[Title 26 CFR 1.954-1]
[Code of Federal Regulations (annual edition) - April 1, 2002 Edition]
[Title 26 - INTERNAL REVENUE]
[Chapter I - INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY]
[Subchapter A - INCOME TAX (CONTINUED)]
[Part 1 - INCOME TAXES]
[Sec. 1.954-1 - Foreign base company income.]
[From the U.S. Government Printing Office]
26INTERNAL REVENUE102002-04-012002-04-01falseForeign base company income.1.954-1Sec. 1.954-1INTERNAL REVENUEINTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURYINCOME TAX (CONTINUED)INCOME TAXES
Sec. 1.954-1 Foreign base company income.
(a) In general--(1) Purpose and scope. Section 954 and Secs. 1.954-1
and 1.954-2 provide rules for computing the foreign base company income
of a controlled foreign corporation. Foreign base company income is
included in the subpart F income of a controlled foreign corporation
under the rules of section 952. Subpart F income is included in the
[[Page 245]]
gross income of a United States shareholder of a controlled foreign
corporation under the rules of section 951 and thus is subject to
current taxation under section 1, 11 or 55 of the Internal Revenue Code.
The determination of whether a foreign corporation is a controlled
foreign corporation, the subpart F income of which is included currently
in the gross income of its United States shareholders, is made under the
rules of section 957.
(2) Gross foreign base company income. The gross foreign base
company income of a controlled foreign corporation consists of the
following categories of gross income (determined after the application
of section 952(b))--
(i) Foreign personal holding company income, as defined in section
954(c);
(ii) Foreign base company sales income, as defined in section
954(d);
(iii) Foreign base company services income, as defined in section
954(e);
(iv) Foreign base company shipping income, as defined in section
954(f); and
(v) Foreign base company oil related income, as defined in section
954(g).
(3) Adjusted gross foreign base company income. The term adjusted
gross foreign base company income means the gross foreign base company
income of a controlled foreign corporation as adjusted by the de minimis
and full inclusion rules of paragraph (b) of this section.
(4) Net foreign base company income. The term net foreign base
company income means the adjusted gross foreign base company income of a
controlled foreign corporation reduced so as to take account of
deductions (including taxes) properly allocable or apportionable to such
income under the rules of section 954(b)(5) and paragraph (c) of this
section.
(5) Adjusted net foreign base company income. The term adjusted net
foreign base company income means the net foreign base company income of
a controlled foreign corporation reduced, first, by any items of net
foreign base company income excluded from subpart F income pursuant to
section 952(c) and, second, by any items excluded from subpart F income
pursuant to the high tax exception of section 954(b). See paragraph
(d)(4)(ii) of this section. The term foreign base company income as used
in the Internal Revenue Code and elsewhere in the Income Tax Regulations
means adjusted net foreign base company income, unless otherwise
provided.
(6) Insurance income. The term gross insurance income includes all
gross income taken into account in determining insurance income under
section 953. The term adjusted gross insurance income means gross
insurance income as adjusted by the de minimis and full inclusion rules
of paragraph (b) of this section. The term net insurance income means
adjusted gross insurance income reduced under section 953 so as to take
into account deductions (including taxes) properly allocable or
apportionable to such income. The term adjusted net insurance income
means net insurance income reduced by any items of net insurance income
that are excluded from subpart F income pursuant to section 952(b) or
pursuant to the high tax exception of section 954(b). The term insurance
income as used in subpart F of the Internal Revenue Code and in the
regulations under that subpart means adjusted net insurance income,
unless otherwise provided.
(7) Additional items of adjusted net foreign base company income or
adjusted net insurance income by reason of section 952(c). Earnings and
profits of the controlled foreign corporation that are recharacterized
as foreign base company income or insurance income under section 952(c)
are items of adjusted net foreign base company income or adjusted net
insurance income, respectively. Amounts subject to recharacterization
under section 952(c) are determined after adjusted net foreign base
company income and adjusted net insurance income are otherwise
determined under subpart F and are not again subject to any exceptions
or special rules that would affect the amount of subpart F income. Thus,
for example, items of gross foreign base company income or gross
insurance income that are excluded from adjusted gross foreign base
company income or adjusted gross insurance income because the de minimis
test is met are subject to recharacterization under section 952(c).
Further, the de minimis and full inclusion tests of paragraph (b)
[[Page 246]]
of this section, and the high tax exception of paragraph (d) of this
section, for example, do not apply to such amounts.
(b) Computation of adjusted gross foreign base company income and
adjusted gross insurance income--(1) De minimis and full inclusion
tests--(i) De minimis test--(A) In general. Except as provided in
paragraph (b)(1)(i)(C) of this section, adjusted gross foreign base
company income and adjusted gross insurance income are equal to zero if
the sum of the gross foreign base company income and the gross insurance
income of a controlled foreign corporation is less than the lesser of--
(1) 5 percent of gross income; or
(2) $1,000,000.
(B) Currency translation. Controlled foreign corporations having a
functional currency other than the United States dollar shall translate
the $1,000,000 threshold using the exchange rate provided under section
989(b)(3) for amounts included in income under section 951(a).
(C) Coordination with sections 864(d) and 881(c). Adjusted gross
foreign base company income or adjusted gross insurance income of a
controlled foreign corporation always includes income from trade or
service receivables described in section 864(d)(1) or (6), and portfolio
interest described in section 881(c), even if the de minimis test of
this paragraph (b)(1)(i) is otherwise satisfied.
(ii) Seventy percent full inclusion test. Except as provided in
section 953, adjusted gross foreign base company income consists of all
gross income of the controlled foreign corporation other than gross
insurance income and amounts described in section 952(b), and adjusted
gross insurance income consists of all gross insurance income other than
amounts described in section 952(b), if the sum of the gross foreign
base company income and the gross insurance income for the taxable year
exceeds 70 percent of gross income. See paragraph (d)(6) of this
section, under which certain items of full inclusion foreign base
company income may nevertheless be excluded from subpart F income.
(2) Character of gross income included in adjusted gross foreign
base company income. The gross income included in the adjusted gross
foreign base company income of a controlled foreign corporation
generally retains its character as foreign personal holding company
income, foreign base company sales income, foreign base company services
income, foreign base company shipping income, or foreign base company
oil related income. However, gross income included in adjusted gross
foreign base company income because the full inclusion test of paragraph
(b)(1)(ii) of this section is met is termed full inclusion foreign base
company income, and constitutes a separate category of adjusted gross
foreign base company income for purposes of allocating and apportioning
deductions under paragraph (c) of this section.
(3) Coordination with section 952(c). Income that is included in
subpart F income because the full inclusion test of paragraph (b)(1)(ii)
of this section is met does not reduce amounts that, under section
952(c), are subject to recharacterization.
(4) Anti-abuse rule--(i) In general. For purposes of applying the de
minimis test of paragraph (b)(1)(i) of this section, the income of two
or more controlled foreign corporations shall be aggregated and treated
as the income of a single corporation if a principal purpose for
separately organizing, acquiring, or maintaining such multiple
corporations is to prevent income from being treated as foreign base
company income or insurance income under the de minimis test. A purpose
may be a principal purpose even though it is outweighed by other
purposes (taken together or separately).
(ii) Presumption. Two or more controlled foreign corporations are
presumed to have been organized, acquired or maintained to prevent
income from being treated as foreign base company income or insurance
income under the de minimis test of paragraph (b)(1)(i) of this section
if the corporations are related persons, as defined in paragraph
(b)(4)(iii) of this section, and the corporations are described in
paragraph (b)(4)(ii)(A), (B), or (C) of this section. This presumption
may be rebutted by proof to the contrary.
(A) The activities carried on by the controlled foreign
corporations, or the
[[Page 247]]
assets used in those activities, are substantially the same activities
that were previously carried on, or assets that were previously held, by
a single controlled foreign corporation. Further, the United States
shareholders of the controlled foreign corporations or related persons
(as determined under paragraph (b)(4)(iii) of this section) are
substantially the same as the United States shareholders of the one
controlled foreign corporation in a prior taxable year. A presumption
made in connection with the requirements of this paragraph (b)(4)(ii)(A)
may be rebutted by proof that the activities carried on by each
controlled foreign corporation would constitute a separate branch under
the principles of Sec. 1.367(a)-6T(g)(2) if carried on directly by a
United States person.
(B) The controlled foreign corporations carry on a business,
financial operation, or venture as partners directly or indirectly in a
partnership (as defined in section 7701(a)(2) and Sec. 301.7701-3 of
this chapter) that is a related person (as defined in paragraph
(b)(4)(iii) of this section) with respect to each such controlled
foreign corporation.
(C) The activities carried on by the controlled foreign corporations
would constitute a single branch operation under Sec. 1.367(a)-6T(g)(2)
if carried on directly by a United States person.
(iii) Related persons. For purposes of this paragraph (b), two or
more persons are related persons if they are in a relationship described
in section 267(b). In determining for purposes of this paragraph (b)
whether two or more corporations are members of the 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 with the application of section 267(c). In
determining for purposes of this paragraph (b) 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).
(iv) Example. The following example illustrates the application of
this paragraph (b)(4).
Example. (i)(1) USP is the sole United States shareholder of three
controlled foreign corporations: CFC1, CFC2 and CFC3. The three
controlled foreign corporations all have the same taxable year. The
three controlled foreign corporations are partners in FP, a foreign
entity classified as a partnership under section 7701(a)(2) and
Sec. 301.7701-3 of the regulations. For their current taxable years,
each of the controlled foreign corporations derives all of its income
other than foreign base company income from activities conducted through
FP, and its foreign base company income from activities conducted both
jointly through FP and separately without FP. Based on the facts in the
table below, the foreign base company income derived by each controlled
foreign corporation for its current taxable year, including income
derived from FP, is less than five percent of the gross income of each
controlled foreign corporation and is less than $1,000,000:
----------------------------------------------------------------------------------------------------------------
CFC1 CFC2 CFC3
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Gross income.................................................... $4,000,000 $8,000,000 $12,000,000
Five percent of gross income.................................... 200,000 400,000 600,000
Foreign base company income..................................... 199,000 398,000 597,000
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(2) Thus, without the application of the anti-abuse rule of this
paragraph (b)(4), each controlled foreign corporation would be treated
as having no foreign base company income after the application of the de
minimis test of section 954(b)(3)(A) and paragraph (b)(1)(i) of this
section.
(ii) However, under these facts, the requirements of paragraph
(b)(4)(i) of this section are met unless the presumption of paragraph
(b)(4)(ii) of this section is successfully rebutted. The sum of the
foreign base company income of the controlled foreign corporations is
$1,194,000. Thus, the amount of gross foreign base company income of
each controlled foreign corporation will not be reduced by reason of the
de minimis rule of section 954(b)(3)(A) and this paragraph (b).
(c) Computation of net foreign base company income--(1) General
rule. The net foreign base company income of a controlled foreign
corporation (as defined in paragraph (a)(4) of this section) is computed
under the rules of this paragraph (c)(1). The principles of
[[Page 248]]
Sec. 1.904-5(k) shall apply where payments are made between controlled
foreign corporations that are related persons (within the meaning of
section 954(d)(3)). Consistent with these principles, only payments
described in Sec. 1.954-2(b)(4)(ii)(B)(2) may be offset as provided in
Sec. 1.904-5(k)(2).
(i) Deductions against gross foreign base company income. The net
foreign base company income of a controlled foreign corporation is
computed first by taking into account deductions in the following
manner:
(A) First, the gross amount of each item of income described in
paragraph (c)(1)(iii) of this section is determined.
(B) Second, any expenses definitely related to less than all gross
income as a class shall be allocated and apportioned under the
principles of sections 861, 864 and 904(d) to the gross income described
in paragraph (c)(1)(i)(A) of this section.
(C) Third, foreign personal holding company income that is passive
within the meaning of section 904 (determined before the application of
the high-taxed income rule of Sec. 1.904-4(c)) is reduced by related
person interest expense allocable to passive income under Sec. 1.904-
5(c)(2); such interest must be further allocated and apportioned to
items described in paragraph (c)(1)(iii)(B) of this section.
(D) Fourth, the amount of each item of income described in paragraph
(c)(1)(iii) of this section is reduced by other expenses allocable and
apportionable to such income under the principles of sections 861, 864
and 904(d).
(ii) Losses reduce subpart F income by operation of earnings and
profits limitation. Except as otherwise provided in Sec. 1.954-2(g)(4),
if after applying the rules of paragraph (c)(1)(i) of this section, the
amount remaining in any category of foreign base company income or
foreign personal holding company income is less than zero, the loss in
that category may not reduce any other category of foreign base company
income or foreign personal holding company income except by operation of
the earnings and profits limitation of section 952(c)(1).
(iii) Items of income--(A) Income other than passive foreign
personal holding company income. A single item of income (other than
foreign personal holding company income that is passive) is the
aggregate amount from all transactions that falls within a single
separate category (as defined in Sec. 1.904-5(a)(1)), and either--
(1) Falls within a single category of foreign personal holding
company income as--
(i) Dividends, interest, rents, royalties and annuities;
(ii) Gain from certain property transactions;
(iii) Gain from commodities transactions;
(iv) Foreign currency gain; or
(v) Income equivalent to interest; or
(2) Falls within a single category of foreign base company income,
other than foreign personal holding company income, as--
(i) Foreign base company sales income;
(ii) Foreign base company services income;
(iii) Foreign base company shipping income;
(iv) Foreign base company oil related income; or
(v) Full inclusion foreign base company income.
(B) Passive foreign personal holding company income. A single item
of foreign personal holding company income that is passive is an amount
of income that falls within a single group of passive income under the
grouping rules of Sec. 1.904-4(c)(3), (4) and (5) and a single category
of foreign personal holding company income described in paragraphs
(c)(1)(iii)(A)(1) (i) through (v).
(2) Computation of net foreign base company income derived from same
country insurance income. Deductions relating to foreign base company
income attributable to the issuing (or reinsuring) of any insurance or
annuity contract in connection with risks located in the country under
the laws of which the controlled foreign corporation is created or
organized shall be allocated and apportioned in accordance with the
rules set forth in section 953.
(d) Computation of adjusted net foreign base company income or
adjusted net insurance income--(1) Application of high tax exception.
Adjusted net foreign base
[[Page 249]]
company income (or adjusted net insurance income) equals the net foreign
base company income (or net insurance income) of a controlled foreign
corporation, reduced by any net item of such income that qualifies for
the high tax exception provided by section 954(b)(4) and this paragraph
(d). Any item of income that is foreign base company oil related income,
as defined in section 954(g), or portfolio interest, as described in
section 881(c), does not qualify for the high tax exception. See
paragraph (c)(1)(iii) of this section for the definition of the term
item of income. For rules concerning the treatment for foreign tax
credit purposes of amounts excluded from subpart F under section
954(b)(4), see Sec. 1.904-4(c). A net item of income qualifies for the
high tax exception only if--
(i) An election is made under section 954(b)(4) and paragraph (d)(5)
of this section to exclude the income from the computation of subpart F
income; and
(ii) It is established that the net item of income was subject to
foreign income taxes imposed by a foreign country or countries at an
effective rate that is greater than 90 percent of the maximum rate of
tax specified in section 11 for the taxable year of the controlled
foreign corporation.
(2) Effective rate at which taxes are imposed. The effective rate
with respect to a net item of income shall be determined separately for
each controlled foreign corporation in a chain of corporations through
which a distribution is made. The effective rate at which taxes are
imposed on a net item of income is--
(i) The United States dollar amount of foreign income taxes paid or
accrued (or deemed paid or accrued) with respect to the net item of
income, determined under paragraph (d)(3) of this section; divided by
(ii) The United States dollar amount of the net item of foreign base
company income or insurance income, described in paragraph (c)(1)(iii)
of this section, increased by the amount of foreign income taxes
referred to in paragraph (d)(2)(i) of this section.
(3) Taxes paid or accrued with respect to an item of income--(i)
Income other than passive foreign personal holding company income. The
amount of foreign income taxes paid or accrued with respect to a net
item of income (other than an item of foreign personal holding company
income that is passive) for purposes of section 954(b)(4) and this
paragraph (d) is the United States dollar amount of foreign income taxes
that would be deemed paid under section 960 with respect to that item if
that item were included in the gross income of a United States
shareholder under section 951(a)(1)(A) (determined, in the case of a
United States shareholder that is an individual, as if an election under
section 962 has been made, whether or not such election is actually
made). For this purpose, in accordance with the regulations under
section 960, the amounts that would be deemed paid under section 960
shall be determined separately with respect to each controlled foreign
corporation and without regard to the limitation applicable under
section 904(a). The amount of foreign income taxes paid or accrued with
respect to a net item of income, determined in the manner provided in
this paragraph (d), will not be affected by a subsequent reduction in
foreign income taxes attributable to a distribution to shareholders of
all or part of such income.
(ii) Passive foreign personal holding company income. The amount of
income taxes paid or accrued with respect to a net item of foreign
personal holding company income that is passive for purposes of section
954(b)(4) and this paragraph (d) is the United States dollar amount of
foreign income taxes that would be deemed paid under section 960 and
that would be taken into account for purposes applying the provisions of
Sec. 1.904-4(c) with respect to that net item of income.
(4) Special rules--(i) Consistency rule. An election to exclude
income from the computation of subpart F income for a taxable year must
be made consistently with respect to all items of passive foreign
personal holding company income eligible to be excluded for the taxable
year. Thus, high-taxed passive foreign personal holding company income
of a controlled foreign corporation must either be excluded in its
entirety, or remain subject to subpart F in its entirety.
[[Page 250]]
(ii) Coordination with earnings and profits limitation. If the
amount of income included in subpart F income for the taxable year is
reduced by the earnings and profits limitation of section 952(c)(1), the
amount of income that is a net item of income, within the meaning of
paragraph (c)(1)(iii) of this section, is determined after the
application of the rules of section 952(c)(1).
(iii) Example. The following example illustrates the provisions of
paragraph (d)(4)(ii) of this section. All of the taxes referred to in
the following example are foreign income taxes. For simplicity, this
example assumes that the amount of taxes that are taken into account as
a deduction under section 954(b)(5) and the amount of the gross-up
required under sections 960 and 78 are equal. Therefore, this example
does not separately illustrate the deduction for taxes and gross-up.
Example. During its 1995 taxable year, CFC, a controlled foreign
corporation, earns royalty income, net of taxes, of $100 that is foreign
personal holding company income. CFC has no expenses associated with
this royalty income. CFC pays $50 of foreign income taxes with respect
to the royalty income. For 1995, CFC has current earnings and profits of
$50. CFC's subpart F income, as determined prior to the application of
this paragraph (d), exceeds its current earnings and profits. Thus,
under paragraph (d)(4)(ii) of this section, the amount of CFC's only net
item of income, the royalty income, will be limited to $50. The
remaining $50 will be subject to recharacterization in a subsequent
taxable year under section 952(c)(2). Because the amount of foreign
income taxes paid with respect to this net item of income is $50, the
effective rate of tax on the item, for purposes of this paragraph (d),
is 50 percent ($50 of taxes/$50 net item + $50 of taxes). Accordingly,
an election under paragraph (d)(5) of this section may be made to
exclude the item of income from the computation of subpart F income.
(5) Procedure. An election made under the procedure provided by this
paragraph (d)(5) is binding on all United States shareholders of the
controlled foreign corporation and must be made--
(i) By the controlling United States shareholders, as defined in
Sec. 1.964-1(c)(5), by attaching a statement to such effect with their
original or amended income tax returns, and including any additional
information required by applicable administrative pronouncements; or
(ii) In such other manner as may be prescribed in applicable
administrative pronouncements.
(6) Coordination of full inclusion and high tax exception rules.
Notwithstanding paragraph (b)(1)(ii) of this section, full inclusion
foreign base company income will be excluded from subpart F income if
more than 90 percent of the adjusted gross foreign base company income
and adjusted gross insurance company income of a controlled foreign
corporation (determined without regard to the full inclusion test of
paragraph (b)(1) of this section) is attributable to net amounts
excluded from subpart F income pursuant to an election to have the high
tax exception described in section 954(b)(4) and this paragraph (d)
apply.
(7) Examples. (i) The following examples illustrate the rules of
this paragraph (d). All of the taxes referred to in the following
examples are foreign income taxes. For simplicity, these examples assume
that the amount of taxes that are taken into account as a deduction
under section 954(b)(5) and the amount of the gross-up required under
sections 960 and 78 are equal. Therefore, these examples do not
separately illustrate the deduction for taxes and gross-up. Except as
otherwise stated, these examples assume there are no earnings, deficits,
or foreign income taxes in the post-1986 pools of earnings and profits
or foreign income taxes.
Example 1. (i) Items of income. During its 1995 taxable year,
controlled foreign corporation CFC earns from outside its country of
operation portfolio dividend income of $100 and interest income, net of
taxes, of $100 (consisting of a gross payment of $150 reduced by a
third-country withholding tax of $50). For purposes of illustration,
assume that CFC incurs no expenses. None of the income is taxed in CFC's
country of operation. The dividend income was not subject to third-
country withholding taxes. Pursuant to the operation of section 904, the
interest income is high withholding tax interest and the dividend income
is passive income. Accordingly, pursuant to paragraph (c)(1)(iii) of
this section, CFC has two net items of income--
(1) $100 of foreign personal holding company (FPHC)/passive income
(the dividends); and
[[Page 251]]
(2) $100 of FPHC/high withholding tax income (the interest).
(ii) Effective rates of tax. No foreign tax would be deemed paid
under section 960 with respect to the net item of income described in
paragraph (i)(1) of this Example 1. Therefore, the effective rate of
foreign tax is 0, and the item may not be excluded from subpart F income
under the rules of this paragraph (d). Foreign tax of $50 would be
deemed paid under section 960 with respect to the net item of income
described in paragraph (i)(2) of this Example 1. Therefore, the
effective rate of foreign tax is 33 percent ($50 of creditable taxes
paid, divided by $150, consisting of the net item of foreign base
company income ($100) plus creditable taxes paid thereon ($50)). The
highest rate of tax specified in section 11 for the 1995 taxable year is
35 percent. Accordingly, the net item of income described in paragraph
(i)(2) of this Example 1 may be excluded from subpart F income if an
election under paragraph (d)(5) of this section is made, since it is
subject to foreign tax at an effective rate that is greater than 31.5
percent (90 percent of 35 percent). However, for purposes of section
904(d), it remains high withholding tax interest.
Example 2. (i) The facts are the same as in Example 1, except that
CFC's country of operation imposes a tax of $50 with respect to CFC's
dividend income (and thus CFC earns portfolio dividend income, net of
taxes, of only $50). The interest income is still high withholding tax
interest. The dividend income is still passive income (without regard to
the possible applicability of the high tax exception of section
904(d)(2)). Accordingly, CFC has two items of income for purposes of
this paragraph (d)--
(1) $50 of FPHC/passive income (net of the $50 foreign tax); and
(2) $100 of FPHC/high withholding tax interest income.
(ii) Each item is taxed at an effective rate greater than 31.5
percent. The net item of income described in paragraph (i)(1) of this
Example 2: foreign tax ($50) divided by sum ($100) of net item of income
($50) plus creditable tax thereon ($50) equals 50 percent. The net item
of income described in paragraph (i)(2) of this Example 2: foreign tax
($50) divided by sum ($150) of income item ($100) plus creditable tax
thereon ($50) equals 33 percent. Accordingly, an election may be made
under paragraph (d)(5) of this section to exclude either or both of the
net items of income described in paragraphs (i)(1) and (2) of this
Example 2 from subpart F income. If no election is made the items would
be included in the subpart F income of CFC.
Example 3. (i) The facts are the same as in Example 1, except that
the $100 of portfolio dividend income is subject to a third-country
withholding tax of $50, and the $150 of interest income is from sources
within CFC's country of operation, is subject to a $10 income tax
therein, and is not subject to a withholding tax. Although the interest
income and the dividend income are both passive income, under paragraph
(c)(1)(iii)(B) of this section they constitute separate items of income
pursuant to the application of the grouping rules of Sec. 1.904-4(c).
Accordingly, CFC has two net items of income for purposes of this
paragraph (d)--
(1) $50 (net of $50 tax) of FPHC/non-country of operation/greater
than 15 percent withholding tax income; and
(2) $140 (net of $10 tax) of FPHC/country of operation income.
(ii) The item described in paragraph (i)(1) of this Example 3 is
taxed at an effective rate greater than 31.5 percent, but Item 2 is not.
The net item of income described in paragraph (i)(1) of this Example 3:
foreign tax ($50) divided by sum ($100) of net item of income ($50) plus
creditable tax thereon ($50) equals 50 percent. The net item of income
described in paragraph (i)(2) of this Example 3: foreign tax ($10)
divided by sum ($150) of net item of income ($140) plus creditable tax
thereon ($10) equals 6.67 percent. Therefore, an election may be made
under paragraph (d)(5) of this section to exclude the net item of income
described in paragraph (i)(1) of this Example 3 but not the net item of
income described in paragraph (i)(2) of this Example 3 from subpart F
income.
Example 4. The facts are the same as in Example 3, except that the
$150 of interest income is subject to an income tax of $50 in CFC's
country of operation. Accordingly, CFC's items of income are the same as
in Example 3, but both items are taxed at an effective rate greater than
31.5 percent. The net item of income described in paragraph (i)(1) of
Example 3: foreign tax ($50) divided by sum ($100) of net item of income
($50) plus creditable tax thereon ($50) equals 50 percent. The net item
of income described in paragraph (i)(2) of Example 3: foreign tax ($50)
divided by sum ($150) of net item of income ($100) plus creditable tax
thereon ($50) equals 33 percent. Pursuant to the consistency rule of
paragraph (d)(4)(i) of this section, an election made by CFC's
controlling United States shareholders must exclude from subpart F
income both items of FPHC income under the high tax exception of section
954(b)(4) and this paragraph (d). The election may not be made only with
respect to one item.
Example 5. The facts are the same as in Example 1, except that CFC
earns $5 of portfolio dividend income and $150 of interest income. In
addition, CFC earns $45 for performing consulting services within its
country of operation for unrelated persons. CFC's gross foreign base
company income for 1995 of $155 ($150 of gross interest income and $5 of
portfolio dividend income) is greater than 70 percent of its gross
income of $200. Therefore, under the full inclusion test of paragraph
[[Page 252]]
(b)(1)(ii) of this section, CFC's adjusted gross foreign base company
income is $200, and under paragraph (b)(2) of this section, the $45 of
consulting income is full inclusion foreign base company income. If CFC
elects, under paragraph (d)(5) of this section, to exclude the interest
income from subpart F income pursuant to the high tax exception, the $45
of full inclusion foreign base company income will be excluded from
subpart F income under paragraph (d)(6) of this section because the $150
of gross interest income excluded under the high tax exception is more
than 90 percent of CFC's adjusted gross foreign base company income of
$155.
(ii) The following examples generally illustrate the application of
paragraph (c) of this section and this paragraph (d). Example 1
illustrates the order of computations. Example 2 illustrates the
computations required by sections 952 and 954 and this Sec. 1.954-1 if
the full inclusion test of paragraph (b)(1)(ii) of this section is met
and the income is not excluded from subpart F income under section
952(b). Computations in these examples involving the operation of
section 952(c) are included for purposes of illustration only and do not
provide substantive rules concerning the operation of that section. For
simplicity, these examples assume that the amount of taxes that are
taken into account as a deduction under section 954(b)(5) and the amount
of the gross-up required under sections 960 and 78 are equal. Therefore,
these examples do not separately illustrate the deduction for taxes and
gross-up.
Example 1. (i) Gross income. CFC, a controlled foreign corporation,
has gross income of $1000 for the current taxable year. Of that $1000 of
income, $100 is interest income that is included in the definition of
foreign personal holding company income under section 954(c)(1)(A) and
Sec. 1.954-2(b)(1)(ii), is not income from a trade or service receivable
described in section 864(d)(1) or (6), or portfolio interest described
in section 881(c), and is not excluded from foreign personal holding
company income under any provision of section 952(b) or section 954(c).
Another $50 is foreign base company sales income under section 954(d).
The remaining $850 of gross income is not included in the definition of
foreign base company income or insurance income under sections 954 (c),
(d), (e), (f) or (g) or 953, and is foreign source general limitation
income described in section 904(d)(1)(I).
(ii) Expenses. For the current taxable year, CFC has expenses of
$500. This amount includes $8 of interest paid to a related person that
is allocable to foreign personal holding company income under section
904, and $2 of other expense that is directly related to foreign
personal holding company income. Another $20 of expense is directly
related to foreign base company sales. The remaining $470 of expenses is
allocable to general limitation income that is not foreign base company
income or insurance income.
(iii) Earnings and losses. CFC has earnings and profits for the
current taxable year of $500. In the prior taxable year, CFC had losses
with respect to income other than gross foreign base company income or
gross insurance income. By reason of the limitation provided under
section 952(c)(1)(A), those losses reduced the subpart F income
(consisting entirely of foreign source general limitation income) of CFC
by $600 for the prior taxable year.
(iv) Taxes. Foreign income tax of $30 is considered imposed on the
interest income under the rules of section 954(b)(4), this paragraph
(d), and Sec. 1.904-6. Foreign income tax of $14 is considered imposed
on the foreign base company sales income under the rules of section
954(b)(4), paragraph (d) of this section, and Sec. 1.904-6. Foreign
income tax of $177 is considered imposed on the remaining foreign source
general limitation income under the rules of section 954(b)(4), this
paragraph (d), and Sec. 1.904-6. For the taxable year of CFC, the
maximum United States rate of taxation under section 11 is 35 percent.
(v) Conclusion. Based on these facts, if CFC elects to exclude all
items of income subject to a high foreign tax under section 954(b)(4)
and this paragraph (d), it will have $500 of subpart F income as defined
in section 952(a) (consisting entirely of foreign source general
limitation income) determined as follows:
Step 1--Determine gross income:
(1) Gross income............................................. $1000
Step 2--Determine gross foreign base company income and gross
insurance income:
(2) Interest income included in gross foreign personal 100
holding company income under section 954(c).................
(3) Gross foreign base company sales income under section 50
954(d)......................................................
(4) Total gross foreign base company income and gross 150
insurance income as defined in sections 954 (c), (d), (e),
(f) and (g) and 953 (line (2) plus line (3))................
Step 3--Compute adjusted gross foreign base company income and
adjusted gross insurance income:
(5) Five percent of gross income (.05 x line (1))............ 50
(6) Seventy percent of gross income (.70 x line (1))......... 700
[[Page 253]]
(7) Adjusted gross foreign base company income and adjusted 150
gross insurance income after the application of the de
minimis test of paragraph (b) (line (4), or zero if line (4)
is less than the lesser of line (5) or $1,000,000) (if the
amount on this line 7 is zero, proceed to Step 8)...........
(8) Adjusted gross foreign base company income and adjusted 150
gross insurance income after the application of the full
inclusion test of paragraph (b) (line (4), or line (1) if
line (4) is greater than line (6))..........................
Step 4--Compute net foreign base company income:
(9) Expenses directly related to adjusted gross foreign base 20
company sales income........................................
(10) Expenses (other than related person interest expense) 2
directly related to adjusted gross foreign personal holding
company income..............................................
(11) Related person interest expense allocable to adjusted 8
gross foreign personal holding company income under section
904.........................................................
(12) Net foreign personal holding company income after 90
allocating deductions under section 954(b)(5) and paragraph
(c) of this section (line (2) reduced by lines (10) and
(11)).......................................................
(13) Net foreign base company sales income after allocating 30
deductions under section 954(b)(5) and paragraph (c) of this
section (line (3) reduced by line (9))......................
(14) Total net foreign base company income after allocating 120
deductions under section 954(b)(5) and paragraph (c) of this
section (line (12) plus line (13))..........................
Step 5--Compute net insurance income:
(15) Net insurance income under section 953.................. 0
Step 6--Compute adjusted net foreign base company income:
(16) Foreign income tax imposed on net foreign personal 30
holding company income (as determined under section
954(b)(4) and this paragraph (d))...........................
(17) Foreign income tax imposed on net foreign base company 14
sales income (as determined under section 954(b)(4) and this
paragraph (d))..............................................
(18) Ninety percent of the maximum United States corporate 31.5%
tax rate....................................................
(19) Effective rate of foreign income tax imposed on net 33%
foreign personal holding company income ($90 of interest)
under section 954(b)(4) and this paragraph (d) (line (16)
divided by line (12)).......................................
(20) Effective rate of foreign income tax imposed on $30 of 47%
net foreign base company sales income under section
954(b)(4) and this paragraph (d) (line (17) divided by line
(13)).......................................................
(21) Net foreign personal holding company income subject to a 90
high foreign tax under section 954(b)(4) and this paragraph
(d) (zero, or line (12) if line (19) is greater than line
(18)).......................................................
(22) Net foreign base company sales income subject to a high 30
foreign tax under section 954(b)(4) and this paragraph (d)
(zero, or line (13) if line (20) is greater than line (18)).
(23) Adjusted net foreign base company income after applying 0
section 954(b)(4) and this paragraph (d) (line (14), reduced
by the sum of line (21) and line (22))......................
Step 7--Compute adjusted net insurance income:
(24) Adjusted net insurance income........................... 0
Step 8--Additions to or reduction of adjusted net foreign base
company income by reason of section 952(c):
(25) Earnings and profits for the current year............... 500
(26) Amount subject to being recharacterized as subpart F 500
income under section 952(c)(2) (excess of line (25) over the
sum of lines (23) and (24)); if there is a deficit, then the
limitation of section 952(c)(1) may apply for the current
year........................................................
(27) Amount of reduction in subpart F income for prior 600
taxable years by reason of the limitation of section
952(c)(1)...................................................
(28) Subpart F income as defined in section 952(a), assuming 500
section 952(a)(3), (4), and (5) do not apply (the sum of
line (23), line (24), and the lesser of line (26) or line
(27)).......................................................
(29) Amount of prior year's deficit to be recharacterized as 100
subpart F income in later years under section 952(c) (excess
of line (27) over line (26))................................
Example 2. (i) Gross income. CFC, a controlled foreign corporation,
has gross income of $1000 for the current taxable year. Of that $1000 of
income, $720 is interest income that is included in the definition of
foreign personal holding company income under section
[[Page 254]]
954(c)(1)(A) and Sec. 1.954-2(b)(1)(ii), is not income from trade or
service receivables described in section 864(d)(1) or (6), or portfolio
interest described in section 881(c), and is not excluded from foreign
personal holding company income under any provision of section 954(c)
and Sec. 1.954-2 or section 952(b). The remaining $280 is services
income that is not included in the definition of foreign base company
income or insurance income under sections 954 (c), (d), (e), (f), or (g)
or 953, and is foreign source general limitation income for purposes of
section 904(d)(1)(I).
(ii) Expenses. For the current taxable year, CFC has expenses of
$650. This amount includes $350 of interest paid to related persons that
is allocable to foreign personal holding company income under section
904, and $50 of other expense that is directly related to foreign
personal holding company income. The remaining $250 of expenses is
allocable to services income other than foreign base company income or
insurance income.
(iii) Earnings and losses. CFC has earnings and profits for the
current taxable year of $350. In the prior taxable year, CFC had losses
with respect to income other than foreign base company income or
insurance income. By reason of the limitation provided under section
952(c)(1)(A), those losses reduced the subpart F income of CFC
(consisting entirely of foreign source general limitation income) by
$600 for the prior taxable year.
(iv) Taxes. Foreign income tax of $120 is considered imposed on the
$720 of interest income under the rules of section 954(b)(4), paragraph
(d) of this section, and Sec. 1.904-6. Foreign income tax of $2 is
considered imposed on the services income under the rules of section
954(b)(4), paragraph (d) of this section, and Sec. 1.904-6. For the
taxable year of CFC, the maximum United States rate of taxation under
section 11 is 35 percent.
(v) Conclusion. Based on these facts, if CFC elects to exclude all
items of income subject to a high foreign tax under section 954(b)(4)
and this paragraph (d), it will have $350 of subpart F income as defined
in section 952(a), determined as follows.
Step 1--Determine gross income:
(1) Gross income............................................. $1000
Step 2--Determine gross foreign base company income and gross
insurance income:
(2) Gross foreign base company income and gross insurance 720
income as defined in sections 954 (c), (d), (e), (f) and (g)
and 953 (interest income)...................................
Step 3--Compute adjusted gross foreign base company income and
adjusted gross insurance income:
(3) Seventy percent of gross income (.70 x line (1))......... 700
(4) Adjusted gross foreign base company income and adjusted 1000
gross insurance income after the application of the full
inclusion rule of this paragraph (b)(1) (line (2), or line
(1) if line (2) is greater than line (3))...................
(5) Full inclusion foreign base company income under 280
paragraph (b)(1)(ii) (line (4) minus line (2))..............
Step 4--Compute net foreign base company income:
(6) Expenses (other than related person interest expense) 50
directly related to adjusted gross foreign personal holding
company income..............................................
(7) Related person interest expense allocable to adjusted 350
gross foreign personal holding company income under section
904.........................................................
(8) Deductions allocable to full inclusion foreign base 250
company income under section 954(b)(5) and paragraph (c) of
this section................................................
(9) Net foreign personal holding company income after 320
allocating deductions under section 954(b)(5) and paragraph
(c) of this section (line (2) reduced by line (6) and line
(7))........................................................
(10) Full inclusion foreign base company income after 30
allocating deductions under section 954(b)(5) and paragraph
(c) of this section (line (5) reduced by line (8))..........
(11) Total net foreign base company income after allocating 350
deductions under section 954(b)(5) and paragraph (c) of this
section (line (9) plus line (10))...........................
Step 5--Compute net insurance income:
(12) Net insurance income under section 953.................. 0
Step 6--Compute adjusted net foreign base company income:
(13) Foreign income tax imposed on net foreign personal 120
holding company income (interest)...........................
(14) Foreign income tax imposed on net full inclusion foreign 2
base company income.........................................
(15) Ninety percent of the maximum United States corporate 31.5%
tax rate....................................................
(16) Effective rate of foreign income tax imposed on $320 of 38%
net foreign personal holding company income under section
954(b)(4) and this paragraph (d) (line (13) divided by line
(9))........................................................
[[Page 255]]
(17) Effective rate of foreign income tax imposed on $30 of 7%
net full inclusion foreign base company income under section
954(b)(4) and this paragraph (d) (line (14) divided by line
(10)).......................................................
(18) Net foreign personal holding company income subject to a 320
high foreign tax under section 954(b)(4) and this paragraph
(d) (zero, or line (9) if line (16) is greater than line
(15)).......................................................
(19) Net full inclusion foreign base company income subject 0
to a high foreign tax under section 954(b)(4) and this
paragraph (d) (zero, or line (10) if line (17) is greater
than line (15)).............................................
(20) Adjusted net foreign base company income after applying 30
section 954(b)(4) and this paragraph (d) (line (11) reduced
by the sum of line (18) and line (19))......................
Step 7--Compute adjusted net insurance income:
(21) Adjusted net insurance income........................... 0
Step 8--Reduction of adjusted net foreign base company income
or adjusted net insurance income by reason of paragraph (d)(6)
of this section:
(22) Adjusted gross foreign base company income and adjusted 720
gross insurance income (determined without regard to the
full inclusion test of paragraph (b)(1) of this section)
(line (4) reduced by line (5))..............................
(23) Ninety percent of adjusted gross foreign base company 648
income and adjusted gross insurance income (determined
without regard to the full inclusion test of paragraph
(b)(1)(ii) of this section) (90% of the amount on line (22))
(24) Net foreign base company income and net insurance income 720
excluded from subpart F income under section 954(b)(4),
increased by the amount of expenses that reduced this income
under section 954(b)(5) and paragraph (c) of this section
(line (18) increased by the sum of line (6) and line (7))...
(25) Adjusted net full inclusion foreign base company income 30
excluded from subpart F income under paragraph (d)(6) of
this section (zero, or line (10) reduced by line (19) if
line (24) is greater than line (23))........................
(26) Adjusted net foreign base company income after 0
application of paragraph (d)(6) of this section (line (20)
reduced by line (25)).......................................
Step 9--Additions to or reduction of subpart F income by reason
of section 952(c):
(27) Earnings and profits for the current year............... 350
(28) Amount subject to being recharacterized as subpart F 350
income under section 952(c)(2) (excess of line (27) over the
sum of line (21) and line (26)); if there is a deficit, then
the limitation of 952(c)(1) may apply for the current year..
(29) Amount of reduction in subpart F income for prior 600
taxable years by reason of the limitation of section
952(c)(1)...................................................
(30) Subpart F income as defined in section 952(a), assuming 350
section 952(a)(3), (4), and (5) do not apply (the sum of
line (21) and line (26) plus the lesser of line (28) or line
(29)).......................................................
(31) Amount of prior years' deficit remaining to be 250
recharacterized as subpart F income in later years under
section 952(c) (excess of line (29) over line (28)).........
(e) Character of income--(1) Substance of the transaction. For
purposes of section 954, income shall be characterized in accordance
with the substance of the transaction, and not in accordance with the
designation applied by the parties to the transaction. For example, an
amount that is designated as rent by the taxpayer but actually
constitutes income from the sale of property, royalties, or income from
services shall not be characterized as rent but shall be characterized
as income from the sale of property, royalties or income from services,
as the case may be. Local law shall not be controlling in characterizing
income.
(2) Separable character. To the extent the definitional provisions
of section 953 or 954 describe the income or gain derived from a
transaction, or any portion or portions thereof, that income or gain, or
portion or portions thereof, is so characterized for purposes of subpart
F. Thus, a single transaction may give rise to income in more than one
category of foreign base company income described in paragraph (a)(2) of
this section. For example, if a controlled foreign corporation, in its
business of purchasing personal property and selling it to related
persons outside
[[Page 256]]
its country of incorporation, also performs services outside its country
of incorporation with respect to the property it sells, the sales income
will be treated as foreign base company sales income and the services
income will be treated as foreign base company services income for
purposes of these rules.
(3) Predominant character. The portion of income or gain derived
from a transaction that is included in the computation of foreign
personal holding company income is always separately determinable and
thus must always be segregated from other income and separately
classified under paragraph (e)(2) of this section. However, the portion
of income or gain derived from a transaction that would meet a
particular definitional provision under section 954 or 953 (other than
the definition of foreign personal holding company income) in unusual
circumstances may not be separately determinable. If such portion is not
separately determinable, it must be classified in accordance with the
predominant character of the transaction. For example, if a controlled
foreign corporation engineers, fabricates, and installs a fixed offshore
drilling platform as part of an integrated transaction, and the portion
of income that relates to services is not accounted for separately from
the portion that relates to sales, and is otherwise not separately
determinable, then the classification of income from the transaction
shall be made in accordance with the predominant character of the
arrangement.
(4) Coordination of categories of gross foreign base company income
or gross insurance income--(i) In general. The computations of gross
foreign base company income and gross insurance income are limited by
the following rules:
(A) If income is foreign base company shipping income, pursuant to
section 954(f), it shall not be considered insurance income or income in
any other category of foreign base company income.
(B) If income is foreign base company oil related income, pursuant
to section 954(g), it shall not be considered insurance income or income
in any other category of foreign base company income, except as provided
in paragraph (e)(4)(i)(A) of this section.
(C) If income is insurance income, pursuant to section 953, it shall
not be considered income in any category of foreign base company income
except as provided in paragraph (e)(4)(i)(A) or (B) of this section.
(D) If income is foreign personal holding company income, pursuant
to section 954(c), it shall not be considered income in any other
category of foreign base company income, other than as provided in
paragraph (e)(4)(i)(A), (B) or (C) of this section.
(ii) Income excluded from other categories of gross foreign base
company income. Income shall not be excluded from a category of gross
foreign base company income or gross insurance income under this
paragraph (e)(4) by reason of being included in another category of
gross foreign base company income or gross insurance income, if the
income is excluded from that other category by a more specific provision
of section 953 or 954. For example, income derived from a commodity
transaction that is excluded from foreign personal holding company
income under Sec. 1.954-2(f) as income from a qualified active sale may
be included in gross foreign base company income if it also meets the
definition of foreign base company sales income. See Sec. 1.954-2(a)(2)
for the coordination of overlapping categories within the definition of
foreign personal holding company income.
(f) Definition of related person--(1) Persons related to controlled
foreign corporation. Unless otherwise provided, for purposes of section
954 and Secs. 1.954-1 through 1.954-8 inclusive, the following persons
are considered under section 954(d)(3) to be related persons with
respect to a controlled foreign corporation:
(i) Individuals. An individual, whether or not a citizen or resident
of the United States, who controls the controlled foreign corporation.
(ii) Other persons. A foreign or domestic corporation, partnership,
trust or estate that controls or is controlled by the controlled foreign
corporation, or is controlled by the same person or persons that control
the controlled foreign corporation.
[[Page 257]]
(2) Control--(i) Corporations. With respect to a corporation,
control means the ownership, directly or indirectly, of stock possessing
more than 50 percent of the total voting power of all classes of stock
entitled to vote or of the total value of the stock of the corporation.
(ii) Partnerships. With respect to a partnership, control means the
ownership, directly or indirectly, of more than 50 percent (by value) of
the capital or profits interest in the partnership.
(iii) Trusts and estates. With respect to a trust or estate, control
means the ownership, directly or indirectly, of more than 50 percent (by
value) of the beneficial interest in the trust or estate.
(iv) Direct or indirect ownership. For purposes of this paragraph
(f), to determine direct or indirect ownership, the principles of
section 958 shall be applied without regard to whether a corporation,
partnership, trust or estate is foreign or domestic or whether or not an
individual is a citizen or resident of the United States.
[T.D. 8618, 60 FR 46509, Sept. 7, 1995; 60 FR 62024, 62025, Dec. 4,
1995, as amended by T.D. 8704, 62 FR 20, Jan. 2, 1997; T.D. 8767, 63 FR
14615, Mar. 26, 1998; T.D. 8827, 64 FR 37677, July 13, 1999]