[4830-01-u] DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1, 4 and 602 [TD 8618] RIN 1545-AM15 Definition of a Controlled Foreign Corporation, Foreign Base Company Income and Foreign Personal Holding Company Income of a Controlled Foreign Corporation AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. SUMMARY: This document contains final Income Tax Regulations governing the definition of a controlled foreign corporation and the definitions of foreign base company income and foreign personal holding company income of a controlled foreign corporation. These regulations are necessary because of changes made to the prior law by the Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the Revenue Reconciliation Act of 1989, and the Omnibus Budget Reconciliation Act of 1993. Certain conforming changes in the regulations were necessary because of changes made by the Deficit Reduction Act of 1984. The regulations will provide the public with the guidance to comply with those acts and will affect United States shareholders of controlled foreign corporations. DATES: These regulations are effective September 7, 1995. For dates of applicability, see 1.954-0(a). FOR FURTHER INFORMATION CONTACT: Valerie Mark of the Office of Associate Chief Counsel (International), within the Office of the Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC 20224 (Attention CC:INTL:2 (INTL-0362-88). Telephone (202) 622-3840 (not a toll-free call). SUPPLEMENTARY INFORMATION: Paperwork Reduction Act The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget (OMB) in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-1068. The estimated average burden per respondent associated with the collection of information in this regulation is one hour. Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503. Background This document contains final regulations amending the Income Tax Regulations (26 CFR Part 1) under sections 954(b), 954(c) and 957(a) of the Internal Revenue Code (Code). Sections 954 and 957 were amended by sections 1201, 1221, 1222 and 1223 of the Tax Reform Act of 1986 (Pub. L. 99-514), by section 1012 of the Technical and Miscellaneous Revenue Act of 1988 (Pub. L. 100-647), by section 7811 of the Revenue Reconciliation Act of 1989 (Pub. L. 101-239) and by section 13233 of the Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66). These regulations are also issued under authority contained in section 7805 of the Code. Temporary regulations (TD 8216) and a cross-referenced notice of proposed rulemaking (INTL-362-88) under sections 954 and 957 of the Code were published in the Federal Register on July 21, 1988 (53 FR 27489 and 53 FR 27532, respectively). Numerous written comments on the proposed and temporary regulations were received from the public. As explained below, the comments were considered in the drafting of the final regulations. Discussion of Major Comments and Changes to the Regulations 1.954-1: Foreign base company income. Section 1.954-1T(a)(3) and (5) (temporary regulations) apply the de minimis and full inclusion tests of section 954(b)(3) before the high tax exception of section 954(b)(4). Commenters have expressed concern that, in certain cases, the only amounts required to be included in the gross income of the United States shareholders of a controlled foreign corporation may be full inclusion income. This result may occur when subpart F income, other than full inclusion foreign base company income, qualifies for the high tax exception. In response to these comments, 1.954-1(d)(6) provides that an amount that otherwise would be included as full inclusion foreign base company income, pursuant to the operation of the full inclusion test of section 954(b)(3)(B), will be excluded from full inclusion foreign base company income if more than 90 percent of the adjusted gross foreign base company and adjusted gross insurance income qualifies for the high tax exception described in section 954(b)(4) and the high tax election is actually made. Section 1.954-1T(a)(4) provides that in computing net foreign base company income, foreign personal holding company income is reduced by related person interest expense before allocating and apportioning other expenses in accordance with 1.904(d)-5(c)(2). Commenters understood this rule to be at variance with 1.904(d)-5(c)(2), which requires related person interest expense to be allocated to passive foreign personal holding company income after the allocation of directly related expenses. In response to this comment, the rule regarding allocation of related person interest expense was removed from 1.954-1T(a)(4) and (c) was amended to clarify that foreign base company income is reduced by directly related expenses before passive foreign personal holding company income is reduced by related person interest expense. Section 1.954-1T(a)(7) treats amounts recharacterized as foreign base company income or insurance income under section 952(c) as adjusted net foreign base company income or adjusted net insurance income. Thus, these amounts are not included in net foreign base company income or net insurance income for purposes of applying the high tax exception. Commenters argued that the rules of paragraph (a)(7) should be amended to provide that amounts that are recharacterized under section 952(c)(2) should not be treated as adjusted net foreign base company income or adjusted net insurance income if the amounts would have qualified for the high tax exception. This comment was rejected because section 952(c)(2) does not incorporate the exclusions and special rules of section 954(b)(4). Additional rules regarding the coordination of sections 952(c) and 954 are being proposed under section 952 in a separate document published elsewhere in this issue of the Federal Register. Several comments were made concerning the anti-abuse rules of 1.954-1T(b)(4), which require aggregation of gross income of related controlled foreign corporations for purposes of the de minimis and full inclusion tests. One comment suggested that the aggregation rules of paragraph (b)(4) should be applied only if a purpose of first importance (as opposed to a principal purpose) is to avoid the application of the de minimis or full inclusion tests described in section 954(b)(3). This comment was rejected because the standard suggested is significantly more subjective than that of the regulations and is therefore unadministrable. However, it was determined that it was unnecessary to make the aggregation rules of paragraph (b)(4) applicable to the full inclusion test, for which there is not the same opportunity for tax avoidance. One commenter suggested that the anti-abuse rules of 1.954- 1T(b)(4) should be amended to provide that the gross income of separate controlled foreign corporations is aggregated only if a substantial portion of the activities of the separate corporations would comprise a single branch, and that the presumptions described in paragraph (b)(4)(ii) should be eliminated. The commenter also suggested that the definition of related person for purposes of these rules should refer to the provisions of section 954(d)(3), rather than the broader provisions of section 267. These comments were rejected because the suggested amendments would unduly restrict the application of the anti-abuse rules. The presumptions described in paragraph (b)(4)(ii) may be rebutted, for example, by establishing reliance on the requirements of foreign law. The anti-abuse rules are necessary to prevent the misuse of the de minimis rule of section 954(b)(3), and do not impose a significant limitation or burden on the activities of controlled foreign corporations. Section 1.954-1T(c) provides that in computing net foreign base company income, the gross amount in each category of foreign base company income may not be reduced below zero. Section 1.954-2T(e) provides that the excess of losses over gains from the sale or exchange of certain property may not be allocated to any other category of foreign personal holding company income. Section 1.954-2T(f) and (g) contain similar provisions with regard to excess losses from commodities and foreign currency transactions, respectively. Because the categories of foreign base company income described in section 954(a) and the categories of foreign personal holding company income described in section 954(c)(1)(B), (C) and (D) are defined in terms of net income, the temporary regulations interpreted the statutory scheme as generally precluding the allocation of excess losses from categories of foreign personal holding company income described in paragraph (e), (f), or (g) against other foreign personal holding company income categories. Commenters contended that by preventing any category of subpart F income from being reduced below zero, paragraph (c) caused inappropriate tax credit results and failed to harmonize the subpart F provisions with section 904(f)(5). Commenters stated that paragraphs (e), (f) and (g) should be amended to allow excess losses described in those paragraphs to be allocated to other categories of foreign personal holding company income. Paragraph (c) has been amended to clarify that, in determining net income, if the amount in any category of foreign base company income (including any category of foreign personal holding company income) is less than zero, the loss may not reduce any other categories of foreign base company income (or foreign personal holding company income) except by operation of the earnings and profits limitation. Proposed regulations published elsewhere in this issue of the Federal Register will provide rules concerning the application of the earnings and profits limitation. Section 1.954-1T(d) provides that the effective rate of foreign income tax on an item of income is determined in a manner consistent with the existing foreign tax credit regime under sections 904 and 960. In some cases, the amount of an item of income for foreign law purposes with respect to which foreign income tax is paid will be different from the amount for United States tax purposes. As a result, the effective rate of tax with respect to the item of income may be affected. In addition, because pursuant to section 960 the foreign income taxes of a controlled foreign corporation more than three tiers below a United States shareholder are not considered, the high tax exception will never apply to items of income of such corporations. Commenters suggested that certain foreign law accounting practices should be considered in determining the effective rate of tax on an item of income, for purposes of applying the high tax exception of section 954(b)(4) and paragraph (d) of the regulations. Commenters also contended that it is inappropriate to use section 960 to determine the effective rate of foreign tax and thus prevent consideration of taxes paid by controlled foreign corporations more than three tiers below the United States shareholder. The comment that the high tax exception should not be limited to creditable taxes under section 960 was rejected. The high tax exception is not intended to apply to the extent that an item of income would be subject to residual United States tax if such item were included in the gross income of the United States shareholder. The taxes paid with respect to such item of income should be considered for purposes of the high tax exception only to the extent they are otherwise considered for United States taxing purposes. See Joint Committee on Taxation Staff, General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 970-71 (1986). The comment that foreign law accounting practices should be considered in determining the effective rate of tax on an item of income, for purposes of applying the high tax exception, was also rejected. Such a rule would impose a significant burden on the IRS. It would require the IRS to monitor and apply foreign tax and accounting principles, and to reconcile their application with United States tax and accounting principles, both in the current tax year and in later tax years to prevent an item of income, deduction, credit, gain or loss from being duplicated or omitted. Further, the IRS would have to consider and identify the particular foreign tax and accounting principles that could be taken into account for purposes of these rules. Section 1.954-1T(d)(4) defines the term item of income for purposes of the high tax exception by reference to the foreign tax credit and subpart F income categories to which the income relates. Thus, it is possible that amounts attributable to separate transactions may be included in the same item of income. If the income from the separate transactions were subject to foreign income tax at different rates, the effective rate of tax for the income item would reflect an average of the two (or more) rates of tax. One commenter has suggested that additional categories of income be created within the existing foreign tax credit and subpart F income groups to limit the effect of this tax rate blending. The regulations rely on existing guidance under the foreign tax credit and subpart F provisions generally to define item of income for purposes of section 954(b)(4). To identify items of income on a transaction-by-transaction basis is inconsistent with the separate limitation categories of income described in section 904, and adds complexity by requiring different computations for purposes of these rules and the rules under the foreign tax credit provisions of the Code. Moreover, there is no bias in the existing rules toward a particular result. Commenters suggested that the consistency rule of 1.954- 1T(d)(4)(ii)(B) be eliminated, to allow taxpayers to apply the high tax exception on an item-by-item basis. The consistency rule prohibits a taxpayer from selectively applying the high tax exception with respect to foreign personal holding company income that is passive income under section 904(d). Elimination of the consistency rule would provide a result that is incompatible with the foreign tax credit provisions of the Code, and thus the comment was rejected. The final regulations clarify how the rules of paragraph (d) coordinate with the earnings and profits limitation of section 952(c)(1). Under 1.954-1(d)(4)(ii), if the amount of income included in subpart F income for the taxable year is reduced by the earnings and profits limitation, the amount of income that is an item of income, for purposes of paragraph (d), is determined after the application of the rules of section 952(c)(1). An example was added to illustrate this rule. Section 1.954-1T(d)(5) provides that the election to apply the high tax exception must be made by the controlling United States shareholders and is binding on all United States shareholders of the controlled foreign corporation. Commenters argued that the Secretary does not have the authority to bind all United States shareholders to a single election. This comment was rejected because it was determined that section 954(b)(4) provides the authority. Further, allowing each United States shareholder to separately elect the high tax exception would add undue complexity to the operation of the foreign tax credit rules. Section 1.954-1(f) provides guidance on the definition of related person under section 954(d)(3). 1.954-2: Foreign Personal Holding Company Income. Section 1.954-2T(a)(2)(i) provides that amounts that fall within the definition of income equivalent to interest, under paragraph (h), will be so treated though such amounts may also fall within the definition of gain from certain property transactions under paragraph (e), gain from a commodities transaction under paragraph (f) or foreign currency gain under paragraph (g). Paragraph (a)(2)(i) provides that amounts will be treated as income equivalent to interest even if these amounts are excluded from the computation of foreign personal holding company income under paragraphs (e), (f), or (g) because they are derived from certain qualifying business transactions. A commenter suggested that paragraph (a)(2)(i) should not treat income from qualifying business transactions excluded under paragraphs (e), (f), or (g) as income equivalent to interest. This comment was rejected. The rules regarding qualifying business transactions in paragraphs (e), (f) and (g) do not operate to exclude interest income from characterization as foreign personal holding company income. Income equivalent to interest within the meaning of section 954(c)(1)(E) and paragraph (h) generally should be treated like interest for purposes of subpart F. Several commenters suggested that the test described in 1.954- 2T(a)(3) to determine the use for which property is held (for purposes of determining the character of the income, gain or loss realized from a disposition of such property) should not focus solely on the use of the property immediately prior to its disposition, but instead should consider the predominant use for which the property was held. This comment was accepted. Section 1.954-2(a)(3) provides that the use for which property is held is the use for which it was held for more than one-half of the period during which the controlled foreign corporation held the property. If there has been a change in use, however, and a principal purpose for such change in use was to avoid characterizing income or gain attributable to the property as foreign personal holding company income, then the change in use will be disregarded. Section 1.954-2T(a)(3)(ii), Examples 2 and 3 illustrate the rules regarding change in use for which property is held. The final regulations delete these examples because Example 1 sufficiently illustrated the rules of this paragraph. Examples 4 and 5 of paragraph (a)(3)(ii) illustrate the change in use rules with respect to hedging transactions. The final regulations delete these examples because the rules governing hedging transactions are now generally contained in paragraph (a)(4)(ii). Section 1.954-2T(a)(4)(i) lists some of the types of income that are included in the term interest. To clarify that this list was not meant to be exclusive, paragraph (a)(4)(i) has been amended to provide that the term interest includes all amounts that are treated as interest (including tax-exempt interest) under the Code and regulations or any other provision of law. A new sentence illustrates the types of income that would be treated as interest. Section 1.954-2T(a)(4)(ii) provides that certain hedging transactions that reduce the risk of price changes in the cost of inventory and similar property are included within the definition of inventory and similar property if certain requirements are met and if they are so identified by the fifth day after which they are entered into. Paragraphs (f)(4) and (g)(4) of the temporary regulations contain definitions of the term qualified hedging transaction that have similar five-day identification requirements. These several definitions of a hedging transaction have been consolidated in 1.954-2(a)(4)(ii) which contains a definition of bona fide hedging transaction and new identification requirements for bona fide hedging transactions that apply for purposes of computing foreign personal holding company income under 1.954-2. Section 1.954-2(a)(4)(ii)(A) generally defines a bona fide hedging transaction as a transaction that meets the requirements of 1.1221-2(a) through (c) with two exceptions. First, the risk being hedged may be with respect to ordinary property, section 1231 property or a section 988 transaction. Second, a transaction that hedges the liabilities, inventory or other assets of a related person, or that is entered into to assume or reduce risks of a related person, will not be treated as a bona fide hedging transaction. Several commenters had sought to expand the definition of qualified hedging transactions to include hedging transactions conducted by a controlled foreign corporation that is a currency coordination center, i.e., a controlled foreign corporation that aggregates the currency exposures of related controlled foreign corporations and hedges such exposures. The statute provides, however, that a transaction must satisfy the business needs of the particular controlled foreign corporation. See also Joint Committee on Taxation Staff, General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 976 (1986). Section 1.954-2(a)(4)(ii)(B) provides identification requirements for a bona fide hedging transaction. The same-day identification and the recordkeeping requirements of 1.1221-2 apply for transactions entered into on or after March 7, 1996. For bona fide hedging transactions entered into prior to this date and after July 22, 1988, the transaction must be identified by the close of the fifth day after the day on which it is entered into. For bona fide hedging transactions entered into prior to July 22, 1988, the transaction must be identified reasonably contemporaneously with the date it is entered into but no later than within the normal period prescribed under the method of accounting of the controlled foreign corporation used for financial reporting purposes. Section 1.954-2(a)(4)(ii)(C) describes the treatment of transactions that are misidentified as hedging transactions, and hedging transactions that the taxpayer fails to identify as such. Paragraph (a)(4)(ii)(C) also provides relief for taxpayers that have identified, or failed to identify, a hedging transaction due to inadvertent error. These misidentification rules are substantially similar to the rules in 1.1221-2(f), modified for purposes of the subpart F regime. Section 1.954-2T(a)(4)(iii) defines regular dealer, and states that, "purchasing and selling property through a regulated exchange or off-exchange market (for example, engaging in futures transactions) is not actively engaging as a merchant" for purposes of these rules. This provision was intended to mean that such purchasing and selling activity alone, in the absence of other activities, will not qualify a controlled foreign corporation as a regular dealer within the meaning of paragraph (a)(4)(iii). Because commenters indicated that this reference to purchasing and selling through a regular exchange or off-exchange market was confusing, this provision was removed. Further, the definition of regular dealer was amended. Section 1.954-2(a)(4)(iv) provides that a controlled foreign corporation will be a regular dealer if it regularly and actively offers to, and in fact does, engage in certain specified activities with customers who are not related persons (as defined in section 954(d)(3)) with respect to the CFC. Examples were added to clarify that a controlled foreign corporation that qualifies as a dealer under 1.954-2(a)(4)(iv) will not be disqualified from being treated as a regular dealer because it also engages in transactions with related persons. The temporary regulations define dealer property as property held by a controlled foreign corporation that is a regular dealer in property of such kind in its capacity as a dealer. The temporary regulations also state that property held for investment or speculation is not dealer property. A commenter suggested that property should be considered dealer property within the meaning of 1.954-2T(a)(4)(iv) if the controlled foreign corporation holding the property is a regular dealer in such property. This comment was rejected because it proposes an unduly expansive definition of dealer property. Paragraph (a)(4), therefore, generally continues to define dealer property in the same manner as the temporary regulations. The final regulations do clarify, however, that if a controlled foreign corporation qualifies as a regular dealer, all of the property held in a dealer capacity by that corporation is treated as dealer property. Thus, dealer property includes property arising from a transaction entered into with a related person, as long as the controlled foreign corporation is a regular dealer and holds the property in its capacity as a dealer, and not for investment or speculation. The examples of 1.954-2(a)(4)(vi) illustrate this rule. A rule has been added for licensed securities dealers under which only securities identified as held for investment under section 475(b) or 1236 will be treated as held for investment or speculation. Also, to conform to amendments to section 954(c)(1)(B) made by the Technical and Miscellaneous Revenue Act of 1988, 1.954-2(a)(4)(v)(C) provides that a bona fide hedging transaction with respect to dealer property is treated as a transaction in dealer property. Section 954(c)(2)(B) and 1.954-2T(b)(2) exclude from foreign personal holding company income export financing interest that is derived in the active conduct of a banking business. A commenter suggested that paragraph (b)(2) should treat a controlled foreign corporation as engaged in the conduct of a banking business even if it transfers the servicing of loans to related or unrelated parties. This comment was rejected because servicing of loans is a fundamental element of banking activity that gives rise to export financing interest for which an exception from foreign personal holding company income is intended. Section 1.954-2T(b)(2) references the definition of export financing interest contained in section 904(d)(2)(G). Under section 904(d)(2)(G), the property that is financed must be manufactured, produced, grown or extracted in the United States by the taxpayer or a related person. Section 1.954-2(b)(2) clarifies that 1.927(a)-1T(c)(1) applies for purposes of determining whether property is manufactured, produced, grown or extracted in the United States. Section 1.954-2T(b)(2) also provides that the term export financing interest does not include income from related party factoring that is treated as interest under section 864(d)(1) or (6). The final regulations contain examples that clarify that if amounts are not treated as interest under section 864(d)(1) or (6) because the exception under section 864(d)(7) applies, these amounts may be export financing interest under paragraph (b)(2). Section 954(c)(3)(A) and 1.954-2T(b)(3) and (4) provide that certain dividend, interest, rent or royalty income received from related corporate payors is not included in foreign personal holding company income. To reflect amendments to section 954(c)(3)(A) by the Revenue Reconciliation Act of 1989, the final regulations provide that if a partnership with one or more corporate partners makes a payment of interest, rent or royalties, the interest, rent or royalty payment will be treated as paid by a corporate partner to the extent the payment gives rise to a partnership item of deduction that is allocable to the corporate partner or to the extent that a partnership item reasonably related to the payment would be allocated to the corporate partner under an existing allocation under the partnership agreement. To the extent the payment is treated as made by the corporate partner, it will be excluded from the foreign personal holding company income of the recipient if the corporate partner otherwise satisfies the conditions of section 954(c)(3)(A). Under 1.954-2T(b)(3)(ii), interest may not be excluded from foreign personal holding company income of the recipient to the extent the deduction for interest is allocated to the payor's subpart F income. To clarify how this rule is to be applied when a controlled foreign corporation is both the recipient and payor of interest, 1.954- 2(b)(4)(ii)(B)(2) was added, which parallels the rule contained in 1.904-5(k)(2). Section 1.954-2T(b)(3) provides that, to exclude dividends and interest received from related corporate payors from foreign personal holding company income, a substantial part of the payor's assets must be used in a trade or business in the payor's country of incorporation. Section 1.954-2T(b)(3)(iv) provides that a substantial part of the payor's assets will be considered to be used in a trade or business in the payor's country of incorporation if, for each quarter of the taxable year, the average value of its assets which are so used is over 50 percent of the average value of all of its assets (determined as of the beginning and end of the quarter). To simplify the application of this rule, 1.954-2(b)(4)(iv) provides that the average value of assets is to be determined on a yearly rather than a quarterly basis by averaging the values of assets as of the close of each quarter. Section 1.954-2T(b)(3)(vi)(A) provides that for purposes of the substantial assets test, tangible property (other than inventory) is generally considered located where it is physically located. Paragraph (b)(3)(vi)(B) contains an exception for property temporarily located elsewhere for inspection or repair. A commenter suggested that, in addition to this exception, the regulations should restore the exception contained in prior regulations that treated purchased property located abroad and intended for prompt shipment to the country of incorporation as property located in the country of incorporation. This comment was rejected because this provision would have been inconsistent with the rule that property purchased for use in a trade or business is not considered used in a trade or business until it is placed in service. Section 1.954-2T(b)(3)(vii)(A) provides that for purposes of the substantial assets test, the location of intangible property is determined based on the site of the activities conducted by the payor during the taxable year in connection with the use or exploitation of the property. The country in which services are performed is determined under the principles of section 954(e) and 1.954-4(c). This rule was amended to provide more comprehensive guidance to determine the situs of activities in connection with the use or exploitation of intangible property. Section 1.954-2(b)(4)(vii)(B) provides that the country in which the activities connected to the use or exploitation of property are conducted is the country in which the expenses associated with these activities are incurred by the payor or its agent or an independent contractor. Section 1.954-2T(b)(3)(vii)(A) provides that the intangible property is considered located in the payor's country of incorporation during each quarter of the taxable year if the activities connected with its use or exploitation are conducted in its country of incorporation during the entire taxable year. A commenter argued that this test is inconsistent with the quarterly determination required by the substantial assets test of 1.954-2T(b)(3)(iv). Changes were made to the location of property rules (1.954-2(b)(4)(vi) through (ix)) so that relevant determinations are made for each quarter separately. The final regulations continue to reserve on the provision of special rules regarding the location of assets of banks and insurance companies for purposes of the same-country exception. Comments are invited regarding the need for special guidance on this issue. Several comments questioned the application of the rules of 1.954-2T(b)(6), pursuant to which interest income of a controlled foreign corporation that is described in section 103 is included in foreign personal holding company income but is characterized as tax- exempt interest when included in the gross income of the United States shareholders. The purpose of this rule was to prevent a person from avoiding the consequences of the alternative minimum tax provisions by investing in tax-exempt obligations described in section 103 through a controlled foreign corporation. The final regulations reserve on the treatment of tax-exempt interest. The administrative complexity of applying the rule described in the temporary regulations, and the potential for double taxation that it creates, argue against its continued application. Proposed regulations, published elsewhere in this issue of the Federal Register, will provide rules regarding the treatment of tax-exempt interest. In the interim, the rules of the temporary regulations continue to apply. Section 1.954-2T(b)(5) provides that the determination whether rents and royalties are derived from the active conduct of a trade or business is made under the facts and circumstances of each case, and refers to paragraphs (c) and (d) for the application of its provisions. Commenters have asked whether only the facts and circumstances described in paragraphs (c) and (d) may be considered. The final regulations are clarified to reflect that whether rents or royalties are derived in the active conduct of a trade or business is determined solely under the provisions of paragraphs (c) and (d). Section 1.954-2T(c)(2)(iii) defines active leasing expenses for purposes of determining whether rental income is derived in the active conduct of a trade or business. A commenter suggested that paragraph (c)(2)(iii) be amended to state that if a corporation sells property of the same type as the property that is leased, the corporation's expenses that are of the type described in that paragraph may be pro-rated on any reasonable basis between the leasing and the sales function. It was determined that the change requested by this commenter was unnecessary because paragraph (c)(2)(iii) already defines active leasing expenses as deductions properly allocable to rental income. A commenter suggested that an example be added to 1.954-2T(c) to illustrate that expenses such as payments to third parties for insurance, utilities and repairs are considered active leasing expenses and not amounts paid to agents or independent contractors. The regulations were amended in response to this comment. Section 1.954- 2(c)(2)(iii)(D) provides that the term active leasing expenses does not include payments to agents or independent contractors other than payments for insurance, utilities and other expenses for like services or capitalized property. A similar change was made to the definition of the term adjusted leasing profit. Section 954(c)(1)(B) and 1.954-2T(e) include in foreign personal holding company income the excess of gains over losses from certain property transactions. Section 1.954-2T(e)(1)(i) provides that gain or loss that is treated as capital gain or loss under section 988(a)(1)(B) is not foreign currency gain or loss but rather gain or loss from a property transaction under paragraph (e). A commenter contended that gain or loss from transactions described in section 988(a)(1)(B) should be characterized as gain or loss described in section 954(c)(1)(C) and 1.954-2T(f) rather than in section 954(c)(1)(B) and paragraph (e). This comment was rejected, because the capital transactions described in section 988(a)(1)(B) are more appropriately subject to the provisions of section 954(c)(1)(B) and paragraph (e). This provision is now contained in 1.954-2(g)(5). A commenter asked that gain from a disposition of stock of a subsidiary be excluded from foreign personal holding company income to the extent that gain from the subsidiary's disposition of its assets would be so excluded. There is no statutory authority for the position recommended by the commenter, however. In addition, the look-through treatment proposed by the commenter is inconsistent with the treatment prescribed for dispositions of interests in a partnership or trust under section 954(c)(1)(B)(ii). For these reasons, the comment was rejected. Pursuant to 1.954-2T(e)(3)(vi), gain from a disposition of non- depreciable intangible property or goodwill is characterized as foreign personal holding company income unless the intangible property is disposed of in connection with a disposition of the entire trade or business of the controlled foreign corporation. Commenters have argued that the gain should be excluded from foreign personal holding company income if such property is used in the trade or business of the controlled foreign corporation, without regard to whether an entire trade or business of the controlled foreign corporation is sold. The regulations were modified in response to this comment. Section 1.954-2(e)(3)(iv) excludes from foreign personal holding company income any gain or loss of a controlled foreign corporation from a disposition of intangible property, goodwill or going concern value to the extent used or held for use in the trade or business of the controlled foreign corporation. Section 1.954-2T(e)(4) provides that gain or loss from the sale, exchange or retirement of a debt instrument is included in the computation of foreign personal holding company income under paragraph (e) with certain exceptions. However, a loss on a debt instrument taken in consideration for the sale or exchange of property is excluded from foreign personal holding company income if the gain or loss from that underlying sale or exchange is not includible in foreign base company income. This rule was eliminated from the final regulations because it was inconsistent to prevent a controlled foreign corporation from using these losses to offset subpart F income when gain from such debt instruments was not excepted from the general inclusion rule. Section 1.954-2T(e)(5) provides that rights to acquire property, other than certain property that is dealer property or inventory property, are characterized as property that does not give rise to income for purposes of section 954(c)(1)(B). One commenter has suggested that such rights should not be characterized as property that does not give rise to income. This comment was rejected because any gain that may arise upon a disposition of an option, warrant, or other right to acquire property, other than gain from a disposition of inventory or dealer property, is income of the type intended to be characterized as foreign personal holding company income for purposes of section 954(c)(1)(B). The provisions of 1.954-2T(e)(5) are now incorporated into the definition of property that does not give rise to income under 1.954-2(e)(3). However, the final regulations clarify that notional principal contracts are excluded from the definition of property that does not give rise to income. (But see 1.954-2(f), (g) and (h).) Section 954(c)(1)(C) and 1.954-2T(f) provide rules for including the excess of gains over losses from commodities transactions in foreign personal holding company income. Several commenters argued that 1.954- 2T(f)(2)(i) defines commodity too broadly, and that, like sections 553 and 864, the regulations should apply only to commodities that are actively traded on a regulated exchange. This comment was rejected because the statute and its legislative history make clear that section 954(c)(1)(C) is intended to apply broadly to any commodity of a kind that is actively traded. Thus, there is no reason to distinguish income from a disposition of a commodity actively traded on a regulated exchange from income from a disposition of a commodity of a kind that is otherwise actively traded. Although 1.954-2(f)(2)(i) no longer explicitly provides that nonfunctional currency is a commodity, nonfunctional currency continues to fall within the general definition of commodity. Consequently, foreign currency is still treated as a commodity if the currency is actively traded or if contractual interests in the currency are actively traded. Under the ordering rules of paragraph (a)(2), however, paragraph (g) (foreign currency transactions) continues to apply before paragraph (f). Thus, unless an election is made under section 988(c)(1)(D)(ii), a currency futures contract is treated as a commodities transaction, while a currency forward contract is generally treated as a foreign currency transaction. Section 1.954-2T(f)(1) excludes gains and losses from qualified active sales and qualified hedging transactions from the computation of foreign personal holding company income under paragraph (f). In defining qualified active sale, paragraph (f)(3) requires substantially all of the controlled foreign corporation's business to be as an active producer, processor, merchant or handler of commodities of like kind. Commenters argued that by using the phrase "of like kind," 1.954- 2T(f)(3) defines qualified active sales too narrowly. The "of like kind" language was not intended to require that all of the commodities be of one kind, but rather that the controlled foreign corporation must be an active producer, etc. with respect to each kind of commodity. To avoid confusion, the "of like kind" language has been eliminated from the definition of the term qualified active sale. Section 1.954-2T(f)(3)(ii) defines the term sale of commodities. Commenters questioned the requirement, incorporated in the definition of this term, that the corporation hold the commodity in physical form. This comment was accepted. The final regulations no longer require the controlled foreign corporation to hold the commodity in physical form. Section 1.954-2(f)(2)(iii)(B) requires only that the controlled foreign corporation hold the commodity directly and not through an independent contractor. The retention of this requirement is consistent with the legislative history of section 954(c)(1)(C), which makes clear that the exclusion from foreign personal holding company income was intended to apply only with respect to commodities for which controlled foreign corporations are active producers, processors, handlers or merchants. Section 1.954-2(f)(2)(iii)(D) provides that activities of employees of entities related to the controlled foreign corporation may be treated as activities directly engaged in by the controlled foreign corporation if the employees are paid and supervised by the controlled foreign corporation. Section 1.954-2(f)(2)(iii)(B) also amends the definition of the term active conduct of a commodities business by clarifying that the requirements specified in that paragraph must be satisfied with respect to each commodity and that property may be held either as dealer property or as inventory or similar property. Section 954(c)(1)(C)(ii) and 1.954-2T(f)(1) and (3) exclude income attributable to commodities transactions from foreign personal holding company income if substantially all of the business of a controlled foreign corporation is as an active producer, processor, merchant or handler of commodities. Section 1.954-2T(f)(3)(iv) provides that the controlled foreign corporation will satisfy the substantially all requirement if 85 percent of its taxable income for the taxable year is attributable to qualified active sales and qualified hedging transactions. Several commenters argued that this test could fail to reflect the nature of the controlled foreign corporation's business accurately in some years because of the volatility of certain commodities markets. To accommodate this concern, 1.954-2(f)(2)(iii)(C) modifies the definition of the term substantially all by applying the 85 percent test to gross receipts rather than taxable income. To prevent manipulation of this modified test, a provision was added under which the District Director may disregard any sale or hedging transaction that has as a principal purposes manipulation of the 85 percent test. Section 1.954-2T(f)(4) defines the term qualified hedging transaction as a bona fide hedging transaction that is entered into primarily to reduce the risk of price change with respect to commodities sold or to be sold in qualified active sales. A commenter argued that a bona fide hedging transaction should not be required to relate to a qualified active sale to be treated as a qualified hedging transaction. This comment was rejected because this provision is based on the statutory requirement that qualified hedging transactions must arise out of the business of the controlled foreign corporation as an active producer, processor, merchant or handler of commodities. Thus, the rule of the temporary regulations is retained. Section 954(c)(1)(D) and 1.954-2T(g) include in foreign personal holding company income the net foreign currency gains attributable to section 988 transactions. The rules in 1.954-2T(g)(2)(i) governing the treatment of gain or loss attributable to foreign currency transactions in hyperinflationary currencies have been removed. Section 1.954- 2(g)(5)(iii) provides that the applicable rules of section 985 will apply to such transactions. Section 1.954-2T(g)(2)(ii) excludes from foreign personal holding company income gain or loss from qualified business transactions that are separately identified, and gain or loss from qualified hedging transactions that are identified with, or traced to, a qualified business transaction. Many commenters argued that these rules are too cumbersome to apply. They contended that a controlled foreign corporation that has a large number of qualified business transactions may not hedge such transactions individually, and that it is difficult or impossible in such cases to relate a hedge to one or even several qualified business transactions. The commenters also argued that the alternative election to treat all currency gain (or loss) as foreign personal holding company income (or loss allocable to foreign personal holding company income) does not provide adequate relief for controlled foreign corporations whose hedging activities relate to qualified business transactions on a net basis but give rise to foreign currency gain that is treated as foreign personal holding company income. The regulations are modified in response to those comments. Section 1.954-2(g)(2)(ii) excludes from foreign personal holding company income foreign currency gain or loss directly related to the business needs of the controlled foreign corporation. Foreign currency gain or loss is directly related to the business needs of the corporation, first, if it can be clearly determined that it arises from a transaction entered into or property used in the normal course of the corporation's trade or business and the transaction or property does not itself give rise to subpart F income (other than foreign currency gain or loss), or, second, if it arises from a bona fide hedging transaction with respect to such a transaction or property. To exclude gain or loss from a hedging transaction from foreign personal holding company income under this rule, corporations need not trace a hedging transaction to a specific transaction or property if all (or all but a de minimis amount) of the aggregate risks being hedged are within the business needs exception and the hedging transaction otherwise satisfies the requirements of section 1221, as modified for this purpose. Section 1.954-2(g)(2)(ii)(C) provides a specific dealer exception under which transactions described in section 988(c)(1)(B)(iii) and (C) that are entered into by a regular dealer, in its capacity as a dealer, are treated as directly related to its business needs for purposes of the exclusion under 1.954-2(g)(2)(ii). Because a corporation's borrowings support all of its activities, paragraph (g)(2)(iii) provides that foreign currency gain or loss attributable to an interest-bearing liability that is not covered by paragraph (g)(5)(iv) is characterized as subpart F income and non-subpart F income on the same basis as interest expense is allocated and apportioned. Thus, for example, exchange gain or loss from an unhedged interest-bearing liability may fall under this rule. Section 1.954-2T(g)(3) provides that a transaction will not be treated as a qualified business transaction if the foreign currency gain or loss from the transaction is attributable to property or an activity of a kind that gives rise to subpart F income. Commenters have argued that this requirement is too restrictive because it may cause the gain or loss from the underlying transaction, and the foreign currency gain or loss attributable to the transaction, to be in different separate categories for foreign tax credit purposes. In response to this comment, a new election was added to paragraph (g). Under 1.954-2(g)(3), the controlling United States shareholders may elect to have the controlled foreign corporation include foreign currency gain or loss that would otherwise be included in foreign personal holding company income under paragraph (g) in the category of subpart F income to which such gain or loss relates. This election works in conjunction with the general rules of paragraph (g)(2). Thus, for example, this election may apply to currency gain or loss that would otherwise be treated as foreign personal holding company income under paragraph (g) even if other currency gain or loss is excluded under the business needs exception of paragraph (g)(2)(ii). As described above, the temporary regulations permit taxpayers to elect to treat all foreign currency gain or loss as foreign personal holding company income. The final regulations retain this election, with modifications. Under 1.954-2(g)(4), the controlling United States shareholders of the controlled foreign corporation may elect to include in the computation of foreign personal holding company income net foreign currency gains or losses attributable to any section 988 transaction and any section 1256 contract that would be a section 988 transaction but for section 988(c)(1)(D). Shareholders are not permitted to make separate elections for section 1256 contracts and section 988 transactions. An election under paragraph (g)(4) supersedes an election under paragraph (g)(3). Section 1.954-2(g)(5)(iv) reserves on the treatment of gain or loss allocated under 1.861-9. It is anticipated that when 1.861-9 is finalized, a provision will be added to this paragraph to indicate that gain or loss that is allocated or apportioned under section 861 in the same manner as interest expense is not foreign currency gain or loss under paragraph (g). Section 954(c)(1)(E) and 1.954-2T(h) include income equivalent to interest in foreign personal holding company income. A commenter argued that the term income equivalent to interest might be read to include income from a wide range of interest rate sensitive transactions entered into by a securities dealer or commodities producer, processor, merchant or handler in the ordinary course of its business. The commenter suggested that the regulations should be modified to confirm that such income is not income equivalent to interest. The final regulations do not contain a general dealer exception that applies to all income equivalent to interest because income equivalent to interest is generally treated like interest, for which no general dealer exception is provided. However, consistent with Notice 89-90 (1989-2 C.B. 407), 1.954-2(h)(3)(ii) provides a specific dealer exception for income from notional principal contracts. Section 1.954-2T(h)(1) provides that income equivalent to interest does not include income attributable to notional principal contracts except to the extent that such contracts are part of an integrated transaction that gives rise to income equivalent to interest. Notice 89-90 stated, however, that final regulations would provide that income equivalent to interest would include income from notional principal contracts regardless of whether the notional principal contract is integrated with an investment, because notional principal contracts generally affect the all-in cost of interest-bearing liabilities or the return on interest-bearing assets. Accordingly, 1.954-2(h)(3) provides that income from notional principal contracts based solely on interest rates or interest rate indices is income equivalent to interest, and paragraph (h)(1)(ii) provides that income from a notional principal contract covered by 1.861-9T is not income equivalent to interest. Paragraph (f) continues to apply to notional principal contracts based on commodities (or a commodities index), and paragraph (g) continues to apply to notional principal contracts covered by section 988. Section 1.954-2T(h)(3) treats factoring income as income equivalent to interest, with certain exceptions. Commenters have argued that income realized by a credit card company from factoring its receivables (which is attributable to the discount at which it acquires the receivables from the business establishments honoring its credit card) does not represent an interest equivalent amount, but instead represents other types of income, such as compensation for services. This comment was rejected. It is true that the income attributable to the discount at which a controlled foreign corporation acquires a receivable reflects not only the time value of money, but also certain other elements (for example, collection risk and cost). However, the factoring income derived by the controlled foreign corporation is analogous to interest income derived from a loan made by a bank, which reflects not only the time value of money, but also the other elements of the discount income received in the factoring transaction described above. The Tax Reform Act of 1986 repealed the exclusion from foreign personal holding company income of such interest income derived by a bank. The repeal of this provision indicates that interest income is not intended to be excluded from foreign personal holding company income merely because it may reflect more than the time value of money. Income equivalent to interest should not be treated differently. Some of the rules described in the final regulations are inconsistent with provisions of 1.954-3 through 1.954-8, as well as the regulations under other provisions of subpart F. In such cases, these final regulations are intended to apply instead of the regulations under other provisions of section 954 and of subpart F generally. Section 1.952-3 is removed because the rules of that section are replaced by 1.954-1. Other conforming changes are being considered in a separate regulations project. Many nonsubstantive structural and editorial changes were made to these final regulations for clarity. Drafting Information The principal authors of these regulations are Valerie Mark and, with respect to financial products, Elissa Shendalman of the Office of the Associate Chief Counsel (International), IRS. However, personnel from other offices of the IRS and Treasury Department participated in developing the regulations. List of Subjects 26 CFR Parts 1 and 4 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 602 Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR parts 1, 4 and 602 are amended to read as follows: PART 1--INCOME TAXES Paragraph 1. The authority for part 1 is amended by removing the authority citation for "Section 1.954-0T, 1.954-1T, 1.954-2T and 1.957- 1T" and adding the following citations in numerical order to read as follows: Authority: 26 U.S.C. 7805. * * * Section 1.954-0 also issued under 26 U.S.C. 954(b) and (c). Section 1.954-1 also issued under 26 U.S.C. 954(b) and (c). Section 1.954-2 also issued under 26 U.S.C. 954(b) and (c). Section 1.957-1 also issued under 26 U.S.C. 957. * * * 1.952-3 [Removed] Par. 2. Section 1.952-3 is removed. Par. 3. Sections 1.954-0, 1.954-1 and 1.954-2 are added to read as follows: 1.954-0 Introduction. (a) Effective dates--(1) Final regulations--(i) In general. Except as otherwise specifically provided, the provisions of 1.954-1 and 1.954-2 apply to taxable years of a controlled foreign corporation beginning after November 6, 1995. If any of the rules described in 1.954-1 and 1.954-2 are inconsistent with provisions of other regulations under subpart F, these final regulations are intended to apply instead of such other regulations. (ii) Election to apply final regulations retroactively --(A) Scope of election. An election may be made to apply the final regulations retroactively with respect to any taxable year of the controlled foreign corporation beginning on or after January 1, 1987. If such an election is made, these final regulations must be applied in their entirety for such taxable year and all subsequent taxable years. All references to section 11 in the final regulations shall be deemed to include section 15, where applicable. (B) Manner of making election. An election under this paragraph (a)(1)(ii) is binding on all United States shareholders of the controlled foreign corporation and must be made-- (1) By the controlling United States shareholders, as defined in 1.964-1(c)(5), by attaching a statement to such effect with their original or amended income tax returns for the taxable year of such United States shareholders in which or with which the taxable year of the CFC ends, and including any additional information required by applicable administrative pronouncements, or (2) In such other manner as may be prescribed in applicable administrative pronouncements. (C) Time for making election. An election may be made under this paragraph (a)(1)(ii) with respect to a taxable year of the controlled foreign corporation beginning on or after January 1, 1987 only if the time for filing a return or claim for refund has not expired for the taxable year of any United States shareholder of the controlled foreign corporation in which or with which such taxable year of the controlled foreign corporation ends. (D) Revocation of election. An election made under this paragraph (a)(1)(ii) may not be revoked. (2) Temporary regulations. The provisions of 4.954-1 and 4.954-2 of this chapter apply to taxable years of a controlled foreign corporation beginning after December 31, 1986 and on or before November 6, 1995. However, the provisions of 4.954-2(b)(6) of this chapter continue to apply. For transactions entered into on or before October 9, 1995, taxpayers may rely on Notice 89-90, 1989-2 C.B. 407, in applying the temporary regulations. (3) 1.954A-1 and 1.954A-2. The provisions of 1.954A-1 and 1.954A-2 (as contained in 26 CFR part 1 edition revised April 1, 1995) apply to taxable years of a controlled foreign corporation beginning before January 1, 1987. All references therein to sections of the Code are to the Internal Revenue Code of 1954 prior to the amendments made by the Tax Reform Act of 1986. (b) Outline of regulation provisions for sections 954(b)(3), 954(b)(4), 954(b)(5) and 954(c) of the Internal Revenue Code. 1.954-0 Introduction. (a) Effective dates. (1) Final regulations. (i) In general. (ii) Election to apply final regulations retroactively. (A) Scope of election. (B) Manner of making election. (C) Time for making election. (D) Revocation of election. (2) Temporary regulations. (3) 1.954A-1 and 1.954A-2. (b) Outline of regulation provisions for sections 954(b)(3), 954(b)(4), 954(b)(5) and 954(c) of the Internal Revenue Code. 1.954-1 Foreign base company income. (a) In general. (1) Purpose and scope. (2) Gross foreign base company income. (3) Adjusted gross foreign base company income. (4) Net foreign base company income. (5) Adjusted net foreign base company income. (6) Insurance income. (7) Additional items of adjusted net foreign base company income or adjusted net insurance income by reason of section 952(c). (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. (B) Currency translation. (C) Coordination with sections 864(d) and 881(c). (ii) Seventy percent full inclusion test. (2) Character of gross income included in adjusted gross foreign base company income. (3) Coordination with section 952(c). (4) Anti-abuse rule. (i) In general. (ii) Presumption. (iii) Related persons. (iv) Example. (c) Computation of net foreign base company income. (1) General rule. (i) Deductions against gross foreign base company income. (ii) Losses reduce subpart F income by operation of earnings and profits limitation. (iii) Items of income. (A) Income other than passive foreign personal holding company income. (B) Passive foreign personal holding company income. (2) Computation of net foreign base company income derived from same country insurance income. (d) Computation of adjusted net foreign base company income or adjusted net insurance income. (1) Application of high tax exception. (2) Effective rate at which taxes are imposed. (3) Taxes paid or accrued with respect to an item of income. (i) Income other than passive foreign personal holding company income. (ii) Passive foreign personal holding company income. (4) Special rules. (i) Consistency rule. (ii) Coordination with earnings and profits limitation. (iii) Example. (5) Procedure. (6) Coordination of full inclusion and high tax exception rules. (7) Examples. (e) Character of income. (1) Substance of the transaction. (2) Separable character. (3) Predominant character. (4) Coordination of categories of gross foreign base company income or gross insurance income. (i) In general. (ii) Income excluded from other categories of gross foreign base company income. (f) Definition of related person. (1) Persons related to controlled foreign corporation. (i) Individuals. (ii) Other persons. (2) Control. (i) Corporations. (ii) Partnerships. (iii) Trusts and estates. (iv) Direct or indirect ownership. 1.954-2 Foreign personal holding company income. (a) Computation of foreign personal holding company income. (1) Categories of foreign personal holding company income. (2) Coordination of overlapping categories under foreign personal holding company provisions. (i) In general. (ii) Priority of categories. (3) Changes in the use or purpose for which property is held. (i) In general. (ii) Special rules. (A) Anti-abuse rule. (B) Hedging transactions. (iii) Example. (4) Definitions and special rules. (i) Interest. (ii) Bona fide hedging transaction. (A) Definition. (B) Identification. (C) Effect of identification and non-identification. (1) Transactions identified. (2) Inadvertent identification. (3) Transactions not identified. (4) Inadvertent error. (5) Anti-abuse rule. (iii) Inventory and similar property. (A) Definition. (B) Hedging transactions. (iv) Regular dealer. (v) Dealer property. (A) Definition. (B) Securities dealers. (C) Hedging transactions. (vi) Examples. (vii) Debt instrument. (b) Dividends, interest, rents, royalties and annuities. (1) In general. (2) Exclusion of certain export financing interest. (i) In general. (ii) Exceptions. (iii) Conduct of a banking business. (iv) Examples. (3) Treatment of tax-exempt interest. [RESERVED] (4) Exclusion of dividends or interest from related persons. (i) In general. (A) Corporate payor. (B) Payment by a partnership. (ii) Exceptions. (A) Dividends. (B) Interest paid out of adjusted foreign base company income or insurance income. (1) In general. (2) Rule for corporations that are both recipients and payors of interest. (C) Coordination with sections 864(d) and 881(c). (iii) Trade or business requirement. (iv) Substantial assets test. (v) Valuation of assets. (vi) Location of tangible property. (A) In general. (B) Exception. (vii) Location of intangible property. (A) In general. (B) Exception for property located in part in the payor's country of incorporation. (viii) Location of inventory and dealer property. (A) In general. (B) Inventory and dealer property located in part in the payor's country of incorporation. (ix) Location of debt instruments. (x) Treatment of certain stock interests. (xi) Treatment of banks and insurance companies. [Reserved] (5) Exclusion of rents and royalties derived from related persons. (i) In general. (A) Corporate payor. (B) Payment by a partnership. (ii) Exceptions. (A) Rents or royalties paid out of adjusted foreign base company income or insurance income. (B) Property used in part in the controlled foreign corporation's country of incorporation. (6) Exclusion of rents and royalties derived in the active conduct of a trade or business. (c) Excluded rents. (1) Active conduct of a trade or business. (2) Special rules. (i) Adding substantial value. (ii) Substantiality of foreign organization. (iii) Active leasing expenses. (iv) Adjusted leasing profit. (3) Examples. (d) Excluded royalties. (1) Active conduct of a trade or business. (2) Special rules. (i) Adding substantial value. (ii) Substantiality of foreign organization. (iii) Active licensing expenses. (iv) Adjusted licensing profit. (3) Examples. (e) Certain property transactions. (1) In general. (i) Inclusions. (ii) Exceptions. (iii) Treatment of losses. (iv) Dual character property. (2) Property that gives rise to certain income. (i) In general. (ii) Gain or loss from the disposition of a debt instrument. (3) Property that does not give rise to income. (f) Commodities transactions. (1) In general. (i) Inclusion in foreign personal holding company income. (ii) Exception. (iii) Treatment of losses. (2) Definitions. (i) Commodity. (ii) Commodities transaction. (iii) Qualified active sale. (A) In general. (B) Active conduct of a commodities business. (C) Substantially all. (D) Activities of employees of a related entity. (E) Financial activities. (iv) Qualified hedging transaction. (A) In general. (B) Exception. (g) Foreign currency gain or loss. (1) Scope and purpose. (2) In general. (i) Inclusion. (ii) Exclusion for business needs. (A) General rule. (B) Business needs. (C) Regular dealers. (D) Example. (iii) Special rule for foreign currency gain or loss from an interest- bearing liability. (3) Election to characterize foreign currency gain or loss that arises from a specific category of subpart F income as gain or loss in that category. (i) In general. (ii) Time and manner of election. (iii) Revocation of election. (iv) Example. (4) Election to treat all foreign currency gains or losses as foreign personal holding company income. (i) In general. (ii) Time and manner of election. (iii) Revocation of election. (5) Gains and losses not subject to this paragraph. (i) Capital gains and losses. (ii) Income not subject to section 988. (iii) Qualified business units using the dollar approximate separate transactions method. (iv) Gain or loss allocated under 1.861-9. [Reserved] (h) Income equivalent to interest. (1) In general. (i) Inclusion in foreign personal holding company income. (ii) Exceptions. (A) Liability hedging transactions. (B) Interest. (2) Definition of income equivalent to interest. (i) In general. (ii) Income from the sale of property. (3) Notional principal contracts. (i) In general. (ii) Regular dealers. (4) Income equivalent to interest from factoring. (i) General rule. (ii) Exceptions. (iii) Factored receivable. (iv) Examples. (5) Receivables arising from performance of services. (6) Examples. 1.954-1 Foreign base company income. (a) In general--(1) Purpose and scope. Section 954 and 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 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) 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 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 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 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 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  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 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 (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 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 1.954-2(b)(4)(ii)(B)(2) may be offset as provided in 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 1.904-4(c)) is reduced by related person interest expense allocable to passive income under 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 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 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 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 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 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 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. (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 $100 of royalty income that is foreign personal holding company income. CFC has no expenses associated with this royalty income. CFC pays $20 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 $20, the effective rate of tax on the item, for purposes of this paragraph (d), is 40 percent. 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 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 (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 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 (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 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 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 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 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 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 holding company income under section 954(c) .......................................... 100 (3) Gross foreign base company sales income under section 954(d) ............................ 50 (4) Total gross foreign base company income and gross insurance income as defined in sections 954(c), (d), (e), (f) and (g) and 953 (line (2) plus line (3)).................................... 150 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 (7) Adjusted gross foreign base company income and adjusted 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) ............................. 150 (8) Adjusted gross foreign base company income and adjusted 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)) .............. 150 Step 4--Compute net foreign base company income: (9) Expenses directly related to adjusted gross foreign base company sales income ......... 20 (10) Expenses (other than related person interest expense) directly related to adjusted gross foreign personal holding company income .... 2 (11) Related person interest expense allocable to adjusted gross foreign personal holding company income under section 904 ....................... 8 (12) Net foreign personal holding company income after allocating deductions under section 954(b)(5) and paragraph (c) of this section (line (2) reduced by lines (10) and (11)) ........ 90 (13) Net foreign base company sales income after allocating deductions under section 954(b)(5) and paragraph (c) of this section (line (3) reduced by line (9)) ................... 30 (14) Total net foreign base company income after allocating deductions under section 954(b)(5) and paragraph (c) of this section (line (12) plus line (13)) ....................... 120 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 holding company income (as determined under section 954(b)(4) and this paragraph (d)) .............................. 30 (17) Foreign income tax imposed on net foreign base company sales income (as determined under section 954(b)(4) and this paragraph (d)) .............................. 14 (18) Ninety percent of the maximum United States corporate tax rate ............................... 31.5% (19) Effective rate of foreign income tax imposed on net foreign personal holding company income ($90 of interest) under section 954(b)(4) and this paragraph (d) (line (16) divided by line (12)) ............................. 33% (20) Effective rate of foreign income tax imposed on $30 of net foreign base company sales income under section 954(b)(4) and this paragraph (d) (line (17) divided by line (13)) .................................... 47% (21) Net foreign personal holding company income subject to a high foreign tax under section 954(b)(4) and this paragraph (d) (zero, or line (12) if line (19) is greater than line (18)) ....................................... 90 (22) Net foreign base company sales income subject to a high foreign tax under section 954(b)(4) and this paragraph (d) (zero, or line (13) if line (20) is greater than line (18)) .................................. 30 (23) Adjusted net foreign base company income after applying section 954(b)(4) and this paragraph (d) (line (14), reduced by the sum of line (21) and line (22)) .......................... 0 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 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 ............................................ 500 (27) Amount of reduction in subpart F income for prior taxable years by reason of the limitation of section 952(c)(1) ................ 600 (28) Subpart F income as defined in section 952(a), assuming 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)) ...................................... 500 (29) Amount of prior year's deficit to be recharacterized as subpart F income in later years under section 952(c) (excess of line (27) over line (26)).................................. 100 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 954(c)(1)(A) and 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 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 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 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 income as defined in sections 954(c), (d), (e), (f) and (g) and 953 (interest income) ............................ 720 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 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)) ........................ 1000 (5) Full inclusion foreign base company income under paragraph (b)(1)(ii) (line (4) minus line (2)) ....................................... 280 Step 4--Compute net foreign base company income: (6) Expenses (other than related person interest expense) directly related to adjusted gross foreign personal holding company income ......... 50 (7) Related person interest expense allocable to adjusted gross foreign personal holding company income under section 904 ........ 350 (8) Deductions allocable to full inclusion foreign base company income under section 954(b)(5) and paragraph (c) of this section .................................. 250 (9) Net foreign personal holding company income after allocating deductions under section 954(b)(5) and paragraph (c) of this section (line (2) reduced by line (6) and line (7)) ..... 320 (10) Full inclusion foreign base company income after allocating deductions under section 954(b)(5) and paragraph (c) of this section (line (5) reduced by line (8)).................... 30 (11) Total net foreign base company income after allocating deductions under section 954(b)(5) and paragraph (c) of this section (line (9) plus line (10)) ........................ 350 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 holding company income (interest) ........................................ 120 (14) Foreign income tax imposed on net full inclusion foreign base company income ........ 2 (15) Ninety percent of the maximum United States corporate tax rate .............................. 31.5% (16) Effective rate of foreign income tax imposed on $320 of net foreign personal holding company income under section 954(b)(4) and this paragraph (d) (line (13) divided by line (9)) ..... 38% (17) Effective rate of foreign income tax imposed on $30 of net full inclusion foreign base company income under section 954(b)(4) and this paragraph (d) (line (14) divided by line (10)) ..... 7% (18) Net foreign personal holding company income subject to a high foreign tax under section 954(b)(4) and this paragraph (d) (zero, or line (9) if line (16) is greater than line (15)) ...................................... 320 (19) Net full inclusion foreign base company income subject 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)) ...................................... 0 (20) Adjusted net foreign base company income after applying section 954(b)(4) and this paragraph (d) (line (11) reduced by the sum of line (18) and line (19)) ........... 30 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 gross insurance income (determined without regard to the full inclusion test of paragraph (b)(1) of this section) (line (4) reduced by line (5)) .................... 720 (23) Ninety percent of adjusted gross foreign base company 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)) ... 648 (24) Net foreign base company income and net insurance income 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)) .... 720 (25) Adjusted net full inclusion foreign base company income 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)) ........................................ 30 (26) Adjusted net foreign base company income after application of paragraph (d)(6) of this section (line (20) reduced by line (25)) ........... 0 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 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 ................................. 350 (29) Amount of reduction in subpart F income for prior taxable years by reason of the limitation of section 952(c)(1) .................. 600 (30) Subpart F income as defined in section 952(a), assuming 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)) ........................................ 350 (31) Amount of prior years' deficit remaining to be recharacterized as subpart F income in later years under section 952(c) (excess of line (29) over line (28)) .............. 250 (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 tra