The temporary and proposed regulations provide that a CFTE is a foreign tax paid or accrued by a partnership that is eligible for a credit under section 901(a). A qualifying domestic corporate shareholder may claim a credit under section 901(a) for taxes paid or accrued by a foreign corporation and deemed paid by the shareholder under section 902 or 960 upon distribution or inclusion of the associated earnings. Several commentators requested guidance concerning whether taxes deemed paid under section 902 or 960 are subject to these regulations. Although a domestic corporation may be eligible to claim a credit for deemed-paid taxes with respect to stock of a foreign corporation it owns indirectly through a partnership, any such deemed-paid taxes are determined directly by the corporate partner based on the partner’s distributive share of dividend income or inclusion. Such deemed-paid taxes, therefore, are not partnership items and are not taxes paid or accrued (or deemed paid or accrued) by a partnership. Accordingly, foreign taxes deemed paid under section 902 or 960 are not subject to these regulations.

The final regulations retain the definition of CFTE contained in the temporary and proposed regulations. In response to the comment, the final regulations clarify that a CFTE does not include foreign taxes deemed paid by a corporate partner under section 902 or 960. The final regulations also clarify that the regulations do not apply to foreign taxes paid or accrued by a partner (foreign taxes for which the partner has legal liability within the meaning of §1.901-2(f)). Finally, the final regulations clarify that a CFTE does include a foreign tax paid or accrued by a partnership that is eligible for a credit under an applicable U.S. income tax treaty.

Examples in the temporary and proposed regulations illustrated that the determination of the income to which a CFTE relates must be made separately for certain categories of income when the partnership agreement provides for different allocations of such income. Commentators requested additional guidance regarding the relevant categories for purposes of the safe harbor, including clarification that the safe harbor does not require the partnership to determine its CFTE categories by reference to section 904(d) categories. Subject to the requirements of section 704(b) and other applicable provisions of U.S. law, partners are free to allocate income in any manner they choose. Although partners must assign their distributive shares of partnership items (along with their other items of income and expense) to section 904(d) categories to compute the applicable limitations on the foreign tax credit, the CFTE categories need not be determined by reference to section 904(d) categories. These principles were illustrated by the examples in the temporary and proposed regulations. However, the IRS and the Treasury Department agree with commentators that it is appropriate to provide additional guidance in determining a partnership’s relevant categories of income. Accordingly, the final regulations provide additional guidance for purposes of making this determination. The additional guidance is also intended to assist in the determination of the distributive share of income to which a foreign tax relates. See the discussion at section C in this preamble. Consistent with the comments, the rules provided for in the final regulations rely to the extent possible on U.S. tax principles.

The final regulations clarify that the relevant category of income is the CFTE category, defined in the final regulations as U.S. net income attributable to one or more activities of the partnership. In general, the final regulations provide that U.S. net income from all of the partnership’s activities is treated as income in a single CFTE category. This general rule does not apply, however, if the partnership agreement provides for an allocation of U.S. net income from one or more activities that differs from the allocation of U.S. net income from other activities. In that case, U.S. net income from each activity or group of activities that is subject to a different allocation is treated as net income in a separate CFTE category. For this purpose, income from a divisible part of a single activity is treated as income from a separate activity if such income is shared in a different ratio than other income from the activity.

Thus, if a partnership agreement allocates all partnership items in the same manner, the partnership will have a single CFTE category, regardless of the number of activities in which the partnership is engaged. Conversely, a partnership agreement that provides for different allocations of net income with respect to one or more activities will have multiple CFTE categories. For example, assume a partnership (AB) with two partners is engaged in two activities and that the partnership agreement provides that all partnership items are shared 50-50. In such a case, the partnership has a single CFTE category. However, the partnership would have two CFTE categories if the items from one activity were shared 50-50 and the items from the second activity were shared 80-20.

Different allocations of the partnership’s U.S. net income from separate activities and, thus, multiple CFTE categories may result if the partnership agreement contains special allocations. For example, assume that AB partnership agreement allocates all items other than depreciation 50-50, and that deductions for depreciation are allocated 100 percent to one of the partners. In such a case, the allocations of U.S. net income from the two activities will differ if AB’s deductions for depreciation relate solely to one activity or if the deductions relate disproportionately to the activities. See paragraph (b)(5) Example 22. A preferential allocation of income will not result in multiple CFTE categories if the allocation relates to all of the partnership’s net income. For example, assume partnership AB allocates $100 of gross income each year to one of the partners and all remaining items 50-50. In such a case, the special allocation of $100 of gross income affects the overall sharing ratio of partnership net income, but does not result in different sharing ratios with respect to income from the partnership’s two activities. Accordingly, the U.S. net income attributable to the two activities is included in a single CFTE category. See paragraph (b)(5) Example 25.

Whether the partnership has different sharing ratios with respect to income from one or more activities, and therefore has more than one CFTE category, depends on the facts and circumstances. Therefore, the final regulations provide that whether a partnership has one or more activities, and the scope of those activities, must be determined in a reasonable manner taking into account all the facts and circumstances. In evaluating whether aggregating or disaggregating income from particular business or investment operations constitutes a reasonable method of determining the scope of an activity, the principal consideration is whether or not the proposed determination has the effect of separating CFTEs from the related foreign income. Accordingly, relevant facts and circumstances include whether the partnership conducts business or investment operations in more than one geographic location or through more than one entity or branch, and whether certain types of income are exempt from foreign tax or subject to preferential foreign tax treatment. In addition, income from a divisible part of a single activity is treated as income from a separate activity if necessary to prevent the separation of CFTEs from the related foreign income. Finally, the final regulations provide that the partnership’s activities must be determined consistently from year to year absent a material change in facts and circumstances.

The temporary and proposed regulations required the allocation of a CFTE to be in proportion to the partner’s distributive share of income to which it relates. Several commentators requested that the final regulations provide additional guidance in determining a partner’s distributive share of income for purposes of the safe harbor. Some commentators believed that it was unclear whether allocations of CFTEs must be proportionate to allocations of income as determined for U.S. tax purposes or as determined under foreign law. One comment recommended that, at least in cases where there is a preferential allocation of income, income as determined for U.S. tax purposes should control. Other commentators requested that the final regulations clarify whether allocations of CFTEs must follow allocations of gross or net income, and that the final regulations clarify the effect of special allocations and allocations of separately stated items on allocations of CFTEs under the safe harbor. Commentators also requested clarifications regarding section 704(c) allocations, income allocations that are deductible under foreign law, guaranteed payments, and situations in which certain partners’ allocable shares of partnership income are excluded from the foreign tax base. In response to the comments, the final regulations provide several clarifications regarding the determination of a partner’s distributive share of income to which a CFTE relates.

The final regulations clarify that the net income in a CFTE category is the net income for U.S. Federal income tax purposes, determined by taking into account all items attributable to the relevant activity or group of activities (or portion thereof). The final regulations provide that the items of gross income included in a CFTE category must be determined in a consistent manner under any reasonable method taking into account all the facts and circumstances. Expenses, losses or other deductions generally must be allocated and apportioned to gross income included in a CFTE category in accordance with the rules of §§1.861-8 and 1.861-8T.

Sections 1.861-8 and 1.861-8T require taxpayers to use special rules contained in §§1.861-9 through 1.861-13T and §1.861-17 to allocate and apportion deductions for interest expense and research and development (R&D) costs. See §§1.861-8(e)(3) and 1.861-8T(e)(2). Those provisions generally require taxpayers to allocate and apportion such deductions at the partner level and do not provide rules for allocating and apportioning the deductions at the partnership level. See §§1.861-9T(e) and 1.861-17(f). Therefore, the final regulations permit a partnership to allocate and apportion deductions for interest and R&D costs for purposes of determining net income in a CFTE category under any reasonable method, including but not limited to the rules contained in §§1.861-9 through 1.861-13T and §1.861-17.

The final regulations clarify that in applying U.S. Federal income tax principles to determine the net income attributable to an activity of a branch, the only items of gross income taken into account are items of gross income that are recognized by the branch for U.S. federal income tax purposes. Therefore, a payment from one branch to another does not increase the gross income attributable to the activity of the recipient. See paragraph (b)(5) Example 24. Similarly, because U.S. tax principles apply to determine net income attributable to an activity of a branch, the inter-branch payment does not reduce the gross income of the payor. See paragraph (b)(4)(viii)(c)(3)(B) and paragraph (b)(5) Example 24.

The discussion in this preamble addresses the effect of the following factors on the determination of net income in a CFTE category: (a) section 704(c) allocations, (b) preferential income allocations and guaranteed payments, and (c) the exclusion of income of certain partners from the foreign tax base.

Several commentators requested clarification of when section 704(c) allocations should be taken into account. Some commentators believed that section 704(c) allocations should only be taken into account where the built-in gain or loss is also recognized in the foreign jurisdiction. A number of commentators suggested further that section 704(c) allocations should be taken into account only upon the disposition of the section 704(c) property, while other commentators believed that section 704(c) allocations should also be taken into account as the section 704(c) property is depreciated or amortized over time.

After consideration of these comments, the final regulations retain the general principle that all section 704(c) allocations must be taken into account when determining net income in the relevant category. The IRS and the Treasury Department concluded that any attempt to trace the impact of built-in gain (or loss) under foreign tax principles to corresponding items under U.S. tax principles would be difficult to do and impractical to administer. Because allocations of net income from a CFTE category are allocations of the net income recognized for U.S. tax purposes, the IRS and the Treasury Department believe that all section 704(c) allocations (including “reverse” section 704(c) allocations and section 704(c) allocations that are made prior to an asset’s disposition) must be taken into account in determining a partner’s distributive share of income. Thus, the final regulations provide that the net income in a CFTE category is the net income for U.S. income tax purposes, determined by taking into account all items attributable to the relevant activity, including, among other items, items allocated pursuant to section 704(c). See paragraph (b)(5) Example 26.

Several commentators requested that the final regulations provide guidance regarding the treatment of preferential income allocations and guaranteed payments when applying the safe harbor. In particular, clarification was requested as to the relevance of the deductibility of such items under foreign law in determining whether CFTEs are related to such items.

The final regulations generally provide that the income to which a CFTE relates is the net income in the CFTE category to which the CFTE is allocated and apportioned. However, if an allocation of partnership income is treated as a deductible payment under foreign law, then no CFTEs are related to that income because it is not included in the foreign tax base. To reflect this principle, the final regulations provide that income attributable to an activity shall not include an item of partnership income to the extent the allocation of such item of income (or payment thereof) to a partner results in a deduction under foreign law. By removing the income associated with a preferential income allocation that is deductible under foreign law from the net income in a CFTE category, this provision of the final regulations ensures that no CFTE will be related to such income, which is not included in the base upon which the creditable foreign tax is imposed.

The principle that no CFTEs are related to income if the allocation of such income results in a deduction under foreign law applies with equal force to cases in which a guaranteed payment made by a partnership to a partner is deductible by the partnership under foreign law. Conversely, where a partner receives a guaranteed payment and the guaranteed payment is not deductible by the partnership under foreign law (and thus does not reduce the foreign tax base), CFTEs should relate to the guaranteed payment. Accordingly, the final regulations contain two provisions to reflect these principles. First, under the final regulations, a guaranteed payment is treated as income in a CFTE category to the extent that the payment is not deductible by the partnership under foreign law. Second, the final regulations provide that such a guaranteed payment is treated as a distributive share of income for purposes of the safe harbor. Consequently, the final regulations provide that CFTEs relate to income taken into account as a guaranteed payment to the extent the payment is not deductible under foreign law, and therefore CFTEs must be allocated to the partner receiving the guaranteed payment.

One commentator requested guidance concerning the source and character of guaranteed payments for other U.S. tax purposes. These issues are clearly important, but they are beyond the scope of this project and are not addressed in these final regulations.

A foreign jurisdiction may impose tax with respect to partnership income that is allocable to certain partners and not with respect to partnership income allocable to other partners. For example, as was the case in Vulcan Materials Co. v. Comm’r, 96 T.C. 410 (1991), aff’d in unpublished opinion, 959 F.2d 973 (11^th Cir. 1992), nonacq. 1995-2 C.B. 2, a foreign jurisdiction may impose tax solely with respect to the nonresident partners’ shares of partnership income. One commentator suggested that the final regulations provide that in these situations, allocations of CFTEs satisfy the safe harbor if they are allocated to the partner or partners whose income is included in the foreign tax base. The final regulations adopt this comment, and provide that income in a CFTE category does not include net income that foreign law would exclude from the foreign tax base as a result of the status of the partner. By removing such income from a CFTE category, this provision of the final regulations ensures that CFTEs will be related only to income of those partners whose income is included in the base upon which the creditable foreign tax is impos.ed.

The final regulations provide that a partner’s distributive share of income generally is the portion of the net income in a CFTE category that is allocated to the partner. Therefore, a partner’s distributive share of income is determined under U.S. tax principles, taking into account the modifications described in section C1 under “Net income in a CFTE category.”

The final regulations provide a special rule for cases in which more than one partner receives positive income allocations (income in excess of expenses) from a CFTE category and the aggregate of such positive income allocations exceeds the net income in the CFTE category because one or more other partners is allocated a net loss (expenses in excess of income). Because in this situation the sum of the positive income allocations from the CFTE category exceeds 100 percent of the net income in the category, an adjustment to the safe harbor formula is required to ensure that aggregate allocations of CFTEs do not exceed 100 percent of the CFTEs in the category. Accordingly, solely for purposes of allocating CFTEs under the safe harbor, the final regulations limit the distributive share of income of each partner that receives a positive income allocation to the partner’s positive income allocation attributable to the CFTE category, divided by the aggregate positive income allocations attributable to the CFTE category, multiplied by the net income in the CFTE category. For example, assume that the partnership has $100 of net income ($130 of gross income and $30 of expenses) in a CFTE category and that partner A is allocated $65 of gross income, partner B is allocated $45 of gross income and partner C is allocated $20 of gross income and $30 of expenses. In this case, solely for purposes of the safe harbor, partner A’s distributive share of income is $59 ($65/$110 x $100) and partner B’s distributive share of income is $41 ($45/$110 x $100).

The final regulations contain a special rule for cases in which CFTEs are allocated and apportioned to a CFTE category that does not have any net income for U.S. tax purposes in the year the foreign taxes are paid or accrued. In such cases, there is no net income in the CFTE category to which the CFTEs relate. In the absence of a special rule, allocations of such CFTEs among the partners would not fall within the general safe harbor of the final regulations and would be required to be allocated in accordance with the partners’ interests in the partnership. To eliminate uncertainty in this situation, the final regulations include a rule that relates such CFTEs to net income recognized for U.S. tax purposes in other years or in other CFTE categories. (For rules relating to the allocation and apportionment of CFTEs to a CFTE category, see section D below.)

Under the final regulations, CFTEs allocated and apportioned to a CFTE category that has no net income for U.S. tax purposes will be deemed to relate to the aggregate net income (if any) recognized by the partnership in that CFTE category during the preceding three-year period (not taking into account years in which there is a net loss in the CFTE category for U.S. tax purposes). Accordingly, the CFTEs in these situations generally must be allocated among the partners in the same proportion as the allocations of such net income for the prior three-year period to satisfy the safe harbor. If the partnership does not have net income in the applicable CFTE category in either the current year or any of the previous three taxable years, the CFTEs must be allocated among the partners in the same proportion that the partnership reasonably expects to allocate net income in the applicable CFTE category over the succeeding three years. If the partnership does not reasonably expect to have net income in the applicable CFTE category in the succeeding three years, the CFTEs must be allocated among the partners in the same proportion as the total partnership net income for the year is allocated. If the CFTE cannot be allocated under any of the foregoing rules, it must be allocated in proportion to the partners’ outstanding capital contributions.

The temporary and proposed regulations provided that the income to which a CFTE relates is determined in accordance with the principles of §1.904-6. Section 1.904-6, which contains rules for allocating and apportioning foreign taxes to the categories of income described in section 904(d), provides generally that a foreign tax is related to income if the income is included in the base upon which the foreign tax is imposed. Section 1.904-6(a)(1)(ii) contains special rules for apportioning taxes among categories of income when the income on which the foreign tax is imposed includes income in more than one category. It also provides special rules for allocating a foreign tax that is imposed on an item that would be income under U.S. tax principles in another year (timing difference) or an item that does not constitute income under U.S. tax principles (base differences).

A number of comments were received requesting clarification of the §1.904-6 principles that apply for purposes of these regulations. In particular, commentators requested guidance concerning the applicability of the related party interest expense rule in §1.904-6(a)(1)(ii), timing and base differences, and inter-branch payments.

The final regulations retain the rule that the determination of the income to which a CFTE relates is made in accordance with the principles of §1.904-6. In response to the comments, however, the final regulations contain several clarifications and modifications regarding how the principles of §1.904-6 apply in allocating foreign taxes to CFTE categories. The final regulations clarify that in applying §1.904-6 for purposes of the safe harbor, the relevant categories are the CFTE categories determined under the rules described in section B in this preamble. Therefore, the final regulations clarify that application of the principles of §1.904-6 requires a CFTE to be allocated to a CFTE category if the net income on which the tax is imposed (the net income recognized for foreign tax purposes) is in the CFTE category. The final regulations also provide guidance on (a) the apportionment rule in §1.904-6(a)(1)(ii), (b) the rules for timing differences, (c) the rules for base differences and (d) the treatment of inter-branch payments.

Section 1.904-6(a)(1)(ii) provides that where foreign taxes are imposed on income that relates to more than one separate category, the foreign taxes must be apportioned among the separate categories pro rata based on the amount of net income in each category. Subject to a special rule for related party interest expense, the net income in each category generally is determined under foreign law. If foreign law does not provide rules for the allocation and apportionment of expenses, losses or other deductions to a particular category of income, then such items must be allocated and apportioned in accordance with the rules of §§1.861-8 through 1.861-14T.

Commentators requested clarification that the apportionment rule in §1.904-6(a)(1)(ii), which apportions foreign taxes among categories based on relative amounts of net income as determined under foreign law, applies for purposes of apportioning taxes among the categories of income created by the partnership agreement. Commentators recommended that the related party interest expense rule be disregarded for purposes of the apportionment rule.

In response to these comments, the final regulations clarify that the principles of §1.904-6(a)(1)(ii) require a taxpayer to apportion foreign taxes among the CFTE categories based on the relative amounts of net income as determined under foreign law in each CFTE category. In addition, the final regulations modify the apportionment rule in two respects. See §1.704-(b)(4)(viii)(d)(1).

The final regulations adopt the recommendation to disregard the related party interest expense rule contained in §1.904-6(a)(1)(ii) for purposes of apportioning taxes among the CFTE categories on the basis of foreign net income. The IRS and the Treasury Department agree that this rule, which coordinates the characterization of taxes and income for section 904(d) purposes, is not relevant for purposes of apportioning CFTEs to CFTE categories. Rather, the apportionment of CFTEs is based on the partnership income, as determined under foreign law, in the CFTE categories, which may include partnership items in one or more section 904(d) categories.

The final regulations also provide that if foreign law does not provide rules for the allocation and apportionment of expenses, losses or other deductions allowed under foreign law to a CFTE category of income, then such expenses, losses or other deductions must be allocated and apportioned to gross income as determined under foreign law in a manner that is consistent with the allocation and apportionment of such items for purposes of determining the net income in the CFTE category for U.S. tax purposes.

A timing difference arises when an item subject to foreign tax is recognized as income under U.S. tax principles in a different year. The temporary and proposed regulations did not contain a specific textual rule regarding the application of the timing difference rule of §1.904-6(a)(1)(iv) in the context of section 704(b). However, the temporary and proposed regulations included an example that involved a timing difference (Example 27), which indicated that a current year CFTE attributable to an item of income recognized in the prior year for U.S. tax purposes related to, and thus must be allocated in accordance with, the income allocated under the partnership agreement in the prior year.

Upon further consideration, the IRS and the Treasury Department have concluded that relating foreign taxes paid or accrued in one year to income recognized for U.S. tax purposes in another year would be difficult for taxpayers to comply with and for the IRS to administer. In many instances, it would be difficult to identify accurately the extent of timing differences and the years in which such differences would be reversed. Moreover, where income allocations change from year to year, it often would be impossible for partnerships to determine how the partners would share related U.S. income in subsequent years. Accordingly, the final regulations provide for a more administrable rule that requires the partnership to allocate a CFTE attributable to a timing difference among the partners in the same proportions as the allocations of income recognized for U.S. tax purposes in the relevant CFTE category in the year such taxes are paid or accrued. See paragraph (b)(5) Example 23 (reflecting modifications to Example 27 in the temporary and proposed regulations). This approach should result in allocations of CFTEs that are generally in proportion to the partners’ distributive shares of U.S. taxable income over time, and therefore is consistent with the underlying purposes of the foreign tax credit rules to mitigate double taxation. See the discussion at section E in this preamble under “Partners’ Interests in the Partnership” for cases in which the partnership agreement allocates CFTEs attributable to a timing difference among the partners in proportion to allocations of U.S. income in an earlier or later year when the income with respect to which the foreign tax is imposed is recognized for U.S. tax purposes.

In addition, the final regulations expressly incorporate the timing difference rule of §1.904-6(a)(1)(iv). Therefore, a CFTE attributable to a timing difference is allocated to the CFTE category to which the income would be assigned if the income were recognized for U.S. tax purposes in the year in which the foreign tax is imposed.

A base difference arises when an item subject to foreign tax is not income under U.S. tax principles. Several commentators observed that the base difference rule under §1.904-6(a)(1)(iv) provides little indication of how a CFTE attributable to a base difference should be allocated for purposes of the safe harbor. The IRS and the Treasury Department agree that this issue should be clarified. In the absence of any income to which such a CFTE relates, the final regulations provide that a CFTE attributable to a base difference is related to the income recognized for U.S. tax purposes in the relevant CFTE category in the year such taxes are paid or accrued. For this purpose, a CFTE attributable to a base difference is allocated and apportioned to the CFTE category that includes the partnership items attributable to the activity with respect to which the creditable foreign tax is imposed. Thus, the final regulations adopt similar rules for dealing with timing and base differences. These changes are intended to provide greater certainty for taxpayers and simplify the administration of the safe harbor.

Several commentators requested additional guidance regarding the application of the final regulations to transactions between branches (including disregarded entities owned by the partnership) that are disregarded for U.S. tax purposes. In response to this comment, the final regulations provide that if a branch of the partnership (including a disregarded entity owned by the partnership) is required to include in income under foreign law a payment (inter-branch payment) it receives from the partnership or another branch of the partnership, any CFTE imposed with respect to the payment relates to the income in the CFTE category that includes the items attributable to the recipient. In cases where the partnership agreement results in more than one CFTE category with respect to the recipient, such tax is allocated to the CFTE category that includes the items attributable to the activity to which the inter-branch payment relates. A similar rule applies to payments received by the partnership from a branch of the partnership. This rule is consistent with the timing and base difference rules in the final regulations because it associates foreign tax imposed on the recipient with net income of the recipient as determined under U.S. tax principles, notwithstanding differences in U.S. and foreign tax rules. Like the timing and base difference rules, this rule avoids the need for complex tracing rules.

It is possible that this approach might result in distortions of the effective foreign tax rates on the partners’ distributive shares of income in certain cases. Nevertheless, the IRS and the Treasury Department have concluded that imposing a requirement to trace taxes imposed on the recipient with respect to such inter-branch payments to income recognized under U.S. tax principles by the payor would be difficult for taxpayers to comply with and for the IRS to administer.

Some commentators recommended that at least in cases where the income allocations take such inter-branch payments into account in determining the partners’ distributive shares of income, the allocation of CFTEs should be respected if made in proportion to income allocations that reflect such payments. The final regulations do not adopt this comment, as the approach suggested by these commentators would require taxpayers and the IRS to identify the inter-branch payments and relate such amounts to items of income of the payor and to CFTEs imposed on the recipient to substantiate that CFTEs of the payor and recipient were properly allocated. The IRS and the Treasury Department concluded that this approach would be difficult to administer and was therefore ill-suited to inclusion in a safe harbor. See the discussion at section E under “Partners’ Interests in the Partnership” for cases in which the partnership agreement allocates partnership items of income to reflect inter-branch payments.

Some commentators suggested that allocations of CFTEs that are not proportionate to allocations of the related income (and therefore fail to satisfy the safe harbor) will nevertheless be valid as in accordance with the partners’ interests in the partnership standard of §1.704-1(b)(3). According to these commentators, the partners’ interests in the partnership with respect to a CFTE are conclusively determined by the manner in which the CFTE is allocated under the partnership agreement. The IRS and the Treasury Department believe that this view of the partners’ interests in the partnership is incorrect, particularly in the context of a CFTE that is allocated to a partner who can use the associated foreign tax credit. In such a situation, the partner is relieved of a corresponding amount of U.S. tax, and thus does not bear the economic burden of the CFTE. Because of this lack of economic burden, the allocation of the CFTE is meaningless in the determination of the partners’ interests in the partnership with respect to the CFTE and with respect to any other partnership item that has a material effect on the amount of CFTE that would be allocated to a partner under the safe harbor of the final regulations. Consequently, the final regulations clarify that in determining the partners’ interests in the partnership with respect to an allocation of a partnership item, the allocation of the CFTE itself must be disregarded. This rule does not apply where the partners to whom the taxes are allocated reasonably expect to claim a deduction for such taxes in determining their U.S. tax liabilities.

As indicated in the preamble to the temporary regulations, the IRS and the Treasury Department believe that only in unusual circumstances (such as where the CFTEs are deducted and not credited) will allocations that fail to satisfy the safe harbor be in accordance with the partners’ interests in the partnership. As discussed in this preamble, for administrative reasons, the final regulations do not adopt a tracing approach for timing differences or inter-branch payments. Allocations of foreign taxes in such situations that are based on a tracing approach may constitute an unusual situation where the safe harbor is not satisfied, but the allocations are in accordance with the partners’ interests in the partnership.

When a CFTE is attributable to a timing difference, the CFTE category to which the CFTE is allocated may or may not have income for U.S. tax purposes in the year the foreign tax is paid or accrued. In either case, allocations of such CFTEs that are proportionate to allocations of the income at the time such income is recognized for U.S. tax purposes may not qualify for safe harbor treatment, but nonetheless be in accordance with the partners’ interests in the partnership.

Allocations of CFTEs imposed on the payor of an inter-branch payment may fail the safe harbor, but nonetheless be in accordance with the partners’ interests in the partnership if the allocations of the CFTEs are in the same proportions as the allocations of the income of the payor, other than income that is eliminated from the foreign tax base because the inter-branch payment is deductible under foreign law. See paragraph (b)(5) Example 24 (iv). Similarly, allocations of CFTEs imposed on the recipient with respect to an inter-branch payment may fail the safe harbor, but nonetheless be in accordance with the partners’ interests in the partnership, if such allocations are proportionate to the allocations of income recognized for U.S. tax purposes out of which the payment is made. See paragraph (b)(5) Example 24 (iii).

Several commentators also requested guidance regarding whether a reallocation of CFTEs will cause the IRS to reallocate other partnership items so that the partners’ ending capital account balances will remain unchanged. If the reallocation of the CFTEs causes the partners’ capital accounts not to reflect their contemplated economic arrangement, the partners may need to reallocate other partnership items to ensure the tax consequences of the partnership allocations are consistent with their contemplated economic arrangement. Consistent with the principles of the proposed and temporary regulations, the final regulations clarify that the IRS generally will not reallocate other partnership items in the year in which a CFTE is reallocated. See paragraph (b)(5) Example 25 (ii). This treatment is also consistent with the results arising from and approach taken with respect to reallocations of other items of income, gain, loss or deduction that are not sustained under section 704(b). The IRS and the Treasury Department believe the parties and not the government should determine what allocations should be changed to reflect their economic arrangement.

The provisions of these final regulations generally apply for partnership taxable years beginning on or after October 19, 2006. A transition rule is provided for existing partnerships. Under the transition rule, if a partnership agreement was entered into before April 21, 2004, then the partnership may apply the provisions of §1.704-1(b) as if the amendments made by these final regulations had not occurred. If the partnership agreement is materially modified on or after April 21,2004, however, transition relief is no longer afforded, and the rules of §1.704-1T(b)(4)(xi) or these final regulations apply, depending upon the date on which the material modification occurs and the tax year at issue. For this purpose, a material modification includes any change in ownership of the partnership. This transition rule does not apply if, as of April 20, 2004, persons that are related to each other (within the meaning of sections 267(b) and 707(b)) collectively have the power to amend the partnership agreement without the consent of any unrelated party. However, taxpayers may rely on the provisions of paragraph (b)(4)(viii) of this section for partnership taxable years beginning on or after April 21, 2004.

As stated in this preamble, the temporary and proposed regulations included a limited transition relief provision which ceases to apply upon a material modification of the partnership agreement, including any change in ownership. In addition, transition relief was not provided to partnerships owned by related parties who collectively have the power to amend the partnership agreement. One commentator requested that the IRS and the Treasury Department consider modifying the transition relief provision to indicate that a change in ownership is not a material modification unless there is more than a 50 percent change in ultimate beneficial ownership over a three-year period. The commentator also requested that the final regulations include a rule providing transition relief to partnerships owned by related parties who collectively have the power to amend the partnership agreement only in a way that does not adversely impact unrelated partners.

After careful consideration of these comments, the IRS and the Treasury Department have decided not to expand the transition relief described in the proposed and temporary regulations. Accordingly, the final regulations do not adopt these comments.

One commentator suggested that where the partners are unrelated, the safe harbor should permit the partnership to allocate CFTEs in the same proportion as all other partnership expenses (rather than in proportion to related income). Section 1.704-1(b)(4)(ii) requires partnership credits to be allocated in the same proportions as items giving rise to the credits. Allocating CFTEs in proportion to other partnership expenses would be inconsistent with §1.704-1(b)(4)(ii). Moreover, such an approach would result in the inappropriate separation of CFTEs from the income to which such CFTEs relate. Thus, the final regulations do not incorporate this comment.

The temporary and proposed regulations provided that the safe harbor is available if the partnership agreement satisfied the requirements of §1.704-1(b)(2)(ii)(b) or (d) (capital account maintenance, liquidation according to capital accounts, and either deficit restoration obligation or qualified income offsets) and the partnership agreement provided for the allocation of the CFTE in proportion to the partner’s distributive share of partnership income. Commentators suggested that the safe harbor also should be available if the partnership allocations satisfy the economic effect equivalence standard of §1.704-1(b)(2)(ii)(i).

The purpose of the safe harbor is to provide assurance that allocations of CFTEs will be respected if the CFTEs are allocated in proportion to the income to which such CFTEs relate. This purpose is satisfied as long as CFTEs are allocated in proportion to valid allocations of net income, regardless of whether the partnership maintains capital accounts or liquidates in accordance with them. Accordingly, the final regulations adopt these comments by eliminating the requirement that the partnership allocations satisfy the requirements of §1.704-1(b)(2)(ii)(b) or (d), and instead condition eligibility for the safe harbor on the validity of income allocations, as described in this preamble.

One commentator suggested that the final regulations clarify that the underlying allocation of income to which the foreign tax relates itself must be valid in order to qualify for the safe harbor. The commentator pointed out that an income allocation may be valid because it has substantial economic effect, or because it is in accordance with (or is deemed to be in accordance with) the partners’ interests in the partnership. If income allocations are not valid, allocations of CFTEs based on such allocations will not be in proportion to the income to which the CFTEs relate. Accordingly, it is appropriate to clarify that the allocations of other items must be valid. However, the IRS and the Treasury Department believe that invalid allocations of other items should not disqualify allocations of CFTEs for safe harbor treatment unless the invalid allocations, in the aggregate, materially affect the allocation of CFTEs. Therefore, the final regulations provide that allocations of CFTEs may qualify for safe harbor treatment so long as allocations of all other partnership items that, in the aggregate, have a material effect on the amount of CFTEs allocated to the partners are valid.

Commentators suggested that the safe harbor should be available if the partnership agreement is silent with regard to the allocation of CFTEs, but actual allocations of CFTEs are made in proportion to related income. The IRS and the Treasury Department agree. Accordingly, the final regulations allow safe harbor treatment if the CFTE is allocated (whether or not pursuant to an express provision in the partnership agreement) and reported on the partnership return in proportion to the distributive shares of income to which the CFTE relates.

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(b) * * * (0) * * *

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(1) * * *

(ii) * * *

(b) Rules relating to foreign tax expenditures—(1) In general. The provisions of paragraphs (b)(3)(iv) and (b)(4)(viii) of this section (regarding the allocation of creditable foreign taxes) apply for partnership taxable years beginning on or after October 19, 2006. The rules that apply to allocations of creditable foreign taxes made in partnership taxable years beginning before October 19, 2006 are contained in §§1.704-1T(b)(1)(ii)(b)(1) and 1.704-1T(b)(4)(xi) as in effect prior to October 19, 2006 (see 26 CFR part 1 revised as of April 1, 2005). However, taxpayers may rely on the provisions of paragraphs (b)(3)(iv) and (b)(4)(viii) of this section for partnership taxable years beginning on or after April 21, 2004.

(2) Transition rule. Transition relief is provided herein to partnerships whose agreements were entered into prior to April 21, 2004. In such case, if there has been no material modification to the partnership agreement on or after April 21, 2004, then the partnership may apply the provisions of paragraph (b) of this section as if the amendments made by paragraphs (b)(3)(iv) and (b)(4)(viii) of this section had not occurred. If the partnership agreement was materially modified on or after April 21, 2004, then the rules provided in paragraphs (b)(3)(iv) and (b)(4)(viii) of this section shall apply to the later of the taxable year beginning on or after October 19, 2006, or the taxable year within which the material modification occurred, and to all subsequent taxable years. If the partnership agreement was materially modified on or after April 21, 2004, and before a tax year beginning on or after October 19, 2006, see §§1.704-1T(b)(1)(ii)(b)(1) and 1.704-1T(b)(4)(xi) as in effect prior to October 19, 2006 (26 CFR part 1 revised as of April 1, 2005). For purposes of this paragraph (b)(1)(ii)(b)(2), any change in ownership constitutes a material modification to the partnership agreement. This transition rule does not apply to any taxable year (and all subsequent taxable years) in which persons that are related to each other (within the meaning of section 267(b) and 707(b)) collectively have the power to amend the partnership agreement without the consent of any unrelated party.

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(3) * * *

(iv) Special rule for creditable foreign tax expenditures. In determining whether an allocation of a partnership item is in accordance with the partners’ interests in the partnership, the allocation of the creditable foreign tax expenditure (CFTE) (as defined in paragraph (b)(4)(viii)(b) of this section) must be disregarded. This paragraph (b)(3)(iv) shall not apply to the extent the partners to whom such taxes are allocated reasonably expect to claim a deduction for such taxes in determining their U.S. tax liabilities.

(4) * * *

(viii) Allocation of creditable foreign taxes—(a) In general. Allocations of creditable foreign taxes do not have substantial economic effect within the meaning of paragraph (b)(2) of this section and, accordingly, such expenditures must be allocated in accordance with the partners’ interests in the partnership. See paragraph (b)(3)(iv) of this section. An allocation of a creditable foreign tax expenditure (CFTE) will be deemed to be in accordance with the partners’ interests in the partnership if—

(1) The CFTE is allocated (whether or not pursuant to an express provision in the partnership agreement) and reported on the partnership return in proportion to the distributive shares of income to which the CFTE relates; and

(2) Allocations of all other partnership items that, in the aggregate, have a material effect on the amount of CFTEs allocated to a partner pursuant to paragraph (b)(4)(viii)(a)(1) of this section are valid.

(b) Creditable foreign tax expenditures (CFTEs). For purposes of this section, a CFTE is a foreign tax paid or accrued by a partnership that is eligible for a credit under section 901(a) or an applicable U.S. income tax treaty. A foreign tax is a CFTE for these purposes without regard to whether a partner receiving an allocation of such foreign tax elects to claim a credit for such tax. Foreign taxes paid or accrued by a partner with respect to a distributive share of partnership income, and foreign taxes deemed paid under section 902 or 960 by a corporate partner with respect to stock owned, directly or indirectly, by or for a partnership, are not taxes paid or accrued by a partnership and, therefore, are not CFTEs subject to the rules of this section. See paragraphs (e) and (f) of §1.901-2 for rules for determining when and by whom a foreign tax is paid or accrued.

(c) Income to which CFTEs relate—(1) In general. For purposes of paragraph (b)(4)(viii)(a) of this section, CFTEs are related to net income in the partnership’s CFTE category or categories to which the CFTE is allocated and apportioned in accordance with the rules of paragraph (b)(4)(viii)(d) of this section. Paragraph (b)(4)(viii)(c)(2) of this section provides rules for determining a partnership’s CFTE categories. Paragraph (b)(4)(viii)(c)(3) of this section provides rules for determining the net income in each CFTE category. Paragraph (b)(4)(viii)(c)(4) of this section provides guidance in determining a partner’s distributive share of income in a CFTE category. Paragraph (b)(4)(viii)(c)(5) of this section provides a special rule for allocating CFTEs when a partnership has no net income in a CFTE category.

(2) CFTE category—(i) Income from activities. A CFTE category is a category of net income (or loss) attributable to one or more activities of the partnership. Net income (or loss) from all the partnership’s activities shall be included in a single CFTE category unless the allocation of net income (or loss) from one or more activities differs from the allocation of net income (or loss) from other activities, in which case income from each activity or group of activities that is subject to a different allocation shall be treated as net income (or loss) in a separate CFTE category.

(ii) Different allocations. Different allocations of net income (or loss) generally will result from provisions of the partnership agreement providing for different sharing ratios for net income (or loss) from separate activities. Different allocations of net income (or loss) from separate activities generally will also result if any partnership item is shared in a different ratio than any other partnership item. A guaranteed payment described in paragraph (b)(4)(viii)(c)(3)(ii) of this section, gross income allocation, or other preferential allocation will result in different allocations of net income (or loss) from separate activities only if the amount of the payment or the allocation is determined by reference to income from less than all of the partnership’s activities. For purposes of this paragraph (b)(4)(viii)(c)(2), a partnership item shall not include any item that is excluded from income attributable to an activity pursuant to the second sentence of paragraph (b)(4)(viii)(c)(3)(ii) of this section (relating to allocations or payments that result in a deduction under foreign law).

(iii) Activity. Whether a partnership has one or more activities, and the scope of each activity, shall be determined in a reasonable manner taking into account all the facts and circumstances. In evaluating whether aggregating or disaggregating income from particular business or investment operations constitutes a reasonable method of determining the scope of an activity, the principal consideration is whether the proposed determination has the effect of separating CFTEs from the related foreign income. Accordingly, relevant considerations include whether the partnership conducts business in more than one geographic location or through more than one entity or branch, and whether certain types of income are exempt from foreign tax or subject to preferential foreign tax treatment. In addition, income from a divisible part of a single activity shall be treated as income from a separate activity if necessary to prevent separating CFTEs from the related foreign income. The partnership’s activities must be determined consistently from year to year absent a material change in facts and circumstances.

(3) Net income in a CFTE category—(i) In general. The net income in a CFTE category means the net income for U.S. Federal income tax purposes, determined by taking into account all partnership items attributable to the relevant activity or group of activities, including items of gross income, gain, loss, deduction, and expense and items allocated pursuant to section 704(c). The items of gross income attributable to an activity shall be determined in a consistent manner under any reasonable method taking into account all the facts and circumstances. Except as otherwise provided below, expenses, losses or other deductions shall be allocated and apportioned to gross income attributable to an activity in accordance with the rules of §§1.861-8 and 1.861-8T. Under these rules, if an expense, loss or other deduction is allocated to gross income from more than one activity, such expense, loss or deduction must be apportioned among each such activity using a reasonable method that reflects to a reasonably close extent the factual relationship between the deduction and the gross income from such activities. See §1.861-8T(c). For purposes of determining net income in a CFTE category, the partnership’s interest expense and research and experimental expenditures described in section 174 may be allocated and apportioned under any reasonable method, including but not limited to the methods prescribed in §1.861-9 through §1.861-13T (interest expense) and §1.861-17 (research and experimental expenditures). For purposes of determining the net income attributable to any activity of a branch, the only items of gross income taken into account in applying this paragraph (b)(4)(viii)(c)(3) are those items of gross income recognized by the branch for U.S. income tax purposes. See paragraph (b)(5) Example 24 of this section (relating to inter-branch payments).

(ii) Special rules. Income attributable to an activity shall include the amount included in a partner’s income as a guaranteed payment (within the meaning of section 707(c)) from the partnership to the extent that the guaranteed payment is not deductible by the partnership under foreign law. See paragraph (b)(5) Example 25 (iv) of this section. Except for an inter-branch payment described in paragraph (b)(4)(viii)(d)(3) of this section, income attributable to an activity shall not include an item of partnership income to the extent the allocation of such item of income (or payment thereof) results in a deduction under foreign law. See paragraph (b)(5) Example 25 (iii) and (iv) of this section. Similarly, income attributable to an activity shall not include net income that foreign law would exclude from the foreign tax base as a result of the status of a partner. See paragraph (b)(5) Example 27 of this section.

(4) Distributive shares of income. For purposes of paragraph (b)(4)(viii)(a)(1) of this section, distributive share of income means the net income from each CFTE category, determined in accordance with paragraph (b)(4)(viii)(c)(3) of this section, that is allocated to a partner. A guaranteed payment shall be treated as a distributive share of income for purposes of paragraph (b)(4)(viii)(a)(1) of this section to the extent that the guaranteed payment is treated as income attributable to an activity pursuant to paragraph (b)(4)(viii)(c)(3)(ii) of this section. See paragraph (b)(5) Example 25 (iv) of this section. If more than one partner receives positive income allocations (income in excess of expenses) from a CFTE category, which in the aggregate exceed the total net income in the CFTE category, then for purposes of paragraph (b)(4)(viii)(a)(1) of this section such partner’s distributive share of income from the CFTE category shall equal the partner’s positive income allocation from the CFTE category, divided by the aggregate positive income allocations from the CFTE category, multiplied by the net income in the CFTE category.