross income: $540,000x$4,000,000/9,000,000....
                                                             -----------
    Total: Apportioned stewardship expense..................    $540,000
 

    (iv) Allocation and apportionment of charitable contributions. 
Pursuant to paragraph (e)(9) of this section, charitable contributions 
are generally treated as deductions which are not definitely related to 
any gross income and are, accordingly, apportioned ratably on the basis 
of gross income for purposes of the overall limitation as follows:

Apportionment of charitable contributions to the statutory       $10,000
 grouping of gross income: $100,000x[($2,000,000 +
 $1,000,000 + $1,000,000)/$40,000,000]......................
Apportionment of charitable contributions to the residual         90,000
 grouping of gross income: $100,000x[($32,000,000 +
 $3,000,000 + $1,000,000)/$40,000,000]......................
                                                             -----------
    Total apportioned charitable contributions..............     100,000
 


[[Page 153]]

    Example 19-- Supportive Expense--(i) Facts. X, a domestic 
corporation, purchases and sells products both in the United States and 
in foreign countries. X has no foreign subsidiary and no international 
department. During the taxable year, X incurs the following expenses 
with respect to its worldwide activities:

Personnel department expenses...............................     $50,000
Training department expenses................................      35,000
General and administrative expenses.........................      55,000
President's salary..........................................      40,000
Sales manager's salary......................................      20,000
                                                             -----------
    Total...................................................     200,000
                                                             ===========
 


X has domestic gross receipts from sales of $750,000 and foreign gross 
receipts from sales of $500,000 and has gross income from such sales in 
the same ratio, namely $300,000 from domestic sources and $200,000 from 
foreign sources.
    (ii) Allocation. The above expenses are definitely related and 
allocable to all of X's gross income derived from both domestic and 
foreign markets.
    (iii) Apportionment. For purposes of applying the overall 
limitation, the statutory grouping is gross income from sources outside 
the United States and the residual grouping is gross income from sources 
within the United States. X's deductions for its worldwide sales 
activities must be apportioned between these groupings. Company X in 
this example (unlike Company X in example 18) does not have a separate 
international division which performs essentially all of the functions 
required to manage and oversee its foreign activities. The president and 
sales manager do not maintain time records. The division of their time 
between domestic and foreign activities varies from day to day and 
cannot be estimated on an annual basis with any reasonable degree of 
accuracy. Similarly, there are no facts which would justify a method of 
apportionment of their salaries or of one of the other listed deductions 
based on more specific factors than gross receipts or gross income. An 
acceptable method of apportionment would be on the basis of gross 
receipts. The apportionment of the $200,000 deduction is as follows:

Apportionment of the $200,000 expense to the statutory           $80,000
 grouping of gross income: $200,000x[$500,000/
 ($500,000+$750,000)].......................................
Apportionment of the $200,000 expense to the residual            120,000
 grouping of gross income: $200,000x[$750,000/
 ($500,000+$750,000)].......................................
                                                             -----------
  Total apportioned supportive expense......................     200,000
 

    Example 20-- Supportive Expense--(i) Facts. Assume the same facts as 
above except that X's president devotes only 5 percent of his time to 
the foreign operations and 95 percent of his time to the domestic 
operations and that X's sales manager devotes approximately 10 percent 
of his time to foreign sales and 90 percent of his time to domestic 
sales.
    (ii) Allocation. The expenses incurred by X with respect to its 
worldwide activities are definitely related, and therefore allocable to 
X's gross income from both its foreign and domestic markets.
    (iii) Apportionment. On the basis of the additional facts it is not 
acceptable to apportion the salaries of the president and the sales 
manager on the basis of gross receipts. It is acceptable to apportion 
such salaries between the statutory grouping (gross income from sources 
without the United States) and residual grouping (gross income from 
sources within the United States) on the basis of time devoted to each 
sales activity. Remaining expenses may still be apportioned on the basis 
of gross receipts. The apportionment is as follows:

Apportionment of the $200,000 expense to the statutory
 grouping of gross income:
  President's salary: $40,000x5 pct.........................      $2,000
  Sales manager's salary: $20,000x10 pct....................       2,000
  Remaining expenses: $140,000x[$500,000/                         56,000
   ($500,000+$750,000)].....................................
                                                             -----------
    Subtotal: Apportionment of expense to statutory grouping      60,000
                                                             ===========
Apportionment of the $200,000 expense to the residual
 grouping of gross income:
  President's salary: $40,000x95 pct........................      38,000
  Sales manager's salary: $20,000x90 pct....................      18,000
  Remaining expenses: $140,000x[$750,000/                         84,000
   ($500,000+$750,000)].....................................
                                                             -----------
    Subtotal: Apportionment of expense to residual grouping.     140,000
                                                             ===========
    Total: Apportioned general and administrative expense...     200,000
 

    Example 21-- Supportive Expense--(i) Facts. X, a foreign corporation 
doing business in the United States, is a manufacturer of metal stamping 
machines. X has no United States subsidiaries and no separate division 
to manage and oversee its business in the United States. X manufactures 
and sells these machines in the United States and in foreign countries A 
and B and has a separate manufacturing facility in each country. Sales 
of these machines are X's only source of income. In 1977, X incurs 
general and administrative expenses related to both its U.S. and foreign 
operations of $100,000. It has machine sales of $500,000, $1,000,000 and 
$1,000,000 on which it earns gross income of $200,000, $400,000 and 
$400,000 in the United States, country A, and country B, respectively. 
The income from the manufacture and sale of the machines in countries A 
and B is not effectively connected with X's business in the United 
States.
    (ii) Allocation. The $100,000 of general and administrative expense 
is definitely related to the income to which it gives rise, namely a 
part of the gross income from sales of machines in the United States, in 
country A,

[[Page 154]]

and in country B. The expenses are allocable to this class of income, 
even though X's gross income from sources outside the United States is 
excluded income since it is not effectively connected with a U.S. trade 
or business.
    (iii) Apportionment Since X is a foreign corporation, the statutory 
grouping is gross income effectively connected with X's trade of 
business in the United States, namely gross income from sources within 
the United States, and the residual grouping is gross income not 
effectively connected with a trade or business in the United States, 
namely gross income from countries A and B. Since there are no facts 
which would require a method of apportionment other than on the basis of 
sales or gross income, the amount may be apportioned between the two 
groupings on the basis of amounts of gross income as follows:

Apportionment of general and administrative expense to the       $20,000
 statutory grouping, gross income from sources within the
 United States: $100,000x[$200,000/($200,000 + $400,000 +
 $400,000)].................................................
Apportionment of general and administrative expense to the        80,000
 residual grouping, gross income from sources without the
 United States: $100,000x[($400,000 + $400,000)/($200,000 +
 $400,000 + $400,000)]......................................
                                                             -----------
    Total apportioned general and administrative expense....     100,000
 

    Example 22-- Domestic International Sales Corporations--(i) Facts. 
X, a domestic corporation, manufactures a line of kitchenware and sells 
it to retailers in the United States, France, and the United Kingdom. 
After the Domestic International Sales Corporation (DISC) legislation 
was passed in 1971, X established, as of January 1, 1972, a DISC and 
thereafter did all of its foreign marketing through sales by the DISC. 
In 1977 the DISC has total sales of $7,700,000 for which X's cost of 
goods sold is $6,000,000. Thus, the gross income attributable to exports 
through the DISC is $1,700,000 ($7,700,000-$6,000,000). Moreover, X has 
U.S. domestic sales of kitchenware of $12,000,000 on which it earned 
gross income of $900,000, and X receives royalty income from the foreign 
license of its kitchenware technology in the amount of $800,000. The 
DISC's expenses attributable to the resale of export property are 
$400,000 of which $300,000 qualify as export promotion expenses. X also 
incurs $125,000 of general and administrative expenses in connection 
with its domestic and foreign sales activities, and its foreign 
licensing activities. X and the DISC determine transfer prices charged 
on the basis of a single product grouping and the ``50-50'' combined 
taxable income method (without marginal costing) which permits the DISC 
to have a taxable income equal to 50 percent of the combined taxable 
income attributable to the production and sales of the export property, 
plus 10 percent of the DISC's export promotion expenses.
    (ii) Allocation. For purposes of determining combined taxable income 
of X and the DISC from export sales, general and administrative expenses 
of $125,000 must be allocated to and apportioned between gross income 
resulting from the production and sale of kitchenware for export, and 
from the production and sale of kitchenware for the domestic market. The 
deduction of $400,000 for expenses attributable to the resale of export 
property is allocated solely to gross income from the production and 
sale of kitchenware in foreign markets.
    (iii) Apportionment. Apportionment of expense takes place in two 
stages. In the first stage, for computing conbined taxable income from 
the production and sale of export property, the general and 
administrative expense should be apportioned between the statutory 
grouping of gross income from the export of kitchenware and the residual 
grouping of gross income from domestic sales and foreign licenses. In 
the second stage, since the limitation on the foreign tax credit 
requires the use of a separate limitation with respect to dividends from 
a DISC (section 904(d)), the general and administrative expense should 
be apportioned between two statutory groupings, DISC dividends and 
foreign royalty income (for which the overall limitation is used), and 
the residual grouping of gross income from sales within the United 
States. In the first stage, in the absence of more specific or contrary 
information, the general and administrative expense may be apportioned 
on the basis of gross income in the respective groupings, as follows:

Apportionment of general and administrative expense to the       $62,500
 statutory grouping, gross income from exports of
 kitchenware: $125,000x[$1,700,000/($1,700,000 + $900,000 +
 $800,000)].................................................
Apportionment of general and administrative expense to the        62,500
 residual grouping, gross income from domestic sales of
 kitchenware and foreign royalty income from licensing
 kitchenware technology: $125,000x[($900,000 + $800,000)/
 ($1,700,000 + $900,000 + $800,000)]........................
                                                             -----------
  Total apportionment of general and administrative expense.     125,000
 


On the basis of this apportionment, the combined taxable income, and the 
DISC portion of taxable income may be calculated as follows:

Gross income from exports....................   $1,700,000
Less:
  DISC expense for resale of export property.      400,000
  Apportioned general and administrative            62,500
   expense...................................
                                              -------------
                                                                $462,500
                                                           -------------

[[Page 155]]

 
Combined taxable income from production and export of          1,237,500
 kitchenware..............................................
                                              ==============
DISC income:
  50 pct of combined taxable income.......................       618,750
  10 pct of export promotion expense of $300,000..........        30,000
                                              --------------
    Total DISC income.....................................       648,750
DISC income as a percentage of combined taxable income....          52.4
 

In the second stage, in the absence of more specific or contrary 
information, the general and administrative expense may also be 
apportioned on the basis of gross income in the respective groupings. 
Since DISC taxable income is 52.4 percent of combined taxable income, 
DISC gross income is treated as 52.4 percent of the gross income from 
exports $1,700,000. The apportionment follows:

Apportionment of general and administrative expense to the       $32,750
 statutory grouping, DISC dividends:
 $125,000x[(0.524x$1,700,000)/($1,700,000 + $900,000 +
 $800,000)].................................................
Apportionment of general and administrative expense to the        29,412
 statutory grouping, foreign royalty income:
 $125,000x[$800,000/($1,700,000 + 900,000 + $800,000)]......
Apportionment of general and administrative expense to the        62,838
 residual grouping, gross income from sources within the
 United States: $125,000x[($900,000 + (0.476 x$1,700,000))/
 ($1,700,000 + $900,000 + $800,000)]........................
                                                             -----------
    Total apportioned general and administrative expense....     125,000
 

    (iv) This Example 22 applies only to DISC taxable years ending 
before January 1, 1987, and to distributions from a DISC or former DISC 
with respect to DISC or former DISC taxable years ending before January 
1, 1987.
    Example 23-- [Reserved]
    Example 24-- [Reserved] For guidance, see Sec. 1.861-8T(g) Example 
24.
    Example 25-- Income Taxes--(i) Facts. X, a domestic corporation, is 
a manufacturer and distributor of electronic equipment with operations 
in states A, B, and C. X also has a branch in country Y which 
manufactures and distributes the same type of electronic equipment. In 
1988, X has taxable income from these activities, as described under the 
Code (without taking into account the deduction for state income taxes), 
of $1,000,000, of which $200,000 is foreign source general limitation 
income subject to a separate limitation under section 904(d)(1)(I) 
(``general limitation income'') and $800,000 is domestic source income. 
States A, B, and C each determine X's income subject to tax within their 
state by making adjustments to X's taxable income as determined under 
the Code, and then apportioning the adjusted taxable income on the basis 
of the relative amounts of X's payroll, property, and sales within each 
state as compared to X's worldwide payroll, property, and sales. The 
adjustments made by states A, B, and C all involve adding and 
subtracting enumerated items from taxable income as determined under the 
Code. However, in making these adjustments to taxable income, none of 
the states specifically exempts foreign source income as determined 
under the Code. On this basis, it is determined that X has taxable 
income of $550,000, $200,000, and $200,000 in states A, B, and C, 
respectively. The corporate tax rates in states A, B, and C are 10 
percent, 5 percent, and 2 percent, respectively, and X has total state 
income tax liabilities of $69,000 ($55,000 + $10,000 + $4,000), which it 
deducts as an expense for federal income tax purposes.
    (ii) Allocation. X's deduction of $69,000 for state income taxes is 
definitely related and thus allocable to the gross income with respect 
to which the taxes are imposed. Since the statutes of states A, B, and C 
do not specifically exempt foreign source income (as determined under 
the Code) from taxation and since, in the aggregate, states A, B, and C 
tax $950,000 of X's income while only $800,000 is domestic source income 
under the Code, it is presumed that state income taxes are imposed on 
$150,000 of foreign source income. The deduction for state income taxes 
is therefore related and allocable to both X's foreign source and 
domestic source income.
    (iii) Apportionment. For purposes of computing the foreign tax 
credit limitation, X's income is comprised of one statutory grouping, 
foreign source general limitation gross income, and one residual 
grouping, gross income from sources within the United States. The state 
income tax deduction of $69,000 must be apportioned between these two 
groupings. Corporation X calculates the apportionment on the basis of 
the relative amounts of foreign source general limitation taxable income 
and U.S. source taxable income subject to state taxation. In this case, 
state income taxes are presumed to be imposed on $800,000 of domestic 
source income and $150,000 of foreign source general limitation income.

State income tax deduction apportioned to foreign source         $10,895
 general limitation income (statutory grouping):
 $69,000x($150,000/$950,000)..................................
State income tax deduction apportioned to income from sources     58,105
 within the United States (residual grouping):
 $69,000x($800,000/$950,000)..................................
                                                               ---------
      Total apportioned state income tax deduction............   $69,000
 

    Example 26-- Income Taxes--(i) Facts. Assume the same facts as in 
Example 25 except that the language of state A's statute and the 
statute's operation exempt from taxation all foreign source income, as 
determined under the Code, so that foreign source income is not included 
in adjusted taxable income subject to apportionment in state A (and 
factors relating to X's country Y branch

[[Page 156]]

are not taken into account in computing the state A apportionment 
fraction).
    (ii) Allocation. X's deduction of $69,000 for state income taxes is 
definitely related and thus allocable to the gross income with respect 
to which the taxes are imposed. Since state A exempts all foreign source 
income by statute, state A is presumed to impose tax on $550,000 of X's 
$800,000 of domestic source income. X's state A tax of $55,000 is 
allocable, therefore, solely to domestic source income. Since the 
statutes of states B and C do not specifically exclude all foreign 
source income as determined under the Code, and since states B and C 
impose tax on $400,000 ($200,000 + $200,000) of X's income of which only 
$250,000 ($800,000 - $550,000) is presumed to be domestic source, the 
deduction for the $14,000 of income taxes imposed by states B and C is 
related and allocable to both foreign source and domestic source income.
    (iii) Apportionment. (A) For purposes of computing the foreign tax 
credit limitation, X's income is comprised of one statutory grouping, 
foreign source general limitation gross income, and one residual 
grouping, gross income from sources within the United States. The 
deduction of $14,000 for income taxes of states B and C must be 
apportioned between these two groupings.
    (B) Corporation X calculates the apportionment on the basis of the 
relative amounts of foreign source general limitation income and U.S. 
source income subject to state taxation.

States B and C income tax deduction apportioned to foreign        $5,250
 source general limitation income (statutory grouping):
 $14,000x($150,000/$400,000)..................................
States B and C income tax deduction apportioned to income from     8,750
 sources within the United States (residual grouping):
 $14,000x($250,000/$400,000)..................................
                                                               ---------
      Total apportioned state income tax deduction............   $14,000
 

    (C) Of X's total income taxes of $69,000, the amount allocated and 
apportioned to foreign source general limitation income equals $5,250. 
The total amount of state income taxes allocated and apportioned to U.S. 
source income equals $63,750 ($55,000 + $8,750).
    Example 27-- Income Tax--(i) Facts. Assume the same facts as in 
Example 25 except that state A, in which X has significant income-
producing activities, does not impose a corporate income tax or other 
state tax computed on the basis of income derived from business 
activities conducted in state A. X therefore has a total state income 
tax liability in 1988 of $14,000 ($10,000 paid to state B plus $4,000 
paid to state C), all of which is subject to allocation and 
apportionment under paragraph (b) of this section.
    (ii) Allocation. (A) X's deduction of $14,000 for state income taxes 
is definitely related and allocable to the gross income with respect to 
which the taxes are imposed. However, in these facts, an adjustment is 
necessary before the aggregate state taxable incomes can be compared 
with U.S. source income on the federal income tax return in the manner 
described in Examples 25 and 26. Unlike the facts in Examples 25 and 26, 
state A imposes no income tax and does not define taxable income 
attributable to activities in state A. The total amount of X's income 
subject to state taxation is, therefore, $400,000 ($200,000 in state B 
and $200,000 in state C). This total presumptively does not include any 
income attributable to activities performed in state A and therefore can 
not properly be compared to total U.S. source taxable income reported by 
X for federal income tax purposes, which does include income 
attributable to state A activities.
    (B)(1) Accordingly, before applying the method used in Examples 25 
and 26 to the facts of this example, it is necessary first to estimate 
the amount of taxable income that state A could reasonably attribute to 
X's activities in state A, and then to reduce federal taxable income by 
that amount.
    (2) Any reasonable method may be used to attribute taxable income to 
X's activities in state A. For example, the rules of the Uniform 
Division of Income for Tax Purposes Act (``UDITPA'') attribute income to 
a state on the basis of the average of three ratios that are based upon 
the taxpayer's facts--property within the state over total property, 
payroll within the state over total payroll, and sales within the state 
over total sales--and, with adjustments, provide a reasonable method for 
this purpose. When applying the rules of UDITPA to estimate U.S. source 
income derived from state A activities, the taxpayer's UDITPA factors 
must be adjusted to eliminate both taxable income and factors 
attributable to a foreign branch. Therefore, in this example all taxable 
income as well as UDITPA apportionment factors (property, payroll, and 
sales) attributable to X's country Y branch must be eliminated.
    (C)(1) Since it is presumed that, if state A had had an income tax, 
state A would not attempt to tax the income derived by X's country Y 
branch, any reasonable estimate of the income that would be taxed by 
state A must exclude any foreign source income.
    (2) When using the rules of UDITPA to estimate the income that would 
have been taxable by state A in these facts, foreign source income is 
excluded by starting with federally defined taxable income (before 
deduction for state income taxes) and subtracting any income derived by 
X's country Y branch. The hypothetical state A taxable income is then

[[Page 157]]

determined by multiplying the resulting difference by the average of X's 
state A property, payroll, and sales ratios, determined using the 
principles of UDITPA (after adjustment by eliminating the country Y 
branch factors). The resulting product is presumed to be exclusively 
U.S. source income, and the allocation and apportionment method 
described in Example 26 must then be applied.
    (3) If, for example, state A taxable income were determined to equal 
$550,000, then $550,000 of U.S. source income for federal income tax 
purposes would be presumed to constitute state A taxable income. Under 
Example 26, the remaining $250,000 ($800,000 - $550,000) of U.S. source 
income for federal income tax purposes would be presumed to be subject 
to tax in states B and C. Since states B and C impose tax on $400,000, 
the application of Example 25 would result in a presumption that 
$150,000 is foreign source income and $250,000 is domestic source 
income. The deduction for the $14,000 of income taxes of states B and C 
would therefore be related and allocable to both foreign source and 
domestic source income and would be subject to apportionment.
    (iii) Apportionment. The deduction of $14,000 for income taxes of 
states B and C is apportioned in the same manner as in Example 26. As a 
result, $5,250 of the $14,000 of state B and state C income taxes is 
apportioned to foreign source general limitation income 
($14,000x$150,000/$400,000), and $8,750 ($14,000x$250,000/$400,000) of 
the $14,000 of state B and state C income taxes is apportioned to U.S. 
source income.
    Example 28-- Income Tax--(i) Facts. (A) Assume the same facts as in 
Example 25 (X has $1,000,000 of taxable income for federal income tax 
purposes, $800,000 of which is U.S. source income and $200,000 of which 
is foreign source general limitation income), except that $100,000 of 
X's $200,000 of foreign source general limitation income consists of 
dividends from first-tier controlled foreign corporations (``CFCs'') (as 
defined in section 957(a) of the Code) which derive exclusively foreign 
source general limitation income. X owns stock representing 10 to 50 
percent of the vote and value in such CFCs.
    (B) State A taxable income is computed by first making adjustments 
to X's federal taxable income. These adjustments result in X having a 
total of $1,100,000 of apportionable taxable income for state A tax 
purposes. None of the $100,000 of adjustments made by state A relate to 
the dividends paid by the CFCs. As in Example 25, the amount of 
apportionable taxable income attributable to business activities 
conducted in state A is determined by multiplying apportionable taxable 
income by a fraction (the ``state apportionment fraction'') that 
compares the relative amounts of X's payroll, property, and sales within 
state A with X's worldwide payroll, property and sales. An analysis of 
state A law indicates that state A law includes in its definition of the 
taxable business income of X which is apportionable to X's state A 
activities, dividends paid to X by its subsidiaries that are in the same 
business as X, but are less than 50 percent owned by X (``portfolio 
dividends''). The dividends received by X from the 10 to 50 percent 
owned first-tier CFCs, therefore, are considered to be portfolio 
dividends includable in apportionable business income for state A tax 
purposes. However, the factors of these CFCs are not included in the 
state A apportionment fraction for purposes of apportioning income to 
X's activities in the state. The comparison of X's state A factors with 
X's worldwide factors results in a state apportionment fraction of 50 
percent. Applying this fraction to apportionable taxable income of 
$1,100,000, as determined under state law, results in attributing 50 
percent of apportionable taxable income to state A, and produces total 
state A taxable income of $550,000. State A imposes an income tax at a 
rate of 10 percent on the amount of income that is attributed to state 
A, which results in $55,000 of tax imposed by state A.
    (ii) Allocation. (A) States A, B, and C impose income taxes of 
$69,000 which must be allocated to the classes of gross income upon 
which the taxes are imposed. A portion of X's federal income tax 
dedution of $55,000 for state A income tax is definitely related and 
thus allocable to the class of gross income consisting of foreign source 
portfolio dividends. A definite relationship exists between a deduction 
for state income tax and portfolio dividends when a state includes 
portfolio dividends in state taxable income apportionable to the state, 
but determines state taxable income by applying an apportionment 
fraction that excludes the factors of the corporations paying those 
dividends. By applying a state apportionment fraction that excludes 
factors of the corporations paying portfolio dividends to apportionable 
taxable income that includes the $100,000 of foreign source portfolio 
dividends, $50,000 (50 percent of the $100,000) of the portfolio 
dividends is attributed to X's activities in state A and subjected to 
state A income tax. Applying the state A income tax rate of 10 percent 
to the $50,000 of foreign source portfolio dividends subjected to state 
A income tax, $5,000 of X's $55,000 total state A income tax liability 
is definitely related and allocable to a class of gross income 
consisting of the foreign source portfolio dividends. Since under the 
look-through rules of section 904(d)(3) the foreign source portfolio 
dividends from the first-tier CFCs are included within the general 
limitation described in section 904(d)(1)(I), the $5,000 of state A tax 
on foreign source portfolio dividends is allocated entirely to foreign 
source general limitation income and, therefore, is not apportioned. (If 
the total amount of state A tax imposed on

[[Page 158]]

foreign source portfolio dividends were to exceed the actual amount of 
X's state A income tax liability (for example, due to net operating 
losses), the actual amount of state A tax would be allocated entirely to 
those foreign source portfolio dividends.) After allocation of a portion 
of the state A tax to portfolio dividends, $50,000 ($55,000-$5,000) of 
state A tax remains to be allocated.
    (B) A total of $64,000 (the aggregate of the $50,000 remaining state 
A tax, and the $10,000 and $4,000 of taxes imposed by states B and C, 
respectively) is to be allocated (as provided in Example 25) by 
comparing U.S. source taxable income (as determined under the Code) with 
the aggregate of the state taxable incomes determined by states A, B, 
and C (after reducing state apportionable taxable incomes by the amount 
of any portfolio dividends included in apportionable taxable income to 
which tax has been specifically allocated). X's state A taxable income, 
after reduction by the $50,000 of portfolio dividends taxed by state A, 
equals $500,000. X also has taxable income of $200,000 and $200,000 in 
states B and C, respectively. In the aggregate, therefore, states A, B, 
and C tax $900,000 of X's income, after excluding state taxable income 
attributable to portfolio dividends. Since X has only $800,000 of U.S. 
source taxable income for federal income tax purposes, it is presumed 
that state income taxes are imposed on $100,000 of foreign source 
income. The remaining deduction of $64,000 for state income taxes is 
therefore related and allocable to both foreign source and domestic 
source income and is subject to apportionment.
    (iii) Apportionment. For purposes of computing the foreign tax 
credit limitation, X's income is comprised of one statutory grouping, 
foreign source general limitation income, and one residual grouping, 
gross income from sources within the United States. The remaining state 
income tax deduction of $64,000 must be apportioned between these two 
groupings on the basis of relative amounts of foreign source general 
limitation taxable income and U.S. source taxable income subject to 
state taxation. In this case, the $64,000 of state income taxes is 
considered to be imposed on $800,000 of domestic source income and 
$100,000 of foreign source general limitation income and is apportioned 
as follows:

 
State income tax deduction apportioned to foreign source          $7,111
 general limitation income (statutory grouping):
 $64,000x($100,000/$900,000)...............................
State income tax deduction apportioned to income from             56,889
 sources within the United States (residual grouping):
 $64,000x($800,000/$900,000)...............................
                                                            ------------
      Total apportioned state income tax deduction.........      $64,000
 

    Of the total state income taxes of $69,000, the amount allocated and 
apportioned to foreign source general limitation income equals $12,111 
($5,000 + $7,111). The total amount of state income taxes allocated and 
apportioned to U.S. source income equals $56,889.
    Example 29-- Income Taxes--(i) Facts. (A) P, a domestic corporation, 
is a manufacturer and distributor of electronic equipment with 
operations in states F, G, and H. P also has a branch in country Y which 
manufactures and distributes the same type of electronic equipment. In 
addition, P has three wholly owned subsidiaries, US1, US2, and FS, the 
latter a controlled foreign corporation (``CFC'') as defined in section 
957(a) of the Code. P also owns stock representing 10 to 50 percent of 
the vote and value of various other first-tier CFCs that derive 
exclusively foreign source general limitation income.
    (B) In 1988, P derives $1,000,000 of federal taxable income (without 
taking into account the deduction for state income taxes), which 
consists of $250,000 of foreign source general limitation income and 
$750,000 of U.S. source income. The foreign source general limitation 
income consists of a $25,000 subpart F inclusion with respect to FS, 
$150,000 of dividends from the other first-tier CFCs deriving 
exclusively foreign source general limitation income, in which P owns 
stock representing 10 to 50 percent of the vote and value, and $75,000 
of manufacturing and sales income derived by P's U.S. operations and 
country Y branch. The $750,000 of U.S. source income consists of 
manufacturing and sales income derived by P's U.S. operations.
    (C) For federal income tax purposes, US1 derives $75,000 of taxable 
income, before deduction for state income taxes, which consists entirely 
of U.S. source income. US2, a so-called ``80/20'' corporation described 
in section 861(c)(1), derives $250,000 of federal taxable income before 
deduction for state or foreign income taxes, all of which is derived 
from foreign operations and consists entirely of foreign source general 
limitation income. FS is not engaged in a U.S. trade or business and 
derives $550,000 of foreign source general limitation income before 
deduction for foreign income taxes.
    (D) State F imposes a corporate income tax of 10 percent of P's 
state F taxable income, which is determined by formulary apportionment 
of the total taxable income attributable to P's worldwide unitary 
business. State F determines P's taxable income for

[[Page 159]]

state F tax purposes by first making adjustments to the taxable income, 
as determined for federal income tax purposes, of the members of the 
unitary business group to determine the total taxable income of the 
group. State F then computes P's state taxable income by attributing a 
portion of that unitary business taxable income to activities of P that 
are conducted in state F. State F does this by multiplying the unitary 
business taxable income (federal taxable income with state adjustments) 
by a fraction (the ``state apportionment fraction'') that compares the 
relative amounts of the unitary business group's payroll, property, and 
sales (the ``factors'') in state F with the payroll, property, and sales 
of the unitary business group. P is the only member of its unitary 
business group that has state F factors and that is thereby subject to 
state F income tax and filing requirements. State F defines the unitary 
business group to include any corporation more than 50 percent of which 
is directly or indirectly owned by a state F taxpayer and is engaged in 
the same unitary business. P's unitary business group, therefore, 
includes P, US1, US2, and FS, but does not include the 10 to 50 percent 
owned CFCs. The income of the unitary business group excludes 
intercompany dividends between members of the unitary business group and 
subpart F inclusions with respect to a member of the unitary business 
group. Dividends paid from nonmembers of the unitary group (the 10 to 50 
percent owned CFCs) for state F tax purposes are referred to as 
``portfolio dividends'' and are included in taxable income of the 
unitary business. None of the factors (in state F or worldwide) of the 
corporations paying portfolio dividends are included in the state F 
apportionment fraction for purposes of apportioning total taxable income 
of the unitary business to P's state F activities.
    (E) After state adjustments to the taxable income of the unitary 
business group, as determined under federal tax principles, the total 
taxable income of P's unitary business group equals $2,000,000, 
consisting of $1,050,000 of P's income ($100,000 of foreign source 
manufacturing and sales income, $150,000 of foreign source portfolio 
dividends, and $800,000 of U.S. source manufacturing and sales income, 
but excluding the $25,000 subpart F inclusion attributable to FS since 
FS is a member of the unitary business group), $100,000 of US1's income 
(from sales made in the United States), $275,000 of US2's income (from 
an active business outside the United States), and $575,000 of FS's 
income. The differences between taxable income under federal tax 
principles and state F apportionable taxable income for P, US1, US2, and 
FS represent adjustments to taxable income under federal tax principles 
that are made pursuant to the tax laws of state F.
    (F) The taxable income for each member of the unitary business group 
under federal tax principles and state law principles is summarized in 
the following table. (The items of income listed in the ``Federal'' 
column of the table refer to taxable income before deduction for state 
income tax.)

------------------------------------------------------------------------
                                                    Federal     State F
------------------------------------------------------------------------
                        P
 
U.S. source income..............................    $750,000    $800,000
Foreign source general limitation income:
    Portfolio dividends.........................     150,000     150,000
    Subpart F income............................      25,000           0
    Manufacturing and sales income..............      75,000     100,000
                                                 -----------------------
      Total taxable income......................   1,000,000   1,050,000
 
                       US1
 
U.S. source income..............................      75,000     100,000
 
                       US2
 
Foreign source general limitation income........     250,000     275,000
 
                       FS
 
Foreign source general limitation income........     550,000     575,000
                                                 -----------------------
Taxable income of the unitary business group....  ..........   2,000,000
                                                 =======================
------------------------------------------------------------------------

    (G) State F deems P to have state F taxable income of $500,000, 
which is determined by multiplying the total taxable income of the 
unitary business group ($2,000,000) by the group's state F apportionment 
fraction, which is assumed to be 25 percent in these facts. P's state F 
taxable income is then multiplied by the state F tax rate of 10 percent, 
resulting in a state F tax liability of $50,000. State G and state H, 
unlike state F, do not tax portfolio dividends. Although state G and 
state H apportion taxable income, respectively, on the basis of an 
apportionment fraction that compares state factors to total factors, 
state G and state H, unlike state F, do not apply a unitary business 
theory and consider only P's taxable income and factors in computing P's 
taxable income. P's taxable income under state G law equals $300,000, 
which is subject to a 5 percent tax rate resulting in a state G tax 
liability of $15,000. P's taxable income under state H law is $300,000, 
which is subject to a tax rate of 2 percent resulting in a state H tax 
liability of $6,000. P has a total federal income tax deduction for 
state income taxes of $71,000 ($50,000 + 15,000 + 6,000).
    (ii) Allocation. (A) P's deduction of $71,000 for state income taxes 
is definitely related and allocable to the gross income with respect to 
which the taxes are imposed. Adjustments may be necessary, however, 
before aggregate state taxable incomes can be compared with U.S. source 
taxable income on the

[[Page 160]]

federal income tax return in the manner described in Examples 25 and 26. 
In allocating P's deduction for state income taxes, it is necessary 
first to determine the portion, if any, of the deduction that is 
definitely related and allocable to a particular class of gross income. 
A definite relationship exists between a deduction for state income tax 
and dividend income when a state includes portfolio dividends in state 
taxable income apportionable to the taxpayer's activities in the state, 
but determines state taxable income by applying an apportionment formula 
that excludes the factors of the corporations paying portfolio 
dividends.
    (B) In this case, $150,000 of foreign source portfolio dividends are 
subject to a state F apportionment fraction of 25 percent, which results 
in a total of $37,500 of state F taxable income attributable to such 
dividends. As illustrated in Example 28, $3,750 ($150,000x25 percent 
state F apportionment percentage x 10 percent state F tax rate) of P's 
state F income tax is definitely related and allocable to a class of 
gross income consisting entirely of the foreign source portfolio 
dividends. Since under the look-through rules of section 904(d)(3) the 
foreign source portfolio dividends paid by first-tier CFCs are included 
within the general limitation described in section 904(d)(1)(I), the 
$3,750 of state F tax on foreign source portfolio dividends is allocated 
entirely to foreign source general limitation income and, therefore, is 
not apportioned.
    (C) After reducing state F taxable income of the unitary business 
group by the taxable income attributable to portfolio dividends, P's 
remaining state F taxable income equals $462,500 ($500,000 - $37,500), 
the portion of the taxable income of the unitary business that state F 
attributes to P's activities in state F. Accordingly, in order to 
allocate and apportion the remaining $46,250 of state F tax ($50,000 of 
state F tax minus the $3,750 of state F tax allocated to foreign source 
portfolio dividends), it is necessary first to determine if state F is 
taxing only P's non-unitary taxable income (as defined below) or is 
imposing its tax partly on other unitary business income that is 
attributed under state F law to P's activities in state F. P's state F 
non-unitary taxable income is computed by applying the state F 
apportionment formula, solely on the basis of P's income (excluding 
portfolio dividends) and state F apportionment factors. If the state F 
taxable income (after reduction by the portfolio dividends attributed to 
state F) attributed to P under state F law exceeds P's non-unitary 
taxable income, a portion of the state F tax must be allocated and 
apportioned on the basis of the other unitary business income that is 
attributed to and taxable to P under state F law. If P's non-unitary 
taxable income equals or exceeds the $462,500 of remaining state F 
taxable income, it is presumed that state F is only taxing P's non-
unitary taxable income, so that the entire amount of the remaining state 
F tax should be allocated and apportioned in the manner described in 
Example 25.
    (D) If P's non-unitary taxable income is less than the $462,500 of 
remaining state F taxable income (after reduction for the $37,500 of 
state F taxable income attributable to portfolio dividends), it is 
presumed that state F is attributing to P, and taxing P upon, other 
unitary business income. In such a case, it is necessary to determine if 
state F is attributing to P, and imposing its income tax on, a part of 
the foreign source income that would be generally presumed under 
separate accounting to be the income of foreign affiliates and 80/20 
companies included in the unitary group, or whether state F is limiting 
the income it attributes to P, and its taxation of P, to the U.S. source 
income that would be generally presumed under separate accounting to be 
the income of domestic members of the unitary group.
    (E) Assume for purposes of this example that the non-unitary taxable 
income attributable to P equals $396,000, computed by multiplying P's 
state F taxable income of $900,000 (P's state F taxable income (before 
state F apportionment) of $1,050,000 less the $150,000 of foreign source 
portfolio dividends) by P's non-unitary state F apportionment fraction, 
which is assumed to be 44 percent. Because P's non-unitary taxable 
income of $396,000 is less than the $462,500 of remaining state F 
taxable income, state F is presumed to be attributing to P and taxing 
the income that would have been generally attributed under separate 
accounting to P's affiliates in the unitary group. To determine if state 
F tax is being imposed on members of the unitary group (other that P) 
that produce foreign source income, it is necessary to compute a 
hypothetical state F taxable income for all companies in the unitary 
group with significant U.S. operations. (For this purpose, the 
hypothetical group of companies with significant domestic operations is 
referred to as the ``water's edge group.'') State F is presumed to be 
attributing to P and taxing income that would have been generally 
attributable under separate accounting to foreign corporations and 80/20 
companies to the extent that the remaining state F taxable income 
($462,500) of P exceeds the hypothetical state F taxable income that 
would have been attributed under state F law to P if state F had defined 
the unitary group to be the water's edge group.
    (F) The members of the water's edge group would have been P and US1. 
The unitary business income of this water's edge group is $1,000,000, 
the sum of $900,000 (P's state F taxable income (before state F 
apportionment) of $1,050,000 less the $150,000 of foreign source 
portfolio dividends) and $100,000 (US1's state

[[Page 161]]

F taxable income). For purposes of this example, the state F 
apportionment fraction determined on a unitary basis for this water's 
edge group is assumed to equal 40 percent, the average of P and US1's 
state F payroll, property, and sales factor ratios (the water's edge 
group's state F factors over its worldwide factors). Applying this 
apportionment fraction to the $1,000,000 of unitary business income of 
the water's edge group yields state F water's edge taxable income of 
$400,000. The excess of the remaining $462,500 of P's state F taxable 
income over the $400,000 of P's state F water's edge taxable income 
equals $62,500, and is attributable to the inclusion of US2 and FS in 
the unitary group. The state F tax attributable to the $62,500 of 
taxable income attributed to P under state F law, and that would have 
generally been attributed to US2 and FS under non-unitary accounting, 
equals $6,250 and is allocated entirely to a class of gross income 
consisting of foreign source general limitation income, because the 
income of FS and US2 consists entirely of such income. After the $6,250 
of state F tax attributable to US2 and FS is subtracted from the 
remaining $46,250 of net state F tax, P has $40,000 of state F tax 
remaining to be allocated and apportioned.
    (G) To the extent that the remainder of P's state F taxable income 
($400,000) exceeds P's non-unitary state F taxable income ($396,000), it 
is presumed that state F is attributing to and imposing on P a tax on 
U.S. source income that would have been attributed under separate 
accounting to members of the water's edge group other than P. In these 
facts, the $4,000 difference in P's state F taxable income results from 
the inclusion of US1 in the unitary group. The $400 of P's state F tax 
attributable to this $4,000 is allocated entirely to P's U.S. source 
income. P's remaining $39,600 of state F tax ($40,000 of P's state F tax 
resulting from the attribution of P of income that would have been 
attributed under non-unitary accounting to other members of the water's 
edge group, minus $400 of state F tax attributable to US1 and allocated 
to P's U.S. source income) is the state F tax attributable to P's non-
unitary state F taxable income that is to be allocated and apportioned 
together with P's state G tax of $15,000 and state H tax of $6,000 as 
illustrated in Example 25.
    (H) In allocating the $60,600 of state tax liabilities ($39,600 
state F tax attributable to P's non-unitary state F income + $15,000 
state G tax + $6,000 state H tax) under Example 25, P's state taxable 
income in state G and state H ($300,000 + $300,000) must be added to P's 
non-unitary state F taxable income ($396,000). The resulting $996,000 of 
combined state taxable incomes is compared with $750,000 of U.S. source 
income on P's federal income tax return. Because P's combined state 
taxable incomes exceeds P's federal U.S. source taxable income, it is 
presumed that the remaining $60,600 of P's total state income taxes is 
imposed in part on foreign source income. Accordingly, P's remaining 
deduction of $60,600 ($39,600 + $15,000 + $6,000) for state income taxes 
is related and allocable to both P's foreign source and domestic source 
income and is subject to apportionment.
    (iii) Apportionment. The $60,600 of state taxes (the remaining 
$39,600 of state F tax + $15,000 of state G tax + $6,000 of state H tax) 
must be apportioned between foreign source general limitation income and 
U.S. source income for federal income tax purposes. This apportionment 
is based upon the relative amounts of foreign source general limitation 
taxable income and U.S. source taxable income comprising the $996,000 of 
income subject to tax by the states, after reducing the total amount of 
income subject to tax by the portfolio dividends and the income 
attributed to P under state F law that would have been attributed under 
arm's length principles to other members of P's state F unitary business 
group. The deduction for the $60,600 of state income taxes is 
apportioned as follows:

State income tax deduction apportioned to foreign source         $14,967
 general limitation income (statutory grouping):
 $60,600x($246,000/$996,000)..................................
State income tax deduction apportioned to income from sources     45,633
 within the United States (residual grouping):
 $60,600x($750,000/$996,000)..................................
                                                               ---------
    Total apportioned state income tax deduction..............    60,600
 
 


Of the total state income taxes of $71,000, the amount allocated and 
apportioned to foreign source general limitation income is $24,967--the 
sum of $14,967 of state F, state G, and state H taxes apportioned to 
foreign source general limitation income, $3,750 of state F tax 
allocated to foreign source apportionable dividend income, and the 
$6,250 of state F tax allocated to foreign source general limitation 
income as the result of state F's worldwide unitary business theory of 
taxation. The total amount of state income taxes allocated and 
apportioned to U.S. source income equals $46,033--the sum of the $400 of 
state F tax attributable to the inclusion of US1 in the state F unitary 
business group and $45,633 of combined state F, G, and H tax apportioned 
under the method provided in Example 25.
    Example 30-- Income Taxes--(i) Facts. (A) As in Example 17 of 
Sec. 1.861-8(g), X is a domestic corporation that wholly owns M, N, and 
O, also domestic corporations. X, M, N, and O file a consolidated income 
tax return. All the income of X and O is from sources within the United 
States, all of M's income is from

[[Page 162]]

sources within South America, and all of N's income is from sources 
within Africa. X receives no dividends from M, N, or O. During the 
taxable year, the consolidated group of corporations earned consolidated 
gross income of $550,000 and incurred total deductions of $370,000. X 
has gross income of $100,000 and deductions of $50,000, without regard 
to its deduction for state income tax. Of the $50,000 of deductions 
incurred by X, $15,000 relates to X's ownership of M; $10,000 relates to 
X's ownership of N; $5,000 relates to X's ownership of O; and the entire 
$30,000 constitutes stewardship expenses. The remainder of X's $20,000 
of deductions (which is assumed not to include state income tax) relates 
to production of income from its plant in the United States. M has gross 
income of $250,000 and deductions of $100,000, which yield foreign 
source taxable income of $150,000. N has gross income of $150,000 and 
deductions of $200,000, which yield a foreign source loss of $50,000. O 
has gross income of $50,000 and deductions of $20,000, which yield U.S. 
source taxable income of $30,000.
    (B) Unlike Example 17 of Sec. 1.861-8(g), however, X also has a 
deduction of $1,800 for state A income taxes. X's state A taxable income 
is computed by first making adjustments to the federal taxable income of 
X to derive apportionable taxable income for state A tax purposes. An 
analysis of state A law indicates that state A law also includes in its 
definition of the taxable business income of X which is apportionable to 
X's state A activities, the taxable income of M, N, and O, which is 
related to X's business. As in Example 25, the amount of apportionable 
taxable income attributable to business activities conducted in state A 
is determined by multiplying apportionable taxable income by a fraction 
(the ``state apportionment fraction'') that compares the relative 
amounts of payroll, property, and sales within state A with worldwide 
payroll, property and sales. Assuming that X's apportionable taxable 
income equals $180,000, $100,000 of which is from sources without the 
United States, and $80,000 is from sources within the United States, and 
that the state apportionment fraction is equal to 10 percent, X has 
state A taxable income of $18,000. The state A income tax of $1,800 is 
then derived by applying the state A income tax rate of 10 percent to 
the $18,000 of state A taxable income.
    (ii) Allocation and apportionment. In accordance with Sec. 1.1502-4, 
each corporation must first compute its separate taxable income for 
purposes of computing the consolidated limitation on the foreign tax 
credit. Assume that under Example 29, it is determined that X's 
deduction for state A income tax is definitely related to a class of 
gross income consisting of income from sources both within and without 
the United States, and that the state A tax is apportioned $1,000 to 
sources without the United States, and $800 to sources within the United 
States. Under Example 17, without regard to the deduction for X's state 
A income tax, X has a separate loss of ($25,000) from sources without 
the United States. After taking into account the deduction for state A 
income tax, X's separate loss from sources without the United States is 
increased by the $1,000 state A tax apportioned to sources without the 
United States, and equals a loss of ($26,000), for purposes of computing 
the numerator of the consolidated foreign tax credit limitation.
    Example 31-- Income Taxes--(i) Facts. Assume that the facts are the 
same as in Example 29, except that state G requires P to adjust its 
federal taxable income by depreciating an asset at a different rate than 
is allowed P under the Internal Revenue Code for the same asset. Before 
using the methodology of Example 25 to determine whether a portion of 
its deduction for state income taxes is allocable to a class of gross 
income that includes foreign source income, P recomputes its taxable 
income under state G law by using the rate of depreciation that it is 
entitled to use under the Code, and uses this recomputed amount in 
applying the methodology of Example 25.
    (ii) Allocation. P's modification of its state G taxable income is 
permissible. Under the methdology of Example 25, this modification of 
state G taxable income will produce a reasonable determination of the 
portion (if any) of P's state income taxes that is allocable to a class 
of gross income that includes foreign sources income.
    Example 32-- Income Taxes--(i) Facts. Assume the facts are the same 
as Example 29, except that P's state F taxable income differs from the 
amount of its U.S. source income under federal income tax principles 
solely because state F determines P's state taxable income under a 
worldwide unitary business theory instead of the arm's length principles 
applied in the Code. Before using the methodology of Example 25 to 
determine whether a portion of its deduction for state income taxes is 
allocable to a class of gross income that includes foreign source 
income, P recomputes state F taxable income under the arm's length 
principles applied in the Code. P substitutes that recomputed amount for 
the amount of taxable income actually determined under state F law in 
applying the methodology of Example 25.
    (ii) Allocation. P's modification of state F taxable income does not 
accurately reflect the factual relationship between the deduction for 
state F income tax and the income on which the tax is imposed, because 
there is no factual relationship between the state F income tax and the 
state F taxable income as recomputed under Code principles. State F does 
not impose its income tax upon P's income as it might have been defined 
under the Internal Revenue Code. Consequently, P's modification of state 
F taxable income is

[[Page 163]]

impermissible because it will not produce a reasonable determination of 
the portion (if any) of P's state income taxes that is allocable to a 
class of gross income that includes foreign source income.
    Example 33-- Income Taxes--(i) Facts. Assume the same facts as in 
Example 29, except that state G does not impose an income tax on 
corporations, and P's non-unitary state F taxable income equals 
$462,500. Thus only $56,000 of state income taxes ($50,000 of state F 
income tax and $6,000 of state H income tax) are deductible and required 
to be allocated and (if necessary) apportioned. As in Example 29, P has 
$800,000 of aggregate state taxable income ($500,000 of state F taxable 
income and $300,000 of state H taxable income).
    (ii) Method One. Assume that P has elected to allocate and apportion 
its deduction for state income tax under the safe harbor method provided 
in Sec. 1.861-8 (e)(6)(ii)(D)(2) (``Method One'').
    (A) Step One--Specific allocation to foreign source portfolio 
dividends. P applies the methodology of paragraph (ii) of Example 28 to 
determine the portion of the deduction that must be allocated to a class 
of gross income consisting solely of foreign source portfolio dividends. 
As illustrated in paragraphs (ii) (A) and (B) of Example 29, $3,750 of 
the deduction for state F income tax is attributable to the $37,500 of 
foreign source portfolio dividends attributed under state F law to P's 
activities in state F. Thus $3,750 of P's deduction for state income tax 
must be specifically allocated to a class of gross income consisting 
solely of $37,500 of foreign source portfolio dividends. No 
apportionment of the $3,750 is necessary. P's adjusted state taxable 
income is $762,500 (aggregate state taxable income of $800,000 reduced 
by $37,500 of foreign source portfolio dividends). Because the remaining 
amount of state F taxable income ($462,500) equals P's non-unitary state 
F taxable income, no further specific allocation of state tax is 
required.
    (B) Step Two--Adjustment of U.S. source federal taxable income. P 
applies the methodology illustrated in paragraph (ii) of Example 27 
(including the rules of UDITPA described therein) to determine the 
amount of its federal taxable income attributable to its activities in 
state G. Assume that P determines under this methodology that $300,000 
of its federal taxable income is attributable to activities in state G. 
P's adjusted U.S. source federal taxable income equals $450,000 
($750,000 minus the $300,000 attributed to P's activities in state G).
    (C) Step Three--Allocation. The portion of P's deduction for state 
income tax remaining to be allocated equals $52,250 ($56,000 minus the 
$3,750 specifically allocated to foreign source portfolio dividends). P 
allocates this portion by applying the methodology illustrated in 
paragraph (ii) of Example 25, as modified by paragraph 
(e)(6)(ii)(D)(2)(iii) of this section. Thus, P compares its adjusted 
state taxable inocme (as determined under Step One in paragraph (A) 
above) with an amount equal to 110% of its adjusted U.S. source federal 
taxable income (as determined under Step Two in paragraph (B) above). 
Because P's adjusted state taxable income ($762,500) exceeds 110% of P's 
adjusted U.S. source federal taxable income ($495,000, or 110% of 
$450,000), the remaining portion of P's deduction for state income tax 
($52,500) must be allocated to a class of gross income that includes 
both U.S. and foreign source income.
    (D) Step Four--Apportionment. P must apportion to U.S. source income 
the portion of the deduction that is attributable to state income tax 
imposed upon state taxable income in an amount equal to 110% of P's 
adjusted U.S. source federal taxable income. The remainder of the 
deduction must be apportioned to foreign source general limitation 
income.

Amount of deduction to be apportioned.....................    $52,250.00
Less portion of deduction to be apportioned to income from    $33,919.67
 sources within the United States (residual grouping):
 ($52,250x($495,000/$762,500).............................
                                                           -------------
Equals Portion of deduction to be apportioned to foreign      $18,330.33
 source general limitation income (statutory grouping):...
 

    (iii) Method Two. Assume that P has elected to allocate and 
apportion its deduction for state income tax under the safe harbor 
method provided in Sec. 1.861-8(e)(6)(ii)(D)(3) (``Method Two'').
    (A) Step One--Specific allocation. Step One of Method Two is the 
same as Step One of Method One. Therefore, as described in paragraph (A) 
of paragraph (ii) above, $3,750 of P's deduction for state income tax 
must be specifically allocated to a class of gross income consisting 
solely of $37,500 of foreign source portfolio dividends. No 
apportionment of the $3,750 is necessary. P's adjusted state taxable 
income is $762,500 (aggregate state taxable income of $800,000 reduced 
by $37,500 of foreign source portfolio dividends).
    (B) Step Two--Adjustment of U.S. source federal taxable income. Step 
Two of Method Two is the same as Step Two of Method One. Therefore, as 
described in paragraph (B) of paragraph (ii) above, assume that P 
determines that $300,000 of its federal taxable income is attributable 
to activities in state G. P's adjusted U.S. source federal taxable 
income equals $450,000 ($750,000 minus the $300,000 attributed to P's 
activities in state G).
    (C) Step Three--Allocation. The portion of P's deduction for state 
income tax remaining

[[Page 164]]

to be allocated equals $52,250 ($56,000 minus the $3,750 of state F 
income tax specifically allocated to foreign source portfolio 
dividends). P allocates this portion by applying the methodology 
illustrated in paragraph (ii) of Example 25, as modified by paragraph 
(e)(6)(ii)(D)(3)(iii) of this section. Thus, P compares its adjusted 
state taxable income (as determined under Step One in paragraph (A) 
above) with its adjusted U.S. source federal taxable income (as 
determined under Step Two in paragraph (B) above). Because P's adjusted 
state taxable income ($762,500) exceeds P's adjusted U.S. source federal 
taxable income ($450,000), the remaining portion of P's deduction for 
state income tax ($52,500) must be allocated to a class of gross income 
that includes both U.S. and foreign source income.
    (D) Step Four--Apportionment. P must apportion to U.S. source income 
the portion of the deduction that is attributable to state income tax 
imposed upon state taxable income in an amount equal to P's adjusted 
U.S. source federal taxable income.

Amount of deduction to be apportioned.....................    $52,250.00
Less portion of deduction initially apportioned to income      30,836.07
 from sources within the United States (residual
 grouping): $52,250x($450,000/$762,500)...................
                                                           -------------
Remainder requiring further apportionment:                     21,413.93
 $52,250x($312,500/$762,500)..............................
 


The remainder of $21,413.93 must be further apportioned between foreign 
source general limitation income and U.S. source federal taxable income 
in the same proportions that P's adjusted U.S. source federal taxable 
income and foreign source general limitation income bear to P's total 
federal taxable income (taking into account the adjustment of U.S. 
source federal taxable income and reduced by the amount of foreign 
source portfolio dividends to which the tax has been specifically 
allocated).

Portion of remainder apportioned to foreign source general     $6,868.62
 limitation income (statutory grouping): $21,413.93 X
 ($212,500/$662,500)......................................
Remaining state income tax deduction to be apportioned to     $14,545.31
 income from sources within the United States (residual
 grouping): $21,413.93 X ($450,000/$662,500)..............
 

    Of P's total deduction of $56,000 for state income tax, the portion 
allocated and apportioned to foreign source general limitation income 
equals $10,618.62--the sum of $6,868.62 apportioned under Step Four and 
the $3,750.00 specifically allocated to foreign source portfolio 
dividend income under Step One. The portion of the deduction allocated 
and apportioned to U.S. source income equals $45,381.38--the sum of the 
$30,836.07 and the $14,545.31 apportioned under Step Four.

[T.D. 7456, 42 FR 1195, Jan. 6, 1977, as amended by T.D. 7749, 46 FR 
1683, Jan. 7, 1981; T.D. 7939, 49 FR 4207, Feb. 3, 1984; T.D. 8228, 53 
FR 35474, Sept. 14, 1988; T.D. 8286, 55 FR 3052, Jan. 30, 1990; T.D. 
8337, 56 FR 10369, Mar. 12, 1991; 56 FR 22760, May 16, 1991; 56 FR 
24001, May 28, 1991; T.D. 8228, 60 FR 36669, July 18, 1995; T.D. 8646, 
60 FR 66503, Dec. 22, 1995; T.D. 8805, 64 FR 1509, Jan 11, 1999; T.D. 
8973, 66 FR 67083, Dec. 28, 2001]



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

    (a) In general.
    (1) [Reserved]
    (2) Allocation and apportionment of deductions in general. If an 
affiliated group of corporations joins in filing a consolidated return 
under section 1501, the provisions of this section are to be applied 
separately to each member in that affiliated group for purposes of 
determining such member's taxable income, except to the extent that 
expenses, losses, and other deductions are allocated and apportioned as 
if all domestic members of an affiliated group were a single corporation 
under section 864(e) and the regulations thereunder. See Sec. 1.861-9T 
through Sec. 1.861-11T for rules regarding the affiliated group 
allocation and apportionment of interest expense, and Sec. 1.861-14T for 
rules regarding the affiliated group allocation and apportionment of 
expenses other than interest.
    (3)-(5) [Reserved]
    (b) Allocation.
    (1)-(2) [Reserved]
    (3) Supportive functions. Deductions which are supportive in nature 
(such as overhead, general and administrative, and supervisory expenses) 
may relate to other deductions which can more readily be allocated to 
gross income. In such instance, such supportive deductions may be 
allocated and apportioned along with the deductions to which they 
relate. On the other hand, it would be equally acceptable to attribute 
supportive deductions on some reasonable basis directly to activities

[[Page 165]]

or property which generate, have generated, or could be reasonably 
expected to generate gross income. This would ordinarily be accomplished 
by allocating the supportive expenses to all gross income or to another 
broad class of gross income and apportioning the expenses in accordance 
with paragraph (c)(1) of this section. For this purpose, reasonable 
departmental overhead rates may be utilized. For examples of the 
application of the principles of this paragraph (b)(3) other than to 
expenses attributable to stewardship activities, see examples 19 through 
21 of paragraph (g) of this section. See paragraph (e)(4) of this 
section for the allocation and apportionment of deductions attributable 
to stewardship activities. However, supportive deductions that are 
described in Sec. 1.861-14T(e)(3) shall be allocated and apportioned in 
accordance with the rules of Sec. 1.1861-14T and shall not be allocated 
and apportioned by reference only to the gross income of a single member 
of an affiliated group of corporations as defined in Sec. 1.861-14T(d).
    (4)-(5) [Reserved]
    (c) Apportionment of deductions--(1) Deductions definitely related 
to a class of gross income. Where a deduction has been allocated in 
accordance with paragraph (b) of this section to a class of gross income 
which is included in one statutory grouping and the residual grouping, 
the deduction must be apportioned between the statutory grouping and the 
residual grouping. Where a deduction has been allocated to a class of 
gross income which is included in more than one statutory grouping, such 
deduction must be apportioned among the statutory groupings and, where 
necessary, the residual grouping. Thus, in determining the separate 
limitations on the foreign tax credit imposed by section 904(d)(1) or by 
section 907, the income within a separate limitation category 
constitutes a statutory grouping of income and all other income not 
within that separate limitation category (whether domestic or within a 
different separate limitation category) constitutes the residual 
grouping. In this regard, the same method of apportionment must be used 
in apportioning a deduction to each separate limitation category. Also, 
see paragraph (f)(1)(iii) of this section with respect to the 
apportionment of deductions among the statutory groupings designated in 
section 904(d)(1). If the class of gross income to which a deduction has 
been allocated consists entirely of a single statutory grouping or the 
residual grouping, there is no need to apportion that deduction. If a 
deduction is not definitely related to any gross income, it must be 
apportioned ratably as provided in paragraph (c)(3) of this section. A 
deduction is apportioned by attributing the deduction to gross income 
(within the class to which the deduction has been allocated) which is in 
one or more statutory groupings and to gross income (within the class) 
which is in the residual grouping. Such attribution must be accomplished 
in a manner which reflects to a reasonably close extent the factual 
relationship between the deduction and the grouping of gross income. In 
apportioning deductions, it may be that for the taxable year there is no 
gross income in the statutory grouping or that deductions will exceed 
the amount of gross income in the statutory grouping. See paragraph 
(d)(1) of this section with respect to cases in which deductions exceed 
gross income. In determining the method of apportionment for a specific 
deduction, examples of bases and factors which should be considered 
include, but are not limited to--
    (i) Comparison of units sold,
    (ii) Comparison of the amount of gross sales or receipts,
    (iii) Comparison of costs of goods sold,
    (iv) Comparison of profit contribution,
    (v) Comparison of expenses incurred, assets used, salaries paid, 
space utilized, and time spent which are attributable to the activities 
or properties giving rise to the class of gross income, and
    (iv) Comparison of the amount of gross income.

Paragraph (e) (2) through (8) of this section provides the applicable 
rules for allocation and apportionment of deductions for interest, 
research and development expenses, and certain other deductions. The 
effects on tax liability of the apportionment of deductions and

[[Page 166]]

the burden of maintaining records not otherwise maintained and making 
computations not otherwise made shall be taken into consideration in 
determining whether a method of apportionment and its application are 
sufficiently precise. A method of apportionment described in this 
paragraph (c)(1) may not be used when it does not reflect, to a 
reasonably close extent, the factual relationship between the deduction 
and the groupings of income. Furthermore, certain methods of 
apportionment described in this paragraph (c)(1) may not be used in 
connection with any deduction for which another method is prescribed. 
The principles set forth above are applicable in apportioning both 
deductions definitely related to a class which constitutes less than all 
of the taxpayer's gross income and to deductions related to all of the 
taxpayer's gross income. If a deduction is not related to any class of 
gross income, it must be apportioned ratably as provided in paragraph 
(c)(3) of this section.
    (2) Apportionment based on assets. Certain taxpayers are required by 
paragraph (e)(2) of this section and Sec. 1.861-9T to apportion interest 
expense on the basis of assets. A taxpayer may apportion other 
deductions based on the comparative value of assets that generate income 
within each grouping, provided that such method reflects the factual 
relationship between the deduction and the groupings of income and is 
applied in accordance with the rules of Sec. 1.861-9T(g). In general, 
such apportionments must be made either on the basis of the tax book 
value of those assets or on their fair market value. However, once the 
taxpayer uses fair market value, the taxpayer and all related persons 
must continue to use such method unless expressly authorized by the 
Commissioner to change methods. For purposes of this paragraph (c)(2) 
the term related persons means two or more persons in a relationship 
described in section 267(b). In determining whether two or more 
corporations are members of same controlled group under section 
267(b)(3), a person is considered to own stock owned directly by such 
person, stock owned with the application of section 1563(e)(1), and 
stock owned by the application of section 267(c). In determining whether 
a corporation is related to a partnership under section 267(b)(10), a 
person is considered to own the partnership interest owned directly by 
such person and the partnership interest owned with the application of 
section 267(e)(3). In the case of any corporate taxpayer that--
    (i) Uses tax book value, and
    (ii) Owns directly or indirectly (within the meaning of Sec. 1.861-
11T(b)(2)(ii)) 10 percent or more of the total combined voting power of 
all classes of stock entitled to vote in any other corporation (domestic 
or foreign) that is not a member of the affiliated group (as defined in 
section 864(e)(5)), such taxpayer shall adjust its basis in that stock 
in the manner described in Sec. 1.861-11T(b).
    (3) [Reserved]
    (d) Excess of deductions and excluded and eliminated items of 
income.
    (1) [Reserved]
    (2) Allocation and apportionment to exempt, excluded or eliminated 
income--(i) In general. In the case of taxable years beginning after 
December 31, 1986, except to the extent otherwise permitted by 
Sec. 1.861-13T, the following rules shall apply to take account of 
income that is exempt or excluded, or assets generating such income, 
with respect to allocation and apportionment of deductions.
    (A) Allocation of deductions. In allocating deductions that are 
definitely related to one or more classes of gross income, exempt income 
(as defined in paragraph (d)(2)(ii) of this section) shall be taken into 
account.
    (B) Apportionment of deductions. In apportioning deductions that are 
definitely related either to a class of gross income consisting of 
multiple groupings of income (whether statutory or residual) or to all 
gross income, exempt income and exempt assets (as defined in paragraph 
(d)(2)(ii) of this section) shall not be taken into account.

For purposes of apportioning deductions which are not taken into account 
under Sec. 1.1502-13 in determining gain or loss from intercompany 
transactions, as defined in Sec. 1.1502-13, income from such 
transactions shall be taken into

[[Page 167]]

account in the year such income is ultimately included in gross income.
    (ii) Exempt income and exempt asset defined--(A) In general. For 
purposes of this section, the term exempt income means any income that 
is, in whole or in part, exempt, excluded, or eliminated for federal 
income tax purposes. The term exempt asset means any asset the income 
from which is, in whole or in part, exempt, excluded, or eliminated for 
federal tax purposes.
    (B) Certain stock and dividends. The term ``exempt income'' includes 
the portion of the dividends that are deductible under--
    (1) Section 243(a) (1) or (2) (relating to the dividends received 
deduction),
    (2) Section 245(a) (relating to the dividends received deduction for 
dividends from certain foreign corporations).

Thus, for purposes of apportioning deductions using a gross income 
method, gross income would not include a dividend to the extent that it 
gives rise to a dividend received deduction under either section 
243(a)(1), section 243(a)(2), or section 245(a). In the case of a life 
insurance company taxable under section 801, the amount of such stock 
that is treated as tax exempt shall not be reduced because a portion of 
the dividends received deduction is disallowed as attributable to the 
policyholder's share of such dividends. See Sec. 1.861-14T(h) for a 
special rule concerning the allocation of reserve expenses of a life 
insurance company. In addition, for purposes of apportioning deductions 
using an asset method, assets would not include that portion of stock 
equal to the portion of dividends paid thereon that would be deductible 
under either section 243(a)(1), section 243(a)(2), or section 245(a). In 
the case of stock which generates, has generated, or can reasonably be 
expected to generate qualifying dividends deductible under section 
243(a)(3), such stock shall not constitute a tax exempt asset. Such 
stock and the dividends thereon will, however, be eliminated from 
consideration in the apportionment of interest expense under the 
consolidation rule set forth in Sec. 1.861-10T(c), and in the 
apportionment of other expenses under the consolidation rules set forth 
in Sec. 1.861-14T.
    (iii) Income that is not considered tax exempt. The following items 
are not considered to be exempt, eliminated, or excluded income and, 
thus, may have expenses, losses, or other deductions allocated and 
apportioned to them:
    (A) In the case of a foreign taxpayer (including a foreign sales 
corporation (FSC)) computing its effectively connected income, gross 
income (whether domestic or foreign source) which is not effectively 
connected to the conduct of a United States trade or business;
    (B) In computing the combined taxable income of a DISC or FSC and 
its related supplier, the gross income of a DISC or a FSC;
    (C) For all purposes under subchapter N of the Code, including the 
computation of combined taxable income of a possessions corporation and 
its affiliates under section 936(h), the gross income of a possessions 
corporation for which a credit is allowed under section 936(a); and
    (D) Foreign earned income as defined in section 911 and the 
regulations thereunder (however, the rules of Sec. 1.911-6 do not 
require the allocation and apportionment of certain deductions, 
including home mortgage interest, to foreign earned income for purposes 
of determining the deductions disallowed under section 911(d)(6)).
    (iv) Prior years. For expense allocation and apportionment rules 
applicable to taxable years beginning before January 1, 1987, and for 
later years to the extent permitted by Sec. 1.861-13T, see Sec. 1.861-
8(d)(2) (Revised as of April 1, 1986).
    (e) Allocation and apportionment of certain deductions.
    (1) [Reserved]. For further guidance, see Sec. 1.861-8(e)(1).
    (2) Interest. The rules concerning the allocation and apportionment 
of interest expense and certain interest equivalents are set forth in 
Sec. Sec. 1.861-9T through Sec. 1.861-13T.
    (3) through (11) [Reserved]. For further guidance, see Sec. 1.861-
8(e)(3) through (e)(11).
    (f) Miscellaneous matters--(1) Operative sections.
    (i) [Reserved]
    (ii) Separate limitations to the foreign tax credit. Section 
904(d)(1) requires

[[Page 168]]

that the foreign tax credit limitation be determined separately in the 
case of the types of income specified therein. Accordingly, the income 
within each separate limitation category constitutes a statutory 
grouping of income and all other income not within that separate 
limitation category (whether domestic or within a different separate 
limitation category) constitutes the residual groups.
    (iii) [Reserved]
    (2)--(5) [Reserved]
    (g) [Reserved]

    Examples (1)-- (23). [Reserved]
    Example (24)-- Exempt, excluded, or eliminated income--(i) Income 
method--(A) Facts. X, a domestic corporation organized on January 1, 
1987, is engaged in a number of businesses worldwide. X owns a 25-
percent voting interest in each of five corporations engaged in the 
business A, two of which are domestic and three of which are foreign. X 
incurs stewardship expenses in connection with these five stock 
investments in the amount of $100. X apportions its stewardship expenses 
using a gross income method. Each of the five companies pays a dividend 
in the amount of $100. X is entitled to claim the 80-percent dividends 
received deduction on dividends paid by the two domestic companies. 
Because tax exempt income is considered in the allocation of deductions, 
X's $100 stewardship expense is allocated to the class of income 
consisting of dividends from business A companies. However, because tax 
exempt income is not considered in the apportionment of deductions 
within a class of gross income, the gross income of the two domestic 
companies must be reduced to reflect the availability of the dividends 
received deduction. Thus, for purposes of apportionment, the gross 
income paid by the three foreign companies is considered to be $100 
each, while the gross income paid by the domestic companies is 
considered to be $20 each. Accordingly, X has total gross income from 
business A companies, for purposes of apportionment, of $340. As a 
result, $29.41 of X's stewardship expense is apportioned to each of the 
foreign companies and $5.88 of X's stewardship expense is apportioned to 
each of the domestic companies.
    (ii) Asset method--(A) Facts. X, a domestic corporation organized on 
January 1, 1987, carries on a trade or business in the United States. X 
has deductible interest expense incurred in 1987 of $60,000. X owns all 
the stock of Y, a foreign corporation. X also owns 49 percent of the 
voting stock of Z, a domestic corporation. Neither Y nor Z has retained 
earnings and profits at the end of 1987. X apportions its interest 
expense on the basis of the fair market value of its assets. X has 
assets worth $1,500,000 that generate domestic source income, among 
which are tax exempt municipal bonds worth $100,000, and the stock of Z, 
which has a value of $500,000. The Y stock owned by X has a fair market 
value of $2,000,000 and generates solely foreign source general 
limitation income.
    (B) Allocation. No portion of X's interest expense is directly 
allocable solely to identified property within the meaning of 
Sec. 1.861-1OT. Thus, X's deduction for interest is definitely related 
to all its gross income as a class.
    (C) Apportionment. For purposes of apportioning expenses, assets 
that generate exempt, eliminated, or excluded income are not taken into 
account. Because X's municipal bonds are tax exempt, they are not taken 
into account in apportioning interest expense. Since X is entitled to 
claim under section 243 to 80-percent dividends received deduction with 
respect to the dividend it received from Z, 80 percent of the value of 
that stock is not taken into account as an asset for purposes of 
apportionment under the asset method. X apportions its interest 
deduction between the statutory grouping of foreign source general 
limitation income and the residual grouping of domestic source income as 
follows:
    To foreign source general limitation income:

[[Page 169]]

[GRAPHIC] [TIFF OMITTED] TC07OC91.000

[GRAPHIC] [TIFF OMITTED] TC07OC91.001

    (h) Effective dates. In general, the rules of this section, as well 
as the rules of Secs. 1.861-9T, 1.861-10T, 1.861-11T, 1.861-12T, and 
1.861-14T shall apply for taxable years beginning after December 31, 
1986. In the case of corporate taxpayers, transition rules set forth in 
Sec. 1.861-13T provide for the gradual phase-in of certain the 
provisions of this and the foregoing sections. However, the following 
rules are effective for taxable years commencing after December 31, 
1988:
    (1) Section 1.861-9T(b)(2) (concerning the treatment of certain 
foreign currency borrowings),
    (2) Section 1.861-9T(d)(2) (concerning the treatment of interest 
incurred by nonresident aliens),
    (3) Section 1.861-10T(b)(3)(ii) (providing an operating costs test 
for purposes of the nonrecourse indebtedness exception), and
    (4) Section 1.861-10T(b)(6) (concerning excess collaterilization of 
nonrecourse borrowings).

In addition, Sec. 1.861-10T(e) (concerning the treatment of related 
controlled foreign corporation indebtedness) is effective for taxable 
years commencing after December 31, 1987. For rules for taxable years 
beginning before January 1, 1987, and for later years to the extent 
permitted by Sec. 1.861-13T, see Sec. 1.861-8 (Revised as of April 1, 
1986).

[T.D. 8228, 53 FR 35474, Sept. 14, 1988, as amended by T.D. 8286, 55 FR 
3054, Jan. 30, 1990; T.D. 8337, 56 FR 10369, Mar. 12, 1991; T.D.8597, 60 
FR 36679, July 18, 1995; T.D. 8805, 64 FR 1509, Jan. 11, 1999; T.D. 
8973, 66 FR 67083, Dec. 28, 2001]



Sec. 1.861-9  Allocation and apportionment of interest expense.

    (a) through (h)(4) [Reserved]. For further guidance, see Sec. 1.861-
9T(a) through (h)(4).
    (h)(5) Characterizing stock in related persons--(i) General rule. 
Stock in a related person held by the taxpayer or by another related 
person shall be characterized on the basis of the fair market value of 
the taxpayer's pro rata share of assets held by the related person 
attributed to each statutory grouping and the residual grouping under 
the stock characterization rules of Sec. 1.861-12T(c)(3)(ii), except 
that the portion of the value of intangible assets of the taxpayer and 
related persons that is apportioned to the related person under 
Sec. 1.861-9T(h)(2) shall be characterized on the basis of the net 
income before interest expense of the related

[[Page 170]]

person within each statutory grouping or residual grouping (excluding 
income that is passive under Sec. 1.904-4(b)).
    (ii) Special rule for section 936 corporations regarding alternative 
minimum tax. For purposes of characterizing stock in a related section 
936 corporation in determining foreign source alternative minimum 
taxable income within each separate category and the alternative minimum 
tax foreign tax credit pursuant to section 59(a), the rules of 
Sec. 1.861-9T(g)(3) shall apply and Sec. 1.861-9(h)(5)(i) shall not 
apply. Thus, for taxable years beginning after December 31, 1989, and 
before January 1, 1994, stock in a related section 936 corporation is 
characterized for alternative minimum tax purposes as a foreign source 
passive asset because the stock produces foreign source passive dividend 
income under sections 861(a)(2)(A), 862(a)(2), and 904(d)(2)(A) and the 
regulations under those sections. For taxable years beginning after 
December 31, 1993, stock in a related section 936 corporation would be 
characterized for alternative minimum tax purposes as an asset subject 
to the separate limitation for section 936 corporation dividends because 
the stock produces foreign source dividend income that, for alternative 
minimum tax purposes, is subject to a separate foreign tax credit 
limitation under section 56(g)(4)(C)(iii)(IV). However, stock in a 
section 936 corporation is characterized as a U.S. source asset to the 
extent required by section 904(g). For the definition of the term 
section 936 corporation, see Sec. 1.861-11(d)(2)(ii).
    (iii) Effective date. This paragraph (h)(5) applies to taxable years 
beginning after December 31, 1989.

[T.D. 8916, 66 FR 272, Jan. 3, 2001]



Sec. 1.861-9T  Allocation and apportionment of interest expense (temporary regulations).

    (a) In general. Any expense that is deductible under section 163 
(including original issue discount) constitutes interest expense for 
purposes of this section, as well as for purposes of Secs. 1.861-10T, 
1.861-11T, 1.861-12T, and 1.861-13T. The term interest refers to the 
gross amount of interest expense incurred by a taxpayer in a given tax 
year. The method of allocation and apportionment for interest set forth 
in this section is based on the approach that, in general, money is 
fungible and that interest expense is attributable to all activities and 
property regardless of any specific purpose for incurring an obligation 
on which interest is paid. Exceptions to the fungibility rule are set 
forth in Sec. 1.861-10T. The fungibility approach recognizes that all 
activities and property require funds and that management has a great 
deal of flexibility as to the source and use of funds. When borrowing 
will generally free other funds for other purposes, and it is reasonable 
under this approach to attribute part of the cost of borrowing to such 
other purposes. Consistent with the principles of fungibility, except as 
otherwise provided, the aggregate of deductions for interest in all 
cases shall be considered related to all income producing activities and 
assets of the taxpayer and, thus, allocable to all the gross income 
which the assets of the taxpayer generate, have generated, or could 
reasonably have been expected to generate. In the case of the interest 
expense of members of an affiliated group, interest expense shall be 
considered to be allocable to all gross income of the members of the 
group under Sec. 1.861-11T. That section requires the members of an 
affiliated group to allocate and apportion the interest expense of each 
member of the group as if all members of such group were a single 
corporation. For the method of determining the interest deduction 
allowed to foreign corporations under section 882(c), see Sec. 1.882-5.
    (b) Interest equivalents--(1) Certain expenses and losses--(i) 
General rule. Any expense or loss (to the extent deductible) incurred in 
a transaction or series of integrated or related transactions in which 
the taxpayer secures the use of funds for a period of time shall be 
subject to allocation and apportionment under the rules of this section 
if such expense or loss is substantially incurred in consideration of 
the time value of money. However, the allocation and apportionment of a 
loss under this paragraph (b) shall not affect the characterization of 
such loss as capital or ordinary for other purposes of the Code and the 
regulations thereunder.

[[Page 171]]

    (ii) Examples. The rule of this paragraph (b)(1) may be illustrated 
by the following examples.

    Example 1. W, a domestic corporation, borrows from X two ounces of 
gold at a time when the spot price for gold is $500 per ounce. W agrees 
to return the two ounces of gold in six months. W sells the two ounces 
of gold to Y for $1000. W then enters into a contract with Z to purchase 
two ounces of gold six months in the future for $1,050. In exchange for 
the use of $1,000 in cash, W has sustained a loss of $50 on related 
transactions. This loss is subject to allocation and apportionment under 
the rules of this section in the same manner as interest expense.
    Example 2. X, a domestic corporation with a dollar functional 
currency, borrows 100 pounds on January 1, 1987 for a three-year term at 
an interest rate greater than the applicable federal rate for dollar 
loans. At this time, the interest rate on the pound was approximately 
equal to the interest rate on dollar borrowings and the forward price on 
the pound, vis-a-vis the dollar, was approximately equal to the spot 
price. On January 1, 1987, X converted 100 pounds into dollars and 
entered into a currency swap that substantially hedged X's foreign 
currency exposure on the pound borrowing, both with respect to interest 
and principal. The borrowing, coupled with the swap, represents a series 
of related transactions in which the taxpayer secures the use of funds 
in its functional currency. Any net foreign currency loss on this series 
of transactions constitutes a loss incurred substantially in 
consideration of the time value of money and shall be apportioned in the 
same manner as interest expense. Thus, if the pound depreciates against 
the dollar, such that when the first payment on the pound borrowing is 
due the taxpayer has a currency loss on the swap payment hedging its 
first interest payment, such loss shall, even if the transaction is not 
integrated under section 988(d), be allocated and apportioned in the 
same manner as interest expense under the authority of this paragraph 
(b)(1).
    Example 3. On January 1, 1987, X, a domestic corporation with a 
dollar functional currency, enters into a dollar interest rate swap 
contract with Y, a domestic counterparty. Under the terms of this 
agreement, X agrees to pay Y floating rate interest with respect to a 
notional principal amount of $100 for five years. In return, Y agrees to 
pay X fixed rate interest at 10 percent with respect to a notional 
principal amount of $100 for five years. On the same day, Y prepays the 
fixed leg of the swap by making a lump sum payment of $37 to X. This 
lump sum payment represents the present value of five $10 swap payments. 
Because X secures the use of $37 in this transaction, any net swap 
expense arising from the transaction represents an expense incurred 
substantially in consideration of the time value of money. Assuming this 
lump sum payment is not otherwise characterized as a loan from Y to X, 
and that X must amortize the $37 lump sum payment under the principles 
of Notice 89-21, any net swap expense incurred by X with respect to this 
transaction (i.e., the excess, if any, of X's annual swap payment to Y 
over the annual amortization of the $37 lump sum payment that is taken 
into income by X) represents an expense equivalent to interest expense. 
The result would be the same if X sold the fixed leg to a third party 
for $37. While this example presents the case of a lump sum payment, the 
rules of paragraph (b)(1) would also apply to any transaction in which 
the swap payments are not substantially contemporaneous if the pricing 
of the transaction is materially affected by the time value of money. 
Thus, expenses and losses will be subject to apportionment under the 
rules of this section to the extent that such expenses or losses were 
incurred in consideration of the time value of money.

    (2) Certain foreign currency borrowings--(i) Rule. If a taxpayer 
borrows in a nonfunctional currency at a rate of interest that is less 
than the applicable federal rate (or its equivalent in functional 
currency if the functional currency is not the dollar), any swap, 
forward, future, option, or similar financial arrangement (or any 
combination thereof) entered into by the taxpayer or by a related person 
(as defined in Sec. 1.861-8T(c)(2)) that exists during the term of the 
borrowing and that substantially diminishes currency risk with respect 
to the borrowing or interest expense thereon will be presumed to 
constitute a hedge of such borrowing, unless the taxpayer can 
demonstrate on the basis of facts and circumstances that the two 
transactions are in fact unrelated. Under this presumption, the currency 
loss incurred on the borrowing during taxable years beginning after 
December 31, 1988, in connection with hedged nonfunctional currency 
borrowings, reduced or increased by the gain or loss on the hedge, will 
be apportioned in the same manner as interest expense. This presumption 
can be rebutted by a showing that the financial arrangement was entered 
into in connection with hedging currency exposure arising in the 
ordinary course of a trade or business (other than with respect to the 
borrowing).

[[Page 172]]

    (ii) Examples. The principles of this paragraph (b)(2) may be 
illustrated by the following examples.

    Example 1. Taxpayer has a dollar functional currency and does not 
have any qualified business units with a functional currency other than 
the dollar. On January 1, 1989, when the unit of foreign currency is 
worth $1, taxpayer borrows 100 units of foreign currency for a three-
year period bearing interest at the annual rate of 3 percent and 
immediately converts the proceeds of the borrowing into dollars for use 
in its business. In the ordinary course of its business, taxpayer has no 
foreign currency exposure in this currency. In March 1989, taxpayer 
enters into a three-year swap agreement that covers most, but not all, 
of the payment of interest and principal. Because the swap substantially 
diminishes currency risk with respect to the borrowing, it is presumed 
to hedge the loan. Since taxpayer cannot demonstrate that it was hedging 
currency exposure arising in the ordinary course of its business (other 
than currency exposure with respect to the borrowing), the net currency 
loss on the borrowing adjusted for any gain or loss on the swap must be 
apportioned in the same manner as interest expense.
    Example 2. Assume the same facts as in Example 1, except that the 
taxpayer borrows in two separate foreign currencies on terms described 
in Example 1 and enters into a swap agreement in a single currency that 
substantially diminishes the taxpayer's aggregate foreign currency risk. 
The net currency loss on the borrowings adjusted for any gain or loss on 
the swap must be apportioned in the same manner as interest expense.

    (3) Losses on sale of certain receivables--(1) General rule. Any 
loss on the sale of a trade receivable (as defined in Sec. 1.954-2(h)) 
shall be allocated and apportioned, solely for purposes of this section 
and Secs. 1.861-10T, 1.861-11T, 1.861-12T, and 1.861-13T, in the same 
manner as interest expense, unless at the time of sale of the 
receivable, it bears interest at a rate which is at least 120 percent of 
the short term applicable federal rate (as determined under section 
1274(d) of the Code), or its equivalent in foreign currency in the case 
of receivables denominated in foreign currency, determined at the time 
the receivable arises. This treatment shall not affect the 
characterization of such expense as interest for other purposes of the 
Internal Revenue Code.
    (ii) Exceptions. To the extent that a loss on the sale of a trade 
receivable exceeds the discount on the receivable that would be computed 
applying to the amount received on the sale of the receivable 120 
percent of the applicable federal rate (or its equivalent in foreign 
currency in the case of receivables denominated in foreign currency) for 
the period commencing with the date on which the receivable is sold and 
ending with the earlier of the date on which the receivable begins to 
bear interest at such rate or the anticipated payment date of the 
receivable, such excess shall not be allocated and apportioned in the 
same manner as interest expense but rather shall be allocated and 
apportioned to the gross income generated by the receivable. In cases of 
transfers of receivables to a domestic international sales corporation 
described Sec. 1.994-1(c)(6)(v), the rule of this paragraph (b)(3) shall 
not apply for purposes of computing combined taxable income. In 
computing the combined taxable income of a foreign sales corporation and 
its related supplier, loss on the sale of receivables to a third party 
incurred either by the foreign sales corporation or its related supplier 
shall offset combined taxable income, notwithstanding the provisions of 
this paragraph (b)(3). See Sec. 1.924(a)-1T(g)(7).

    Example. On October 1, X sells a widget to Y for $100 payable in 30 
days, after which the receivable will bear stated interest at 13 
percent. On October 4, X sells Y's obligation to Z for $98. Assume that 
the applicable federal rate for the month of October is 10 percent. 
Applying 120 percent of the applicable federal rate to the $98 received 
on the sale of the receivable, the obligation is discounted at a 12 
percent rate for a period of 27 days. At this discount rate, the 
obligation would have sold for $99.22. Thus, 88 cents of the $2 loss on 
the sale is apportioned in the same manner as interest expense, and 
$1.22 of the $2 loss on the sale is directly allocated to the income 
generated on the widget sale.

    (4) Rent in certain leasing transactions. [Reserved]
    (5) Treatment of bond premium--(i) Treatment by the issuer. If a 
bond or other debt obligation is issued at a premium, an amount of 
interest expense incurred by the issuer on that bond or other debt 
obligation equal to the amortized portion of that premium that is 
included in gross income for the year

[[Page 173]]

shall be allocated and apportioned solely to the amortized portion of 
premium derived by the issuer for the year.
    (ii) Treatment by the holder. If a bond or debt obligation is 
purchased at a premium, the portion of that premium amortized during the 
year by the holder under section 171 and the regulations thereunder 
shall be allocated and apportioned solely to interest income derived 
from the bond by the holder for the year.
    (6) Financial products that alter effective cost of borrowing--(i) 
In general. Various derivative financial products can be part of 
transactions or series of transactions described in paragraph (b)(1) of 
this section. Such derivative financial products, including interest 
rate swaps, options, forwards, caps, and collars, potentially alter a 
taxpayer's effective cost of borrowing with respect to an actual 
liability of the taxpayer. For example, a taxpayer that is obligated to 
pay interest at a fixed rate may, in effect, pay interest at a floating 
rate by entering into an interest rate swap. Similarly, a taxpayer that 
is obligated to pay interest at a floating rate may, in effect, limit 
its exposure to rising interest rates by purchasing a cap. Such a 
taxpayer may have gains or losses associated with such derivative 
financial products. This paragraph (b)(6) provides rules for the 
treatment of gains and losses from such derivative financial products 
(``financial products'') that are part of transactions described in 
paragraph (b)(1) of this section and that are used by the taxpayer to 
alter its effective cost of borrowing with respect to an actual 
liability. This paragraph (b)(6) shall only apply where the hedge and 
the borrowing are in the same currency and shall not apply to the extent 
otherwise provided in section 988 and the regulations thereunder. The 
allocation and apportionment of a loss under this paragraph (b) shall 
not affect the characterization of such loss as capital or ordinary for 
other purposes of the Code and the regulations thereunder.
    (ii) Definition of gain and loss. For purposes of this paragraph 
(b)(6), the term ``gain'' refers to the excess of the amounts properly 
taken into income under a financial product that alters the effective 
cost of borrowing over the amounts properly allowed as a deduction 
thereunder within a given taxable year. See. e.g., Notice 89-21. The 
term ``loss'' refers to the excess of the amounts properly allowed as a 
deduction under such a financial product over the amounts properly taken 
into income thereunder within a given taxable year.
    (iii) Treatment of gain or loss on the disposition of a financial 
product. [Reserved]
    (iv) Entities that are not financial services entities. An entity 
that does not constitute a financial services entity within the meaning 
of Sec. 1.904-4(e)(3) shall treat gains and losses on financial products 
described in paragraph (b)(6)(i) of this section as follows.
    (A) Losses. Losses on any financial product described in paragraph 
(b)(6)(i) of this section shall be apportioned in the same manner as 
interest expense whether or not such financial product is identified by 
the taxpayer under paragraph (b)(6)(iv)(C) of this section as a 
liability hedge.
    (B) Gains. Gains on any financial product described in paragraph 
(b)(6)(i) of this section shall reduce the taxpayer's total interest 
expense that is subject to apportionment, but only if such financial 
product is identified by the taxpayer under paragraph (b)(6)(iv)(C) of 
this section as a liability hedge. Such reduction is accomplished by 
directly allocating interest expense to the income derived from such a 
financial product.
    (C) Identification of financial products. A taxpayer can identify a 
financial product described in paragraph (b)(6)(i) of this section as 
hedging a particular interest-bearing liability (or any group of such 
liabilities) by clearly identifying on its books and records on the same 
day that it becomes a party to such arrangement that such arrangement 
hedges a given liability (or group of liabilities). In the case of a 
partial hedge, such identification shall apply to only that part of the 
liability that is hedged. If the taxpayer clearly identifies on its 
books and records a financial product as a hedge of an interest-bearing 
asset (or any group of such assets), it will create a rebuttable 
presumption that such financial product is not described in paragraph 
(b)(6)(i) of this

[[Page 174]]

section. A taxpayer may identify a hedge as relating to an anticipated 
liability, provided that such liability is in fact incurred within 120 
days following the date of such identification. Gains and losses on such 
an anticipatory arrangement accruing prior to the time at which the 
liability is incurred shall constitute an adjustment to interest 
expense.
    (v) Financial services entities. [Reserved]
    (vi) Dealers. The rule of paragraph (b)(6)(iv) of this section shall 
not apply to a person acting in its capacity as a regular dealer in the 
financial products described in paragraph (b)(6)(i) of this section. 
Instead, losses sustained by a regular dealer in connection with such 
financial products shall be allocated to the class of gross income from 
such arrangements. Gains of a regular dealer in notional principal 
contracts are governed by the rules of Sec. 1.863-7T(b). Amounts 
received or accrued by any person from any financial product that is 
integrated as specified in Notice 89-90 with an asset shall not be 
treated as amounts received or accrued by a person acting in its 
capacity as a regular dealer in financial products.
    (vii) Examples. The principles of this paragraph (b)(6) may be 
illustrated by the following examples.

    Example 1. X is not a financial services entity or regular dealer in 
the financial products described in paragraph (b)(6)(i) of this section 
and has a dollar functional currency. In 1990, X incurred a total of 
$200 of interest expense. On January 1, 1990, X entered into an interest 
rate swap agreement with Y, in order to hedge its interest rate exposure 
with respect to a pre-existing floating rate liability. On the same day, 
X properly identified the agreement as a hedge of such liability. Under 
the agreement, X is required to pay Y an amount equal to a fixed rate of 
10 percent on a notional principal amount of $1,000. Y is required to 
pay X an amount equal to a floating rate of interest on the same 
notional principal amount. Under the agreement, X received from Y during 
1990 a net payment of $25. Because X identified the swap agreement as a 
liability hedge under the rules of paragraph (b)(6)(iv)(C), X may 
effectively reduce its total allocable interest expense for 1990 to $175 
by directly allocating $25 of interest expense to the swap income. Had X 
not properly identified the swap as a liability hedge, this swap payment 
would have been treated as domestic source income in accordance with the 
rule of Sec. 1.863-7T(b).
    Example 2. Assume the same facts as Example (1), except that X did 
not properly identify the agreement as a liability hedge on January 1, 
l990. In 1990, X made a net payment of $25 to Y under the swap 
agreement. This swap payment is allocated and apportioned in the same 
manner as interest expense under the rules of paragraph (b)(6)(iv)(A).

    (viii) Effective dates--(A) Losses. The rules of this paragraph 
(b)(6) shall apply to losses on any transaction described in paragraph 
(b)(6)(i) of this section that was entered into after September 14, 
1988.
    (B) Gains. Except as provided in paragraph (b)(6)(viii)(C) of this 
section, the rules of this paragraph (b)(6) shall apply to any gain that 
was realized on any transaction described in paragraph (b)(6)(i) of this 
section that was entered into after August 14, 1989.
    (C) Exception for interim gains. Taxpayers shall be permitted to 
apply the rules of this paragraph (b)(6) to any gain that was realized 
on any transaction described in paragraph (b)(6)(i) of this section that 
was entered into after September 14, 1988 and on or before August 14, 
1989, if the taxpayer can demonstrate to the satisfaction of the 
Commissioner that substantially all of the arrangements described in 
paragraph (b)(6)(i) of this section to which the taxpayer became a party 
during that interim period were identified on the taxpayer's books and 
records with the liabilities of the taxpayer in a substantially 
contemporaneous manner and that all losses and expenses that are subject 
to the rules of this paragraph (b)(6) were treated in the same manner as 
interest expense. For this purpose, arrangements that were identified in 
a substantially contemporaneous manner with the taxpayer's assets shall 
be ignored.
    (7) Foreign currency gain or loss. In addition to the rules of 
paragraph (b)(1), (b)(2), and (b)(6) of this section, any foreign 
currency loss that is treated as an adjustment to interest expense under 
regulations issued under section 988 shall be allocated and apportioned 
in the same manner as interest expense. Any foreign currency gain that 
is treated as an adjustment to interest expense under regulations issued 
under section 988 shall offset apportionable interest expense.

[[Page 175]]

    (c) Allowable deductions. In order for an interest expense to be 
allocated and apportioned, it must first be determined that the interest 
expense is currently deductible. A number of provisions in the Code 
disallow or suspend deductions of interest expense or require the 
capitalization thereof.
    (1) Disallowed deductions. A taxpayer does not allocate and 
apportion interest expense under this section that is permanently 
disallowed as a deduction by operation of section 163(h), section 265, 
or any other provision or rule that permanently disallows the deduction 
of interest expense.
    (2) Section 263A. Section 263A requires the capitalization of 
interest expense that is allocable to designated types of property. Any 
interest expense that is capitalized under section 263A does not 
constitute deductible interest expense for purposes of this section. 
Furthermore, interest expense capitalized in inventory or depreciable 
property is not separately allocated and apportioned when the inventory 
is sold or depreciation is allowed. Capitalized interest expense is 
effectively allocated and apportioned as part of, and in the same manner 
as, the cost of goods sold, amortization, or depreciation deduction.
    (3) Section 163(d). Section 163(d) suspends the deduction for 
interest expense to the extent that it exceeds net investment income. In 
the year that suspended investment interest expense becomes allowable 
under the rules of section 163(d), that interest expense is apportioned 
under rules set forth in paragraph (d)(1) of this section as though it 
were incurred in the taxable year in which the expense is deducted.
    (4) Section 469--(i) General rule. Section 469 suspends the 
deduction of passive activity losses to the extent that they exceed 
passive activity income for the year. Passive activity losses may 
consist in part of interest expense properly allocable to passive 
activity. In the year that suspended interest expense becomes allowable 
as a deduction under the rules of section 469, that interest expense is 
apportioned under rules set forth in paragraph (d)(1) of this section as 
though it were incurred in the taxable year in which the expense is 
deducted.
    (ii) Identification of the interest component of a suspended passive 
loss. A suspended passive loss may consist of a variety of items of 
expense other than interest expense. Suspended interest expense for any 
taxable year is computed by multiplying the total suspended passive loss 
for the year by a fraction, the numerator of which is passive interest 
expense for the year (determined under regulations issued under section 
163) and the denominator of which is total passive expenses for the 
year. The amount of the suspended interest expense that is considered to 
be deductible in a subsequent taxable year is computed by multiplying 
the amount of any cumulative suspended interest expense (reduced by 
suspended interest expense allowed as a deduction in prior taxable 
years) times a fraction, the numerator of which is the portion of 
cumulative suspended passive losses that become deductible in the 
taxable year and the denominator of which is the cumulative suspended 
passive losses for prior taxable years (reduced by suspended passive 
losses allowed as deductions in prior taxable years).
    (iii) Example. The rules of this paragraph (c)(4) may be illustrated 
by the following example.

    Example. On January 1, 1987, A, a United States citizen, invested in 
a passive activity. In 1987, the passive activity generated no passive 
income and $100 in passive losses, all of which were suspended by 
operation of section 469. The suspended loss included $10 of suspended 
interest expense. In 1988, the passive activity generated $50 in passive 
income and $150 in passive expenses which included $30 of interest 
expense. The entire $100 passive loss was suspended in 1988 and included 
$20 of interest expense ($100 suspended passive loss x $30 passive 
interest expense/$150 total passive expenses). Thus, at the end of 1988, 
A had total suspended passive losses of $200, including $30 of suspended 
interest expense. In 1989, the passive activity generated $100 in 
passive income and no passive expenses. Thus, $100 of A's cumulative 
suspended passive loss was therefore allowed in 1989. The $100 of 
deductible passive loss includes $15 of suspended interest expense ($30 
cumulative suspended interest expense x $100 of cumulative suspended 
passive losses allowable in 1989/$200 of total cumulative suspended 
passive losses). The $15 of interest expense is apportioned under the 
rules of paragraph (d) of this section as though it were incurred in 
1989.


[[Page 176]]


    (d) Apportionment rules for individuals, estates, and certain 
trusts--(1) United States individuals. In the case of taxable years 
beginning after December 31, 1986, individuals generally shall apportion 
interest expense under different rules according to the type of interest 
expense incurred. The interest expense of individuals shall be 
characterized under the regulations issued under section 163. However, 
in the case of an individual whose foreign source income (including 
income that is excluded under section 911) does not exceed a gross 
amount of $5,000, the apportionment of interest expense under this 
section is not required. Such an individual's interest expense may be 
allocated entirely to domestic source income.
    (i) Interest incurred in the conduct of a trade or business. An 
individual who incurs business interest described in section 
163(h)(2)(A) shall apportion such interest expense using an asset method 
by reference to the individual's business assets.
    (ii) Investment interest. An individual who incurs investment 
interest described in section 163(h)(2)(B) shall apportion that interest 
expense on the basis of the individual's investment assets.
    (iii) Interest incurred in a passive activity. An individual who 
incurs passive activity interest described in section 163(h)(2)(C) shall 
apportion that interest expense on the basis of the individual's passive 
activity assets. Individuals who receive a distributive share of 
interest expense incurred in a partnership are subject to special rules 
set forth in paragraph (e) of this section.
    (iv) Qualified residence and deductible personal interest. 
Individuals who incur qualified residence interest described in section 
163(h)(2)(D) shall apportion that interest expense under a gross income 
method, taking into account all income (including business, passive 
activity, and investment income) but excluding income that is exempt 
under section 911. For purposes of this section, any qualified residence 
that is rented shall be considered to be a business asset for the period 
in which it is rented, with the result that the interest on such a 
residence is not apportioned under this subdivision (iv) but instead 
under subdivisions (i) or (iii) of this paragraph (d)(1). To the extent 
that personal interest described in section 163(h)(2) remains deductible 
under transitional rules, individuals shall apportion such interest 
expense in the same manner as qualified residence interest.
    (v) Example. The following example illustrates the principles of 
this section.

    Example --(i) Facts. A is a resident individual taxpayer engaged in 
the active conduct of a trade or business, which A operates as a sole 
proprietor. A's business generates only domestic source income. A's 
investment portfolio consists of several less than 10 percent stock 
investments. Certain stocks in which A's adjusted basis is $40,000 
generate domestic source income and other stocks in which A's adjusted 
basis is $60,000 generate foreign source passive income. In addition, A 
owns his personal residence, which is subject to a mortgage in the 
amount of $100,000. All interest expense incurred with respect to A's 
mortgage is qualified residence interest for purposes of section 
163(h)(2)(D). A's other indebtedness consists of a bank loan in the 
amount of $40,000. Under the regulations issued under section 163(h), it 
is determined that the proceeds of the $40,000 loan were divided equally 
between A's business and his investment portfolio. In 1987, the gross 
income of A's business, before the apportionment of interest expense, 
was $50,000. A's investment portfolio generated $4,000 in domestic 
source income and $6,000 in foreign source passive income. All of A's 
debt obligations bear interest at the annual rate of 10 percent.
    (ii) Analysis of business interest. Under section 163(h) of the 
Code, $2,000 of A's interest expense is attributable to his business. 
Under the rules of paragraph (d)(1)(i), such interest must be 
apportioned on the basis of the business assets. Applying the asset 
method described in paragraph (g) of this section, it is determined that 
all of A's business assets generate domestic income and, therefore, 
constitute domestic assets. Thus, the $2,000 in interest expense on the 
business loan is allocable to domestic source income.
    (iii) Analysis of investment interest. Under section 163(h) of the 
Code, $2,000 of A's interest expense is investment interest. Under the 
rules of paragraph (d)(1)(ii) of this section, such interest must be 
apportioned on the basis of investment assets. Applying the asset 
method, A's investment assets consist of stock generating domestic 
source income with an adjusted basis of $40,000 and stock generating 
foreign source passive income with an adjusted basis of $60,000. Thus, 
40 percent ($800) of A's investment interest is apportioned to domestic 
source income and

[[Page 177]]

60 percent ($1,200) of A's investment interest is apportioned to foreign 
source passive income for purposes of section 904.
    (iv) Analysis of qualified residence interest. The $10,000 of 
qualified residence interest expense is apportioned under the rules of 
paragraph (d)(1)(iv) of this section on the basis of all of A's gross 
income. A's gross income consists of $60,000, $54,000 of which is 
domestic source and $6,000 of which is foreign source passive income. 
Thus, $9,000 of A's qualified residence interest is apportioned to 
domestic source income and $1,000 of A's qualified residence interest is 
apportioned to foreign source passive income.

    (2) Nonresident aliens--(i) General rule. For taxable years 
beginning on or after January 1, 1988, interest expense incurred by a 
nonresident alien shall be considered to be connected with income 
effectively connected with a United States trade or business only to the 
extent that interest expense is incurred with respect to liabilities 
that--
    (A) Are entered on the books and records of the United States trade 
or business when incurred, or
    (B) Are secured by assets that generate such effectively connected 
income.
    (ii) Limitations--(A) Maximum debt capitalization. Interest expense 
incurred by a nonresident alien is not considered to be connected with 
effectively connected income to the extent that it is incurred with 
respect to liabilities that exceed 80 percent of the gross assets of the 
United States trade or business.
    (B) Collateralization by other assets. Interest expense on 
indebtedness that is secured by specific assets (not including the 
general credit of the nonresident alien) other than the assets of the 
United States trade or business shall not be considered to be connected 
with effectively connected income.
    (3) Estates and trusts. Estates shall be treated in the same manner 
as individuals. In the case of a trust that is beneficially owned by 
individuals and is a complex trust, the trust shall be treated in the 
same manner as individuals under the rules of paragraph (d) of this 
section, except that no de minimis amount shall apply. In the case of a 
trust that is beneficially owned by one or more corporations, the trust 
shall be treated either as a partnership or as a corporation depending 
on how the trust is characterized under the rules of section 7701 and 
the regulations thereunder.
    (e) Partnerships--(1) In general--aggregate rule. A partner's 
distributive share of the interest expense of a partnership that is 
directly allocable under Sec. 1.861-10T to income from specific 
partnership property shall be treated as directly allocable to the 
income generated by such partnership property. Subject to the exceptions 
set forth in paragraph (e)(4), a partner's distributive share of the 
interest expense of a partnership that is not directly allocable under 
Sec. 1.861-10T generally is considered related to all income producing 
activities and assets of the partner and shall be subject to 
apportionment under the rules described in this paragraph. For purposes 
of this section, a partner's percentage interest in a partnership shall 
be determined by reference to the partner's interest in partnership 
income for the year. Similarly, a partner's pro rata share of 
partnership assets shall be determined by reference to the partner's 
interest in partnership income for the year.
    (2) Corporate partners whose interest in the partnership is 10 
percent or more. A corporate partner shall apportion its distributive 
share of partnership interest expense by reference to the partner's 
assets, including the partner's pro rata share of partnership assets, 
under the rules of paragraph (f) of this section if the corporate 
partner's direct and indirect interest in the partnership (as determined 
under the attribution rules of section 318) is 10 percent or more. A 
corporation using the tax book value method of apportionment shall use 
the partnership's inside basis in its assets, adjusted to the extent 
required under Sec. 1.861-10T(d)(2). A corporation using the fair market 
value method of apportionment shall use the fair market value of the 
partnership's assets, adjusted to the extent required under Sec. 1.861-
10T(d)(2).
    (3) Individual partners who are general partners or who are limited 
partners with an interest in the partnership of 10 percent or more. An 
individual partner is subject to the rules of this paragraph (e)(3) if 
either the individual is a general partner or the individual's direct 
and indirect interest (as determined

[[Page 178]]

under the attribution rules of section 318) in the partnership is 10 
percent or more. The individual shall first classify his or her 
distributive share of partnership interest expense as interest incurred 
in the active conduct of a trade or business, as passive activity 
interest, or as investment interest under regulations issued under 
sections 163 and 469. The individual must then apportion his or her 
interest expense (including the partner's distributive share of 
partnership interest expense) under the rules of paragraph (d) of this 
section. Each such individual partner shall take into account his or her 
distributive share of partnership gross income or pro rata share of the 
partnership assets in applying such rules. An individual using the tax 
book value method of apportionment shall use the partnership's inside 
basis in its assets, adjusted to the extent required under Sec. 1.861-
10T(d)(2). An individual using the fair market value method of 
apportionment shall use the fair market value of the partnership's 
assets, adjusted to the extent required under Sec. 1.861-10T(d)(2).
    (4) Less than 10 percent limited partners and less than 10 percent 
corporate general partners--entity rule--(i) Partnership interest 
expense. A limited partner (whether individual or corporate) or 
corporate general partner whose direct and indirect interest (as 
determined under the attribution rules of section 318) in the 
partnership is less than 10 percent shall directly allocate its 
distributive share of partnership interest expense to its distributive 
share of partnership gross income. Under Sec. 1.904-7(i)(2) of the 
regulations, such a partner's distributive share of foreign source 
income of the partnership is treated as passive income (subject to the 
high taxed income exception of section 904(d)(2)(F)), except in the case 
of high withholding tax interest or income from a partnership interest 
held in the ordinary course of the partner's active trade or business, 
as defined in Sec. 1.904-7(i)(2). A partner's distributive share of 
partnership interest expense (other than partnership interest expense 
that is directly allocated to identified property under Sec. 1.861-10T) 
shall be apportioned in accordance with the partner's relative 
distributive share of gross foreign source income in each limitation 
category and of domestic source income from the partnership. To the 
extent that partnership interest expense is directly allocated under 
Sec. 1.861-10T, a comparable portion of the income to which such 
interest expense is allocated shall be disregarded in determining the 
partner's relative distributive share of gross foreign source income in 
each limitation category and domestic source income. The partner's 
distributive share of the interest expense of the partnership that is 
directly allocable under Sec. 1.861-10T shall be allocated according to 
the treatment, after application of Sec. 1.904-7(i)(2), of the partner's 
distributive share of the income to which the expense is allocated.
    (ii) Other interest expense of the partner. For purposes of 
apportioning other interest expense of the partner on an asset basis, 
the partner's interest in the partnership, and not the partner's pro 
rata share of partnership assets, is considered to be the relevant 
asset. The value of this asset for apportionment purposes is either the 
tax book value or fair market value of the partner's partnership 
interest, depending on the method of apportionment used by the taxpayer. 
This amount of a partner's interest in the partnership is allocated 
among various limitation categories in the same manner as partnership 
interest expense (that is not directly allocable under Sec. 1.861-10T) 
is apportioned in subdivision (i) of this paragraph (e)(4). If the 
partner uses the tax book value method of apportionment, the partner's 
interest in the partnership must be reduced, for this purpose, to the 
extent that the partner's basis consists of liabilities that are taken 
into account under section 752. Under either the tax book value or fair 
market value method of apportionment, for purposes of this section only, 
the value of the partner's interest in the partnership must be reduced 
by the principal amount of any indebtedness of the partner the interest 
on which is directly allocated to its partnership interest under 
Sec. 1.861-10T.
    (5) Tiered partnerships. If a partnership is a partner in another 
partnership, the distributive share of interest expense of a lower-tier 
partnership

[[Page 179]]

that is subject to the rules of paragraph (e)(4) shall not be 
reapportioned in the hands of any higher-tier partner. However, the 
distributive share of interest expense of lower-tier partnership that is 
subject to the rules of paragraph (e) (2) or (3) shall be apportioned by 
the partner of the higher-tier partnership or by any higher-tier 
partnership to which the rules of paragraph (e)(4) apply, taking into 
account the partner's indirect pro rata share of the lower-tier 
partnership's income or assets.
    (6) Example--(i) Facts. A, B, and C are partners in a limited 
partnership. A is a corporate general partner, owns a 5 percent interest 
in the partnership, and has an adjusted basis in its partnership 
interest, determined without regard to section 752 of the Code, of $5. 
A's investment in the partnership is not held in the ordinary course of 
the taxpayer's active trade or business, as defined in Sec. 1.904-
7(i)(2). B, a corporate limited partner, owns a 70 percent interest in 
the partnership, and has an adjusted basis in its partnership interest, 
determined without regard to section 752 of the Code, of $70. C is an 
individual limited partner, owns a 25 percent interest in the 
partnership, and has an adjusted basis in the partnership interest, 
determined without regard to section 752 of the Code, of $25. The 
partners' interests in the profits and losses of the partnership conform 
to their respective interests. None of the interest expense incurred 
directly by any of the partners is directly allocable to their 
partnership interest under Sec. 1.861-10T. The ABC partnership's sole 
assets are two apartment buildings, one domestic and the other foreign. 
The domestic building has an adjusted inside basis of $600 and the 
foreign building has an adjusted inside basis of $500. Each of the 
buildings is subject to a nonrecourse liability in the amount of $500. 
The ABC partnership's total interest expense for the taxable year is 
$120, both nonrecourse liabilities bearing interest at the rate of 12 
percent. The indebtedness on the domestic building qualifies for direct 
allocation under the rules of Sec. 1.861-10T. The indebtedness on the 
foreign building does not so qualify. The partnership incurred no 
foreign taxes. The partnership's gross income for the taxable year is 
$360, consisting of $100 in foreign source income and $260 in domestic 
source income. Under Sec. 1.752-1(e), the nonrecourse liabilities of the 
partnership are allocated among the partners according to their share of 
the partnership profits. Accordingly, the adjusted basis of A, B, and C 
in their respective partnership interests (for other than apportionment 
purposes) is, respectively, $55, $770, and $275.
    (ii) Determination of the amount of partnership interest expense 
that is subject to allocation and apportionment. Interest on the 
nonrecourse loan on the domestic building is, under Sec. 1.861-10T, 
directly allocable to income from that investment. The interest expense 
is therefore directly allocable to domestic income. Interest on the 
nonrecourse loan on the foreign building is not directly allocable. The 
interest expense is therefore subject to allocation and apportionment. 
Thus, $60 of interest expense is directly allocable to domestic income 
and $60 of interest expense is subject to allocation and apportionment.
    (iii) Analysis for Partner A. A's distributive share of the 
partnership's gross income is $18, which consists of $5 in foreign 
source income and $13 in domestic source income. A's distributive share 
of the ABC interest expense is $6, $3 of which is directly allocable to 
domestic income and $3 of which is subject to apportionment. After 
direct allocation of qualifying interest expense, A's distributive share 
of the partnership's gross income consists of $5 in foreign source 
income and $10 in domestic source income. Because A is a less than 10 
percent corporate partner, A's distributive share of any foreign source 
partnership income is considered to be passive income. Accordingly, in 
apportioning the $3 of partnership interest expense that is subject to 
apportionment on a gross income method, one-third ($1) is apportioned to 
foreign source passive income and two-thirds ($2) is apportioned to 
domestic source income. In apportioning its other interest expense, A 
uses the tax book value method. A's adjusted basis in A's partnership 
interest ($55) includes A's share of the partnership's liabilities 
($50), which are included in basis under section 752. For purposes of 
apportioning other interest expense, A's adjusted basis in the 
partnership must be reduced to the extent of such liabilities. Thus, A's 
adjusted basis in the partnership, for purposes of apportionment, is $5. 
For the purpose of apportioning A's other interest expense, this $5 in 
basis is characterized one-third as a foreign passive asset and two-
thirds as a domestic asset, which is the ratio determined in paragraph 
(e)(4)(i).
    (iv) Analysis for Partner B. B's distributive share of the ABC 
interest expense is $84, $42 of which is directly allocable to domestic 
income and $42 of which is subject to apportionment. As a corporate 
limited partner whose interest in the partnership is 10 percent or more, 
B is subject to the rules of paragraph (e)(2) and paragraph (f) of this 
section. These rules require that a corporate partner apportion its 
distributive share of partnership interest expense at the partner level 
on the asset method described in paragraph (g) of this section by 
reference to its corporate assets, which include, for this purpose, 70 
percent of the partnership's assets,

[[Page 180]]

adjusted in the manner described in Sec. 1.861-10T(e) to reflect 
directly allocable interest expense.
    (v) Analysis for Partner C. C's distributive share of the ABC 
interest expense is $30, $15 of which is directly allocable to domestic 
income and $15 of which is subject to apportionment. As an individual 
limited partner whose interest in the partnership is 10 percent or more, 
C is subject to the rules of paragraph (e)(3) of this section. These 
rules require that an individual's share of partnership interest expense 
be classified under regulations issued under section 163(h) and then 
apportioned under the rules applicable to individuals, which are set 
forth in paragraph (d) of this section.
    (7) Foreign partners. The distributive share of partnership interest 
expense of a nonresident alien who is a partner in a partnership shall 
be considered to be connected with effectively connected income based on 
the percentage of the assets of the partnership that generate 
effectively connected income. No interest expense directly incurred by 
the partner may be allocated and apportioned to effectively connected 
income derived by the partnership.
    (f) Corporations--(1) Domestic corporations. Domestic corporations 
shall apportion interest expense using the asset method described in 
paragraph (g) of this section and the applicable rules of Secs. 1.861-
10T through 1.861-13T.
    (2) Foreign branches of domestic corporations. In the application of 
the asset method described in paragraph (g) of this section, a domestic 
corporation shall--
    (i) Take into account the assets of any foreign branch, translated 
according to the rules set forth in paragraph (g) of this section, and
    (ii) Combine with its own interest expense any deductible interest 
expense incurred by a branch, translated according to the rules of 
section 987 and the regulations thereunder.

For purposes of computing currency gain or loss on any remittance from a 
branch or other qualified business unit (as defined in Sec. 1.989(a)-1T) 
under section 987, the rules of this paragraph (f) shall not apply. The 
branch shall compute its currency gain or loss on remittances by taking 
into account only its separate expenses and its separate income.

    Example --(i) Facts. X is a domestic corporation which operates B, a 
branch doing business in a foreign country. In 1988, without regard to 
branch B, X has gross domestic source income of $1,000 and gross foreign 
source general limitation income of $500 and incurs $200 of interest 
expense. Using the tax book value method of apportionment, X, without 
regard to branch B, determines the value of its assets that generate 
domestic source income to be $6,000 and the value of its assets that 
generate foreign source general limitation income to be $1,000. B 
constitutes a qualified business unit within the meaning of section 989 
with a functional currency other than the U.S. dollar and uses the 
profit and loss method prescribed by section 987. Applying the 
translation rules of section 987, B earned $500 of gross foreign general 
limitation income and incurred $100 of interest expense. B incurred no 
other expenses. For 1988, the average functional currency book value of 
B's assets that generate foreign general limitation income translated at 
the year-end rate for 1988 is $3,000.
    (ii) Computation of net income. The combined assets of X and B for 
1988 (averaged under the rules of Sec. 1.861-9T(g)(3)) consist 60 
percent of assets generating domestic source income and 40 percent of 
assets generating foreign source general limitation income. The combined 
interest expense of both X and B is $300. Thus, $180 of the combined 
interest expense is apportioned to domestic source income and $120 is 
apportioned to the foreign source income, yielding net domestic source 
income of $820 and net foreign source general limitation income of $880.
    (iii) Computation of currency gain or loss. For purposes of 
computing currency gain or loss on branch remittances, B takes into 
account only its gross income and its separate expenses. In 1988, B 
therefore has a net amount of income in foreign currency units equal in 
value to $400. Gain or loss on remittances shall be computed by 
reference to this amount.

    (3) Controlled foreign corporations--(i) In general. For purposes of 
computing subpart F income and computing earnings and profits for all 
other federal tax purposes, the interest expense of a controlled foreign 
corporation may be apportioned either using the asset method described 
in paragraph (g) of this section or using the modified gross income 
method described in paragraph (j) of this section, subject to the rules 
of subdivisions (ii) and (iii) of this paragraph (f)(2). However, the 
gross income method described in paragraph (j) of this section is not 
available to any controlled foreign corporation if a United States 
shareholder and the

[[Page 181]]

members of its affiliated group (as defined in Sec. 1.861-11T(d)) 
constitute controlling shareholders of such controlled foreign 
corporation and such affiliated group elects the fair market value 
method of apportionment under paragraph (g) of this section.
    (ii) Manner of election. The election to use the asset method 
described in paragraph (g) of this section or the modified gross income 
method described in paragraph (j) of this section may be made either by 
the controlled foreign corporation or by the controlling United States 
shareholders on behalf of the controlled foreign corporation. The term 
``controlling United States shareholders'' means those United States 
shareholders (as defined in section 951(b)) who, in aggregate, own 
(within the meaning of section 958(a)) greater than 50 percent of the 
total combined voting power of all classes of stock of the foreign 
corporation entitled to vote. In the case of a controlled foreign 
corporation in which the United States shareholders own stock 
representing more than 50 percent of the value of the stock in such 
corporation, but less than 50 percent of the combined voting power of 
all classes of stock in such corporation, the term ``controlling United 
States shareholders'' means all the United States shareholders (as 
defined in section 951(b)) who own (within the meaning of section 
958(a)) stock of the controlled foreign corporation. All United States 
shareholders are bound by the election of either the controlled foreign 
corporation or the controlling United States shareholders. The election 
shall be made by filing a written statement described in Sec. 1.964-
1(c)(3)(ii) at the time and in the manner described therein and 
providing a written notice described in Sec. 1.964-1(c)(3)(iii), except 
that no such written statement or notice is required to be filed or sent 
before March 13, 1989.
    (iii) Consistency requirement. The same method of apportionment must 
be employed by all controlled foreign corporations in which a United 
States taxpayer and the members of its affiliated group (as defined in 
Sec. 1.861-11T(d)) constitute controlling United States shareholders. A 
controlled foreign corporation that is required by this paragraph 
(f)(3)(iii) to utilize a particular method of apportionment must do so 
with respect to all United States shareholders.
    (iv) Stock characterization. Pursuant to Sec. 1.861-12T(c)(2), the 
stock of a controlled foreign corporation shall be characterized in the 
hands of any United States shareholder using the same method that the 
controlled foreign corporation uses to apportion its interest expense.
    (4) Other relevant provisions. Affiliated groups of corporations are 
subject to special rules set forth in Sec. 1.861-11T. Section 1.861-12T 
sets forth rules relating to basis adjustments for stock in 
nonaffiliated 10 percent owned corporations, special rules relating to 
the consideration and characterization of certain assets in the 
apportionment of interest expense, and to other special rules pertaining 
to the apportionment of interest expense. Section 1.861-13T contains 
transition rules limiting the application of the rules of Secs. 1.861-8T 
through 1.861-12T, which are otherwise applicable to taxable years 
beginning after 1986. In the case of an affiliated group of corporations 
as defined in Sec. 1.861-11T(d), any reference in Secs. 1.861-8T through 
1.861-13T to the ``taxpayer'' with respect to the allocation and 
apportionment of interest expense generally denotes the entire 
affiliated group of corporations and not the separate members thereof, 
unless the context otherwise requires.
    (g) Asset method--(1) In general. (i) Under the asset method, the 
taxpayer apportions interest expense to the various statutory groupings 
based on the average total value of assets within each such grouping for 
the taxable year, as determined under the asset valuation rules of this 
paragraph (g)(1) and paragraph (g)(2) of this section and the asset 
characterization rules of paragraph (g)(3) of this section and 
Sec. 1.861-12T. Except to the extent otherwise provided (see, e.g., 
paragraph (d)(1)(iv) of this section), taxpayers must apportion interest 
expense only on the basis of asset values and may not apportion any 
interest deduction on the basis of gross income.
    (ii) A taxpayer may elect to determine the value of its assets on 
the basis of either the tax book value or the fair market value of its 
assets. For

[[Page 182]]

rules concerning the application of the fair market value method, see 
paragraph (h) of this section. In the case of an affiliated group--
    (A) The parent of which used the fair market value method prior to 
1987, or
    (B) A substantial portion of which used the fair market value method 
prior to 1987, such a taxpayer may use either the fair market value 
method or the tax book value method for its tax year commencing in 1987 
and may use either such method in its tax year commencing in 1988 
without regard to which method was used in its tax year commencing in 
1987 and without securing the Commissioner's consent. The use of the 
fair market value method in 1988, however, shall operate as a binding 
election as described in Sec. 1.861-8T(c)(2). For rules requiring 
consistency in the use of the tax book value or fair market value 
method, see Sec. 1.861-8T(c)(2).
    (iii) A taxpayer electing to apportion its interest expense on the 
basis of the fair market value of its assets must establish the fair 
market value to the satisfaction of the Commissioner. If a taxpayer 
fails to establish the fair market value of an asset to the satisfaction 
of the Commissioner, the Commissioner may determine the appropriate 
asset value. If a taxpayer fails to establish the value of a substantial 
portion of its assets to the satisfaction of the Commissioner, the 
Commissioner may require the taxpayer to use the tax book value method 
of apportionment.
    (iv) For rules relating to earnings and profits adjustments by 
taxpayers using the tax book value method for the stock in certain 
nonaffiliated 10 percent owned corporations, see Sec. 1.861-12T(b).
    (v) The provisions of this paragraph (g)(1) may be illustrated by 
the following examples.

    Example 1 --(i) Facts. X, a domestic corporation organized on 
January 1, 1987, has deductible interest expense in 1987 in the amount 
of $150,000. X apportions its expenses according to the tax book value 
method. The adjusted basis of X's assets is $3,600,000, $3,000,000 of 
which generate domestic source income and $600,000 of which generate 
foreign source general limitation income.
    (ii) Allocation. No portion of the $150,000 deduction is directly 
allocable solely to identified property within the meaning of 
Sec. 1.861-10T. Thus, X's deduction for interest is related to all its 
activities and assets.
    (iii) Apportionment. X apportions its interest expense as follows:
    To foreign source general limitation income:
    [GRAPHIC] [TIFF OMITTED] TC14NO91.113
    
    To domestic source income:
    [GRAPHIC] [TIFF OMITTED] TC14NO91.114
    
    Example 2 --(i) Facts. Assume the same facts as in Example 1, except 
that X apportions its interest expense on the basis of the fair market 
value of its assets. X's total assets have a fair market value of 
$4,000,000, $3,200,000 of which generate domestic source income and 
$800,000 of which generate foreign source general limitation income.
    (ii) Allocation. No portion of the $150,000 deduction is directly 
allocable solely to identified property within the meaning of 
Sec. 1.861-10T. Thus, X's deduction for interest is related to all its 
activities and properties.
    (iii) Apportionment. If it establishes the fair market value of its 
assets to the satisfaction of the Commissioner, X may apportion its 
interest expense as follows:
    To foreign source general limitation income:
    [GRAPHIC] [TIFF OMITTED] TC14NO91.115
    
    To domestic source income:
    [GRAPHIC] [TIFF OMITTED] TC14NO91.116
    
    (2) Asset values--(i) General rule. For purposes of determining the 
value of assets under this section, an average of values (book or 
market) within each statutory grouping and the residual grouping shall 
be computed for the year on the basis of values of assets at the 
beginning and end of the year. For the first taxable year beginning 
after 1986, a taxpayer may choose to determine asset values solely by 
reference to the year-end value of its assets, provided that all the 
members of an affiliated group as defined in Sec. 1.861-11T(d) make the 
same choice. Thus, no averaging is required for the first taxable year 
beginning after 1986. Where a substantial distortion of asset values 
would result from averaging beginning-of-year and year-end values, as 
might

[[Page 183]]

be the case in the event of a major corporate acquisition or 
disposition, the taxpayer must use a different method of asset valuation 
that more clearly reflects the average value of assets weighted to 
reflect the time such assets are held by the taxpayer during the taxable 
year.
    (ii) Special rule for qualified business units of domestic 
corporations with functional currency other than the U.S. dollar--(A) 
Tax book value method. In the case of taxpayers using the tax book value 
method of apportionment, the following rules shall apply to determine 
the value of the assets of a qualified business unit (as defined in 
section 989(a)) of a domestic corporation with a functional currency 
other than the dollar.
    (1) Profit and loss branch. In the case of a branch for which an 
election is not effective under Sec. 1.985-2T to use the dollar 
approximate separate transactions method of computing currency gain or 
loss, the tax book value shall be determined by applying the rules of 
paragraph (g)(2)(i) and (3) of this section with respect to beginning-
of-year and end-of-year tax book value in units of functional currency 
that are translated into dollars at the end-of-year exchange rate 
between the functional currency and the U.S. dollar.

    Example. At the end of 1987, a profit and loss branch has assets 
that generate foreign source general limitation income with a tax book 
value in units of functional currency of 100. At the end of 1987, the 
unit is worth $1. At the end of 1988, the branch has assets that 
generate foreign source general limitation income with a tax book value 
in units of functional currency of 80. At the end of 1988, the unit is 
worth $2. The average value of foreign source general limitation assets 
for 1988 is 90 units, which is worth $180.

    (2) Approximate separate transactions method. In the case of a 
branch for which an election is effective under Sec. 1.985-2T to use the 
dollar approximate separate transactions method to compute currency gain 
or loss, the beginning-of-year dollar amount of the assets shall be 
determined by reference to the end-of-year balance sheet of the branch 
for the immediately preceding taxable year, adjusted for United States 
generally accepted accounting principles and United States tax 
accounting principles, and translated into U.S. dollars as provided in 
Sec. 1.985-3T. The year-end dollar amount of the assets of the branch 
shall be determined in the same manner by reference to the end-of-year 
balance sheet for the current taxable year. The beginning-of-year and 
end-of-year dollar tax book value of assets, as so determined, within 
each grouping must then be averaged as provided in paragraph (g)(2)(i) 
of this section.
    (B) Fair market value method. In the case of taxpayers using the 
fair market value method of apportionment, the beginning-of-year and 
end-of-year fair market values of branch assets within each grouping 
shall be computed in dollars and averaged as provided in this paragraph 
(g)(2).
    (iii) Adjustment for directly allocated interest. Prior to 
averaging, the year-end value of any asset to which interest expense is 
directly allocated during the current taxable year under the rules of 
Sec. 1.861-10T (b) or (c) shall be reduced (but not below zero) by the 
percentage of the principal amount of indebtedness outstanding at year-
end equal to the percentage of all interest on the debt for the taxable 
year that is directly allocated.
    (iv) Assets in intercompany transactions. In the application of the 
asset method described in this paragraph (g), the tax book value of 
assets transferred between affiliated corporations in intercompany 
transactions shall be determined without regard to the gain or loss that 
is deferred under the regulations issued under section 1502.

    (v) Example. X is a domestic corporation that uses the fair market 
value method of apportionment. X is a calendar year taxpayer. X owns 25 
percent of the stock of A, a noncontrolled section 902 corporation. At 
the end of 1987, the fair market value of X's assets by income grouping 
are as follows:

Domestic......................................................$1,000,000
Foreign general limitation.......................................500,000
Foreign passive..................................................500,000
Noncontrolled section 902 corporation.............................50,000

    For its 1987 tax year, X apportions its interest expense by 
reference to the 1987 year-end values. In July of 1988, X sells a 
portion of its investment in A and in an asset acquisition purchases a 
shipping business, the assets of which generate exclusively foreign 
shipping income. At the end of 1988, the fair

[[Page 184]]

market values of X's assets by income grouping are as follows:
Domestic........................................................$800,000
Foreign general limitation.......................................900,000
Foreign passive..................................................300,000
Noncontrolled section 902 corporation.............................40,000
Foreign shipping.................................................100,000

    For its 1988 tax year, X shall apportion its interest expense by 
reference to the average of the 1988 beginning-of-year values (the 1987 
year-end values) and the 1988 year-end values, assuming that the 
averaging of beginning-of-year and end-of-year values does not cause a 
substantial distortion of asset values. These averages are as follows:
Domestic........................................................$900,000
Foreign general limitation.......................................700,000
Foreign passive..................................................400,000
Foreign shipping..................................................50,000
Noncontrolled section 902 corporation.............................45,000

    (3) Characterization of assets. Assets are charactrized for purposes 
of this section according to the source and type of the income that they 
generate, have generated, or may reasonably be expected to generate. The 
physical location of assets is not relevant to this determination. 
Subject to the special rules of paragraph (h) concerning the application 
of the fair market value method of apportionment, the value of assets 
within each statutory grouping and the residual grouping at the 
beginning and end of each year shall be determined by dividing the 
taxpayer's assets into three types--
    (i) Single category assets. Assets that generate income that is 
exclusively within a single statutory grouping or the residual grouping;
    (ii) Multiple category assets. Assets that generate income within 
more than one grouping of income (statutory or residual); and
    (iii) Assets without directly identifiable yield. Assets that 
produce no directly identifiable income yield or that contribute equally 
to the generation of all the income of the taxpayer (such as assets used 
in general and administrative functions).

Single category assets are directly attributable to the relevant 
statutory or residual grouping of income. In order to attribute multiple 
category assets to the relevant groupings of income, the income yield of 
each such asset for the taxable year must be analyzed to determine the 
proportion of gross income generated by it within each relevant 
grouping. The value of each asset is then prorated among the relevant 
groupings of income according to their respective proportions of gross 
income. The value of each asset without directly identifiable income 
yield must be identified. However, because prorating the value of such 
assets cannot alter the ratio of assets within the various groupings of 
income (as determined by reference to the single and multiple category 
assets), they are not taken into account in determining that ratio. 
Special asset characterization rules that are set forth in Sec. 1.861-
12T. An example demonstrating the application of the asset method is set 
forth in Sec. 1.861-12T(d).
    (h) The fair market value method. An affiliated group (as defined in 
Sec. 1.861-11T(d)) or other taxpayer (the ``taxpayer'') that elects to 
use the fair market value method of apportionment shall value its assets 
according to the following methodology.
    (1) Determination of values--(i) Valuation of group assets. The 
taxpayer shall first determine the aggregate value of the assets of the 
taxpayer on the last day of its taxable year without excluding the value 
of stock in foreign subsidiaries or any other asset. In the case of a 
publicly traded corporation, this determination shall be equal to the 
aggregate trading value of the taxpayer's stock traded on established 
securities markets at year-end increased by the taxpayer's year-end 
liabilities to unrelated persons and its pro rata share of year-end 
liabilities of all related persons owed to unrelated persons. In 
determining whether persons are related, Sec. 1.861-8T(c)(2) shall 
apply. In the case of a corporation that is not publicly traded, this 
determination shall be made by reference to the capitalization of 
corporate earnings, in accordance with the rules of Rev. Rul. 68-609. In 
either case, control premium shall not be taken into account.
    (ii) Valuation of tangible assets. The taxpayer shall determine the 
value of all assets held by the taxpayer and its pro rata share of 
assets held by other related persons on the last day of its taxable 
year, excluding stock or indebtedness in such persons, any intangible 
property as defined in section

[[Page 185]]

936(h)(3)(B), or goodwill or going concern value intangibles. Such 
valuations shall be made using generally accepted valuation techniques. 
For this purpose, assets may be combined into reasonable groupings. 
Statistical methods of valuation may only be used in connection with 
fungible property, such as commodities. The value of stock in any 
corporation that is not a related person shall be determined under the 
rules of paragraph (h)(1)(i) of this section, except that no liabilities 
shall be taken into account.
    (iii) Computation of intangible asset value. The value of the 
intangible assets of the taxpayer and of intangible assets of all 
related persons attributable to the taxpayer's ownership in related 
persons is equal to the amount obtained by subtracting the amount 
determined under paragraph (h)(1)(ii) of this section from the amount 
determined under paragraph (h)(1)(i) of this section.
    (2) Apportionment of intangible asset value. The value of the 
intangible assets determined under paragraph (h)(1)(iii) of this section 
is apportioned among the taxpayer and all related persons in proportion 
to the net income before interest expense of the taxpayer and the 
taxpayer's pro rata share of the net income before interest expense of 
each ralated person held by the taxpayer, excluding income that is 
passive under Sec. 1.904-4(b). For this purpose, net income is 
determined before reduction for income taxes. Net income of the taxpayer 
and of related persons shall be computed without regard to dividends or 
interest received from any person that is related to the taxpayer.
    (3) Characterization of affiliated group's portion of intangible 
asset value. The portion of the value of intangible assets of the 
taxpayer and related persons that is apportioned to the taxpayer under 
paragraph (h)(2) of this section is characterized on the basis of net 
income before interest expense, as determined under paragraph (h)(2) of 
this section, of the taxpayer within each statutory or residual grouping 
of income.
    (4) Valuing stock in related persons held by the taxpayer. The value 
of stock in a related person held by the taxpayer equals the sum of the 
following amounts reduced by the taxpayer's pro rata share of 
liabilities of such related person:
    (i) The portion of the value of intangible assets of the taxpayer 
and related persons that is apportioned to such related person under 
paragraph (h)(2) of this section;
    (ii) The taxpayer's pro rata share of tangible assets held by the 
related person (as determined under paragraph (h)(1)(ii) of this 
section); and
    (iii) The total value of stock in all related person held by the 
related person as determined under this paragraph (h)(4).
    (5) [Reserved]. For further guidance, see Sec. 1.861-9(h)(5).
    (6) Adjustments for apportioning related person expenses. For 
purposes of apportioning expenses of a related person, the value of 
stock in a second related person as otherwise determined under paragraph 
(h)(4) of this section (which is determined on the basis of the 
taxpayer's percentage ownership interest in the second related person) 
shall be increased to reflect the first related person's percentage 
ownership interest in the second related person to the extent it is 
larger.

    Example. Assume that a taxpayer owns 80 percent of CFC1, which owns 
100 percent of CFC2. The value of CFC1 is determined generally under 
paragraph (h)(4) on the basis of the taxpayer's 80 percent indirect 
interest in CFC2. For purposes of apportioning expenses of CFC1, 100 
percent of the stock of CFC1 must be taken into account. Therefore, the 
value of CFC2 stock in the hands of CFC1 shall equal the value of CFC2 
stock in the hands of CFC1 as determined under paragraph (h)(4) of this 
section, increased by 25 percent of such amount to reflect the fact that 
CFC1 owns 100 percent and not 80 percent of CFC2.

    (i) [Reserved]
    (j) Modified gross income method. Subject to rules set forth in 
paragraph (f)(3) of this section, the interest expense of a controlled 
foreign corporation may be allocated according to the following rules.
    (1) Single-tier controlled foreign corporation. In the case of a 
controlled foreign corporation that does not hold stock in any lower-
tier controlled foreign corporation, the interest expense of the 
controlled foreign corporation

[[Page 186]]

shall be apportioned based on its gross income.
    (2) Multiple vertically owned controlled foreign corporations. In 
the case of a controlled foreign corporation that holds stock in any 
lower-tier controlled foreign corporation, the interest expense of that 
controlled foreign corporation and such upper-tier controlled foreign 
corporation shall be apportioned based on the following methodology:
    (i) Step 1. Commencing with the lowest-tier controlled foreign 
corporation in the chain, allocate and apportion its interest expense 
based on its gross income as provided in paragraph (j)(1) of this 
section, yielding gross income in each grouping net of interest expense.
    (ii) Step 2. Moving to the next higher-tier controlled foreign 
corporation, combine the gross income of such corporation within each 
grouping with its pro rata share of the gross income net of interest 
expense of all lower-tier controlled foreign corporations held by such 
higher-tier corporation within the same grouping adjusted as follows:
    (A) Exclude from the gross income of the upper-tier corporation any 
dividends or other payments received from the lower-tier corporation 
other than interest subject to look-through under section 904(d)(3); and
    (B) Exclude from the gross income net of interest expense of any 
lower-tier corporation any subpart F income (net of interest expense 
apportioned to such income).

Then apportion the interest expense of the higher-tier controlled 
foreign corporation based on the adjusted combined gross income amounts. 
Repeat this step 2 for each next higher-tier controlled foreign 
corporation in the chain. For purposes of this paragraph (j)(2)(ii), pro 
rata share shall be determined under principles similar to section 
951(a)(2).

[T.D. 8228, 53 FR 35477, Sept. 14, 1988, as amended by T.D. 8257, 54 FR 
31819, Aug. 2, 1989; T.D. 8597, 60 FR 36679, July 18, 1995; T.D. 8658, 
61 FR 9329, Mar. 8, 1996; T.D. 8916, 66 FR 273, Jan. 3, 2001]



Sec. 1.861-10  Special allocations of interest expense.

    (a)-(d) [Reserved]
    (e) Treatment of certain related group indebtedness--(1) In general. 
If, for any taxable year beginning after December 31, 1991, a U.S. 
shareholder (as defined in paragraph (e)(5)(i) of this section) has 
both--
    (i) Excess related group indebtedness (as determined under Step One 
in paragraph (e)(2) of this section) and
    (ii) Excess U.S. shareholder indebtedness (as determined under Step 
Two in paragraph (e)(3) of this section),

the U.S. shareholder shall allocate, to its gross income in the various 
separate limitation categories described in section 904(d)(1), a portion 
of its interest expense paid or accrued to any obligee who is not a 
member of the affiliated group (as defined in Sec. 1.861-11T(d)) of the 
U.S. shareholder (``third party interest expense''), excluding amounts 
allocated under paragraphs (b) and (c) of Sec. 1.861-10T. The amount of 
third party interest expense so allocated shall equal the total amount 
of interest income derived by the U.S. shareholder during the year from 
related group indebtedness, multiplied by the ratio of the lesser of the 
foregoing two amounts of excess indebtedness for the year to related 
group indebtedness for the year. This amount of third party interest 
expense is allocated as described in Step Three in paragraph (e)(4) of 
this section.
    (2) Step One: Excess related group indebtedness. (i) The excess 
related group indebtedness of a U.S. shareholder for the year equals the 
amount by which its related group indebtedness for the year exceeds its 
allowable related group indebtedness for the year.
    (ii) The ``related group indebtedness'' of the U.S. shareholder is 
the average of the aggregate amounts at the beginning and end of the 
year of indebtedness owed to the U.S. shareholder by each controlled 
foreign corporation which is a related person (as defined in paragraph 
(e)(5)(ii) of this section) with respect to the U.S. shareholder.
    (iii) The ``allowable related group indebtedness'' of a U.S. 
shareholder for the year equals--
    (A) The average of the aggregate values at the beginning and end of 
the year of the assets (including stock holdings in and obligations of 
related persons, other than related controlled

[[Page 187]]

foreign corporations) of each related controlled foreign corporation, 
multiplied by
    (B) The foreign base period ratio of the U.S. shareholder for the 
year.
    (iv) The ``foreign base period ratio'' of the U.S. shareholder for 
the year is the average of the related group debt-to-asset ratios of the 
U.S. shareholder for each taxable year comprising the foreign base 
period for the current year (each a ``base year''). For this purpose, 
however, the related group debt-to-asset ratio of the U.S. shareholder 
for any base year may not exceed 110 percent of the foreign base period 
ratio for that base year. This limitation shall not apply with respect 
to any of the five taxable years chosen as initial base years by the 
U.S. shareholder under paragraph (e)(2)(v) of this section or with 
respect to any base year for which the related group debt-to-asset ratio 
does not exceed 0.10.
    (v)(A) The foreign base period for any current taxable year (except 
as described in paragraphs (e)(2)(v) (B) and (C) of this section) shall 
consist of the five taxable years immediately preceding the current 
year.
    (B) The U.S. shareholder may choose as foreign base periods for all 
of its first five taxable years for which this paragraph (e) is 
effective the following alternative base periods:
    (1) For the first effective taxable year, the 1982, 1983, 1984, 1985 
and 1986 taxable years;
    (2) For the second effective taxable year, the 1983, 1984, 1985 and 
1986 taxable years and the first effective taxable year;
    (3) For the third effective taxable year, the 1984, 1985 and 1986 
taxable years and the first and second effective taxable years;
    (4) For the fourth effective taxable year, the 1985 and 1986 taxable 
years and the first, second and third effective taxable years; and
    (5) For the fifth effective taxable year, the 1986 taxable year and 
the first, second, third and fourth effective taxable years.
    (C) If, however, the U.S. shareholder does not choose, under 
paragraph (e)(10)(ii) of this section, to apply this paragraph (e) to 
one or more taxable years beginning before January 1, 1992, the U.S. 
shareholder may not include within any foreign base period the taxable 
year immediately preceding the first effective taxable year. Thus, for 
example, a U.S. shareholder for which the first effective taxable year 
is the taxable year beginning on October 1, 1992, may not include the 
taxable year beginning on October 1, 1991, in any foreign base period. 
Assuming that the U.S. shareholder does not elect the alternative base 
periods described in paragraph (e)(2)(v)(B) of this section, the initial 
foreign base period for the U.S. shareholder will consist of the taxable 
years beginning on October 1 of 1986, 1987, 1988, 1989, and 1990. The 
foreign base period for the U.S. shareholder for the following taxable 
year, beginning on October 1, 1993, will consist of the taxable years 
beginning on October 1 of 1987, 1988, 1989, 1990, and 1992.
    (D) If the U.S. shareholder chooses the base periods described in 
paragraph (e)(2)(v)(B) of this section as foreign base periods, it must 
make a similar election under paragraph (e)(3)(v)(B) of this section 
with respect to its U.S. base periods.
    (vi) The ``related group debt-to-asset ratio'' of a U.S. shareholder 
for a year is the ratio between--
    (A) The related group indebtedness of the U.S. shareholder for the 
year (as determined under paragraph (e)(2)(ii) of this section); and
    (B) The average of the aggregate values at the beginning and end of 
the year of the assets (including stock holdings in and obligations of 
related persons, other than related controlled foreign corporations) of 
each related controlled foreign corporation.
    (vii) Notwithstanding paragraph (e)(2)(i) of this section, a U.S. 
shareholder is considered to have no excess related group indebtedness 
for the year if--
    (A) Its related group indebtedness for the year does not exceed its 
allowable related group indebtedness for the immediately preceding year 
(as determined under paragraph (e)(2)(iii) of this section); or
    (B) Its related group debt-to-asset ratio (as determined under 
paragraph (e)(2)(vi) of this section) for the year does not exceed 0.10.

[[Page 188]]

    (3) Step Two: Excess U.S. shareholder indebtedness. (i) The excess 
indebtedness of a U.S. shareholder for the year equals the amount by 
which its unaffiliated indebtedness for the year exceeds its allowable 
indebtedness for the year.
    (ii) The ``unaffiliated indebtedness'' of the U.S. shareholder is 
the average of the aggregate amounts at the beginning and end of the 
year of indebtedness owed by the U.S. shareholder to any obligee, other 
than a member of the affiliated group (as defined in Sec. 1.861-11T(d)) 
of the U.S shareholder.
    (iii) The ``allowable indebtedness'' of a U.S. shareholder for the 
year equals--
    (A) The average of the aggregate values at the beginning and end of 
the year of the assets of the U.S. shareholder (including stock holdings 
in and obligations of related controlled foreign corporations, but 
excluding stock holdings in and obligations of members of the affiliated 
group (as defined in Sec. 1.861-11T(d)) of the U.S. shareholder), 
reduced by the amount of the excess related group indebtedness of the 
U.S. shareholder for the year (as determined under Step One in paragraph 
(e)(2) of this section), multiplied by
    (B) The U.S. base period ratio of the U.S. shareholder for the year.
    (iv) The ``U.S. base period ratio'' of the U.S. shareholder for the 
year is the average of the debt-to-asset ratios of the U.S. shareholder 
for each taxable year comprising the U.S. base period for the current 
year (each a ``base year''). For this purpose, however, the debt-to-
asset ratio of the U.S. shareholder for any base year may not exceed 110 
percent of the U.S. base period ratio for that base year. This 
limitation shall not apply with respect to any of the five taxable years 
chosen as initial base years by the U.S. shareholder under paragraph 
(e)(3)(v) of this section or with respect to any base year for which of 
the debt-to-asset ratio does not exceed 0.10.
    (v)(A) The U.S. base period for any current taxable year (except as 
described in paragraphs (e)(3)(v) (B) and (C) of this section) shall 
consist of the five taxable years immediately preceding the current 
year.
    (B) The U.S. shareholder may choose as U.S. base periods for all of 
its first five taxable years for which this paragraph (e) is effective 
the following alternative base periods:
    (1) For the first effective taxable year, the 1982, 1983, 1984, 1985 
and 1986 taxable years;
    (2) For the second effective taxable year, the 1983, 1984, 1985 and 
1986 taxable years and the first effective taxable year;
    (3) For the third effective taxable year, the 1984, 1985 and 1986 
taxable years and the first and second effective taxable years;
    (4) For the fourth effective taxable year, the 1985 and 1986 taxable 
years and the first, second and third effective taxable years; and
    (5) For the fifth effective taxable year, the 1986 taxable year and 
the first, second, third and fourth effective taxable years.
    (C) If, however, the U.S. shareholder does not choose, under 
paragraph (e)(10)(ii) of this section, to apply this paragraph (e) to 
one or more taxable years beginning before January 1, 1992, the U.S. 
shareholder may not include within any U.S. base period the taxable year 
immediately preceding the first effective taxable year. Thus, for 
example, a U.S. shareholder for which the first effective taxable year 
is the taxable year beginning on October 1, 1992, may not include the 
taxable year beginning on October 1, 1991, in any U.S. base period. 
Assuming that the U.S. shareholder does not elect the alternative base 
periods described in paragraph (e)(3)(v)(B) of this section, the initial 
U.S. base period for the U.S. shareholder will consist of the taxable 
years beginning on October 1, of 1986, 1987, 1988, 1989, and 1990. The 
U.S. base period for the U.S. shareholder for the following taxable 
year, beginning on October 1, 1993, will consist of the taxable years 
beginning on October 1, 1987, 1988, 1989, 1990, and 1992.
    (D) If the U.S. shareholder chooses the base periods described in 
paragraph (e)(3)(v)(B) of this section as U.S. base periods, it must 
make a similar election under paragraph (e)(2)(v)(B) of this section 
with respect to its foreign base periods.
    (vi) The ``debt-to-asset ratio'' of a U.S. shareholder for a year is 
the ratio between--

[[Page 189]]

    (A) The unaffiliated indebtedness of the U.S. shareholder for the 
year (as determined under paragraph (e)(3)(ii) of this section); and
    (B) The average of the aggregate values at the beginning and end of 
the year of the assets of the U.S. shareholder. For this purpose, the 
assets of the U.S. shareholder include stock holdings in and obligations 
of related controlled foreign corporations but do not include stock 
holdings in and obligations of members of the affiliated group (as 
defined in Sec. 1.861-11T(d)).
    (vii) A U.S. shareholder is considered to have no excess 
indebtedness for the year if its debt-to-asset ratio (as determined 
under paragraph (e)(3)(vi) of this section) for the year does not exceed 
0.10.
    (4) Step Three: Allocation of third party interest expense. (i) A 
U.S. shareholder shall allocate to its gross income in the various 
separate limitation categories described in section 904(d)(1) a portion 
of its third party interest expense incurred during the year equal in 
amount to the interest income derived by the U.S. shareholder during the 
year from allocable related group indebtedness.
    (ii) The ``allocable related group indebtedness'' of a U.S. 
shareholder for any year is an amount of related group indebtedness 
equal to the lesser of--
    (A) The excess related group indebtedness of the U.S. shareholder 
for the year (determined under Step One in paragraph (e)(2) of this 
section); or
    (B) The excess U.S. shareholder indebtedness for the year 
(determined under Step Two in paragraph (e)(3) of this section).
    (iii) The amount of interest income derived by a U.S. shareholder 
from allocable related group indebtedness during the year equals the 
total amount of interest income derived by the U.S. shareholder during 
the year with respect to related group indebtedness, multiplied by the 
ratio of allocable related group indebtedness for the year to the 
aggregate amount of related group indebtedness for the year.
    (iv) The portion of third party interest expense described in 
paragraph (e)(4)(i) of this section shall be allocated in proportion to 
the relative average amounts of related group indebtedness held by the 
U.S. shareholder in each separate limitation category during the year. 
The remaining portion of third party interest expense of the U.S. 
shareholder for the year shall be apportioned as provided in 
Secs. 1.861-8T through 1.861-13T, excluding paragraph (e) of Sec. 1.861-
10T and this paragraph (e).
    (v) The average amount of related group indebtedness held by the 
U.S. shareholder in each separate limitation category during the year 
equals the average of the aggregate amounts of such indebtedness in each 
separate limitation category at the beginning and end of the year. 
Solely for purposes of this paragraph (e)(4), each debt obligation of a 
related controlled foreign corporation held by the U.S. shareholder at 
the beginning or end of the year is attributed to separate limitation 
categories in the same manner as the stock of the obligor would be 
attributed under the rules of Sec. 1.861-12T(c)(3), whether or not such 
stock is held directly by the U.S. shareholder.
    (vi) The amount of third party interest expense of a U.S. 
shareholder allocated pursuant to this paragraph (e)(4) shall not exceed 
the total amount of the third party interest expense of the U.S. 
shareholder for the year (excluding any third party interest expense 
allocated under paragraphs (b) and (c) of Sec. 1.861-10T).
    (5) Definitions. For purposes of this paragraph (e), the following 
terms shall have the following meanings.
    (i) U.S. shareholder. The term ``U.S. shareholder'' has the same 
meaning as the term ``United States shareholder'' when used in section 
957, except that, in the case of a United States shareholder that is a 
member of an affiliated group (as defined in Sec. 1.861-11T(d)), the 
entire affiliated group is considered to constitute a single U.S. 
shareholder.
    (ii) Related person. For the definition of the term ``related 
person'', see Sec. 1.861-8T(c)(2). A controlled foreign corporation is 
considered ``related'' to a U.S. shareholder if it is a related person 
with respect to the U.S. shareholder.
    (6) Determination of asset values. A U.S. shareholder shall 
determine the values of the assets of each related controlled foreign 
corporation (for purposes of Step One in paragraph (e)(2) of this 
section) and the assets of the U.S.

[[Page 190]]

shareholder (for purposes of Step Two in paragraph (e)(3) of this 
section) for any year in accordance with the valuation method (tax book 
value or fair market value) elected for that year pursuant to 
Sec. 1.861-9T(g). However, solely for purposes of this paragraph (e), a 
U.S. shareholder may instead choose to determine the values of the 
assets of all related controlled foreign corporations by reference to 
their values as reflected on Forms 5471 (the annual information return 
with respect to each related controlled foreign corporation), subject to 
the translation rules of paragraph (e)(8)(i) of this section. This 
method of valuation may be used only if the taxable years of each of the 
related controlled foreign corporations begin with, or no more than one 
month earlier than, the taxable year of the U.S. shareholder. Once 
chosen for a taxable year, this method of valuation must be used in each 
subsequent taxable year and may be changed only with the consent of the 
Commissioner.
    (7) Adjustments to asset value. For purposes of apportioning 
remaining interest expense under Sec. 1.861-9T, a U.S. shareholder shall 
reduce (but not below zero) the value of its assets for the year (as 
determined under Sec. 1.861-9T (g) (3) or (h)) by an amount equal to the 
allocable related group indebtedness of the U.S. shareholder for the 
year (as determined under Step Three in paragraph (e)(4)(ii) of this 
section). This reduction is allocated among assets in each separate 
limitation category in proportion to the average amount of related group 
indebtedness held by the U.S. shareholder in each separate limitation 
category during the year (as determined under Step Three in paragraph 
(e)(4)(v) of this section).
    (8) Special rules--(i) Exchange rates. All indebtedness amounts and 
asset values (including current year and base year amounts and values) 
denominated in a foreign currency shall be translated into U.S. dollars 
at the exchange rate for the current year. The exchange rate for the 
current year may be determined under any reasonable method (e.g., 
average of month-end exchange rates for each month in the current year) 
if it is consistently applied to the current year and all base years. 
Once chosen for a taxable year, a method for determining an exchange 
rate must be used in each subsequent taxable year and will be treated as 
a method of accounting for purposes of section 446. A taxpayer may apply 
a different translation rule only with the prior consent of the 
Commissioner. In this regard, the Commissioner will be guided by the 
extent to which a different rule would reduce the comparability of 
dollar amounts of indebtedness and dollar asset values for the base 
years and the current year.
    (ii) Exempt assets. Solely for purposes of this paragraph (e), any 
exempt assets otherwise excluded under section 864(e)(3) and Sec. 1.861-
8T(d) shall be included as assets of the U.S. shareholder or related 
controlled foreign corporation.
    (iii) Exclusion of certain directly allocated indebtedness and 
assets. Qualified nonrecourse indebtedness (as defined in Sec. 1.861-
10T(b)(2)) and indebtedness incurred in connection with an integrated 
financial transaction (as defined in Sec. 1.861-10T(c)(2)) shall be 
excluded from U.S. shareholder indebtedness and related group 
indebtedness. In addition, assets which are the subject of qualified 
nonrecourse indebtedness or integrated financial transactions shall be 
excluded from the assets of the U.S. shareholder and each related 
controlled foreign corporation.
    (iv) Exclusion of certain receivables. Receivables between related 
controlled foreign corporations (or between members of the affiliated 
group constituting the U.S. shareholder) shall be excluded from the 
assets of the related controlled foreign corporation (or affiliated 
group member) holding such receivables. See also Sec. 1.861-11T(e)(1).
    (v) Classification of certain loans as related group indebtedness. 
If--
    (A) A U.S. shareholder owns stock in a related controlled foreign 
corporation which is a resident of a country that--
    (1) Does not impose a withholding tax of 5 percent or more upon 
payments of dividends to a U.S. shareholder; and
    (2) Does not, for the taxable year of the controlled foreign 
corporation, subject the income of the controlled foreign corporation to 
an income tax which is greater than that percentage specified under 
Sec. 1.954-1T(d)(1)(i) of the

[[Page 191]]

maximum rate of tax specified under section 11 of the Code, and
    (B) The controlled foreign corporation has outstanding a loan or 
loans to one or more other related controlled foreign corporations, or 
the controlled foreign corporation has made a direct or indirect capital 
contribution to one or more other related controlled foreign 
corporations which have outstanding a loan or loans to one or more other 
related controlled foreign corporations, then, to the extent of the 
aggregate amount of its capital contributions in taxable years beginning 
after December 31, 1986, to the related controlled foreign corporation 
that made such loans or additional contributions, the U.S. shareholder 
itself shall be treated as having made the loans decribed in paragraph 
(e)(8)(v)(B) of this section and, thus, such loan amounts shall be 
considered related group indebtedness. However, for purposes of 
paragraph (e)(4) of this section, interest income derived by the U.S. 
shareholder during the year from related group indebtedness shall not 
include any income derived with respect to the U.S. shareholder's 
ownership of stock in the related controlled foreign corporation that 
made such loans or additional contributions.
    (vi) Classification of certain stock as related person indebtedness. 
In determining the amount of its related group indebtedness for any 
taxable year, a U.S. shareholder must treat as related group 
indebtedness its holding of stock in a related controlled foreign 
corporation if, during such taxable year, such related controlled 
foreign corporation claims a deduction for interest under foreign law 
for distributions on such stock. However, for purposes of paragraph 
(e)(4) of this section, interest income derived by the U.S. shareholder 
during the year from related group indebtedness shall not include any 
income derived with respect to the U.S. shareholder's ownership of stock 
in the related controlled foreign corporation.
    (9) Corporate events--(i) Initial acquisition of a controlled 
foreign corporation. If the foreign base period of the U.S. shareholder 
for any year includes a base year in which the U.S. shareholder did not 
hold stock in any related controlled foreign corporation, then, in 
computing the foreign base period ratio, the related group debt-to-asset 
ratio of the U.S. shareholder for any such base year shall be deemed to 
be 0.10.
    (ii) Incorporation of U.S. shareholder--(A) Nonapplication. This 
paragraph (e) does not apply to the first taxable year of the U.S. 
shareholder. However, this paragraph (e) does apply to all following 
years, including years in which later members of the affiliated group 
may be incorporated.
    (B) Foreign and U.S. base period ratios. In computing the foreign 
and U.S. base period ratios, the foreign and U.S. base periods of the 
U.S. shareholder shall be considered to be only the period prior to the 
current year that the U.S. shareholder was in existence if this prior 
period is less than five taxable years.
    (iii) Acquisition of additional corporations. (A) If a U.S. 
shareholder acquires (directly or indirectly) stock of a foreign or 
domestic corporation which, by reason of the acquisition, then becomes a 
related controlled foreign corporation or a member of the affiliated 
group, then in determining excess related group indebtedness or excess 
U.S. shareholder indebtedness, the indebtedness and assets of the 
acquired corporation shall be taken into account only at the end of the 
acquisition year and in following years. Thus, amounts of indebtedness 
and assets and the various debt-to-asset ratios of the U.S. shareholder 
existing at the beginning of the acquisition year or relating to 
preceding years are not recalculated to take account of indebtedness and 
assets of the acquired corporation existing as of dates before the end 
of the year. If, however, a major acquisition is made within the last 
three months of the year and a substantial distortion of values for the 
year would otherwise result, the taxpaper must take into account the 
average values of the acquired indebtedness and assets weighted to 
reflect the time such indebtedness is owed and such assets are held by 
the taxpayer during the year.
    (B) In the case of a reverse acquisition subject to this paragraph 
(e)(9), the rules of Sec. 1.1502-75(d)(3) apply in determining which 
corporations are the acquiring and acquired corporations. For this 
purpose, whether corporations

[[Page 192]]

are affiliated is determined under Sec. 1.861-11T(d).
    (C) If the stock of a U.S. shareholder is acquired by (and, by 
reason of such acquisition, the U.S. shareholder becomes affiliated 
with) a corporation described below, then such U.S. shareholder shall be 
considered to have acquired such corporation for purposes of the 
application of the rules of this paragraph (e). A corporation to which 
this paragraph (e)(9)(iii)(C) applies is--
    (1) A corporation which is not affiliated with any other corporation 
(other than other similarly described corporation); and
    (2) Substantially all of the assets of which consist of cash, 
securities and stock.
    (iv) Election to compute base period ratios by including acquired 
corporations. A U.S. shareholder may choose, solely for purposes of 
paragraph (e)(9) (i) and (iii) of this section, to compute its foreign 
and U.S. base period ratios for the acquisition year and all subsequent 
years by taking into account the indebtedness and asset values of the 
acquired corporation or corporations (including related group 
indebtedness owed to a former U.S. shareholder) at the beginning of the 
acquisition year and in each of the five base years preceding the 
acquisition year. This election, if made for an acquisition, must be 
made for all other acquisitions occurring during the same taxable year 
or initiated in that year and concluded in the following year.
    (v) Dispositions. If a U.S. shareholder disposes of stock of a 
foreign or domestic corporation which, by reason of the disposition, 
then ceases to be a related controlled foreign corporation or a member 
of the affiliated group (unless liquidated or merged into a related 
corporation), in determining excess related group indebtedness or excess 
U.S. shareholder indebtedness, the indebtedness and assets of the 
divested corporation shall be taken into account only at the beginning 
of the disposition year and for the relevant preceding years. Thus, 
amounts of indebtedness and assets and the various debt-to-asset ratios 
of the U.S. shareholder existing at the end of the year or relating to 
following years are not affected by indebtedness and assets of the 
divested corporation existing as of dates after the beginning of the 
year. If, however, a major disposition is made within the first three 
months of the year and a substantial distortion of values for the year 
would otherwise result, the taxpayer must take into account the average 
values of the divested indebtedness and assets weighted to reflect the 
time such indebtedness is owed and such assets are held by the taxpayer 
during the year.
    (vi) Election to compute base period ratios by excluding divested 
corporations. A U.S. shareholder may choose, solely for purposes of 
paragraph (e) (9) (v) and (vii) of this section, to compute its foreign 
and U.S. base period ratios for the disposition year and all subsequent 
years without taking into account the indebtedness and asset values of 
the divested corporation or corporations at the beginning of the 
disposition year and in each of the five base years preceding the 
disposition year. This election, if made for a disposition, must be made 
for all other dispositions occurring during the same taxable year or 
initiated in that year and concluded in the following year.
    (vii) Section 355 transactions. A U.S. corporation which becomes a 
separate U.S. shareholder as a result of a distribution of its stock to 
which section 355 applies shall be considered--
    (A) As disposed of by the U.S. shareholder of the affiliated group 
of which the distributing corporation is a member, with this disposition 
subject to the rules of paragraphs (e) (9) (v) and (vi) of this section; 
and
    (B) As having the same related group debt-to-asset ratio and debt-
to-asset ratio as the distributing U.S. shareholder in each year 
preceding the year of distribution for purposes of applying this 
paragraph (e) to the year of distibution and subsequent years of the 
distributed corporation.
    (10) Effective date--(i) Taxable years beginning after December 31, 
1991. The provisions of this paragraph (e) apply to all taxable years 
beginning after December 31,1991.
    (ii) Taxable years beginning after December 31, 1987 and before 
January 1, 1992. The provisions of Sec. 1.861-10T (e) apply to taxable 
years beginning after December 31, 1987, and before January

[[Page 193]]

1, 1992. The taxpayer may elect to apply the provisions of this 
paragraph (e) (in lieu of the provisions of Sec. 1.861-10T (e)) for any 
taxable year beginning after December 31, 1987, but this paragraph (e) 
must then be applied to all subsequent taxable years.
    (11) The following example illustrates the provisions of this 
paragraph (e):

    Example. (i) Facts. X, a domestic corporation, elects to apply this 
paragraph (e) to its 1990 tax year. X has a calendar taxable year and 
apportions its interest expense on the basis of the tax book value of 
its assets. In 1990, X incurred deductible third-party interest expense 
of $24,960 on an average amount of indebtedness (determined on the basis 
of beginning-of-year and end-of-year amounts) of $249,600. X 
manufactures widgets, all of which are sold in the United States. X owns 
all of the stock of Y, a controlled foreign corporation that also has a 
calendar taxable year and is also engaged in the manufacture and sale of 
widgets. Y has no earnings and profits or deficit of earnings and 
profits attributable to taxable years prior to 1987. X's total assets 
and their average tax book values (determined on the basis of beginning-
of-year and end-of-year tax book values) for 1990 are:

------------------------------------------------------------------------
                                                             Average tax
                           Asset                              book value
------------------------------------------------------------------------
Plant and equipment........................................     $315,000
Corporate headquarters.....................................       60,000
Y stock....................................................       75,000
Y note.....................................................       50,000
    Total..................................................      500,000
------------------------------------------------------------------------

    Y had $25,000 of income before the deduction of any interest 
expense. Of this total, $5,000 is high withholding tax interest income. 
The remaining $20,000 is derived from widget sales, and constitutes 
foreign source general limitation income. Assume that Y has no 
deductions from gross income other than interest expense. During 1990, Y 
paid $5,000 of interest expense to X on the Y note and $10,000 of 
interest expense to third parties, giving Y total interest expense of 
$15,000. X elects pursuant to Sec. 1.861-9T to apportion Y's interest 
expense under the gross income method prescribed in section 1.861-9T 
(j).
    (ii) Step 1: Using a beginning and end of year average, X (the U.S. 
shareholder) held the following average amounts of indebtedness of Y and 
Y had the following average asset values:

----------------------------------------------------------------------------------------------------------------
                                                                  1985       1986-88        1989         1990
----------------------------------------------------------------------------------------------------------------
(A) Related group indebtedness..............................      $11,000       24,000       26,000       50,000
(B) Average Value of Assets of Related CFC..................      100,000      200,000      200,000      250,000
(C) Related Group Debt-to-Asset Ratio.......................          .11          .12          .13          .20
----------------------------------------------------------------------------------------------------------------

    (1) X's ``foreign base period ratio'' for 1990, an average of its 
ratios of related group indebtedness to related group assets for 1985 
through 1989, is:

(.11+.12+.12+.12+.13)/5=.12

    (2) X's ``allowable related group indebtedness'' for 1990 is:

$250,000x.12=$30,000.

    (3) X's ``excess related group indebtedness'' for 1990 is:

$50,000-$30,000=$20,000

    X's related group indebtedness of $50,000 for 1990 is greater than 
its allowable related group indebtedness of $24,000 for 1989 (assuming a 
foreign base period ratio in 1989 of .12), and X's related group debt-
to-asset ratio for 1990 is .20, which is greater than the ratio of .10 
described in paragraph (e)(2)(vii)(B) of this section. Therefore, X's 
excess related group indebtedness for 1990 remains at $20,000.
    (iii) Step 2: Using a beginning and end of year average, X has the 
following average amounts of U.S. and foreign indebtedness and average 
asset values:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                               1985            1986            1987            1988            1989            1990
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1).....................................................        $231,400         225,000         225,000         225,000         220,800         249,600
(2).....................................................         445,000         450,000         450,000         450,000         460,000         480,000
                                                                                                                                                     (a)
(3).....................................................             .52             .50             .50             .50             .48             .52
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (1) U.S. and foreign indebtedness
    (2) Average value of assets of U.S. shareholder
    (3) Debt-to-Asset ratio of U.S. shareholder
    (a) [500,000-20,000 (excess related group indebtedness determined in 
Step 1)]
    X's ``U.S. base period ratio'' for 1990 is:

(.52+.50+.50+.50+.48)/5=.50


[[Page 194]]


    X's ``allowable indebtedness'' for 1990 is:

$480,000x.50=$240,000

    X's ``excess U.S. shareholder indebtedness'' for 1990 is:

$249,000-$240,000=$9,600

    X's debt-to-asset ratio for 1990 is .52, which is greater than the 
ratio of .10 described in paragraph (e)(3)(vii) of this section. 
Therefore, X's excess U.S. shareholder indebtedness for 1990 remains at 
$9,600.
    (iv) Step 3: (a) Since X's excess U.S. shareholder indebtedness of 
$9,600 is less than its excess related group indebtedness of $20,000, 
X's allocable related group indebtedness for 1990 is $9,600. The amount 
of interest received by X during 1990 on allocable related group 
indebtedness is:

$5,000x$9,600/$50,000=$960

    (b) Therefore, $960 of X's third party interest expense ($24,960) 
shall be allocated among various separate limitation categories in 
proportion to the relative average amounts of Y obligations held by X in 
each such category. The amount of Y obligations in each limitation 
category is determined in the same manner as the stock of Y would be 
attributed under the rules of Sec. 1.861-12T(c)(3). Since Y's interest 
expense is apportioned under the gross income method prescribed in 
Sec. 1.861-9T (j), the Y stock must be characterized under the gross 
income method described in Sec. 1.861-12T(c)(3)(iii). Y's gross income 
net of interest expense is determined as follows:

Foreign source high withholding tax interest income
    =$5,000-[($15,000) multiplied by ($5,000)/($5,000+$20,000)]
    =$2,000
        and
Foreign source general limitation income
    =$20,000-[($15,000) multiplied by ($20,000)/($5,000+$20,000)]
    =$8,000.

    (c) Therefore, $192 [($960x$2,000/($2,000+$8,000)] of X's third 
party interest expense is allocated to foreign source high withholding 
tax interest income and $768 [$960x$8,000/($2,000+$8,000)] is allocated 
to foreign source general limitation income.
    (v) As a result of these direct allocations, for purposes of 
apportioning X's remaining interest expense under Sec. 1.861-9T, the 
value of X's assets generating foreign source general limitation income 
is reduced by the principal amount of indebtedness the interest on which 
is directly allocated to foreign source general limitation income 
($7,680), and the value of X's assets generating foreign source high 
withholding tax interest income is reduced by the principal amount of 
indebtedness the interest on which is directly allocated to foreign 
source high withholding tax interest income ($1,920), determined as 
follows:
    Reduction of X's assets generating foreign source general limitation 
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.002

    Reduction of X's assets generating foreign source high withholding 
tax interest income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.003


[T.D. 8410, 57 FR 13022, Apr. 15, 1992; 57 FR 28012, June 23, 1992]

[[Page 195]]



Sec. 1.861-10T  Special allocations of interest expense (temporary regulations).

    (a) In general. This section applies to all taxpayers and provides 
three exceptions to the rules of Sec. 1.861-9T that require the 
allocation and apportionment of interest expense on the basis of all 
assets of all members of the affiliated group. Paragraph (b) of this 
section describes the direct allocation of interest expense to the 
income generated by certain assets that are subject to qualified 
nonrecourse indebtedness. Paragraph (c) of this section describes the 
direct allocation of interest expense to income generated by certain 
assets that are acquired in integrated financial transaction. Paragraph 
(d) of this section provides special rules that are applicable to all 
transactions described in paragraphs (b) and (c) of this section. 
Paragraph (e) of this section requires the direct allocation of third 
party interest of an affiliated group to such group's investment in 
related controlled foreign corporations in cases involving excess 
related person indebtedness (as defined therein). See also Sec. 1.861-
9T(b)(5), which requires direct allocation of amortizable bond premium.
    (b) Qualified nonrecourse indebtedness--(1) In general. In the case 
of qualified nonrecourse indebtedness (as defined in paragraph (b)(2) of 
this section), the deduction for interest shall be considered directly 
allocable solely to the gross income which the property acquired, 
constructed, or improved with the proceeds of the indebtedness 
generates, has generated, or could reasonably be expected to generate.
    (2) Qualified nonrecourse indebtedness defined. The term ``qualified 
nonrecourse indebtedness'' means any borrowing that is not excluded by 
paragraph (b)(4) of this section if:
    (i) The borrowing is specifically incurred for the purpose of 
purchasing, constructing, or improving identified property that is 
either depreciable tangible personal property or real property with a 
useful life of more than one year or for the purpose of purchasing 
amortizable intangible personal property with a useful life of more than 
one year;
    (ii) The proceeds are actually applied to purchase, construct, or 
improve the identified property;
    (iii) Except as provided in paragraph (b)(7)(ii) (relating to 
certain third party guarantees in leveraged lease transactions), the 
creditor can look only to the identified property (or any lease or other 
interest therein) as security for payment of the principal and interest 
on the loan and, thus, cannot look to any other property, the borrower, 
or any third party with respect to repayment of principal or interest on 
the loan;
    (iv) The cash flow from the property, as defined in paragraph (b)(3) 
of this section, is reasonably expected to be sufficient in the first 
year of ownership as well as in each subsequent year of ownership to 
fulfill the terms and conditions of the loan agreement with respect to 
the amount and timing of payments of interest and original issue 
discount and periodic payments of principal in each such year; and
    (v) There are restrictions in the loan agreement on the disposal or 
use of the property consistent with the assumptions described in 
subdivisions (iii) and (iv) of this paragraph (b)(2).
    (3) Cash flow defined--(i) In general. The term ``cash flow from the 
property'' as used in paragraph (b)(2)(iv) of this section means a 
stream of revenue (as computed under paragraph (b)(3)(ii) of this 
section) substantially all of which derives directly from the property. 
The phrase ``cash flow from the property'' does not include revenue if a 
significant portion thereof is derived from activities such as sales, 
labor, services, or the use of other property. Thus, revenue derived 
from the sale or lease of inventory or of similar property does not 
constitute cash flow from the property, including plant or equipment 
used in the manufacture and sale or lease, or purchase and sale or 
lease, of such inventory or similar property. In addition, revenue 
derived in part from the performance of services that are not ancillary 
and subsidiary to the use of property does not constitute cash flow from 
the property.
    (ii) Self-constructed assets. The activities associated with self-
construction of assets shall be considered to constitute labor or 
services for purposes of

[[Page 196]]

paragraph (b)(3)(i) only if the self-constructed asset--
    (A) Is constructed for the purpose of resale, or
    (B) Without regard to purpose, is sold to an unrelated person within 
one year from the date that the property is placed in service for 
purposes of section 167.
    (iii) Computation of cash flow. Cash flow is computed by subtracting 
cash disbursements excluding debt service from cash receipts.
    (iv) Analysis of operating costs. [Reserved]
    (v) Examples. The principles of this paragraph may be demonstrated 
by the following examples.

    Example 1. In 1987, X borrows $100,000 in order to purchase an 
apartment building, which X then purchases. The loan is secured only by 
the building and the leases thereon. Annual debt service on the loan is 
$12,000. Annual gross rents from the building are $20,000. Annual taxes 
on the building are $2,000. Other expenses deductible under section 162 
are $2,000. Rents are reasonably expected to remain stable or increase 
in subsequent years, and taxes and expenses are reasonably expected to 
remain proportional to gross rents in subsequent years. X provides 
security, maintenance, and utilities to the tenants of the building. 
Based on facts and circumstances, it is determined that, although 
services are provided to tenants, these services are ancillary and 
subsidiary to the occupancy of the apartments. Accordingly, the case 
flow of $16,000 is considered to constitute a return from the property. 
Furthermore, such cash flow is sufficient to fulfill the terms and 
conditions of the loan agreement as required by paragraph (b)(2)(iii).
    Example 2. In 1987, X borrows funds in order to purchase a hotel, 
which X then purchases and operates. The loan is secured only by the 
hotel. Based on facts and circumstances, it is determined that the 
operation of the hotel involves services the value of which is 
significant in relation to amounts paid to occupy the rooms. Thus, a 
significant portion of the cash flow is derived from the performance of 
services incidental to the occupancy of hotel rooms. Accordingly, the 
cash flow from the hotel is considered not to constitute a return on or 
from the property.
    Example 3. In 1987, X borrows funds in order to build a factory, 
which X then builds and operates. The loan is secured only by the 
factory and the equipment therein. Based on the facts and circumstances, 
it is determined that the operation of the factory involves significant 
expenditures for labor and raw materials. Thus, a significant portion of 
the cash flow is derived from labor and the processing of raw materials. 
Accordingly, the cash flow from the factory is considered not to 
constitute a return on or from the property.

    (4) Exclusions. The term ``qualified nonrecourse indebtedness' shall 
not include any transaction that--
    (i) Lacks economic significance within the meaning of paragraph 
(b)(5) of this section;
    (ii) Involves cross collateralization within the meaning of 
paragraph (b)(6) of this section;
    (iii) Except in the case of a leveraged lease described in paragraph 
(b)(7)(ii) of this section, involves credit enhancement within the 
meaning of paragraph (b)(7) of this section or, with respect to loans 
made on or after October 14, 1988, does not under the terms of the loan 
documents, prohibit the acquisition by the holder of bond insurance or 
similar forms of credit enhancement;
    (iv) Involves the purchase of inventory;
    (v) Involves the purchase of any financial asset, including stock in 
a corporation, an interest in a partnership or a trust, or the debt 
obligation of any obligor (although interest incurred in order to 
purchase certain financial instruments may qualify for direct allocation 
under paragraph (c) of this section);
    (vi) Involves interest expense that constitutes qualified residence 
interest as defined in section 163(h)(3); or
    (vii) [Reserved]
    (5) Economic significance. Indebtedness that otherwise qualifies 
under paragraph (b)(2) shall nonetheless be subject to apportionment 
under Sec. 1.861-9T if, taking into account all the facts and 
circumstances, the transaction (including the security arrangement) 
lacks economic significance.
    (6) Cross collateralization. The term ``cross collateralization'' 
refers to the pledge as security for a loan of--
    (i) Any asset of the borrower other than the identified property 
described in paragraph (b)(2) of this section, or
    (ii) Any asset belonging to any related person, as defined in 
Sec. 1.861-8T(c)(2).
    (7) Credit enhancement--(i) In general. Except as provided in 
paragraph (b)(7)(ii) of this section, the term

[[Page 197]]

``credit enhancement'' refers to any device, including a contract, 
letter of credit, or guaranty, that expands the creditor's rights, 
directly or indirectly, beyond the identified property purchased, 
constructed, or improved with the funds advanced and, thus effectively 
provides as security for a loan the assets of any person other than the 
borrower. The acquisition of bond insurance or any other contract of 
suretyship by an initial or subsequent holder of an obligation shall 
constitute credit enhancement.
    (ii) Special rule for leveraged leases. For purposes of this 
paragraph (b), the term ``credit enhancement'' shall not include any 
device under which any person that is not a related person within the 
meaning of Sec. 1.861-8T(c)(2) agrees to guarantee, without recourse to 
the lessor or any person related to the lessor, a lessor's payment of 
principal and interest on indebtedness that was incurred in order to 
purchase or improve an asset that is depreciable tangible personal 
property or depreciable tangible real property (and the land on which 
such real property is situated) that is leased to a lessee that is not a 
related person in a transaction that constitutes a lease for federal 
income tax purposes.
    (iii) Syndication of credit risk and sale of loan participations. 
The term ``syndication of credit risk'' refers to an arrangement in 
which one primary lender secures the promise of a secondary lender to 
bear a portion of the primary lender's credit risk on a loan. The term 
``sale of loan participations'' refers to an arrangement in which one 
primary lender divides a loan into several portions, sells and assigns 
all rights with respect to one or more portions to participating 
secondary lenders, and does not remain at risk in any manner with 
respect to the portion assigned. For purposes of this paragraph (b), the 
syndication of credit risk shall constitute credit enhancement because 
the primary lender can look to secondary lenders for payment of the 
loan, notwithstanding limitations on the amount of the secondary 
lender's liability. Conversely, the sale of loan participations does not 
constitute credit enhancement, because the holder of each portion of the 
loan can look solely to the asset securing the loan and not to the 
credit or other assets of any person.
    (8) Other arrangements that do not constitute cross 
collateralization or credit enhancement. For purposes of paragraphs (b) 
(6) and (7) of this section, the following arrangements do not 
constitute cross collateralization or credit enhancement:
    (i) Integrated projects. A taxpayer's pledge of multiple assets of 
an integrated project, provided that the integrated project. An 
integrated project consists of functionally related and geographically 
contiguous assets that, as to the taxpayer, are used in the same trade 
or business.
    (ii) Insurance. A taxpayer's purchase of third-party casualty and 
liability insurance on the collateral or, by contract, bearing the risk 
of loss associated with destruction of the collateral or with respect to 
the attachment of third party liability claims.
    (iii) After-acquired property. Extension of a creditor's security 
interest to improvements made to the collateral, provided that the 
extension does not constitute excess collateralization under paragraph 
(b)(6), determined by taking into account the value of improvements at 
the time the improvements are made and the value of the original 
property at the time the loan was made.
    (iv) Warranties of completion and maintenance. A taxpayer's warranty 
to a creditor that it will complete construction or manufacture of the 
collateral or that it will maintain the collateral in good condition.
    (v) Substitution of collateral. A taxpayer's right to substitute 
collateral under any loan contract. However, after the right is 
exercised, the loan shall no longer constitute qualified nonrecourse 
indebtedness.
    (9) Refinancings. If a taxpayer refinances qualified nonrecourse 
indebtedness (as defined in paragraph (b)(2) of this section) with new 
indebtedness, such new indebtedness shall continue to qualify only if--
    (i) The principal amount of the new indebtedness does not exceed by 
more than five percent the remaining principal amount of the original 
indebtedness,

[[Page 198]]

    (ii) The term of the new indebtedness does not exceed by more than 
six months the remaining term of the original indebtedness, and
    (iii) The requirements of this paragraph (other than those of 
paragraph (b)(2) (i) and (ii) of this section) are satisfied at the time 
of the refinancing, and the exclusions contained in this paragraph 
(b)(4) do not apply.
    (10) Post-construction permanent financing. Financing that is 
obtained after the completion of constructed property will be deemed to 
satisfy the requirements of paragraph (b)(2) (i) and (ii) of this 
section if--
    (i) The financing is obtained within one year after the constructed 
property or substantially all of a constructed integrated project (as 
defined in paragraph (b)(9)(i) of this section) is placed in service for 
purposes of section 167; and
    (ii) The financing does not exceed the cost of construction 
(including construction period interest).
    (11) Assumptions of pre-existing qualified nonrecourse indebtedness. 
If a transferee of property that is subject to qualified nonrecourse 
indebtedness assumes such indebtedness, the indebtedness shall continue 
to constitute qualified nonrecourse indebtedness, provided that the 
assumption in no way alters the qualified status of the debt.
    (12) Excess collateralization. [Reserved]
    (c) Direct allocations in the case of certain integrated financial 
transactions--(1) General rule. Interest expense incurred on funds 
borrowed in connection with an integrated financial transaction (as 
defined in paragraph (c)(2) of this section) shall be directly allocated 
to the income generated by the investment funded with the borrowed 
amounts.
    (2) Definition. The term ``integrated financial transaction'' refers 
to any transaction in which--
    (i) The taxpayer--
    (A) Incurs indebtedness for the purpose of making an identified term 
investment,
    (B) Identifies the indebtedness as incurred for such purpose at the 
time the indebtedness is incurred, and
    (C) Makes the identified term investment within ten business days 
after incurring the indebtedness;
    (ii) The return on the investment is reasonably expected to be 
sufficient throughout the term of the investment to fulfill the terms 
and conditions of the loan agreement with respect to the amount and 
timing of payments of principal and interest or original issue discount;
    (iii) The income constitutes interest or original issue discount or 
would constitute income equivalent to interest if earned by a controlled 
foreign corporation (as described in Sec. 1.954-2T(h));
    (iv) The debt incurred and the investment mature within ten business 
days of each other;
    (v) The investment does not relate in any way to the operation of, 
and is not made in the normal course of, the trade or business of the 
taxpayer or any related person, including the financing of the sale of 
goods or the performance of services by the taxpayer or any related 
person, or the compensation of the taxpayer's employees (including any 
contribution or loan to an employee stock ownership plan (as defined in 
section 4975(e)(7)) or other plan that is qualified under section 
401(a)); and
    (vi) The borrower does not constitute a financial services entity 
(as defined in section 904 and the regulations thereunder).
    (3) Rollovers. In the event that a taxpayer sells of otherwise 
liquidates an investment described in paragraph (c)(2) of this section, 
the interest expense incurred on the borrowing shall, subsequent to that 
liquidation, no longer qualify for direct allocation under this 
paragraph (c).
    (4) Examples. The principles of this paragraph (c) may be 
demonstrated by the following examples.

    Example 1. X is a manufacturer and does not constitute a financial 
services entity as defined in the regulations under section 904. On 
January 1, 1988, X borrows $100 for 6 months at an annual interest rate 
of 10 percent. X identifies on its books and records by the close of 
that day that the indebtedness is being incurred for the purpose of 
making an investment that is intended to qualify as an integrated 
financial transaction. On January 5, 1988, X uses the proceeds to 
purchase a portfolio of stock that approximates the composition of the 
Standard & Poor's 500 Index. On that day, X also enters into a forward 
sale contract that requires X to sell the stock on June 1, 1988 for 
$110. X identifies on its books and records by the close of January

[[Page 199]]

5, 1988, that the portfolio stock purchases and the forward sale 
contract constitute part of the integrated financial transaction with 
respect to which the identified borrowing was incurred. Under 
Sec. 1.954-2T(h), the income derived from the transaction would 
constitute income equivalent to interest. Assuming that the return on 
the investment to be derived on June 1, 1988, will be sufficient to pay 
the interest due on June 1, 1988, the interest on the borrowing is 
directly allocated to the gain from the investment.
    Example 2. X does not constitute a financial services entity as 
defined in the regulations under section 904. X is in the business of, 
among other things, issuing credit cards to consumers and purchasing 
from merchants who accept the X card the receivables of consumers who 
make purchases with the X card. X borrows from Y in order to purchase X 
credit card receivables from Z, a merchant. Assuming that the Y 
borrowing satisfies the other requirements of paragraph (c)(2) of this 
section, the transaction nonetheless cannot constitute an integrated 
financial transaction because the purchase relates to the operation of 
X's trade or business.
    Example 3. Assume the same facts as in Example 2, except that X 
borrows in order to purchase the receivables of A, a merchant who does 
not accept the X card and is not otherwise engaged directly or 
indirectly in any business transaction with X. Because the borrowing is 
not related to the operation of X's trade or business, the borrowing may 
qualify as an integrated financial transaction if the other requirements 
of paragraph (c)(2) of this section are satisfied.

    (d) Special rules. In applying paragraphs (b) and (c) of this 
section, the following special rules shall apply.
    (1) Related person transactions. The rules of this section shall not 
apply to the extent that any transaction--
    (i) Involves either indebtedness between related persons (as defined 
in section Sec. 1.861-8T(c)(2)) or indebtedness incurred from unrelated 
persons for the purpose of purchasing property from a related person; or
    (ii) Involves the purchase of property that is leased to a related 
person (as defined in Sec. 1.861-8T(c)(2)) in a transaction described in 
paragraph (b) of this section. If a taxpayer purchases property and 
leases such property in whole or in part to a related person, a portion 
of the interest incurred in connection with such an acquisition, based 
on the ratio that the value of the property leased to the related person 
bears to the total value of the property, shall not qualify for direct 
allocation under this section.
    (2) Consideration of assets or income to which interest is directly 
allocated in apportioning other interest expense. In apportioning 
interest expense under Sec. 1.861-9T, the year-end value of any asset to 
which interest expense is directly allocated under this section during 
the current taxable year shall be reduced to the extent provided in 
Sec. 1.861-9T(g)(2)(iii) to reflect the portion of the principal amount 
of the indebtedness outstanding at year-end relating to the interest 
which is directly allocated. A similar adjustment shall be made to the 
end-of-year value of assets for the prior year for purposes of 
determining the beginning-of-year value of assets for the current year. 
These adjustments shall be made prior to averaging beginning-of-year and 
end-of-year values pursuant to Sec. 1.861-9T(g)(2). In apportioning 
interest expense under the modified gross income method, gross income 
shall be reduced by the amount of income to which interest expense is 
directly allocated under this section.
    (e) Treatment of certain related controlled foreign corporation 
indebtedness--(1) In general. In taxable years beginning after 1987, if 
a United States shareholder has incurred substantially disproportionate 
indebtedness in relation to the indebtedness of its related controlled 
foreign corporations so that such corporations have excess related 
person indebtedness (as determined under step 4 in subdivision (iv) of 
this paragraph (e)(1), the third party interest expense of the related 
United States shareholder (excluding amounts allocated under paragraphs 
(b) and (c)) in an amount equal to the interest income received on such 
excess related person indebtedness shall be allocated to gross income in 
the various separate limitation categories described in section 
904(d)(1) in the manner prescribed in step 6 in subdivision (vi) of this 
paragraph (e)(1). This computation shall be performed as follows.
    (i) Step 1: Compute the debt-to-asset ratio of the related United 
States shareholder. The debt-to-asset ratio of the related United States 
shareholder is the ratio between--

[[Page 200]]

    (A) The average month-end debt level of the related United States 
shareholder taking into account debt owing to any obligee who is not a 
related person as defined in section Sec. 1.861-8T(c)(2), and
    (B) The value of assets (tax book or fair market) of the related 
United States shareholder including stockholdings and obligations of 
related controlled foreign corporations but excluding stockholdings and 
obligations of members of the affiliated group (as defined in 
Sec. 1.861-11T(d)).
    (ii) Step 2: Compute aggregate debt-to-asset ratio of all related 
controlled foreign corporations. The aggregate debt-to-asset ratio of 
all related controlled foreign corporations is the ratio between--
    (A) The average aggregate month-end debt level of all related 
controlled foreign corporations for their taxable years ending during 
the related United States shareholder's taxable year taking into account 
only indebtedness owing to persons other than the related United States 
shareholder or the related United States shareholder's other related 
controlled foreign corporations (``third party indebtedness''), and
    (B) The aggregate value (tax book or fair market) of the assets of 
all related controlled foreign corporations for their taxable years 
ending during the related United States shareholder's taxable year 
excluding stockholdings in and obligations of the related United States 
shareholder or the related United States shareholder's other related 
controlled foreign corporations.
    (iii) Step 3: Compute aggregate related person debt of all related 
controlled foreign corporations. This amount equals the average 
aggregate month-end debt level of all related controlled foreign 
corporations for their taxable years ending with or within the related 
United States shareholder's taxable year, taking into account only debt 
which is owned to the related United States shareholder (``related 
person indebtedness'').
    (iv) Step 4: Computation of excess related person indebtedness and 
computation of the income therefrom--(A) General rule. If the ratio 
computed under step 2 is less than applicable percentage of the ratio 
computed under step 1, the taxpayer shall add to the aggregate third 
party indebtedness of all related controlled foreign corporations 
determined under paragraph (e)(1)(ii)(A) of this section that portion of 
the related person indebtedness computed under step 3 that, when 
combined with the aggregate third party indebtedness of all controlled 
foreign corporations, makes the ratio computed under step 2 equal to 
applicable percentage of the ratio computed under step 1. The amount of 
aggregate related person debt that is so added to the aggregate third 
party debt of related controlled foreign corporations is considered to 
constitute excess related person indebtedness. For purposes of this 
paragraph (e)(1)(iv)(A), the term ``applicable percentage'' means the 
designated percentages for taxable years beginning during the following 
calendar years:

------------------------------------------------------------------------
                                                              Applicable
                 Taxable years beginning in                   percentage
------------------------------------------------------------------------
1988........................................................         50
1989........................................................         65
1990 and thereafter.........................................         80
------------------------------------------------------------------------

    (B) Elective quadratic formula. In calculating the amount of excess 
related party indebtedness of related controlled foreign corporations, 
the United States shareholder's debt-to-asset ratio may be adjusted to 
reflect the amount by which its debt and assets would be reduced had the 
related controlled foreign corporations incurred the excess related 
party indebtedness directly to third parties. In such case, the ratio 
computed in Step 1 is adjusted to reflect a reduction of both portions 
of the ratio by the amount of excess related person indebtedness as 
computed under this paragraph (e)(1)(ii)(A). Excess related person 
indebtedness may be computed under the following formula, under which 
excess related person indebtedness equals the smallest positive amount 
(not exceeding the aggregate amount of related controlled foreign 
corporation indebtedness) that is a solution to the following formula 
(with X equalling the amount of excess related person indebtedness):

[[Page 201]]

[GRAPHIC] [TIFF OMITTED] TC14NO91.117


Guidance concerning the solution of this equation is set forth in 
Example (2) of Sec. 1.861-12(k).
    (C) Computation of interest income received on excess related party 
indebtedness. The amount of interest income received on excess related 
person indebtedness equals the total interest income on related person 
indebtedness derived by the related United States shareholder during the 
taxable year multiplied by the ratio of excess related person 
indebtedness over the aggregate related person indebtedness for the 
taxable year.
    (v) Step 5: Determine the aggregate amount of related controlled 
foreign corporation obligations held by the related United States 
shareholder in each limitation category. The aggregate amount of related 
controlled foreign corporation obligations held by the related United 
States shareholder in each limitation category equals the sum of the 
value of all such obligations in each limitation category. Solely for 
purposes of this paragraph (e)(1)(v), each debt obligation in a related 
controlled foreign corporation held by a related United States 
shareholder shall be attributed to separate limitation categories in the 
same manner as the stock of the obligor would be attributed under the 
rules of Sec. 1.861-12T(c)(3), whether or nor such stock is held 
directly by such related United States shareholder.
    (vi) Step 6: Direct allocation of United States shareholder third 
party interest expense. Third party interest expense of the related 
United States shareholder equal to the amount of interest income 
received on excess related person indebtedness as determined in step 4 
shall be allocated among the various separate limitation categories in 
proportion to the relative aggregate amount of related controlled 
foreign corporation obligations held by the related United States 
shareholder in each such category, as determined under step 5. The 
remaining portion of third party interest expense will be apportioned as 
provided in Secs. 1.861-8T through 1.861-13T, excluding this paragraph.
    (2) Definitions--(i) United States shareholder. For purposes of this 
paragraph, the term ``United States shareholder'' has the same meaning 
as defined by section 957, except that, in the case of a United States 
shareholder that is a member an affiliated group (as defined in 
Sec. 1.861-11T(d)), the entire affiliated group shall be considered to 
constitute a single United States shareholder. The term ``related United 
States shareholder'' is the United States shareholder (as defined in 
this paragraph (e)(2)(i)) with respect to which related controlled 
foreign corporations (as defined in paragraph (e)(2)(ii) of this 
section) are related within the meaning of that paragraph.
    (ii) Related controlled foreign corporation. For purposes of this 
section, the term ``related controlled foreign corporation'' means any 
controlled foreign corporation which is a related person (as defined in 
Sec. 1.861-8T(c)(2)) to a United States shareholder (as defined 
paragraph (e)(2)(i) of this section).
    (iii) Value of assets and amount of liabilities. For purposes of 
this section, the value of assets is determined under Sec. 1.861-9T(g). 
Thus, in the case of assets that are denominated in foreign currency, 
the average of the beginning-of-year and end-of-year values is 
determined in foreign currency and translated into dollars using 
exchange rates on the last day of the related United States 
shareholder's taxable year. In the case of liabilities that are 
denominated in foreign currency, the average month-end debt level of 
such liabilities is determined in foreign currency and then translated 
into dollars using exchange rates on the last day of the related United 
States shareholder's taxable year.
    (3) Treatment of certain stock. To the extent that there is 
insufficient related person indebtedness of all related controlled 
foreign corporations under step 3 in paragraph (e)(1)(iii) of this 
section to achieve as equal ratio in step 4 of

[[Page 202]]

paragraph (e)(1)(iv) of this section, certain stock held by the related 
United States shareholder will be treated as related person 
indebtedness. Such stock includes--
    (i) Any stock in the related controlled foreign corporation that is 
treated in the same manner as debt under the law of any foreign country 
that grants a deduction for interest or original issue discount relating 
to such stock, and
    (ii) Any stock in a related controlled foreign corporation that has 
made loans to, or held stock described in this paragraph (e)(3) in, 
another related controlled foreign corporation. However, such stock 
shall be treated as related person indebtedness only to the extent of 
the principal amount of such loans.

For purposes of computing income from excess related person indebtedness 
in step 4 of paragraph (e)(1)(iv) of this section, stock that is treated 
under this paragraph as related person indebtedness shall be considered 
to yield interest in an amount equal to the interest that would be 
computed on an equal amount of indebtedness under section 1274. Only 
dividends actually paid thereon shall be included in gross income for 
other purposes.
    (4) Adjustments to assets in apportioning other interest expense. In 
apportioning interest expense under Sec. 1.861-9T, the value of assets 
in each separate limitation category for the taxable year as determined 
under Sec. 1.861-9T(g)(3) shall be reduced (but not below zero) by the 
principal amount of third party indebtedness of the related United 
States shareholder the interest expense on which is allocated to each 
such category under paragraph (e)(1) of this section.
    (5) Exceptions--(i) Per company rule. If--
    (A) A related controlled foreign corporation with obligations owing 
to a related United States shareholder has a greater proportion of 
passive assets than the proportion of passive assets held by the related 
United States shareholder,
    (B) Such passive assets are held in liquid or short term 
investments, and
    (C) There are frequent cash transfers between the related controlled 
foreign corporation and the related United States shareholder,

the Commissioner, in his discretion, may choose to exclude such a 
corporation from other related controlled foreign corporations in the 
application of the rules of this paragraph (e).
    (ii) Aggregate rule. If it is determined that, in aggregate, the 
application of the rules of this paragraph (e) increases a taxpayer's 
foreign tax credit as determined under section 901(a), the Commissioner, 
in his discretion, may choose not to apply the rules of this paragraph. 
If the Commissioner exercises discretion under this paragraph 
(e)(5)(ii), then paragraph (e) shall not apply to any extent to any 
interest expense of the taxpayer.

[T.D. 8228, 53 FR 35485, Sept. 14, 1988]



Sec. 1.861-11  Special rules for allocating and apportioning interest expense of an affiliated group of corporations.

    (a) through (c) [Reserved]. For further guidance, see Sec. 1.861-
11T(a) through (c).
    (d) Definition of affiliated group--(1) General rule. For purposes 
of this section, in general, the term affiliated group has the same 
meaning as is given that term by section 1504, except that section 936 
corporations are also included within the affiliated group to the extent 
provided in paragraph (d)(2) of this section. Section 1504(a) defines an 
affiliated group as one or more chains of includible corporations 
connected through 80-percent stock ownership with a common parent 
corporation which is an includible corporation (as defined in section 
1504(b)). In the case of a corporation that either becomes or ceases to 
be a member of the group during the course of the corporation's taxable 
year, only the interest expense incurred by the group member during the 
period of membership shall be allocated and apportioned as if all 
members of the group were a single corporation. In this regard, assets 
held during the period of membership shall be taken into account. Other 
interest expense incurred by the group member during its taxable year 
but not during the period of membership shall be allocated and 
apportioned without regard to the other members of the group.

[[Page 203]]

    (2) Inclusion of section 936 corporations--(i) Rule--(A) In general. 
Except as otherwise provided in paragraph (d)(2)(i)(B) of this section, 
the exclusion of section 936 corporations from the affiliated group 
under section 1504(b)(4) does not apply for purposes of this section. 
Thus, a section 936 corporation that meets the ownership requirements of 
section 1504(a) is a member of the affiliated group.
    (B) Exception for purposes of alternative minimum tax. The exclusion 
from the affiliated group of section 936 corporations under section 
1504(b)(4) shall be operative for purposes of the application of this 
section solely in determining the amount of foreign source alternative 
minimum taxable income within each separate category and the alternative 
minimum tax foreign tax credit pursuant to section 59(a). Thus, a 
section 936 corporation that meets the ownership requirements of section 
1504(a) is not a member of the affiliated group for purposes of 
determining the amount of foreign source alternative minimum taxable 
income within each separate category and the alternative minimum tax 
foreign tax credit pursuant to section 59(a).
    (ii) Section 936 corporation defined. For purposes of this section, 
Sec. 1.861-9, and Sec. 1.861-14, the term section 936 corporation means, 
for any taxable year, a corporation with an election in effect to be 
eligible for the credit provided under section 936(a)(1) or section 30A 
for the taxable year.
    (iii) Example. This example illustrates the provisions of paragraph 
(d)(2)(i) of this section:

    Example--(A) Facts. X owns all of the stock of Y. XY constitutes an 
affiliated group of corporations within the meaning of section 1504(a) 
and uses the tax book value method of apportionment. In 2000, Y owns all 
of the stock of Z, a section 936 corporation. Z manufactures widgets in 
Puerto Rico. Y purchases these widgets and markets them exclusively in 
the United States. Of the three corporations, only Z has foreign source 
income, which includes both qualified possessions source investment 
income and general limitation income. For purposes of section 904, Z's 
qualified possessions source investment income constitutes foreign 
source passive income. In computing the section 30A benefit, Y and Z 
have elected the cost sharing method. Of the three corporations, only X 
has debt and, thus, only X incurs interest expense. (B) Analysis for 
regular tax. Assume first that X has no alternative minimum tax 
liability. Under paragraph (d)(2) of this section, Z is treated as a 
member of the XY affiliated group for purposes of allocating and 
apportioning interest expense for regular tax purposes. As provided in 
Sec. 1.861-11T(b)(2), section 864(e)(1) and (5) do not apply in 
computing the combined taxable income of Y and Z under section 936, but 
these rules do apply in computing the foreign source taxable income of 
the XY affiliated group. The effect of including Z in the affiliated 
group is that X, the only debtor corporation in the group, must, under 
the asset method described in Sec. 1.861-9T(g), apportion a part of its 
interest expense to foreign source passive income and foreign source 
general limitation income. This is because the assets of Z that generate 
qualified possessions source investment income and general limitation 
income are included in computing the group apportionment fractions. The 
result is that, under section 904(f), X has an overall foreign loss in 
both the passive and general limitation categories, which currently 
offsets domestic income and must be recaptured against any subsequent 
years' foreign passive income and general limitation income, 
respectively, under the rules of that section.
    (C) Analysis for alternative minimum tax. Assume, alternatively, 
that X is liable to pay the alternative minimum tax. Pursuant to section 
59(a), X must compute its alternative minimum tax foreign tax credit as 
if section 904 were applied on the basis of alternative minimum taxable 
income instead of taxable income. Under paragraph (d)(2)(i)(B) of this 
section, for purposes of the apportionment of interest expense in 
determining alternative minimum taxable income within each limitation 
category, Z is not considered a member of the XY affiliated group. Thus, 
the stock (and not the assets) of Z are included in computing the group 
apportionment fractions. Pursuant to sections 59(g)(4)(C)(iii)(IV), 
861(a)(2)(A), and 862(a)(2), dividends paid by a section 936 corporation 
are foreign source income subject to a separate foreign tax credit 
limitation for alternative minimum tax purposes. Thus, under Sec. 1.861-
9T(g)(3), the stock of Z must be considered attributable solely to the 
statutory grouping consisting of foreign source dividends from Z. The 
effect of excluding Z from the affiliated group is that X must apportion 
a part of its interest expense to the separate category for foreign 
source dividends from Z in computing alternative minimum taxable income 
within each separate category. If, as a result, under section 904(f), X 
has a separate limitation loss or an overall foreign loss in the 
category for dividends from Z for alternative minimum tax purposes, then 
that loss must be allocated against X's other income (separate 
limitation or United States source, as the case may be). The loss must 
be recaptured in subsequent years under the

[[Page 204]]

rules of section 904(f) for purposes of the alternative minimum tax 
foreign tax credit. * * *

    (iv) Effective date. This paragraph (d)(2) applies to taxable years 
beginning after December 31, 1989.
    (d)(3) through (6) [Reserved]. For further guidance, see Sec. 1.861-
11T(d)(3) through (6).
    (7) Special rules for the application of Sec. 1.861-11T(d)(6). The 
attribution rules of section 1563(e) and the regulations under that 
section shall apply in determining indirect ownership under Sec. 1.861-
11T(d)(6). The Commissioner shall have the authority to disregard 
trusts, partnerships, and pass-through entities that break affiliated 
status. Corporations described in Sec. 1.861-11T(d)(6) shall be 
considered to constitute members of an affiliated group that does not 
file a consolidated return and shall therefore be subject to the 
limitations imposed under Sec. 1.861-11T(g). The affiliated group filing 
a consolidated return shall be considered to constitute a single 
corporation for purposes of applying the rules of Sec. 1.861-11T(g). For 
taxable years beginning after December 31, 1989, Sec. 1.861-11T(d)(6)(i) 
shall not apply in determining foreign source alternative minimum 
taxable income within each separate category and the alternative minimum 
tax foreign tax credit pursuant to section 59(a) to the extent that such 
application would result in the inclusion of a section 936 corporation 
within the affiliated group. This paragraph (d)(7) applies to taxable 
years beginning after December 31, 1986.
    (e) through (g) [Reserved]. For further guidance, see Sec. 1.861-
11T(e) through (g).

[T.D. 8916, 66 FR 273, Jan. 3, 2001]



Sec. 1.861-11T  Special rules for allocating and apportioning interest expense of an affiliated group of corporations (temporary regulations.)

    (a) In general. Sections 1.861-9T, 1.861-10T, 1.861-12T, and 1.861-
13T provide rules that are generally applicable in apportioning interest 
expense. The rules of this section relate to affiliated groups of 
corporations and implement section 864(e) (1) and (5), which requires 
affiliated group allocation and apportionment of interest expense. The 
rules of this section apply to taxable years beginning after December 
31, 1986, except as otherwise provided in Sec. 1.861-13T. Paragraph (b) 
of this section describes the scope of the application of the rule for 
the allocation and apportionment of interest expense of affiliated 
groups of corporations, which is contained in paragraph (c) of this 
section. Paragraph (d) of this section sets forth the definition of the 
term ``affiliated group'' for purposes of this section. Paragraph (e) 
describes the treatment of loans between members of an affiliated group. 
Paragraph (f) of this section provides rules concerning the affiliated 
group allocation and apportionment of interest expense in computing the 
combined taxable income of a FSC or DISC and its related supplier. 
Paragraph (g) of this section describes the treatment of losses caused 
by apportionment of interest expense in the case of an affiliated group 
that does not file a consolidated return.
    (b) Scope of application--(1) Application of section 864(e) (1) and 
(5) (concerning the definition and treatment of affiliated groups). 
Section 864(e) (1) and (5) and the portions of this section implementing 
section 864(e) (1) and (5) apply to the computation of foreign source 
taxable income for purposes of section 904 (relating to various 
limitations on the foreign tax credit). Section 904 imposes separate 
foreign tax credit limitations on passive income, high withholding 
interest income, financial services income, shipping income, income 
consisting of dividends from each noncontrolled section 902 corporation, 
income consisting of dividends from a DISC or former DISC, taxable 
income attributable to foreign trade income within the meaning of 
section 923(b), distributions from a FSC or former FSC, and all other 
forms of foreign source income not enumerated above (``general 
limitation income''). Section 864(e) (1) and (5) and the portions of 
this section implementing section 864(e) (1) and (5) also apply in 
connection with section 907 to determine reductions in the amount 
allowed as a foreign tax credit under section 901. Section 864(e) (1) 
and (5) and the portions of this section implementing section 864(e) (1) 
and (5) also apply to the computation of the combined taxable

[[Page 205]]

income of the related supplier and a foreign sales corporation (FSC) 
(under sections 921 through 927) as well as the combined taxable income 
of the related supplier and a domestic international sales corporation 
(DISC) (under sections 991 through 997).
    (2) Nonapplication of section 864(e) (1) and (5) (concerning the 
definition and treatment of affiliated groups). Section 864(e) (1) and 
(5) and the portions of this section implementing section 864(e) (1) and 
(5) do not apply to the computation of subpart F income of controlled 
foreign corporations (under sections 951 through 964), the computation 
of combined taxable income of a possessions corporation and its 
affiliates (under section 936), or the computation of effectively 
connected taxable income of foreign corporations. For the rules with 
respect to the allocation and apportionment of interest expenses of 
foreign corporations other than controlled foreign corporations, see 
Secs. 1.882-4 and 1.882-5.
    (c) General rule for affiliated corporations. Except as otherwise 
provided in this section, the taxable income of each member of an 
affiliated group within each statutory grouping shall be determined by 
allocating and apportioning the interest expense of each member 
according to apportionment fractions which are computed as if all 
members of such group were a single corporation. For purposes of 
determining these apportionment fractions, stock in corporations within 
the affiliated group (as defined in section 864(e)(5) and the rules of 
this section) shall not be taken into account. In the case of an 
affiliated group of corporations that files a consolidated return, 
consolidated foreign tax credit limitations are computed for the group 
in accordance with the rules of Sec. 1.1502-4. Except as otherwise 
provided, all the interest expense of all members of the group will be 
treated as definitely related and therefore allocable to all the gross 
income of the members of the group and all the assets of all the members 
of the group shall be taken into account in apportioning this interest 
expense. For purposes of this section, the term ``taxpayer'' refers to 
the affiliated group (regardless of whether the group files a 
consolidated return), rather than to the separate members thereof.
    (d)(1) and (2) [Reserved]. For further guidance, see Sec. 1.861-
11(d)(1) and (2).
    (3) Treatment of life insurance companies subject to taxation under 
section 801--(i) General rule. A life insurance company that is subject 
to taxation under section 801 shall be considered to constitute a member 
of the affiliated group composed of companies not taxable under section 
801 only if a parent corporation so elects under section 1504(c)(2)(A) 
of the Code. If a parent does not so elect, no adjustments shall be 
required with respect to such an insurance company under paragraph (g) 
of this section.
    (ii) Treatment of stock. Stock of a life insurance company that is 
subject to taxation under section 801 that is not included in an 
affiliated group shall be disregarded in the allocation and 
apportionment of the interest expense of such affiliated group.
    (4) Treatment of certain financial corporations--(i) In general. In 
the case of an affiliated group (as defined in paragraph (d)(1) of this 
section), any member that constitutes financial corporations as defined 
in paragraph (d)(4)(ii) of this section shall be treated as a separate 
affiliated group consisting of financial corporations (the ``financial 
group''). The members of the group that do not constitute financial 
corporations shall be treated as members of a separate affiliated group 
consisting of nonfinancial corporations (``the nonfinancial group'').
    (ii) Financial corporation defined. The term ``financial 
corporation'' means any corporation which meets all of the following 
conditions:
    (A) It is described in section 581 (relating to the definition of a 
bank) or section 591 (relating to the deduction for dividends paid on 
deposits by mutual savings banks, cooperative banks, domestic building 
and loan associations, and other savings institutions chartered and 
supervised as savings and loan or similar associations);
    (B) Its business is predominantly with persons other than related 
persons (within the meaning of section 864(d)(4) and the regulations 
thereunder) or their customers; and

[[Page 206]]

    (C) It is required by state or Federal law to be operated separately 
from any other entity which is not such an institution.
    (iii) Treatment of bank holding companies. The total aggregate 
interest expense of any member of an affiliated group that constitutes a 
bank holding company subject to regulation under the Bank Holding 
Company Act of 1956 shall be prorated between the financial group and 
the nonfinancial group on the basis of the assets in the financial and 
nonfinancial groups. For purposes of making this proration, the assets 
of each member of each group, and not the stock basis in each member, 
shall be taken into account. Any direct or indirect subsidiary of a bank 
holding company that is predominantly engaged in the active conduct of a 
banking, financing, or similar business shall be considered to be a 
financial corporation for purposes of this paragraph (d)(4). The 
interest expense of the bank holding company must be further apportioned 
in accordance with Sec. 1.861-9T(f) to the various section 904(d) 
categories of income contained in both the financial group and the 
nonfinancial group on the basis of the assets owned by each group. For 
purposes of computing the apportionment fractions for each group, the 
assets owned directly by a bank holding company within each limitation 
category described in section 904(d)(1) (other than stock in affiliates 
or assets described in Sec. 1.861-9T(f)) shall be treated as owned pro 
rata by the nonfinancial group and the financial group based on the 
relative amounts of investments of the bank holding company in the 
nonfinancial group and financial group.
    (iv) Consideration of stock of the members of one group held by 
members of the other group. In apportioning interest expense, the 
nonfinancial group shall not take into account the stock of any lower-
tier corporation that is treated as a member of the financial group 
under paragraph (d)(4)(i) of this section. Conversely, in apportioning 
interest expense, the financial group shall not take into account the 
stock of any lower-tier corporation that is treated as a member of the 
nonfinancial group under paragraph (d)(4)(i) of this section. For the 
treatment of loans between members of the financial group and members of 
the nonfinancial group, see paragraph (e)(1) of this section.

    (5) Example-- (i) Facts. X, a domestic corporation which is not a 
bank holding company, is the parent of domestic corporations Y and Z. Z 
owns 100 percent of the stock Z1, which is also a domestic corporation. 
X, Y, Z, and Z1 were organized after January 1, 1987, and constitute an 
affiliated group within the meaning of paragraph (d)(1) of this section. 
Y and Z are financial corporations described in paragraph (d)(4) of this 
section. X also owns 25 percent of the stock of A, a domestic 
corporation. Y owns 25 percent of the voting stock of B, a foreign 
corporation that is not a controlled foreign corporation. Z owns less 
than 10 percent of the voting stock of C, another foreign corporation. 
The foreign source income generated by Y's or Z's direct assets is 
exclusively financial services income. The foreign source income 
generated by X's or Z1's direct assets is exclusively general limitation 
income. X and Z1 are not financial corporations described in paragraph 
(d)(4)(ii) of this section. Y and Z, therefore, constitute a separate 
affiliated group apart from X and Z1 for purposes of section 864(e). The 
combined interest expense of Y and Z of $100,000 ($50,000 each) is 
apportioned separately on the basis of their assets. The combined 
interest expense of X and Z1 of $50,000 ($25,000 each) is allocated on 
the basis of the assets of the XZ1 group.

 
 
 
                     Analysis of the YZ group assets
 
Adjusted basis of assets of the YZ group that generate          $200,000
 foreign source financial services income (excluding stock
 of foreign subsidiaries not included in the YZ affiliated
 group)....................................................
Z's basis in the C stock (not adjusted by the allocable         $100,000
 amount of C's earnings and profits because Z owns less
 than 10 percent of the stock) which would be considered to
 generate passive income in the hands of a nonfinancial
 services entity but is considered to generate financial
 services income when in the hands of Z, a financial
 services entity...........................................
Y's basis in the B stock (adjusted by the allocable amount      $100,000
 of B's earnings and profits) which generates dividends
 subject to a separate limitation for B dividends..........

[[Page 207]]

 
Adjusted basis of assets of the YZ group that generate U.S.     $600,000
 source income.............................................
                                                            ------------
      Total assets.........................................   $1,000,000
 
                    Analysis of the XZ1 group assets
 
Adjusted basis of assets of the XZ1 group that generate         $500,000
 foreign source general limitation income..................
Adjusted basis of assets of the XZ1 group other than A        $1,900,000
 stock that generate domestic source income................
X's basis in the A stock adjusted by the allocable amount       $100,000
 of A's earnings and profits...............................
                                                            ------------
      Total domestic assets................................   $2,000,000
                                                            ------------
      Total assets.........................................   $2,500,000
 

    (ii) Allocation. No portion of the $50,000 deduction of the YZ group 
is definitely related solely to specific property within the meaning of 
Sec. 1.861-10T. Thus, the YZ group's deduction for interest is related 
to all its activities and properties. Similarly, no portion of the 
$50,000 deduction of the XZ1 group is definitely related solely to 
specific property within the meaning of Sec. 1.861-10T. Thus, the XZ1 
group's deduction for interest is related to all its activities and 
properties.
    (iii) Apportionment. The YZ group would apportion its interest 
expense as follows:

To gross financial services income from sources outside the United 
States:
[GRAPHIC] [TIFF OMITTED] TC07OC91.004

To gross income subject to a separate limitation for dividends from B:
[GRAPHIC] [TIFF OMITTED] TC07OC91.005

To gross income from sources inside the United States:
[GRAPHIC] [TIFF OMITTED] TC07OC91.006

    The XZ1 group would apportion its interest expense as follows:

To gross general limitation income from sources outside the United 
States:
[GRAPHIC] [TIFF OMITTED] TC07OC91.007

To gross income from sources inside the United States:

[GRAPHIC] [TIFF OMITTED] TC07OC91.008

    (6) Certain unaffiliated corporations. Certain corporations that are 
not described in paragraph (d)(1) of this section will nonetheless be 
considered to constitute affiliated corporations for purposes of 
Secs. 1.861-9T through 1.861-13T. These corporations include:
    (i) Any includible corporation (as defined in section 1504(b) 
without regard to section 1504(b)(4)) if 80 percent of either the vote 
or value of all outstanding stock of such corporation is owned directly 
or indirectly by an includible corporation or by members of an 
affiliated group, and
    (ii) Any foreign corporation if 80 percent of either the vote or 
value of all outstanding stock of such corporation is owned directly or 
indirectly by members of an affiliated group, and if more than 50 
percent of the gross income of such corporation for the taxable year is 
effectively connected with the conduct of a United States trade or 
business. If 80 percent or more of the gross income of such corporation 
is effectively connected income, then all the assets of such corporation 
and all of its interest expense shall be taken into account. If between 
50 and 80 percent of the gross income of such corporation is effectively 
connected income, then only the assets of such corporation that generate 
effectively connected income and a percentage of its interest expense 
equal to the percentage of its assets that generate effectively 
connected income shall be taken into account.
    (7) Special rules for the application of Sec. 1.861-11T(d)(6). 
[Reserved]. For special

[[Page 208]]

rules for the application of Sec. 1.861-11T(d)(6), see Sec. 1.861-
11(d)(7).
    (e) Loans between members of an affiliated group--(1) General rule. 
In the case of loans (including any receivable) between members of an 
affiliated group, as defined in paragraph (d) of this section, for 
purposes of apportioning interest expense, the indebtedness of the 
member borrower shall not be considered an asset of the member lender. 
However, in the case of members of separate financial and nonfinancial 
groups under paragraph (d)(4) of this section, the indebtedness of the 
member borrower shall be considered an asset of the member lender and 
such asset shall be characterized by reference to the member lender's 
income from the asset as determined under paragraph (e)(2)(ii) of this 
section. For purposes of this paragraph (e), the terms ``related person 
interest income'' and ``related person interest payment'' refer to 
interest paid and received by members of the same affiliated group as 
defined in paragraph (d) of this section.
    (2) Treatment of interest expense within the affiliated group--(i) 
General rule. A member borrower shall deduct related person interest 
payments in the same manner as unrelated person interest expense using 
group apportionment fractions computed under Sec. 1.861-9T(f). A member 
lender shall include related person interest income in the same class of 
gross income as the class of gross income from which the member borrower 
deducts the related person interest payment.
    (ii) Special rule for loans between financial and nonfinancial 
affiliated corporations. In the case of a loan between two affiliated 
corporations only one of which constitutes a financial corporation under 
paragraph (d)(4) of this section, the member borrower shall allocate and 
apportion related person interest payments in the same manner as 
unrelated person interest expense using group apportionment fractions 
computed under Sec. 1.861-9T(f). The source of the related person 
interest income to the member lender shall be determined under section 
861(a)(1).
    (iii) Special rule for high withholding tax interest. In the case of 
an affiliated corporation that pays interest that is high withholding 
tax interest under Sec. 1.904-5(f)(1) to another affiliated corporation, 
the interest expense of the payor shall be allocated to high withholding 
tax interest.
    (3) Back-to-back loans. If a member of the affiliated group makes a 
loan to a nonmember who makes a loan to a member borrower, the rule of 
paragraphs (e) (1) and (2) of this section shall apply, in the 
Commissioner's discretion, as if the member lender made the loan 
directly to the member borrower, provided that the loans constitute a 
back-to-back loan transaction. Such loans will constitute a back-to-back 
loan for purposes of this paragraph (e) if the loan by the nonmember 
would not have been made or maintained on substantially the same terms 
irrespective of the loan of funds by the lending member to the nonmember 
or other intermediary party.
    (4) Examples. The rules of this paragraph (e) may be illustrated by 
the following examples.

    Example 1. X, a domestic corporation, is the parent of Y, a domestic 
corporation. X and Y were organized after January 1, 1987, and 
constitute an affiliated group within the meaning of paragraph (d)(1) of 
this section. Among X's assets is the note of Y for the amount of 
$100,000. Because X and Y are members of an affiliated group, Y's note 
does not constitute an asset for purposes of apportionment. The 
apportionment fractions for the relevant tax year of the XY group are 50 
percent domestic, 40 percent foreign general, and 10 percent foreign 
passive. Y deducts its related person interest payment using those 
apportionment fractions. Of the $10,000 in related person interest 
income received by X, $5,000 consists of domestic source income, $4,000 
consists of foreign general limitation income, and $1,000 consists of 
foreign passive income.
    Example 2. X is a domestic corporation organized after January 1, 
1987. X owns all the stock of Y, a domestic corporation. On June 1, 
1987, X loans $100,000 to Z, an unrelated person. On June 2, 1987, Z 
makes a loan to Y with terms substantially similar to those of the loan 
from X to Z. Based on the facts and circumstances of the transaction, it 
is determined that Z would not have made the loan to Y on the same terms 
if X had not made the loan to Z. Because the transaction constitutes a 
back-to-back loan, as defined in paragraph (e)(3) of this section, the 
Commissioner may require, in his discretion, that neither the note of Y 
nor the note of Z may be considered an asset of X for purposes of this 
section.


[[Page 209]]


    (f) Computations of combined taxable income. In the computation of 
the combined taxable income of any FSC or DISC and its related supplier 
which is a member of an affiliated group under the pricing rules of 
sections 925 or 994, the combined taxable income of such FSC or DISC and 
its related supplier shall be reduced by the portion of the total 
interest expense of the affiliated group that is incurred in connection 
with those assets of the group used in connection with export sales 
involving that FSC or DISC. This amount shall be computed by multiplying 
the total interest expense of the affiliated group and interest expense 
of the FSC or DISC by a fraction the numerator of which is the assets of 
the affiliated group and of the FSC or DISC generating foreign trade 
income or gross income attributable to qualified export receipts, as the 
case may be, and the denominator of which is the total assets of the 
affiliated group and the FSC or DISC. Under this rule, interest of other 
group members may be attributed to the combined taxable income of a FSC 
or DISC and its related supplier without affecting the amount of 
interest otherwise deductible by the FSC or DISC, the related supplier 
or other member of the affiliated group. The FSC or DISC is entitled to 
only the statutory portion of the combined taxable income, net of any 
deemed interest expense, which determines the commission paid to the FSC 
or DISC or the transfer price of qualifying export property sold to the 
FSC or DISC.
    (g) Losses created through apportionment--(1) General rules. In the 
case of an affiliated group that is eligible to file, but does not file, 
a consolidated return and in the case of any corporation described in 
paragraph (d)(6) of this section, the foreign tax credits in any 
separate limitation category are limited to the credits computed under 
the rules of this paragraph (g). As a consequence of the affiliated 
group allocation and apportionment of interest expense required by 
section 864(e)(1) and this section, interest expense of a group member 
may be apportioned for section 904 purposes to a limitation category in 
which that member has no gross income, resulting in a loss in that 
limitation category. The same is true in connection with any expense 
other than interest that is subject to apportionment under the rules of 
section 864(e)(6) of the Code. Any reference to ``interest expense'' in 
this paragraph (g) shall be treated as including such expenses. For 
purposes of this paragraph, the term ``limitation category'' includes 
domestic source income, as well as the types of income described in 
section 904(d)(1) (A) through (I). A loss of one affiliate in a 
limitation category will reduce the income of another member in the same 
limitation category if a consolidated return is filed. (See Sec. 1.1502-
4.) If a consolidated return is not filed, this netting does not occur. 
Accordingly, in such a case, the following adjustments among members are 
required in order to give effect to the group allocation of interest 
expense:
    (i) Losses created through group apportionment of interest expense 
in one or more limitation categories within a given member must be 
eliminated; and
    (ii) A corresponding amount of income of other members in the same 
limitation category must be recharacterized.

Such adjustments shall be accomplished, in accordance with paragraph 
(g)(2) of this section, without changing the total taxable income of any 
member and before the application of section 904(f). Section 904(f) 
(including section 904(f)(5)) does not apply to a loss created through 
the apportionment of interest expense to the extent that the loss is 
eliminated pursuant to paragraph (g)(2)(ii) of this section. For 
purposes of this section, the terms ``limitation adjustment'' and 
``recharacterization'' mean the recharacterization of income in one 
limitation category as income in another limitation category.
    (2) Mechanics of computation--(i) Step 1: Computation of 
consolidated taxable income. The members of an affiliated group must 
first allocate and apportion all other deductible expenses other than 
interest. The members must then deduct from their respective gross 
incomes within each limitation category interest expense apportioned 
under the rules of Sec. 1.861-9T(f). The taxable income of the entire 
affiliated group

[[Page 210]]

within each limitation category is then totalled.
    (ii) Step 2: Loss offset adjustments. If, after step 1, a member has 
losses in a given limitation category or limitation categories created 
through apportionment of interest expense, any such loss (i.e., the 
portion of such loss equal to interest expense) shall be eliminated by 
offsetting that loss against taxable income in other limitation 
categories of that member to the extent of the taxable income of other 
members within the same limitation category as the loss. If the member 
has taxable income in more than one limitation category, then the loss 
shall offset taxable income in all such limitation categories on a pro 
rata basis. If there is insufficient domestic income of the member to 
offset the net losses in all foreign limitation categories caused by the 
apportionment of interest expense, the losses in each limitation 
category shall be recharacterized as domestic losses to the extent of 
the taxable income of other members in the same respective limitation 
categories. After these adjustments are made, the income of the entire 
affiliated group within each limitation category is totalled again.
    (iii) Step 3: Determination of amount subject to recharacterization. 
In order to determine the amount of income to be recharacterized in step 
4, the income totals computed under step 1 in each limitation category 
shall be subtracted from the income totals computed under step 2 in each 
limitation category.
    (iv) Step 4: Recharacterization. Because any differences determined 
under step 3 represent deviations from the consolidated totals computed 
under Step 1, such differences (in any limitation category) must be 
eliminated.
    (A) Limitation categories to be reduced. In the case of any 
limitation category in which there is a positive change, the income of 
group members with income in that limitation category must be reduced on 
a pro rata basis (by reference to net income figures as determined under 
Step 2) to the extent of such positive change (``limitation 
reductions''). Each member shall separately compute the sum of the 
limitation reductions.
    (B) Limitation categories to be increased. In any case in which only 
one limitation category has a negative change in Step 3, the sum of the 
limitation reductions within each member is added to that limitation 
category. In the case in which multiple limitation categories have 
negative changes in Step 3, the sum of the limitation reductions within 
each member is prorated among the negative change limitation categories 
based on the ratio that the negative change for the entire group in each 
limitation category bears to the total of all negative changes for the 
entire group in all limitation categories.
    (3) Examples. The following examples illustrate the principles of 
this paragraph.

    Example 1 --(i) Facts. X, a domestic corporation, is the parent of 
domestic corporations Y and Z. X, Y, and Z were organized after Janaury 
1, 1987, constitute an affiliated group within the meaning of paragraph 
(d)(1) of this section, but do not file a consolidated return. The XYZ 
group apportions its interest expense on the basis of the fair market 
value of its assets. X, Y, and Z have the following assets, interest 
expense, and taxable income before apportioning interest expense:

------------------------------------------------------------------------
              Assets                   X        Y         Z       Total
------------------------------------------------------------------------
Domestic.........................  2,000.00     0     1,000.00  3,000.00
Foreign Passive..................      0       50.00     50.00    100.00
Foreign General..................      0      700.00    200.00    900.00
Interest expense.................     48.00    12.00     80.00    140.00
Taxable Income (pre-interest):
  Domestic.......................    100.00     0        63.00    163.00
  Foreign Passive................      0        5.00      5.00     10.00
  Foreign General................      0       60.00     35.00     95.00
------------------------------------------------------------------------

    (ii) Step 1: Computation of consolidated taxable income. Each member 
of the XYZ group apportions its interest expense according to group 
apportionment ratios determined under the asset method decribed in 
Sec. 1.861-9T(f), yielding the following results:

------------------------------------------------------------------------
     Apportioned interest expense          X       Y       Z      Total
------------------------------------------------------------------------
Domestic..............................   36.00    9.00   60.00    105.00
Foreign Passive.......................    1.20    0.30    2.00      3.50
Foreign General.......................   10.80    2.70   18.00     31.50
                                       ---------------------------------
    Total.............................   48.00   12.00   80.00    140.00
------------------------------------------------------------------------

    The members of the group then compute taxable income within each 
category by deducting the apportioned interest expense from the amounts 
of pre-interest taxable income specified in the facts in paragraph (i), 
yielding the following results:

------------------------------------------------------------------------
         Taxable income               X         Y         Z       Total
------------------------------------------------------------------------
Domestic........................     64.00      9.00      3.00     58.00

[[Page 211]]

 
Foreign Passive.................     -1.20      4.70      3.00      6.50
Foreign General.................    -10.80     57.30     17.00     63.50
                                 ---------------------------------------
    Total.......................     52.00     53.00     23.00    128.00
------------------------------------------------------------------------

    (iii) Step 2: Loss offset adjustments. Because X and Y have losses 
created through apportionment, these losses must be eliminated by 
reducing taxable income of the member in other limitation categories. 
Because X has a total of $12 in apportionment losses and because it has 
only one limitation category with income (i.e., domestic), domestic 
income must be reduced by $12, thus eliminating its apportionment 
losses. Because Y has a total of $9 in apportionment losses and because 
it has two limitation categories with income (i.e., foreign passive and 
foreign general limitation), the income in these two limitation 
categories must be reduced on a pro rata basis in order to eliminate its 
apportionment losses. In summary, the following adjustments are 
required:

------------------------------------------------------------------------
     Loss offset adjustments          X         Y         Z       Total
------------------------------------------------------------------------
Domestic........................    -12.00     +9.00         0     -3.00
Foreign Passive.................     +1.20     -0.68         0     +0.52
Foreign General.................    +10.80     -8.32         0     +2.48
------------------------------------------------------------------------

    These adjustments yield the following adjusted taxable income 
figures:

------------------------------------------------------------------------
       Adjusted taxable income           X        Y        Z      Total
------------------------------------------------------------------------
Domestic............................    52.00     0       3.00     55.00
Foreign Passive.....................     0        4.02    3.00      7.02
Foreign General.....................     0       48.98   17.00     65.98
                                     -----------------------------------
    Total...........................    52.00    53.00   23.00    128.00
------------------------------------------------------------------------

    (iv) Step 3: Determination of amount subject to recharacterization. 
The adjustments performed under Step 2 led to a change in the group's 
taxable income within each limitation category. The total loss offset 
adjustments column shown in paragraph (iii) above shows the net 
deviations between Step 1 and 2.
    (v) Step 4: Recharacterization. The loss offset adjustments yield a 
positive change in the foreign passive and the foreign general 
limitation categories. Y and Z both have income in these limitation 
categories. Accordingly, the income of Y and Z in each of these 
limitation categories must be reduced on a pro rata basis (by reference 
to the adjusted taxable income figures) to the extent of the positive 
change in each limitation category. The total positive change in the 
foreign passive limitation category is $0.52. The adjusted taxable 
income of Y in the foreign passive limitation category is $4.02 and the 
adjusted taxable income of Z in the foreign passive limitation category 
is $3. Therefore, $0.30 is drawn from Y and $0.22 is drawn from Z. The 
total positive change in the foreign general limitation category is 
$2.48. The adjusted taxable income of Y in the foreign general 
limitation category is $48.98, and the adjusted taxable income of Z in 
the foreign general limitation category is $17. Therefore, $1.84 is 
drawn from Y and $.64 is drawn from Z.
    The members must then separately compute the sum of the limitation 
reductions. Y has limitation reductions of $0.30 in the foreign passive 
limitation category and $1.84 in the foreign general limitation 
category, yielding total limitation reduction of $2.14. Under these 
facts, domestic income is the only limitation category requiring a 
positive adjustment. Accordingly, Y's domestic income is increased by 
$2.14. Z has limitation reductions of $0.22 in the foreign passive 
limitation category and $0.64 in the foreign general limitation 
category, yielding total limitation reductions of $0.86. Under these 
facts, domestic income is the only limitation category of Z requiring a 
positive adjustment. Accordingly, Z's domestic income is increased by 
$0.86.

------------------------------------------------------------------------
   Recharacterization adjustments        X        Y        Z      Total
------------------------------------------------------------------------
Domestic............................        0    +2.14    +0.86    +3.00
Foreign Passive.....................        0    -0.30    -0.22    -0.52
Foreign General.....................        0    -1.84    -0.64    -2.48
------------------------------------------------------------------------

    These recharacterization adjustments yield the following final 
taxable income figures:

------------------------------------------------------------------------
         Final taxable income             X        Y       Z      Total
------------------------------------------------------------------------
Domestic.............................    52.00    2.14    3.86     58.00
Foreign Passive......................     0       3.72    2.78      6.50
Foreign General......................     0      47.14   16.36     63.50
                                      ----------------------------------
    Total............................    52.00   53.00   23.00    128.00
------------------------------------------------------------------------

    Example 2 --(i) Facts. X, a domestic corporation, is the parent of 
domestic corporations Y and Z. X, Y, and Z were organized after January 
1, 1987, constitute an affiliated group within the meaning of paragraph 
(d)(1) of this section, but do not file a consolidated return. Moreover, 
X has served as the sole borrower in the group and, as a result, has 
sustained an overall loss. The XYZ group apportions its interest expense 
on the basis of the fair market value of its assets. X, Y, and Z have 
the following assets, interest expense, and taxable income before 
interest expense:

------------------------------------------------------------------------
                Assets                    X        Y       Z      Total
------------------------------------------------------------------------
Domestic.............................    2,000       0   1,000     3,000
Foreign Passive......................        0      50      50       100
Foreign General......................        0     700     200       900
Interest Expense.....................      140       0       0       140
Taxable Income (pre-interest):
Domestic.............................      100       0     100       200
Foreign Passive......................        0       5       5        10

[[Page 212]]

 
Foreign General......................        0      70      35       105
------------------------------------------------------------------------

    (ii) Step 1: Computation of consolidated taxable income. Each member 
of the XYZ group apportions its interest expense according to group 
apportionment ratios determined under the asset method described in 
Sec. 1.861-9T(g), yielding the following results:

------------------------------------------------------------------------
      Apportioned interest expense          X       Y      Z      Total
------------------------------------------------------------------------
Domestic...............................   105.00      0      0    105.00
Foreign Passive........................     3.50      0      0      3.50
Foreign General........................    31.50      0      0     31.50
                                        --------------------------------
    Total..............................   140.00      0      0    140.00
------------------------------------------------------------------------

    The members of the group then compute taxable income within each 
category by deducting the apportioned interest expense from the amounts 
of pre-interest taxable income specified in the facts in paragraph (i), 
yielding the following results:

------------------------------------------------------------------------
          Taxable income               X        Y         Z       Total
------------------------------------------------------------------------
Domestic.........................     -5.00     0       100.00     95.00
Foreign Passive..................     -3.50     5.00      5.00      6.50
Foreign General..................    -31.50    70.00     35.00     73.50
                                  --------------------------------------
    Total........................    -40.00    75.00    140.00    175.00
------------------------------------------------------------------------

    (iii) Step 2: Loss offset adjustment. Because X has insufficient 
domestic income to offset the sum of the losses in the foreign 
limitation categories caused by apportionment, the amount of 
apportionment losses in each limitation category shall be 
recharacterized as domestic losses to the extent of taxable income of 
other members in the same limitation category. This is accomplished by 
adding to each foreign limitation categories an amount equal to the loss 
therein and by subtracting the sum of such foreign losses from domestic 
income, as follows:

------------------------------------------------------------------------
    Loss offset adjustments          X          Y         Z       Total
------------------------------------------------------------------------
Domestic.......................     -35.00         0         0    -35.00
Foreign Passive................      +3.50         0         0     +3.50
Foreign General................     +31.50         0         0    +31.50
------------------------------------------------------------------------

    These adjustments yield the following adjusted taxable income 
figures:

------------------------------------------------------------------------
     Adjusted taxable income          X         Y         Z       Total
------------------------------------------------------------------------
Domestic........................       -40         0       100        60
Foreign Passive.................         0         5         5        10
Foreign General.................         0        70        35       105
                                 ---------------------------------------
    Total.......................       -40        75       140       175
------------------------------------------------------------------------

    (iv) Step 3: Determination of amount subject to recharacterization. 
The adjustments performed under Step 2 led to a change in the group's 
taxable income within each limitation category. The total loss offset 
adjustment column shown in paragraph (iii) above shows the net 
deviations between Steps 1 and 2.
    (v) Step 4: Recharacterization. The loss offset adjustments yield a 
positive change in the foreign passive and the foreign general 
limitation categories. Y and Z both have income in these limitation 
categories. Accordingly, the income of Y and Z in each of these 
limitation categories must be reduced on a pro rata basis (by reference 
to the adjusted taxable income figures) to the extent of the positive 
change in each limitation category. The total positive change in the 
foreign passive limitation category is $3.50. The adjusted taxable 
income of Y in the foreign passive limitation category is $5, and the 
adjusted taxable income of Z in the foreign passive limitation category 
is $5. Therefore, $1.75 is drawn from Y and $1.75 is drawn from Z. The 
total positive change in the foreign general limitation category is 
$31.50. The adjusted taxable income of Y in the foreign general 
limitation category is $70, and the adjusted taxable income of Z in the 
foreign general limitation category is $35. Therefore, $21 is drawn from 
Y and $10.50 is drawn from Z.
    The members must then separately compute the sum of the limitation 
reductions. Y has limitation reductions of $1.75 in the foreign passive 
limitation category and $21 in the foreign general limitation category, 
yielding total limitation reductions of $22.75. Under these facts, 
domestic income is the only limitation category requiring a positive 
adjustment. Accordingly, Y's domestic income is increased by $22.75. Z 
has limitation reductions of $1.75 in the foreign passive limitation 
category and $10.50 in the foreign general limitation category, yielding 
total limitation reductions of $12.25. Under these facts, domestic 
income is the only limitation category requiring a positive adjustment. 
Accordingly, Z's domestic income is increased by $12.25.

------------------------------------------------------------------------
 Recharacterization adjustments       X         Y         Z       Total
------------------------------------------------------------------------
Domestic........................         0    +22.75    +12.25    +35.00
Foreign Passive.................         0     -1.75     -1.75     -3.50
Foreign General.................         0    -21.00    -10.50    -31.50
------------------------------------------------------------------------

    These recharacterization adjustments yield the following final 
taxable income figures:

------------------------------------------------------------------------
      Final taxable income            X         Y         Z       Total
------------------------------------------------------------------------
Domestic........................    -40.00     22.75    112.25     95.00
Foreign Passive.................      0         3.25      3.25      6.50
Foreign General.................      0        49.00     24.50     73.50
                                 ---------------------------------------
    Total.......................    -40.00     75.00    140.00    175.00
------------------------------------------------------------------------


[[Page 213]]


[T.D. 8228, 53 FR 35490, Sept. 14, 1988, as amended by T.D. 8916, 65 FR 
274, Jan. 3, 2001]



Sec. 1.861-12T  Characterization rules and adjustments for certain assets (temporary regulations.)

    (a) In general. These rules are applicable to taxpayers in 
apportioning expenses under an asset method to income in various 
separate limitation categories under section 904(d), and supplement 
other rules provided in Secs. 1.861-9T, 1.861-10T, and 1.861-11T. The 
rules of this section apply to taxable years beginning after December 
31, 1986, except as otherwise provided in Sec. 1.861-13T. Paragraph (b) 
of this section describes the treatment of inventories. Paragraph (c)(1) 
of this section concerns the treatment of various stock assets. 
Paragraph (c)(2) of this section describes a basis adjustment for stock 
in nonaffiliated 10 percent owned corporations. Paragraph (c)(3) of this 
section sets forth rules for characterizing the stock in controlled 
foreign corporations. Paragraph (c)(4) of this section describes the 
treatment of stock of noncontrolled section 902 corporations. Paragraph 
(d)(1) of this section concerns the treatment of notes. Paragraph (d)(2) 
of this section concerns the treatment of the notes of controlled 
foreign corporations. Paragraph (e) of this section describes the 
treatment of certain portfolio securities that constitute inventory or 
generate income primarily in the form of gains. Paragraph (f) of this 
section describes the treatment of assets that are subject to the 
capitalization rules of section 263A. Paragraph (g) of this section 
concerns the treatment of FSC stock and of assets of the related 
supplier generating foreign trade income. Paragraph (h) of this section 
concerns the treatment of DISC stock and of assets of the related 
supplier generating qualified export receipts. Paragraph (i) of this 
section is reserved. Paragraph (j) of this section sets forth an example 
illustrating the rules of this section, as well as the rules of 
Sec. 1.861-9T(g).
    (b) Inventories. Inventory must be characterized by reference to the 
source and character of sales income, or sales receipts in the case of 
LIFO inventory, from that inventory during the taxable year. If a 
taxpayer maintains separate inventories for any federal tax purpose, 
including the rules for establishing pools of inventory items under 
sections 472 and 474 of the Code, each separate inventory shall be 
separately characterized in accordance with the previous sentence.
    (c) Treatment of stock--(1) In general. Subject to the adjustment 
and special rules of paragraphs (c) and (e) of this section, stock in a 
corporation is taken into account in the application of the asset method 
described in Sec. 1.861-9T(g). However, an affiliated group (as defined 
in Sec. 1.861-11T(d)) does not take into account the stock of any member 
in the application of the asset method.
    (2) Basis adjustment for stock in nonaffiliated 10 percent owned 
corporations--(i) Taxpayers using the tax book value method. For 
purposes of apportioning expenses on the basis of the tax book value of 
assets, the adjusted basis of any stock in a 10 percent owned 
corporation owned directly by the taxpayer shall be--
    (A) Increased by the amount of the earnings and profits of such 
corporation (and of lower-tier 10 percent owned corporations) 
attributable to such stock and accumulated during the period the 
taxpayer or other members of its affiliated group held 10 percent or 
more of such stock, or
    (B) Reduced (but not below zero) by any deficit in earnings and 
profits of such corporation (and of lower-tier 10 percent owned 
corporations) attributable to such stock for such period.

Solely for purposes of this section, a taxpayer's basis in the stock of 
a controlled foreign corporation shall not include any amount included 
in basis under section 961 or 1293(d) of the Code. For purposes of this 
paragraph (c)(2), earnings and profits and deficits are computed under 
the rules of section 312 and, in the case of a foreign corporation, 
section 902 and the regulations thereunder for taxable years of the 10 
percent owned corporation ending on or before the close of the taxable 
year of the taxpayer. The rules of section 1248 and the regulations 
thereunder shall apply to determine the amount of earnings and profits 
that is attributable to stock without regard to whether earned and 
profits (or deficits)

[[Page 214]]

were derived (or incurred) during taxable years beginning before or 
after December 31, 1962. This adjustment is to be made annually and is 
noncumulative. Thus, the adjusted basis of the stock (determined without 
prior years' adjustments under this section) is to be adjusted annually 
by the amount of accumulated earnings and profits (or any deficit) 
attributable to such stock as of the end of each year. Earnings and 
profits or deficits of a qualified business unit that has a functional 
currency other than the dollar must be computed under this paragraph 
(c)(2) in functional currency and translated into dollars using the 
exchange rate at the end of the taxpayer's current taxable year with 
respect to which interest is being allocated (and not the exchange rates 
for the years in which the earnings and profits or deficits were derived 
or incurred).
    (ii) 10 percent owned corporation defined--(A) In general. The term 
``10 percent owned corporation'' means any corporation (domestic or 
foreign)--
    (1) Which is not included within the taxpayer's affiliated group as 
defined in Sec. 1.861-11T(d) (1) or (6).
    (2) In which the members of the taxpayer's affiliated group own 
directly or indirectly 10 percent or more of the total combined voting 
power of all classes of the stock entitled to vote, and
    (3) Which is taken into account for purposes of apportionment.
    (B) Rule of attribution. Stock that is owned by a corporation, 
partnership, or trust shall be treated as being indirectly owned 
proportionately by its shareholders, partners, or beneficiaries. For 
this purpose, a partner's interest in stock held by a partnership shall 
be determined by reference to the partner's distributive share of 
partnership income.
    (iii) Earnings and profits of lower-tier corporations taken into 
account. For purposes of the adjustment to the basis of the stock of the 
10 percent owned corporation owned by the taxpayer under paragraph 
(c)(2)(i) of this section, the earnings and profits of that corporation 
shall include its pro rata share of the earnings and profits (or any 
deficit therein) of each succeeding lower-tier 10 percent owned 
corporation. Thus, a first-tier 10 percent owned corporation shall 
combine with its own earnings and profits its pro rata share of the 
earnings and profits of all such lower-tier corporations. The affiliated 
group shall then adjust its basis in the stock of the first-tier 
corporation by its pro rata share of the total combined earnings and 
profits of the first-tier and the lower-tier corporations. In the case 
of a 10 percent owned corporation whose tax year does not conform to 
that of the taxpayer, the taxpayer shall include the annual earnings and 
profits of such 10 percent owned corporation for the tax year ending 
within the tax year of the taxpayer, whether or not such 10 percent 
owned corporation is owned directly by the taxpayer.
    (iv) Special rules for foreign corporations in pre-effective date 
tax years. Solely for purposes of determining the adjustment required 
under paragraph (c)(2)(i) of this section, for tax years beginning after 
1912 and before 1987, financial earnings (or losses) of a foreign 
corporation computed using United States generally accepted accounting 
principles may be substituted for earnings and profits in making the 
adjustment required by paragraph (c)(2)(i) of this section. A taxpayer 
is not required to isolate the financial earnings of a foreign 
corporation derived or incurred during its period of 10 percent 
ownership or during the post-1912 taxable years and determine earnings 
and profits (or deficits) attributable under section 1248 principles to 
the taxpayer's stock in a 10 percent owned corporation. Instead, the 
taxpayer may include all historic financial earnings for purposes of 
this adjustment. If the affiliated group elects to use financial 
earnings with respect to any foreign corporation, financial earnings 
must be used by that group with respect to all foreign corporations, 
except that earnings and profits may in any event be used for controlled 
foreign corporations for taxable years beginning after 1962 and before 
1987. However, if the affiliated group elects to use earnings and 
profits with respect to any single controlled foreign corporation for 
the 1963 through 1986 period, such election shall apply with respect to 
all its controlled foreign corporations.

[[Page 215]]

    (v) Taxpayers using the fair market value method. Because the fair 
market value of any asset which is stock will reflect retained earnings 
and profits, taxpayers who use the fair market value method shall not 
adjust stock basis by the amount of retained earnings and profits, as 
otherwise required by paragraph (c)(2)(i) of this section.
    (vi) Examples. Certain of the rules of this paragraph (c)(2) may be 
illustrated by the following examples.

    Example 1. X, an affiliated group that uses the tax book value 
method of apportionment, owns 20 percent of the stock of Y, which owns 
50 percent of the stock of Z. X's basis in the Y stock is $1,000. X, Y, 
and Z have calendar taxable years. The undistributed earnings and 
profits of Y and Z at year-end attributable to X's period of ownership 
are $80 and $40, respectively. Because Y owns half of the Z stock, X's 
pro rata share of Z's earnings and profits attributable to X's Y stock 
is $4. X's pro rata share of Y's earnings attributable to X's Y stock is 
$16. For purposes of apportionment, the tax book value of the Y stock 
is, therefore, considered to be $1,020.
    Example 2. X, an unaffiliated domestic corporation that was 
organized on January 1, 1987, has owned all the stock of Y, a foreign 
corporation with a functional currency other than the U.S. dollar, since 
January 1, 1987. Both X and Y have calendar taxable years. All of Y's 
assets generate general limitation income. X has a deductible interest 
expense incurred in 1987 of $160,000. X apportions its interest expense 
using the tax book value method. The adjusted basis of its assets that 
generate domestic income is $7,500,000. The adjusted basis of its assets 
that generate foreign source general limitation income (other than the 
stock of Y) is $400,000. X's adjusted basis in the Y stock is 
$2,000,000. Y has undistributed earnings and profits for 1987 of 
$100,000, translated into dollars from Y's functional currency at the 
exchange rate on the last day of X's taxable year. Because X is required 
under paragraph (b)(1) of this Sec. 1.861-10T to increase its basis in 
the Y stock by the computed amount of earnings and profits, X's adjusted 
basis in the Y stock is considered to be $2,100,000, and its adjusted 
basis of assets that generate foreign source general limitation income 
is, thus, considered to be $2,500,000. X would apportion its interest 
expense as follows:
    To foreign source general limitation income:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.009
    
    To domestic source income:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.010
    
    (3) Characterization of stock of controlled foreign corporations--
(i) In general. Stock in a controlled foreign corporation (as defined in 
section 957) shall be characterized as an asset in the various separate 
limitation categories either on the basis of:
    (A) The asset method described in paragraph (c)(3)(ii) of this 
section, or

[[Page 216]]

    (B) The modified gross income method described in paragraph 
(c)(3)(iii) of this section.

Stock in a controlled foreign corporation whose interest expense is 
apportioned on the basis of assets shall be characterized in the hands 
of its United States shareholders under the asset method described in 
paragraph (c)(3)(ii). Stock in a controlled foreign corporation whose 
interest expense is apportioned on the basis of gross income shall be 
characterized in the hands of its United States shareholders under the 
gross income method described in paragraph (c)(3)(iii).
    (ii) Asset method. Under the asset method, the taxpayer 
characterizes the tax book value or fair market value of the stock of a 
controlled foreign corporation based on an analysis of the assets owned 
by the controlled foreign corporation during the foreign corporation's 
taxable year that ends with or within the taxpayer's taxable year. This 
process is based on the application of Sec. 1.861-9T(g) at the level of 
the controlled foreign corporation. In the case of a controlled foreign 
corporation that owns stock in one or more lower-tier controlled foreign 
corporations in which the United States taxpayer is a United States 
shareholder, the characterization of the tax book value of the fair 
market value of the stock of the first-tier controlled foreign 
corporation to the various separate limitation categories of the 
affiliated group must take into account the stock in lower-tier 
corporations. For this purpose, the stock of each such lower-tier 
corporation shall be characterized by reference to the assets owned 
during the lower-tier corporation's taxable year that ends during the 
taxpayer's taxable year. The analysis of assets within a chain of 
controlled foreign corporations must begin at the lowest-tier controlled 
foreign corporation and proceed up the chain to the first-tier 
controlled foreign corporation. For purposes of this paragraph (c), the 
value of any passive asset to which related person interest is allocated 
under Sec. 1.904-5(c)(2)(ii) must be reduced by the principal amount of 
indebtedness on which such interest is incurred. Furthermore, the value 
of any asset to which interest expense is directly allocated under 
Sec. 1.861-10T must be reduced as provided in Sec. 1.861-9T(g)(2)(iii). 
See Sec. 1.861-9T(h)(5) for further guidance concerning characterization 
of stock in a related person under the fair market value method.
    (iii) Modified gross income method. Under the gross income method, 
the taxpayer characterizes the tax book value of the stock of the first-
tier controlled foreign corporation based on the gross income net of 
interest expense of the controlled foreign corporation (as computed 
under Sec. 1.861-9T(j)) within each relevant category for the taxable 
year of the controlled foreign corporation ending with or within the 
taxable year of the taxpayer. For this purpose, however, the gross 
income of the first-tier controlled foreign corporation shall include 
the total amount of net subpart F income of any lower-tier controlled 
foreign corporation that was excluded under the rules of Sec. 1.861-
9T(j)(2)(ii)(B).
    (4) Stock of noncontrolled section 902 corporations--(i) General 
rule. Because each noncontrolled section 902 corporation constitutes a 
separate limitation category, the value of such stock, increased to the 
extent required under paragraph (c)(2) of this section, is attributable 
solely to each such category.
    (ii) Special rule for separate limitation losses--(A) Election. If, 
as a result of the allocation and apportionment of interest expense 
using the asset method described in Sec. 1.861-9T(g), the taxpayer has a 
loss in the separate limitation category for a given noncontrolled 
section 902 corporation, the taxpayer may elect to reallocate interest 
expense equal to such loss to any other separate limitation category 
that is in excess credit (without regard to carryovers from other 
years), to the extent that the reallocation of such interest to such 
other category does not create a loss in that category. For this 
purpose, the term ``category in excess credit'' means any category of 
income with respect to which the foreign income taxes paid or accrued 
for the current taxable year exceed the limitation computed under 
section 904 with respect to such category. The election to reallocate 
interest expense under this paragraph shall be made in the manner

[[Page 217]]

prescribed in Sec. 1.861-9T(f)(3) (relating to the election to use a 
gross income method for controlled foreign corporations). Furthermore, 
such election is irrevocable and, thus, cannot be amended by an amended 
return.

    (B) Example. X, a domestic corporation organized on January 1, 1987, 
incurred deductible interest expense in 1987 in the amount of 
$1,000,000. X uses the tax book value method of apportionment. X owns 25 
percent of the stock of A, a noncontrolled section 902 corporation. At 
the end of 1987, the tax book value of X's assets by income grouping are 
as follows:

Domestic......................................................$3,500,000
Foreign general limitation.....................................1,000,000
Noncontrolled section 902 corporation............................500,000

    In 1987, A paid no dividends. X received $100,000 of foreign general 
limitation income, on which it incurred $50,000 of tax to foreign 
governments.
    The stock of A constitutes ten percent of X's assets. Therefore, ten 
percent of X's interest expense ($100,000) is allocated and apportioned 
to the separate limitation category for dividends on the A stock. Since 
A paid no dividends, this amount would constitute a separate limitation 
loss under the rules of section 904(f)(5).
    Because X incurred more tax to foreign governments on its foreign 
general limitation income than it can credit against its U.S. tax 
liability, for the current tax year, and because the reallocation of 
interest expense allocated and apportioned to dividends from A to 
foreign general limitation income would not create a loss in that 
category, X may elect to reallocate such interest expense to the foreign 
general limitation category to the extent of the loss in the separate 
limitation category for dividends received from A.

    (d) Treatment of notes--(1) General rule. Subject to the adjustments 
and special rules of this paragraph (d) and paragraph (e) of this 
section, all notes held by a taxpayer are taken into account in the 
application of the asset method described in Sec. 1.861-9T(g). However, 
the notes of an affiliated corporation are subject to special rules set 
forth in Sec. 1.861-11T(e). For purposes of this section, the term 
``notes'' means all interest bearing debt, including debt bearing 
original issue discount.
    (2) Characterization of related controlled foreign corporation 
notes. The debt of a controlled foreign corporation shall be 
characterized according to the taxpayer's treatment of the interest 
income derived from that debt obligation after application of the look-
through rule of section 904(d)(3)(C). Thus, a United States shareholder 
includes interest income from a controlled foreign corporation in the 
same category of income as the category of income from which the 
controlled foreign corporation deducts the interest expense. See section 
954(b)(5) and Sec. 1.904-5(c)(2) for rules concerning the allocation of 
related person interest payments to the foreign personal holding company 
income of a controlled foreign corporation.
    (e) Portfolio securities that constitute inventory or generate 
primarily gains. Because gain on the sale of securities is sourced by 
reference to the residence of the seller, a resident of the United 
States will generally receive domestic source income (and a foreign 
resident will generally receive foreign source income) upon sale or 
disposition of securities that otherwise generate foreign source 
dividends and interest (or domestic source dividends and interest in the 
case of a foreign resident). Although under paragraphs (c) and (d) of 
this section securities are characterized by reference to the source and 
character of dividends and interest, the source and character of income 
on gain or disposition must also be taken into account for purposes of 
characterizing portfolio securities if:
    (1) The securities constitute inventory in the hands of the holder, 
or
    (2) 80 percent or more of the gross income generated by a taxpayer's 
entire portfolio of such securities during a taxable year consists of 
gains.

For this purpose, a portfolio security is a security in any entity other 
than a controlled foreign corporation with respect to which the taxpayer 
is a United States shareholder under section 957, a noncontrolled 
section 902 corporation with respect to the taxpayer, or a 10 percent 
owned corporation as defined in Sec. 1.861-12(c)(2)(ii). In taking gains 
into account, a taxpayer must treat all portfolio securities generating 
foreign source dividends and interest as a single asset and all 
portfolio securities generating domestic source dividends as a single 
asset and shall characterize the total value of that asset based on

[[Page 218]]

the source of all income and gain generated by those securities in the 
taxable year.
    (f) Assets funded by disallowed interest--(1) Rule. In the case of 
any asset in connection with which interest expense accruing at the end 
of the taxable year is capitalized, deferred, or disallowed under any 
provision of the Code, the adjusted basis or fair market value 
(depending on the taxpayer's choice of apportionment methods) of such an 
asset shall be reduced by the principal amount of indebtedness the 
interest on which is so capitalized, deferred, or disallowed.
    (2) Example. The rules of this paragraph (f) may be illustrated by 
the following example.

    Example. X is a domestic corporation which uses the tax book value 
method of apportionment. X has $1000 of indebtedness and $100 of 
interest expense. X constructs an asset with an adjusted basis of $800 
before interest capitalization and is required under the rules of 
section 263A to capitalize $80 in interest expense. Because interest on 
$800 of debt is capitalized and because the production period is in 
progress at the end of X's taxable year, $800 of the principal amount of 
X's debt is allocable to the building. The $800 of debt allocable to the 
building reduces its adjusted basis for purposes of apportioning the 
balance of X's interest expense ($20).

    (g) Special rules for FSCs--(1) Treatment of FSC stock. No interest 
expense shall be allocated or apportioned to stock of a foreign sales 
corporation (``FSC'') to the extent that the FSC stock is attributable 
to the separate limitation for certain FSC distributions described in 
section 904(d)(1)(H). FSC stock is considered to be attributable solely 
to the separate limitation category described in section 904(d)(1)(H) 
unless the taxpayer can demonstrate that more than 20 percent of the 
FSC's gross income for the taxable year consists of income other than 
foreign trading income.
    (2) Treatment of assets that generate foreign trade income. Assets 
of the related supplier that generate foreign trade income must be 
prorated between assets attributable to foreign source general 
limitation income and assets attributable to domestic source income in 
proportion to foreign source general limitation income and domestic 
source income derived from transactions generating foreign trade income.
    (i) Value of assets attributable to foreign source income. The value 
of assets attributable to foreign source general limitation income is 
computed by multiplying the value of assets for the taxable year 
generating foreign trading gross receipts by a fraction:
    (A) The numerator of which is foreign source general limitation 
income for the taxable year derived from transactions giving rise to 
foreign trading gross receipts, after the application of the limitation 
provided in section 927(e)(1), and
    (B) The denominator of which is total income for the taxable year 
derived from the transaction giving rise to foreign trading gross 
receipts.
    (ii) Value of assets attributable to domestic source income. The 
value of assets attributable to domestic source income is computed by 
subtracting from the total value of assets for the taxable year 
generating foreign trading gross receipts the value of assets 
attributable to foreign source general limitation income as computed 
under paragraph (g)(2)(i) of this section.
    (h) Special rules for DISCs--(1) Treatment of DISC stock. No 
interest shall be allocated or apportioned to stock in a DISC (or stock 
in a former DISC to the extent that the stock in the former DISC is 
attributable to the separate limitation category described in section 
904(d)(1)(F)).
    (2) Treatment of assets that generate qualified export receipts. 
Assets of the related supplier that generate qualified export receipts 
must be prorated between assets attributable to foreign source general 
limitation income and assets attributable to domestic source income in 
proportion to foreign source general limitation income and domestic 
source income derived from transactions during the taxable year from 
transactions generating qualified export receipts.
    (i) [Reserved]
    (j) Examples. Certain of the rules in this section and Secs. 1.861-
9T(g) and 1.861-10(e) are illustrated by the following example.

    Example 1 --(1) Facts. X, a domestic corporation organized on 
January 1, 1987, has a

[[Page 219]]

calendar taxable year and apportions its interest expense on the basis 
of the tax book value of its assets. In 1987, X incurred a deductible 
third-party interest expense of $100,000 on an average month-end debt 
amount of $1 million. The total tax book value of X's assets (adjusted 
as required under paragraph (b) of this section for retained earnings 
and profits) is $2 million. X manufactures widgets. One-half of the 
widgets are sold in the United States and one-half are exported and sold 
through a foreign branch with title passing outside the United States.
    X owns all the stock of Y, a controlled foreign corporation that 
also has a calendar taxable year and is also engaged in the manufacture 
and sale of widgets. Y has no earnings and profits or deficits in 
earnings and profits prior to 1987. For 1987, Y has taxable income and 
earnings and profits of $50,000 before the deductible for related person 
interest expense. Half of the $50,000 is foreign source personal holding 
company income and the other half is derived from widget sales and 
constitutes foreign source general limitation income. Assume that Y has 
no deductibles from gross income other than interest expense. Y's 
foreign personal holding company taxable income is included in X's gross 
income under section 951. Y paid no dividends in 1987. Prior to 1987, Y 
did not borrow any funds from X. The average month-end level of 
borrowings by Y from X in 1987 is $100,000, on which Y paid a total of 
$10,000 in interest. The total tax book value of Y's assets in 1987 is 
$500,000. Y has no liabilities to third parties. X elects pursuant to 
Sec. 1.861-9T for Y to apportion Y's interest expense under the gross 
income method prescribed in Sec. 1.861-9T(g).
    In addition to its stock in Y, X owns 20 percent of the stock of Z, 
a noncontrolled section 902 corporation.

X's total assets and their tax book values are:

------------------------------------------------------------------------
                                                               Tax book
                            Asset                                value
------------------------------------------------------------------------
Plant & equipment...........................................  $1,000,000
Corporate headquarters......................................     500,000
Inventory...................................................     200,000
Automobiles.................................................      20,000
Patents.....................................................      50,000
Trademarks..................................................      10,000
Y stock (including paragraph (c)(2) adjustment).............      80,000
Y note......................................................     100,000
Z stock.....................................................      40,000
------------------------------------------------------------------------

    (2) Categorization of Assets.

                         Single Category Assets

    1. Automobiles: X's automobiles are used exclusively by its domestic 
sales force in the generation of United States source income. Thus, 
these assets are attributable solely to the grouping of domestic income.
    2. Y Note: Under paragraph (d)(2) of this section, the Y note in the 
hands of X is characterized according to X's treatment of the interest 
income received on the Y note. In determining the source and character 
of the interest income on the Y note, the look-through rules of sections 
904(d)(3)(C) and 904(g) apply. Under section 954(b)(5) and Sec. 1.904-
5(c)(2)(ii), Y's $10,000 interest payment to X is allocated directly to, 
and thus reduces, Y's foreign personal holding company income of $25,000 
(yielding foregin personal holding company taxable income of $15,000). 
Therefore, the Y note is attributable solely to the statutory grouping 
of foreign source passive income.
    3. Z stock: Because Z is a noncontrolled section 902 corporation, 
the dividends paid by Z are subject to a separate limitation under 
section 904(d)(1)(E). Thus, this asset is attributable solely to the 
statutory grouping consisting of Z dividends.

                        Multiple Category Assets

    1. Plant & equipment, inventory, patents, and trademarks: In 1987, X 
sold half its widgets in the United States and exported half outside the 
United States. A portion of the taxable income from export sales will be 
foreign source income, since the export sales were accomplished through 
a foreign branch and title passed outside the United States. Thus, these 
assets are attributable both to the statutory grouping of foreign 
general limitation and the grouping of domestic income.
    2. Y Stock: Since Y's interest expense is apportioned under the 
gross income method prescribed in Sec. 1.861-9T(j), the Y stock must be 
characterized under the gross income method described in paragraph 
(c)(3)(iii) of this section.

               Assets without Directly Identifiable Yield

    1. Corporate headquarters: This asset generates no directly 
identifiable income yield. The value of the asset is disregarded.
    (3) Analysis of Income Yield for Multiple Category Assets.
    1. Plant & Equipment, inventory, patents, and trademarks: As noted 
above, X's 1987 widget sales were half domestic and half foreign. Assume 
that Example 2 of Sec. 1.863-3(b)(2) applies in sourcing the export 
income from the export sales. Under Example 2, the income generated by 
the export sales is sourced half domestic and half foreign. The income 
gnerated by the domestic sales is entirely domestic source. Accordingly, 
three-quarters of the income generated on all sales is domestic source 
and one-quarter of the income is foreign source. Thus, three-quarters of 
the fair market value of these assets are attributed to the grouping of 
domestic source income and one-quarter of the fair market value of these 
assets is attributed to

[[Page 220]]

the statutory grouping of foreign source general limitation income.
    2. Y Stock: Under the gross income method described in paragraph 
(c)(3)(iii) of this section, Y's gross income net of interest expenses 
in each limitation category must be determined--$25,000 foreign source 
general limitation income and $15,000 of foreign source passive income. 
Of X's adjusted basis of $80,000 in Y stock, $50,000 is attributable to 
foreign source general limitation income and $30,000 is attributable to 
foreign source passive income.
    (4) Application of the Special Allocation Rule of Sec. 1.861-10T(e). 
Assume that the taxable year in question is 1990 and that the appliable 
percentage prescribed by Sec. 1.861-10T(e)(1)(iv)(A) is 80 percent. 
Assume that X has elected to use the quadratic formula provided in 
Sec. 1.861-10T(e)(1)(iv)(B).
    Step 1. X's average month-end level of debt owning to unrelated 
persons is $1 million. The tax book value of X's assets is $2 million. 
Thus, X's debt-to-asset ratio computed under Sec. 1.861-10T(e)(1)(i) is 
1 to 2.
    Step 2. The tax book value of Y's assets is $500,000. Because Y has 
no debt to persons other than X, Y's debt-to-asset ratio computed under 
Sec. 1.861-10T(e)(1)(ii) is $0 to $500,000.
    Step 3. Y's average month-end liabilities to X, as computed under 
Sec. 1.861-10T(e)(1)(iii) for 1987 are $100,000.
    Step 4. Adding the $100,000 of Y's liabilities owed to X as computed 
under Step 3 to Y's third party liabilities ($0) would be insufficient 
to make Y's debt-to-asset ratio computed in Step 2 ($100,000-to-
$500,000, or 1:5) equal to at least 80 percent of X's debt-to-asset 
ratio computed under Step 1, as adjusted to reflect a reduction in X's 
debt and assets by the $100,000 of excess related person indebtedness 
(.80x$900,000/$1,900,000 or 1:2.6). Therefore, the entire amount of Y's 
liabilities to X ($100,000) constitute excess related person 
indebtedness under Sec. 1.861-10T(e)(1)(ii). Thus, the entire $10,000 of 
interest received by X from Y during 1987 constitutes interest received 
on excess related person indebtedness.
    Step 5. The Y note held by X has a tax book value of $100,000. 
Solely for purposes of Sec. 1.861-10(e)(1)(v), the Y note is attributed 
to separate limitation categories in the same manner as the Y stock. 
Under paragraph (c)(3)(iii) of this section, of the $80,000 of Y stock 
held by X, $50,000 is attributable to foreign source general limitation 
income, and $30,000 is attributable to foreign source passive income. 
Thus, for purposes of $1.861-10T(e)(1)(v), $62,500 of the $100,000 Y 
note is considered to be a foreign source general limitation asset and 
$37,500 of the $100,000 Y note is considered to be a foreign source 
passive asset.
    Step 6. Since $8,000 of the $10,000 in related person interest 
income received by Y constitutes interest received on excessive related 
person indebtedness, $10,000 of X's third party interest expense is 
allocated to X's debt investment in Y. Under Sec. 1.861-10T(e)(1)(vi), 
62.5 percent of the $10,000 of X's third party interest expense ($6,250) 
is allocated to foreign source general limitation income and 37.5 
percent of the $10,000 of X's third party interest expense ($3,750) is 
allocated to foreign source passive income. As a result of this direct 
allocation, the value of X's assets generating foreign source general 
limitation income shall be reduced by the principal amount of 
indebtedness the interest on which is directly allocated to foreign 
source general limitation income ($62,500), and X's assets generating 
foreign general limitation income shall be reduced by the principal 
amount of indebtedness the interest on which is directly allocated to 
foreign passive income ($37,500).
    (5) Totals.
    Having allocated $10,000 of its third party interest expense to its 
debt investment in Y, X would apportion the $90,000 balance of its 
interest according to the following apportionment fractions:

----------------------------------------------------------------------------------------------------------------
                                                             Domestic     Foreign      Foreign     Noncontrolled
                          Asset                               source      general      passive      section 902
----------------------------------------------------------------------------------------------------------------
Plant and equipment......................................     $750,000    $250,000   ...........  ..............
Inventory................................................     $150,000     $50,000   ...........  ..............
Automobiles..............................................      $20,000  ...........  ...........  ..............
Patents..................................................      $37,500     $12,500   ...........  ..............
Trademarks...............................................       $7,500      $2,500   ...........  ..............
Y stock..................................................  ...........     $50,000      $30,000   ..............
Y note...................................................  ...........  ...........    $100,000   ..............
Z stock..................................................  ...........  ...........  ...........         $40,000
 
                                                          ------------------------------------------------------
      Totals.............................................     $965,000    $365,000     $130,000          $40,000
 
                                                          ======================================================
      Adjustments for directly allocable interest........  ...........    ($62,250)    ($37,750)  ..............
 
                                                          ------------------------------------------------------
      Adjusted totals....................................     $965,000    $302,750      $92,250          $40,000
 
                                                          ======================================================
Percentage...............................................           69          22            6                3
----------------------------------------------------------------------------------------------------------------


[[Page 221]]

    Example 2 --Assume the same facts as in Example 1, except that Y has 
$100,000 of third party indebtedness. Further, assume for purposes of 
the application of the special allocation rule of Sec. 1.861-10T(e) that 
the taxable year is 1990 and that the applicable percentage prescribed 
by Sec. 1.861-10T(e)(1)(iv)(A) is 80 percent. The application of the 
Sec. 1.861-10(e) would be modified as follows.
    Step 1. X's debt-to-asset ratio computed under Sec. 1.861-
10T(e)(1)(i) remains 1 to 2 (or 0.5).
    Step 2. The tax book value of Y's assets is $500,000. Y has $100,000 
of indebtedness to third parties. Y's debt-to-asset ratio computed under 
Sec. 1.861-10T(e)(1)(ii) is $100,000 to $500,000 (1:5 or 0.2).
    Step 3. Y's average month-end liabilities to X, as computed under 
Sec. 1.861-10T(e)(1)(iii) remain $100,000.
    Step 4. X's debt-to-asset ratio is 0.5 and 80 percent of 0.5 is 0.4. 
Because Y's debt-to-asset ratio is 0.2, there is excess related person 
indebtedness, the amount of which can be computed based on the following 
formula:
[GRAPHIC] [TIFF OMITTED] TC07OC91.011

    Supplying the facts as given, this equation is as follows:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.012
    
    Multiply both sides by 500,000 and (2,000,000-X), yielding:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.013
    
    Since there is an X2 in this equation, a quadratic 
formula must be utilized to solve for X. Group the components in this 
equation, segregating the X and the X2:
[GRAPHIC] [TIFF OMITTED] TC07OC91.014

    Apply the quadratic formula:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.015
    
a=1 (coefficient of X2)
b=-2,300,000 (coefficient of X)
c=2x1011 (remaining element of equation)


Therefore, X equals either 90,519 or (2.21x1011). for 
purposes of computing excess related person indebtedness, X is the 
lowest positive amount derived from this equation, which is 90,519.
    Steps 5 and 6 are unchanged from Example 1, except that the total 
amount of interest on excess related party indebtedness is $9,051.

[T.D. 8228, 53 FR 35495, Sept. 14, 1988]



Sec. 1.861-13T  Transition rules for interest expenses (temporary regulations).

    (a) In general--(1) Optional application. The rules of this section 
may be applied at the choice of a corporate taxpayer. In the case of an 
affiliated group, however, the choice must be made on a consistent basis 
for all members. Therefore, a corporate taxpayer (or affiliated group) 
may allocate and apportion its interest expense entirely on the basis of 
the rules contained in Secs. 1.861-8T through 1.861-12T and without 
regard to the rules of this section. The choice is made on an annual 
basis

[[Page 222]]

and, thus, is not binding with respect to subsequent tax years.
    (2) Transition relief. This section contains transitional rules that 
limit the application of the rules for allocating and apportioning 
interest expense of corporate taxpayers contained in Secs. 1.861-8T 
through 1.861-12T, which are applicable in allocating and apportioning 
the interest expense of corporate taxpayers generally for taxable years 
beginning after 1986. Sections 1.861-9(d) (relating to individuals, 
estates, and certain trusts) and 1.861-9(e) (relating to partnerships) 
are effective for taxable years beginning after 1986. Thus, the 
taxpayers to whom those sections apply do not qualify for transition 
relief under this section.
    (3) Indebtedness defined. For purposes of this section, the term 
``indebtedness'' means any obligation or other evidence of indebtedness 
that qenerates an expense that constitutes interest expense within the 
meaning of Sec. 1.861-9T(a). In the case of an obligation that does not 
bear interest initially, but becomes interest bearing with the lapse of 
time or upon the occurrence of an event, such obligation shall only be 
considered to constitute indebtedness when it first bears interest. 
Obligations that are outstanding as of November 16, 1985 shal1 only 
qualify for transition relief under this section if they bear interest-
bearing as of that date. For this purpose, any obligation that has 
original issue discount within the meaning of section 1273(a)(1) of the 
Code shall be considered to be interest-bearing.
    (4) Exceptions. The term ``indebtedness'' shall not include any 
obligation existing between affiliated corporations, as defined in 
Sec. 1.861-llT(d). Moreover, the term ``indebtedness'' shall not include 
any obligation the interest on which is directly allocable under 
Secs. 1.861-10T(b) and 1.861-10T(c). Under Sec. 1.861-9T(b)(6)(iv)(B), 
certain interest expense is directly allocated to the gain derived from 
an appropriately identified financial product. When interest expense on 
a liability is reduced by such gain, the principal amount of such 
liability shall be reduced pro rata by the relative amount of interest 
expense that is directly allocated.
    (b) General phase-in--(1) In general. In the case of each of the 
first three taxable years of the taxpayer beginning after December 31, 
1986, the rules of Secs. 1.861-8T through 1.861-12T shall not apply to 
interest expenses paid or accrued by the taxpayer during the taxable 
year with respect to an aggregate amount of indebtedness which does not 
exceed the general phase-in amount, as defined in paragraph (b)(2) of 
this section.
    (2) General phase-in amount defined. Subject to the limitation 
imposed by paragraph (b)(3) of this section, the general phase-in amount 
means the amount which is the applicable percentage (determined under 
the following table) of the aggregate amount of indebtedness of the 
taxpayer outstanding on November 16, 1985:

 
       Taxable year beginning after December 31, 1986         Percentage
 
First......................................................           75
Second.....................................................           50
Third......................................................           25
 

    (3) Reductions in indebtedness. The general phase-in amount shall 
not exceed the taxpayer's historic lowest month-end debt level taking 
into account all months after October 1985. However, for the taxable 
year ln which a taxpayer attains a new historic lowest month-end debt 
level (but not for subsequent taxable years), the general phase-in 
amount shall not exceed the average of month-end debt levels within that 
taxable year (without taking into account any increase in month-end debt 
levels occurring in such taxable Year after the new historic lowest 
month-end debt level is attained).
    Example. X is a calendar year taxpayer that had $100 of indebtedness 
outstanding on November 16, 1985. X's month-end debt level remained $100 
for all subsequent months until July 1987, when X's month-end debt level 
fell to $50. In computing transition relief for 1987, X's general phase-
in amount cannot exceed $75 (900 divided by 12), which is the average of 
month-end debt levels in 1987. Assuming that X's month-end debt level 
for any subsequent month does not fall below $50, the limitation on its 
general phase-in amount for all taxable years after 1987 will be $50, 
its historic lowest month-end debt level after October 1985.

    (c) Nonapplication of the consolidation rule--(1) General rule. In 
the case of

[[Page 223]]

each of the first five taxable years of the taxpayer beginning after 
December 31, 1986, the consolidation rule contained in Sec. 1.861-11T(c) 
shall not apply to interest expenses paid or accrued by the taxpayer 
during the taxable year with respect to an aggregate amount of 
indebtedness which does not exceed the special phase-in amount, as 
defined in paragraph (c)(2) of this section.
    (2) Special phase-in amount. The special phase-in amount is the sum 
of--
    (i) The general phase-in amount,
    (ii) The five-year phase-in amount, and
    (iii) The four-year phase-in amount.
    (3) Five-year phase-in amount. The five-year phase-in amount is the 
lesser of--
    (i) The applicable percentage (the ``unreduced percentage'' in the 
following table) of the five-year debt amount, or
    (ii) The applicable percentage (the ``reduced percentage'' in the 
following table) of the five-year debt amount reduced by paydowns (if 
any):

------------------------------------------------------------------------
                                                 Unreduced     Reduced
                Transition year                  percentage   percentage
------------------------------------------------------------------------
Year 1........................................       8\1/3\           10
Year 2........................................      16\2/3\           25
Year 3........................................           25           50
Year 4........................................      33\1/3\          100
Year 5........................................      16\2/3\          100
------------------------------------------------------------------------

    (4) Four-year phase-in amount. The four-year phase-in amount is the 
lesser of--
    (i) The applicable percentage (the ``unreduced percentage'' in the 
following table) of the four-year debt amount, or
    (ii) The applicable percentage (the ``reduced percentage'' in the 
following table) of the four-year debt amount reduced by paydowns (if 
any) to the extent that such paydowns exceed the five-year debt amount:

------------------------------------------------------------------------
                                                 Unreduced     Reduced
                Transition year                  percentage   percentage
------------------------------------------------------------------------
Year 1........................................            5       6\1/4\
Year 2........................................           10      16\2/3\
Year 3........................................           15      37\1/2\
Year 4........................................           20          100
------------------------------------------------------------------------

    (5) Five-year debt amount. The ``five-year debt amount'' means the 
excess (if any) of--
    (i) The amount of the outstanding indebtedness of the taxpayer on 
May 29, 1985, over
    (ii) The amount of the outstanding indebtedness of the taxpayer on 
December 31, 1983. The five-year debt amount shall not exceed the 
aggregate amount of indebtedness of the taxpayer outstanding on November 
16, 1985.
    (6) Four-year debt amount. The ``four-year debt amount'' means the 
excess (if any) of--
    (i) The amount of the outstanding indebtedness of the taxpayer on 
December 31, 1983, over
    (ii) The amount of the outstanding indebtedness of the taxpayer on 
December 31, 1982.

The four-year debt amount shall not exceed the aggregate amount of 
indebtedness of the taxpayer outstanding on November 16, 1985, reduced 
by the five-year debt amount.
    (7) Paydowns. The term ``paydowns'' means the excess (if any) of--
    (i) The aggregate amount of indebtedness of the taxpayer outstanding 
on November 16, 1985, over
    (ii) The limitation on the general phase-in amount described in 
paragraph (b)(3) of this section.
    Paydowns are first applied to the five-year debt amount to the 
extent thereof and then to the four-year debt amount for purposes of 
computing the five-year and the four-year phase-in amounts.
    (d) Treatment of affiliated group. For purposes of this section, all 
members of the same affiliated group of corporations (as defined in 
Sec. 1.861-11(d)) shall be treated as one taxpayer whether or not such 
members filed a consolidated return. Interaffiliate debt is not taken 
into account in computing transition relief. Moreover, any reduction in 
the amount of interaffiliate debt is not taken into account in 
determining the amount of paydowns.
    (e) Mechanics of computation--(1) Step 1: Determination of the 
amounts within the various categories of debt. Each separate member of 
an affiliated group must determine each of its following amounts:
    (i) November 16, 1985 amount. The amount of its debt outstanding on 
November 16, 1985 (after the elimination of interaffiliate 
indebtedness),

[[Page 224]]

    (ii) Unreduced five-year debt. The amount of any net increase in the 
amount of its indebtedness on May 29, 1985 (after elimination of 
interaffiliate indebtedness) over the amount of its indebtedness on 
December 31, 1983 (after elimination of interaffiliate indebtedness),
    (iii) Unreduced four-year debt. The amount of any net increase in 
the amount of its indebtedness on December 31, 1983 (after elimination 
of interaffiliate indebtedness) over the amount of its indebtedness on 
December 31, 1982 (after elimination of interaffiliate indebtedness), 
and
    (iv) Month-end debt. The amount of its month-end debt level for all 
months after October 1985 (after elimination of interaffiliate 
indebtedness).
    (2) Step 2: Aggregation of the separate company amounts. Each of the 
designated amounts for the separate companies identified in Step 1 must 
be aggregated in order to compute consolidated transition relief. 
Paragraph (e)(10)(iv) of this section (Step 10) requires the use of the 
taxpayer's current year average debt level for the purpose of computing 
the percentages of debt that are subject to the three sets of rules that 
are identified in Step 10. For use in that computation, the taxpayer 
should compute the current year average debt level by aggregating 
separate company month-end debt levels and then by averaging those 
aggregate amounts.
    (3) Step 3: Calculation of the lowest historic month-end debt level 
of the taxpayer. In order to calculate the lowest historic month-end 
debt level of the taxpayer, determine the month-end debt level of each 
separate company for each month ending after October 1985 and aggregate 
these amounts on a month-by-month basis. On such aggregate basis, in any 
taxable year in which the taxpayer attains an aggregate new lowest 
historic month-end debt level, add together all the aggregate month-end 
debt levels within the taxable year (without taking into account any 
increase in aggregate debt level subsequent to the attainment of such 
lowest historic month-end debt level) and divide by the number of months 
in that taxable year, yielding the average of month-end debt levels for 
such year. Such average shall constitute the taxpayer's lowest historic 
month-end debt level for that taxable year in which the aggregate new 
lowest historic month-end debt level was attained. Unless otherwise 
specified, all subsequent references to any amount refer to the 
aggregate amount for all members of the same affiliated group of 
corporations.
    (4) Step 4: Computation of paydowns. Paydowns equal the amount by 
which the November 16, 1985 amount exceeds the taxpayer's lowest 
historic month-end debt level, determined under Step 3.
    (5) Step 5: Computation of limitations on unreduced five-year debt 
and unreduced four-year debt. (i) The unreduced five-year debt cannot 
exceed the November 16, 1985 amount.
    (ii) The unreduced four-year debt cannot exceed the November 16, 
1985 amount less the unreduced five-year debt.
    (6) Step 6: Computation of reduced five-year and reduced four-year 
debt--(i) Reduced five-year debt. Compute the amount of reduced five-
year debt by subtracting from the unreduced five-year debt (see Step 5) 
the amount of paydowns (see Step 4).
    (ii) Reduced four-year debt. To the extent that the amount of 
paydowns (see step 4) exceeds the amount of unreduced five-year debt 
(see Step 5), compute the amount of reduced four-year debt by 
subtracting such excess from the unreduced four-year debt (see Step 1).
    (iii) To the extent that paydowns do not offset either the unreduced 
five-year amount or the unreduced four-year amount, the reduced and the 
unreduced amounts are the same.
    (7) Step 7: Computation of the general phase-in amount. The general 
phase-in amount is the lesser of--
    (i) The percentage of the November 16, 1985 amount designated for 
the relevant transition year in the table below, or
    (ii) The lowest group month-end debt level (see Step 3).

                         General Phase-in Table
------------------------------------------------------------------------
                      Transition year                         Percentage
------------------------------------------------------------------------
Year 1.....................................................           75
Year 2.....................................................           50

[[Page 225]]

 
Year 3.....................................................           25
------------------------------------------------------------------------

    (8) Step 8: Computation of Five-Year Phase-in Amount. The five-year 
phase-in amount is the lesser of--
    (i) The percentage of the unreduced five-year debt designated for 
the relevant transition year in the table below, or
    (ii) The percentage of the reduced five-year debt designated for the 
relevant transition year in the table below.

                        Five-Year Phase-In Table
------------------------------------------------------------------------
                                                 Unreduced     Reduced
                Transition year                  percentage   percentage
------------------------------------------------------------------------
Year 1.............