Part I. Rulings — Internal Revenue Bulletin 1998-16

II. Hybrid Branches

As announced in Notice 98–11 (1998– 6 I.R.B. 13), the Treasury and the IRS understand that certain taxpayers are using arrangements involving hybrid branches to circumvent the purposes of subpart F (sections 951 through 964 of the Code). These arrangements generally involve the use of deductible payments to reduce the taxable income of a CFC under foreign law, thereby reducing that CFC’s foreign tax and, also under foreign law, the corresponding creation in another entity of low-taxed, passive income of the type to which subpart F was intended to apply. Because of the structure of these arrangements, however, taxpayers take the position that this income is not taxed under subpart F. Treasury and the IRS have concluded that use of these hybrid branch arrangements is contrary to the policies and rules of subpart F.

U.S. international tax policy seeks to balance the objective of neutrality of taxation between domestic and foreign business enterprises (seeking neither to encourage nor to discourage one over the other), while keeping U.S. business competitive. Subpart F strongly reflects and enforces that balance, while the arrangements described above involving hybrid branches upset that balance.

Section 954.—Foreign Base Company Income

26 CFR 1.954–9T: Hybrid branches (temporary).

T.D. 8767

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 301

Guidance Under Subpart F Relating to Partnerships and Branches

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary and final regulations.

SUMMARY: This document contains regulations relating to the treatment under subpart F of certain payments involving branches of a controlled foreign corporation (CFC) that are treated as separate entities for foreign tax purposes or partnerships in which CFCs are partners. These regulations are necessary to provide guidance on transactions relating to such entities. These regulations will affect United States shareholders of controlled foreign corporations. The text of these temporary regulations also serves as the text of the proposed regulations published in REG–104537–97, page 21 of this Bulletin.

DATES: Effective date: These regulations are effective March 23, 1998.

Applicability date: For dates of applicability see §§1.904–5T(o), 1.954–1T(c)(1)(i)(E), 1.954–2T(a)(5)(iii) and (a)(6)(ii), 1.954–9T(d) and 301.7701– 3T(f) of these regulations.

FOR FURTHER INFORMATION CONTACT: Valerie Mark, (202) 622-3840 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

I. In general

In these temporary regulations and in proposed regulations published in REG–104537–97, the Treasury and IRS set forth a framework for dealing with is

sues posed by the use of certain entities that are regarded as fiscally transparent for purposes of U.S. tax law, with regard to the application of subpart F of the Internal Revenue Code.

Subpart F was enacted by Congress to limit the deferral of U.S. taxation of certain income earned outside the United States by foreign corporations controlled by U.S. persons. Limited deferral was retained after the enactment of subpart F to protect the competitiveness of controlled foreign corporations (CFCs) doing business overseas. See S. Rep. No. 1881, 87th Cong., 2d Sess. 78–80 (1962). This limited deferral furthers the objective of allowing a CFC engaged in an active business, and located in a foreign country for appropriate economic reasons, to compete in a similar tax environment with non-U.S. owned corporations located in the same country.

Conversely, one of the purposes of subpart F is to prevent CFCs from converting active income that is not easily moveable and is earned in a jurisdiction in which a business is located for non-tax reasons, into passive, easily moveable income that is shifted to a lower tax jurisdiction primarily for tax avoidance. Moreover, when subpart F was first enacted it was realized that related person transactions can be easily manipulated to reduce both United States and foreign taxes. Consequently, in enacting subpart F, Congress provided that transactions of CFCs that involve related persons generally give rise to subpart F income with certain enumerated exceptions.

Hybrid branches, which, by definition, are not regarded as fiscally transparent under foreign law, are particularly well suited to the type of tax avoidance described above. In light of the recent proliferation of hybrid branches, Treasury and the IRS believe that it is appropriate to consider the issues related to transactions involving hybrid branches, or other hybrid entities, under subpart F.

The use of partnerships that are fiscally transparent for U.S. tax purposes raises additional issues in the context of subpart F that are similar to those raised in connection with hybrid branches. Such partnerships may or may not be fiscally transparent under foreign law. (Other fis

cally-transparent entities, such as grantor trusts, will be the subject of guidance issued in conjunction with the finalization of regulations under section 672(f).)

The entity classification regulations of §§301.7701–1 through 301.7701–3 (the check-the-box regulations) make entity classification generally elective, in part so that taxpayers can choose a tax status that is consistent with their business objectives. This administrative provision was not intended to change substantive law. Particularly in the international area, the ability to more easily achieve fiscal transparency can lead to inappropriate results under certain substantive international provisions of the Code. Thus, the Treasury and the IRS believe that it is necessary to provide additional guidance regarding the use of hybrid entities in the international context. See preamble to TD 8697, 61 Fed. Reg. 66585 (December 18, 1996).

April 20, 1998 4 1998–16 I.R.B.

hybrid branch payment that is similar to the one contained in section 954(b)(4). Comments are invited on whether the rules of §1.954–9T could cause inappropriate multiple recharacterizations where the hybrid branch payments are made through a series of related hybrid entities.

The temporary regulations provide that if these provisions affect an entity that has elected under §301.7701–3(c) to be treated as an entity disregarded as separate from its owner, such an entity may elect to be classified as a corporation, provided it fulfills certain requirements, notwithstanding the sixty-month limitation in that section.

Explanation of Provisions

Under these temporary regulations, hybrid branch payments, as defined in the regulations, between a CFC and its hybrid branch, or between hybrid branches of the CFC may give rise to subpart F income. When certain conditions are present, the non-subpart F income of the CFC, in the amount of the hybrid branch payment, is recharacterized as subpart F income of the CFC. Those conditions include that: the hybrid branch payment reduces the foreign tax of the payor; the hybrid branch payment would have been foreign personal holding company income if made between separate CFCs; and there is a disparity between the effective rate of tax on the payment in the hands of the payee and the hypothetical rate of tax that would have applied if the income had been taxed in the hands of the payor. Treasury and the IRS are considering applying similar principles with respect to the foreign base company services income rules of section 954(e). Comments are requested on this issue. Any regulations promulgated on this issue will be prospective.

Policies underlying subpart F would also be avoided in certain non-hybrid branch transactions that do not reduce the tax of the payor. Treasury and the IRS invite comments on the extent to which rules should be provided to address such transactions. Any regulations promulgated on this issue will be prospective. Comments are also requested regarding the application of these rules to dividend and other equity distributions.

The temporary regulations make clear that the CFC and the hybrid branch, or the hybrid branches, are treated as separate corporations only to recharacterize nonsubpart F income as subpart F income in the amount of the hybrid branch payment, and to apply the tax disparity rule of §1.954–9T(a)(5)(iv). For all other purposes (e.g., for purposes of the earnings and profits limitation of section 952), a CFC and its hybrid branch, or hybrid branches, are not treated as separate corporations.

The temporary regulations provide that the amount recharacterized as subpart F income is the gross amount of the hybrid branch payment limited by the amount of the CFC’s earnings and profits attributable to non-subpart F income. This

amount is the excess of current earnings and profits over subpart F income, determined after the application of the rules of sections 954(b) and 952(c) and before the application of these temporary regulations. To the extent that the full amount required to be recharacterized under this provision cannot be recharacterized because it exceeds earnings and profits attributable to non-subpart F income, there is no requirement to carry such amounts back or forward to another year.

For purposes of determining the amount of taxes deemed paid under section 960, the amount of non-subpart F income recharacterized as subpart F income is treated as attributable to income in separate foreign tax credit baskets in proportion to the ratio of non-subpart F income in each basket to the total amount of nonsubpart F income of the CFC for the taxable year.

The temporary regulations provide that, under certain circumstances, the recharacterization rules will also apply to a CFC’s proportionate share of any hybrid branch payment made between a partnership in which the CFC is a partner and a hybrid branch of the partnership, or between hybrid branches of such a partnership. When the partnership is treated as fiscally transparent by the CFC’s taxing jurisdiction, the recharacterization rules are applied by treating the hybrid branch payment as if it had been made directly between the CFC and the hybrid branch, or as though the hybrid branches of the partnership had been hybrid branches of the CFC, as applicable. If the partnership is treated as a separate entity by the CFC’s taxing jurisdiction, the recharacterization rules are applied to the partnership as if it were a CFC. Comments are requested on whether the rule for such non-fiscally transparent partnerships should be relaxed in the case of small ownership interests.

The temporary regulations provide that income will not be recharacterized unless there is a disparity between the effective rate at which the hybrid branch payment is taxed to the payee and a hypothetical tax rate that measures the tax savings to the payor from the deductible payment. This provision is similar to the rule in §1.954–3(b), and adopts the same percentage tests as contained in that provision. The regulations also provide a special high tax exception applicable to the

III. Related Provisions

These temporary regulations provide rules, contained in §1.954–1T(c)(1)(i)(B), to prevent expenses, including related person interest expense which would normally be allocable under section 954(b)(5) to subpart F income of a CFC, from being allocated to a payment from which the expense arises. The allocation limit applies: (i) to the extent such payment is included in the subpart F income of the CFC; (ii) if the expense arises from any payment by the CFC to a hybrid partnership in which the CFC is a partner; and (iii) if the payment reduces foreign tax and there is a significant disparity in tax rates between the payor and payee jurisdictions.

These temporary regulations also address the application of the related person exceptions to the foreign personal holding company income rules in the context of partnership distributive shares and transactions involving hybrid branches. Under section 954(c)(3), foreign personal holding company income does not include certain interest, dividends, rents and royalties received from related corporations. These exceptions apply, in the case of interest and dividends, when the related corporate payor is organized in the country in which the CFC is organized and uses a substantial part of its assets in a trade or business in that country and, in the case of rents and royalties, when the rent or royalty payment is made for the use or privilege of using property within the CFC’s country of incorporation.

The rules regarding the application of the related person exceptions with respect to a CFC partner’s distributive share of

1998–16 I.R.B. 5 April 20, 1998

Par. 3. §1.904–5T is added to read as follows:

§1.904–5T Look-through rules as applied to controlled foreign corporations and other entities (temporary).

(a) through (j) [Reserved]. For further guidance, see §1.904–5(a) through (j).

(k) Ordering rules —(1) In general. Income received or accrued by a related person to which the look-through rules apply is characterized before amounts included from, or paid or distributed by, that person and received or accrued by a related person. For purposes of determining the character of income received or accrued by a person from a related person if the payor or another related person also receives or accrues income from the recipient and the look-through rules apply to the income in all cases, the rules of paragraph (k)(2) of this section apply. Notwithstanding any other provision of this section, the principles of §1.954– 1T(c)(1)(i) will apply to any expense subject to that subparagraph.

(k)(2) through (n) [Reserved]. For further guidance, see §1.904–5(k)(2) through (n).

(o) Effective date. Section 1.904– 5T(k)(1) applies on or after March 23, 1998. For rules prior to March 23, 1998, see §1.904–5(k)(1).

Par. 4. Section 1.954–0(b) is amended by revising the paragraph heading and the entry for §1.954–0(b) in the list to read as follows:

§1.954–0 Introduction.

(b) Outline of §§1.954–0, 1.954–1 and 1.954–2.

§1.954–0 Introduction.

(b) Outline of §§1.954–0, 1.954–1, and 1.954–2.

Par. 5. Section 1.954–1 is amended by adding a new paragraph (c)(1)(iv) to read as follows:

§1.954–1 Foreign base company income.

partnership income are part of the broader set of rules addressing distributive share issues in the context of subpart F contained in the proposed regulations published in REG–104537–97. Certain rules relating to the related person exception with respect to a CFC partner’s distributive share of partnership income, and certain rules relating to the related person exception with respect to hybrid branches, however, are included in these temporary regulations because they address a fact pattern similar to the one to which the hybrid branch payment rules apply. No inference is intended as to the treatment under existing law of such arrangements in relation to the related party exceptions.

Under these rules, if the partnership receives an item of income that reduces the income tax of the payor, the related person exceptions of section 954(c)(3) apply to exclude the income from the foreign personal holding company income of the CFC partner only where: the exception would have applied if the CFC earned the income directly (testing relatedness and country of incorporation at the CFC partner level); and either the partnership is organized and operates in the CFC’s country of incorporation, the partnership is treated as fiscally transparent in the CFC’s countries of incorporation and operation, or there is no significant disparity between the effective rate of tax imposed on the income and the rate of tax that would be imposed on the income if earned directly by the CFC partner.

The rules applying the related person exceptions with respect to hybrid branches address transactions illustrated in the first example of Notice 98–11 (1998–6 I.R.B. 13). These rules apply to payments by a CFC to a hybrid branch of a related CFC. Under these rules, the related person exceptions will apply to exclude the payments from the foreign personal holding company income of the recipient CFC only if the payment would have qualified for the exception if the hybrid branch had been a separate CFC incorporated in the jurisdiction in which the payment is subject to tax (other than a withholding tax).

IV. Effective Date.

These regulations are effective March 23, 1998. For dates of applicability see §§1.904–5T(o), 1.954–1T(c)(1)(i)(E),

1.954–2T(a)(5)(iii) and (6)(iii), 1.954– 9T(d) and 301.7701–3T(f) of these regulations.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedures Act (5 U.S.C. chapter 5) does not apply to these regulations and, because the regulation does not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal author of these regulations is Valerie Mark, of the Office of the Associate Chief Counsel (International). Other personnel from the IRS and Treasury Department also participated in the development of these regulations.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 301 are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for 26 CFR part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. In §1.904–5, paragraph (o) is amended by adding a sentence at the end to read as follows:

§1.904–5 Look-through rules as applied to controlled foreign corporations and other entities.

(o) * * * Paragraph (k)(1) of this section does not apply on or after March 23, 1998. For rules applicable on or after March 23, 1998, see §1.904–5T(k)(1).

April 20, 1998 6 1998–16 I.R.B.

(c) * * * (1) * * * (iv) Effective date. Paragraph (c)(1)(i) of this section does not apply to all amounts paid or accrued on or after March 23, 1998, except for amounts paid or accrued pursuant to arrangements entered into before March 23, 1998, and not substantially modified (including, for example, by expansion of the arrangement (whether by exercise of an option or otherwise) such as by an increase in the amount of or term of any borrowing, leasing or licensing constituting the arrangement, changes in direct or indirect control of any entity that is a party to the arrangement, or any similar measure which materially increases the tax benefit of the arrangement) on or after March 23, 1998. For rules applicable on or after March 23, 1998, see §1.954–1T(c)(1)(i). Par. 6. Section 1.954–1T is added to read as follows:

§1.954–1T Foreign base company income (temporary).

(a) through (c)(1)(i) [Reserved]. For further guidance, see §1.954–1(a) through (c)(1).

(c)(1)(i) Deductions against gross for- eign base company income —(A) In gen- eral. [Reserved]. For further guidance, see §1.954–1(c)(1)(i).

(B) Special rule for deductible pay- ments to certain non-fiscally transparent entities. Notwithstanding any other provision of this section, except as provided in paragraph (c)(1)(i)(C) of this section, an expense (including a distributive share of any expense) that would otherwise be allocable under section 954(b)(5) against the subpart F income of a controlled foreign corporation shall not be allocated against subpart F income of the controlled foreign corporation resulting from the payment giving rise to the expense if—

( 1 ) Such expense arises from a payment between the controlled foreign corporation and a partnership in which the controlled foreign corporation is a partner and the partnership is not regarded as fiscally transparent, as defined in §1.954– 9T(a)(7), by any country in which the controlled foreign corporation does business or has substantial assets; and

( 2 ) The payment from which the expense arises would have met the foreign tax reduction test of §1.954–9T(a)(3) and

the tax disparity test of §1.954– 9T(a)(5)(iv) if those provisions had been applicable to the payment.

(C) Limitations. Paragraph (c)(1)(i)(B) shall not apply to the extent that the controlled foreign corporation partner has no income against which to allocate the expense, other than its distributive share of a payment described in paragraph (c)(1)(i)(B) of this section. Similarly, to the extent an expense described in paragraph (c)(1)(i)(B) of this section exceeds the controlled foreign corporation partner’s distributive share of the payment from which the expense arises, such excess amount of the expense may reduce subpart F income (other than such payment) to which it is properly allocable or apportionable under section 954(b)(5).

(D) Example. The following example illustrates the application of paragraph (c)(1)(i)(B) and (C) of this section:

Example. CFC, a controlled foreign corporation in Country A, is a 70 percent partner in partnership P, located in Country B. Country A’s tax laws do not classify P as a fiscally transparent entity. The rate of tax in country B is 15 percent of the tax rate in country A. P loans $100 to CFC at a market rate of interest. In year 1, CFC pays P $10 of interest on the loan. The interest payment would have caused the recharacterization rules of §1.954–9T to apply if the payment were made between the entities described in §1.954–9T(a)(2). CFC’s distributive share of P’s interest income is $7, which is foreign personal holding company income to CFC under section 954(c). Under paragraph (c)(1)(i)(B) of this section, $7 of the $10 interest expense may not be allocated against any of CFC’s subpart F income. However, to the extent the remaining $3 of interest expense is properly allocable to subpart F income of CFC other than its distributive share of P’s interest income, this expense may offset such other subpart F income.

(E) Effective date. Paragraph (c)(1)(i)(B), (C) and (D) of this section shall apply to all amounts paid or accrued on or after March 23, 1998, except for amounts paid or accrued pursuant to arrangements entered into before March 23, 1998, and not substantially modified (including, for example, by expansion of the arrangement (whether by exercise of an option or otherwise) such as by an increase in the amount of or term of any borrowing, leasing or licensing constituting the arrangement, changes in direct or indirect control of any entity that is a party to the arrangement, or any similar measure which materially increases the tax benefit of the arrangement) on or after March 23, 1998. For rules applicable to amounts paid or

accrued pursuant to arrangements entered into before March 23, 1998, see §1.954–1.

(c)(1)(ii) through (f) [Reserved]. For further guidance, see §1.954–1(c)(1)(ii) through (f).

Par. 7. Section 1.954–2T is added to read as follows:

§1.954–2T Foreign personal holding company income (temporary).

(a)(1) through (4) [Reserved]. For further guidance, see §1.954–2(a) through (4).

(5) Special rules applicable to distribu- tive share of partnership income —(i) Ap- plication of related person exceptions where payment reduces foreign tax of payor. If a partnership receives an item of income that reduced the foreign income tax of the payor (determined under the principles of §1.954–9T(a)(3)), to determine the extent to which a controlled foreign corporation’s distributive share of such item of income is foreign personal holding company income, the exceptions contained in section 954(c)(3) shall apply only if—

(A)( 1 ) Any such exception would have applied to exclude the income from foreign personal holding company income if the controlled foreign corporation had earned the income directly (determined by testing, with reference to such controlled foreign corporation, whether an entity is a related person, within the meaning of section 954(d)(3), or is organized under the laws of, or uses property in, the foreign country in which the controlled foreign corporation is created or organized); and

( 2 ) The distributive share of such income is not in respect of a payment made by the controlled foreign corporation to the partnership; and

(B)( 1 ) The partnership is created or organized, and uses a substantial part of its assets in a trade or business in the country under the laws of which the controlled foreign corporation is created or organized (determined under the principles of §1.954–2(b)(4));

( 2 ) The partnership is regarded as fiscally transparent, as defined in §1.954– 9T(a)(7), by all countries under the laws of which the controlled foreign corporation is created or organized or has substantial assets; or

( 3 ) The income is taxed in the year when earned at an effective rate of tax

1998–16 I.R.B. 7 April 20, 1998

(determined under the principles of §1.954–1(d)(2)) that is not less than 90 percent of, and not more than five percentage points less than, the effective rate of tax that would have applied to such income under the laws of the country in which the controlled foreign corporation is created or organized if such income were earned directly by the controlled foreign corporation partner from local sources.

(ii) Certain other exceptions applicable to foreign personal holding company in- come. [Reserved].

(iii) Effective date. Paragraph (a)(5)(i) of this section shall apply to all amounts paid or accrued on or after March 23, 1998, except for amounts paid or accrued pursuant to arrangements entered into before March 23, 1998, and not substantially modified (including, for example, by expansion of the arrangement (whether by exercise of an option or otherwise) such as by an increase in the amount of or term of any borrowing, leasing or licensing constituting the arrangement, changes in direct or indirect control of any entity that is a party to the arrangement, or any similar measure which materially increases the tax benefit of the arrangement) on or after March 23, 1998.

(6) Special rules applicable to excep- tions from foreign personal holding com- pany income treatment in circumstances involving hybrid branches —(i) In gen- eral. In the case of a payment between a controlled foreign corporation (or its hybrid branch, as defined in §1.954–9T(a)(6)) and the hybrid branch of a related controlled foreign corporation, the exceptions contained in section 954(c)(3) shall apply only if the payment would have qualified for the exception if the payor were a separate controlled foreign corporation created or organized in the jurisdiction where foreign tax is reduced and the payee were a separate controlled foreign corporation created or organized under the laws of the jurisdiction in which the payment is subject to tax (other than a withholding tax).

(ii) Exception where no tax reduction or tax disparity. Paragraph (a)(6)(i) of this section shall not apply unless the payment would have met the foreign tax reduction test of §1.954–9T(a)(3) and the tax disparity test of §1.954–9T(a)(5)(iv) if those provisions had been applicable to the payment.

(iii) Effective date. The rules of this section shall apply to all amounts paid or accrued on or after January 16, 1998, except for amounts paid or accrued pursuant to arrangements entered into before January 16, 1998, and not substantially modified (including, for example, by expansion of the arrangement (whether by exercise of an option or otherwise) such as by an increase in the amount of or term of any borrowing, leasing or licensing constituting the arrangement, changes in direct or indirect control of any entity that is a party to the arrangement, or any similar measure which materially increases the tax benefit of the arrangement) on or after January 16, 1998.

(b) through (h) [Reserved]. For further guidance, see §1.954–2(b) through (h).

Par. 8. Section 1.954–9T is added to read as follows:

§1.954–9T Hybrid branches (temporary).

(a) Subpart F income arising from cer- tain payments involving hybrid branches —(1) Payment causing foreign tax reduction gives rise to additional sub- part F income. The non-subpart F income of the controlled foreign corporation will be recharacterized as subpart F income, to the extent provided in paragraph (a)(5) of this section, if—

(i) A hybrid branch payment, as defined in paragraph (a)(6) of this section, is made between the entities described in paragraph (a)(2) of this section;

(ii) The hybrid branch payment reduces foreign tax, as determined under paragraph (a)(3) of this section; and

(iii) The hybrid branch payment is treated as falling within a category of foreign personal holding company income under the rules of paragraph (a)(4) of this section.

(2) Hybrid branch payment between certain entities —(i) In general. Paragraph (a)(1) of this section shall apply to hybrid branch payments between—

(A) A controlled foreign corporation and its hybrid branch;

(B) Hybrid branches of a controlled foreign corporation;

(C) A partnership in which a controlled foreign corporation is a partner (either directly or through one or more branches or other partnerships) and a hybrid branch of the partnership; or

(D) Hybrid branches of a partnership in which a controlled foreign corporation is a partner (either directly or through one or more branches or other partnerships).

(ii) Hybrid branch payment involving partnership —(A) Fiscally transparent partnership. To the extent of the controlled foreign corporation’s proportionate share of a hybrid branch payment, the rules of paragraphs (a)(3), (4) and (5) of this section shall be applied by treating the hybrid branch payment between the partnership and the hybrid branch as if it were made directly between the controlled foreign corporation and the hybrid branch, or as if the hybrid branches of the partnership were hybrid branches of the controlled foreign corporation, if the hybrid branch payment is made between—

( 1 ) A fiscally transparent partnership in which a controlled foreign corporation is a partner (either directly or through one or more branches or other fiscally transparent partnerships) and the partnership’s hybrid branch; or

( 2 ) Hybrid branches of a fiscally transparent partnership in which a controlled foreign corporation is a partner (either directly or through one or more branches or other fiscally transparent partnerships).

(B) Non-fiscally transparent partner- ship. To the extent of the controlled foreign corporation’s proportionate share of a hybrid branch payment, the rules of paragraphs (a)(3) and (4) and (a)(5)(iv) of this section shall be applied to the non-fiscally transparent partnership as if it were the controlled foreign corporation, if the hybrid branch payment is made between—

( 1 ) A non-fiscally transparent partnership in which a controlled foreign corporation is a partner (either directly or through one or more branches or other partnerships) and the partnership’s hybrid branch; or

( 2 ) Hybrid branches of a non-fiscally transparent partnership in which a controlled foreign corporation is a partner (either directly or through one or more branches or other partnerships).

Example 1. CFC, a controlled foreign corporation in Country A, is a 90 percent partner in partnership P, which is treated as fiscally transparent under the laws of Country A. P has a hybrid branch, BR,

April 20, 1998 8 1998–16 I.R.B.

rules of sections 952(c) and 954(b). Further, such amount is determined by treating the controlled foreign corporation and all of its hybrid branches as a single corporation.

(iii) Recharacterization limited to gross amount of hybrid branch payment —(A) In general. The amount recharacterized as subpart F income under paragraph (a)(1) of this section is limited to the amount of the hybrid branch payment.

(B) Exception for duplicative pay- ments. [Reserved].

(iv) Tax disparity rule —(A) In general. Paragraph (a)(1) of this section will apply only if the hybrid branch payment falls within the tax disparity rule. The hybrid branch payment falls within the tax disparity rule if it is taxed in the year when earned at an effective rate of tax that is less than 90 percent of, and at least 5 percentage points less than, the hypothetical effective rate of tax imposed on the hybrid branch payment, as determined under paragraph (a)(5)(iv)(B) of this section.

(B) Hypothetical effective rate of tax (1) In general. The hypothetical effective rate of tax imposed on the hybrid branch payment is—

( i ) For the taxable year of the payor in which the hybrid branch payment is made, the amount of income taxes that would have been paid or accrued by the payor if the hybrid branch payment had not been made, less the amount of income taxes paid or accrued by the payor; divided by

( ii ) The amount of the hybrid branch payment.

(2) Hypothetical effective rate of tax when hybrid branch payment causes or increases loss or deficit. If the hybrid branch payment causes or increases a loss or deficit of the payor for foreign tax purposes, and such loss or deficit can be carried forward or back, the hypothetical effective rate of tax imposed on the hybrid branch payment is the effective rate of tax that would be imposed on the taxable income of the payor for the year in which the foreign law payment is made if the payor’s taxable income were equal to the amount of the hybrid branch payment.

Example 1 . In 1998, CFC organized in Country A had net income of $60 from manufacturing for

in Country B. P makes an interest payment of $100 to BR. Under Country A law, CFC’s 90 percent share of the payment reduces CFC’s Country A income tax. Under paragraph (a)(2)(ii)(A) of this section, the recharacterization rules of this section are applied by treating the payment as if made by CFC to BR. Ninety dollars of CFC’s non-subpart F income, to the extent available, and subject to the earnings and profits and tax rate limitations of §1.954–9T(a)(5), is recharacterized as subpart F income.

Example 2 . CFC, a controlled foreign corporation in Country A, is a 90 percent partner in partnership P, which is treated as fiscally transparent under the laws of Country A. P has two branches in Country B, BR1 and BR2. BR1 is treated as fiscally transparent under the laws of Country A. BR2 is a hybrid branch. BR1 makes an interest payment of $100 to BR2. Under paragraph (a)(2)(ii)(A) of this section, the payment by BR1, the fiscally transparent branch, is treated as a payment by P, and the deemed payment by P, a fiscally transparent partnership, is treated as made by CFC. Under Country A law, CFC’s 90 percent share of BR1’s payment reduces CFC’s Country A income tax. Ninety dollars of CFC’s non-subpart F income, to the extent available, and subject to the earnings and profits and tax rate limitations of §1.954–9T(a)(5), is recharacterized as subpart F income.

(3) Application when payment reduces foreign tax. For purposes of paragraph (a)(1) of this section, a hybrid branch payment reduces foreign tax when the foreign tax imposed on the income of the payor or any owner of the payor is less than the foreign tax that would have been imposed on such income had the hybrid branch payment not been made, or the hybrid branch payment creates or increases a loss or deficit or other tax attribute which may be carried back or forward to reduce the foreign income tax of the payor or any owner in another year (determined by taking into account any refund of such tax made to the payor, payee or any other person).

(4) Hybrid branch payment that is in- cluded within a category of foreign per- sonal holding company income —(i) In general. For purposes of paragraph (a)(1) of this section, whether the hybrid branch payment is treated as income included within a category of foreign personal holding company income is determined by treating a hybrid branch that is either the payor or recipient of the hybrid branch payment as a separate wholly-owned subsidiary corporation of the controlled foreign corporation that is incorporated in the jurisdiction under the laws of which such hybrid branch is created, organized for foreign law purposes, or has substantial assets. Thus, the hybrid branch pay

ment will be treated as included within a category of foreign personal holding company income if, taking into account any specific exceptions for that category, the payment would be included within a category of foreign personal holding company income if the branch or branches were treated as separately incorporated for U.S. tax purposes.

(ii) Extent to which controlled foreign corporation and hybrid branches treated as separate entities. For purposes other than the determination under paragraph (a)(4)(i) of this section, a controlled foreign corporation and its hybrid branch, a partnership and its hybrid branch, or hybrid branches shall not be treated as separate entities. Thus, for example, if a controlled foreign corporation, including all of its hybrid branches, has an overall deficit in earnings and profits to which section 952(c) applies, the limitation of such section on the amount includible in the subpart F income of such corporation will apply. Similarly, for purposes of applying the de minimis and full inclusion rules of section 954(b)(3), a controlled foreign corporation and its hybrid branch, or hybrid branches shall not be treated as separate corporations. Further, a hybrid branch payment that would reduce foreign personal holding company income under section 954(b)(5) if made between two separate entities will not create an expense if made between a controlled foreign corporation and its hybrid branch, a partnership and its hybrid branch, or hybrid branches.

(5) Recharacterization of income at- tributable to current earnings and profits as subpart F income —(i) General rule. Non-subpart F income of a controlled foreign corporation in an amount equal to the excess of earnings and profits of the controlled foreign corporation for the taxable year over subpart F income, as defined in section 952(a), will be recharacterized as subpart F income under paragraph (a)(1) of this section only to the extent provided under paragraphs (a)(5)(ii) through (vi) of this section.

(ii) Subpart F income. For purposes of determining the excess of current earnings and profits over subpart F income under paragraph (a)(1) of this section, the amount of subpart F income is determined before the application of the rules of this section but after the application of the

1998–16 I.R.B. 9 April 20, 1998

cally transparent under this paragraph (a)(7).

(b) Election to change classification (1) In general. If a hybrid branch subject to the provisions of paragraph (a) of this section is an entity that has made an election under §301.7701–3(c)(1) of this chapter to be disregarded as an entity separate from its owner, such entity may elect to change its classification to that of an association taxable as a corporation, under the procedures described in §301.7701–3(c) of this chapter, without regard to the limitation of §301.7701–3T(c)(1)(iv) of this chapter, but only if such election is made on or before the last day of the first taxable year beginning on or after January 1, 1998. An election made pursuant to this paragraph (b)(1) is effective as of the first day of such taxable year. The 75 day limitation on retroactivity in §301.7701–3(c)(1)(iii) of this chapter does not apply.

(2) Limitation. An entity can elect to change its classification under the provisions of this paragraph only one time.

(c) Application of section 960. For purposes of determining the amount of taxes deemed paid under section 960, the amount of non-subpart F income recharacterized as subpart F income under this section shall be treated as attributable to income in separate categories, as defined in §1.904–5(a)(1), in proportion to the ratio of non-subpart F income in each such category to the total amount of nonsubpart F income of the controlled foreign corporation for the taxable year.

(d) Effective dates —(1) Hybrid branches of controlled foreign corpora- tions. With respect to hybrid branch payments described in paragraph (a)(2)(i)(A) and (B) of this section, the rules of this section shall apply to all amounts paid or accrued on or after January 16, 1998, except for amounts paid or accrued pursuant to arrangements entered into before January 16, 1998, and not substantially modified (including, for example, by expansion of the arrangement (whether by exercise of an option or otherwise) such as by an increase in the amount of or term of any borrowing, leasing or licensing constituting the arrangement, changes in direct or indirect control of any entity that is a party to the arrangement, or any similar measure which materially increases the tax benefit of the arrangement) on or after January 16, 1998.

Country A tax purposes. It also had a branch (BR) in Country B. BR is a hybrid entity under paragraph (a)(1) of this section. CFC made a payment of $40 to BR, which was a hybrid branch payment under paragraph (a)(6) of this section, and was treated by CFC as a deductible payment for Country A tax purposes. CFC paid $30 of Country A taxes in 1998. It would have paid $50 of Country A taxes without the deductible payment. Country A did not impose any withholding tax on the $40 payment to BR. Country B also did not impose a tax on the $40 received by BR. Therefore, the effective rate of tax on that payment is 0%. Furthermore, the hypothetical effective rate of tax on the $40 hybrid branch payment is 50% ($50-$30/$40). The effective rate of tax (0%) is less than 90% of, and more than 5 percentage points less than, this hypothetical rate of tax of 50%. As a result, the $40 hybrid branch payment falls within the tax disparity rule of this paragraph (a)(5)(iv).

Example 2 . Assume the same facts as in Example 1, except that CFC has a loss of $100 for the year for Country A tax purposes. Under Country A law, CFC can carry the loss forward for use in subsequent years. CFC paid no Country A taxes in 1998. The rate of tax in Country A is graduated from 20% to 50%. If the $40 hybrid branch payment were the only item of taxable income of CFC, Country A would have imposed tax at an effective rate of 30%. The effective rate of tax (0%) is less than 90 percent of, and more than 5 percentage points less than, the hypothetical effective rate of tax (30%) imposed on the hybrid branch payment. As a result, the $40 hybrid branch payment falls within the tax disparity rule of this paragraph (a)(5)(iv).

Example 3. Assume the same facts as in Example 1, except that Country B imposes tax on the $40 hybrid payment to BR at an effective rate of 50%. The effective rate of 50% is equal to the hypothetical effective rate of tax. As a result, the hybrid branch payment does not fall within the tax disparity rule of this paragraph (a)(5)(iv) and, thus, the recharacterization rules of paragraph (a)(1) of this section do not apply. See also the special high tax exception of paragraph (a)(5)(v) of this section.

(v) Special high tax exception —(A) In general. Paragraph (a)(1) of this section shall not apply if the non-subpart F income recharacterized as subpart F income under this section 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.

(B) Effective rate of tax. The effective rate of tax imposed on the net amount of the hybrid branch payment is determined under the principles of §1.954–1(d)(2) and (3). See paragraph (c) of this section for the application of section 960 to amounts recharacterized as subpart F income under this section.

(vi) No carryback or carryforward of amounts in excess of current year earn-

ings and profits limitation. To the extent that some or all of the amount required to be recharacterized under this section is not recharacterized as subpart F income because the hybrid branch payment exceeds the amount that can be recharacterized, as determined under paragraph (a)(5)(i) of this section, this excess shall not be carried back or forward to another year.

(6) Definitions. For purposes of this section—

Entity means any person that is treated by the United States or any jurisdiction as other than an individual.

Hybrid branch means an entity that— (i) Has a single owner (including ownership through branches) that is either a controlled foreign corporation or a partnership in which a controlled foreign corporation is a partner (either directly or indirectly through one or more branches or partnerships);

(ii) Is treated as fiscally transparent by the United States; and

(iii) Is treated as non-fiscally transparent by the country in which the payor entity, any owner of a fiscally-transparent payor entity, the controlled foreign corporation, or any intermediary partnership is created, organized or has substantial assets.

Hybrid branch payment means the gross amount of any payment (including any accrual) which, under the tax laws of any foreign jurisdiction to which the payor is subject, is regarded as a payment between two separate entities but which, under U.S. income tax principles, is not income to the recipient because it is between two parts of a single entity.

(7) Fiscally transparent and non-fis- cally transparent. For purposes of this section an entity shall be treated as fiscally transparent with respect to an interest holder of the entity, if such interest holder is required, under the laws of any jurisdiction to which it is subject, to take into account separately, on a current basis, such interest holder’s share of all items which, if separately taken into account by such interest holder, would result in an income tax liability for the interest holder in such jurisdiction different from that which would result if the interest holder did not take the share of such items into account separately. A non-fiscally transparent entity is an entity that is not fis

April 20, 1998 10 1998–16 I.R.B.

(c)(1)(v) through (e) [Reserved]. For further guidance, see §301.7701–3(c)(1)(v) through (e).

(f) Effective date. Section 301.7701– 3T(a) and (c)(1)(iv) applies on or after March 23, 1998. For rules prior to March 23, 1998, see §301.7701–3(a) and (c)(1)(iv).

Michael P. Dolan, Deputy Commissioner of

Internal Revenue.

Donald C. Lubick, Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on March 23, 1998, 12:58 p.m., and published in the issue of the Federal Register for March 26, 1998, 63 F.R. 14613)

Section 985.—Functional Currency

26 CFR 1.985–1: Functional currency.

T.D. 8765

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Change From Dollar Approximate Separate Transactions Method of Accounting (DASTM) to the Profit and Loss Method of Accounting/Change From the Profit and Loss Method to DASTM

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final Regulations.

SUMMARY: This document contains final Income Tax Regulations relating to adjustments required when a qualified business unit (QBU) that used the profit and loss method of accounting (P&L) in a post-1986 year begins to use the dollar approximate separate transaction method of accounting (DASTM) and adjustments required when a QBU that used DASTM begins using P&L. The regulations provide rules for taxpayers to construct an

(2) Hybrid branches of partnerships in which controlled foreign corporations are partners. With respect to hybrid branch payments described in paragraph (a)(2)(i)(C) and (D) of this section, the rules of this section shall apply to all amounts paid or accrued on or after March 23, 1998, except for amounts paid or accrued pursuant to arrangements entered into before March 23, 1998, and not substantially modified (including, for example, by expansion of the arrangement (whether by exercise of an option or otherwise) such as by an increase in the amount of or term of any borrowing, leasing or licensing constituting the arrangement, changes in direct or indirect control of any entity that is a party to the arrangement, or any similar measure which materially increases the tax benefit of the arrangement) on or after March 23, 1998.

PART 301—PROCEDURE AND ADMINISTRATION

Par. 9. The authority citation for 26 CFR part 301 continue to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 10. In §301.7701–3, paragraph (f)(1) is amended by adding a sentence at the end to read as follows:

§301.7701–3. Classification of certain business entities.

(f)(1) * * * Paragraphs (a), (c)(1)(iv) and (f) of this section do not apply on or after March 23, 1998. For rules applicable on or after March 23, 1998, see §301.7701–3T(a), (c)(1)(iv) and (f).

Par. 11. Section 301.7701–3T is added to read as follows:

§301.7701–3T Classification of certain business entities (temporary).

(a) In general. A business entity that is not classified as corporation under §301.7701–2(b)(1), (3), (4), (5), (6), (7), or (8) (an eligible entity) can elect its classification for federal tax purposes as provided in this section. An eligible entity with at least two members can elect to be classified as either an association (and thus a corporation under §301.7701– 2(b)(2)) or a partnership, and an eligible entity with a single owner can elect to be classified as an association or to be disre

garded as an entity separate from its owner. Paragraph (b) of this section provides a default classification for an eligible entity that does not make an election. Thus, elections are necessary only when an eligible entity chooses to be classified initially as other than the default classification or when an eligible entity chooses to change its classification. An entity whose classification is determined under the default classification retains that classification (regardless of any changes in the members’ liability that occurs at any time during the time that the entity’s classification is relevant as defined in paragraph (d) of this section) until the entity makes an election to change that classification under paragraph (c)(1) of this section. Paragraph (c) of this section provides rules for making express elections. Paragraph (d) provides special rules for foreign eligible entities. Paragraph (e) of this section provides special rules for classifying entities resulting from partnership terminations and divisions under section 708(b). Paragraph (f) of this section sets forth the effective date of this section and a special rule relating to prior periods. An entity that has elected to be disregarded as an entity separate from its owner may nevertheless be treated as a corporation for the limited purposes of §1.954–9T(a)(4)(i) of this chapter.

(b) through (c)(1)(iii) [Reserved]. For further guidance, see §301.7701–3(b) through (c)(1)(iii).

(c)(1)(iv) Limitation. If an eligible entity makes an election under paragraph (c)(1)(i) of this section to change its classification (other than an election made by an existing entity to change its classification as of the effective date of this section), the entity cannot change its classification by election again during the sixty months succeeding the effective date of the election. However, the Commissioner may permit the entity to change its classification by election within the sixty months if more than fifty percent of the ownership interests in the entity as of the effective date of the subsequent election are owned by person that did not own any interests in the entity on the filing date or on the effective date of the entity’s prior election. See §1.954–9T(b) of this chapter, for circumstances under which certain eligible entities may make an election to change their classification within the sixty-month period.

1998–16 I.R.B. 11 April 20, 1998

opening dollar balance sheet for the QBU and require income adjustments in certain cases.

DATES: These regulations are effective April 6, 1998.

FOR FURTHER INFORMATION CONTACT: Howard Wiener at (202) 6223870 (not a toll-free number) of the office of Chief Counsel (International) within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC 20224.

SUPPLEMENTARY INFORMATION:

Background

On January 5, 1993 and July 25, 1994, the IRS published proposed amendments to §1.985–7 in the Federal Register at 58 F.R. 300 (INTL–0045–92) and §1.985–1 in the Federal Register at 59 F.R. 37733 (INTL–0066–92), respectively. No public hearing was held and few comments were received. After consideration of these comments, the regulations are adopted as a Treasury Decision with modifications as described below.

Explanation of Provisions

I. Proposed Rules for Changing From P&L to DASTM (§1.985–7)

The Proposed Regulations The proposed regulations under §1.985–7 set forth transition rules for QBUs changing from the profit and loss method of accounting (P&L) to DASTM in tax years after 1987. Section 1.985–6 provides the translation rules for QBUs using DASTM in 1987. Generally, when a QBU changes its functional currency, two basic issues arise: (1) How should the QBU translate its balance sheet accounts into the new functional currency in a way that preserves any unrecognized currency gain or loss which accrued in the old functional currency; and (2) whether income adjustments need to be made to recognize any currency gain or loss which accrued in the old functional currency that cannot be preserved.

Section 1.985–5 provides rules that generally apply when a QBU changes its functional currency. Under §1.985–5 balance sheet accounts are translated using the spot rate on the last day prior to the

taxable year of change. In addition, §1.985–5 generally requires recognition of unrealized exchange gain or loss on instruments and other accounts that were maintained in the functional currency to which the QBU is changing.

The proposed regulations issued under §1.985–7 were issued in response to taxpayer comments that §1.985–5 resulted in significant distortions when a QBU either elected or was required to use DASTM. Applying the spot rate on the last day prior to the year in which the QBU begins to use DASTM (the “taxable year of change”) to translate fixed assets typically results in a significant loss of basis in dollar terms and does not take into account certain income and expense distortions that occur in the period immediately preceding the taxable year of change.

In response to taxpayers’ comments, the proposed regulations provide for use of the translation rules provided under §1.985–3. These rules generally translate fixed assets at the historical exchange rate and other assets and liabilities at the current exchange rate. To correct for distortions that would result from applying historic exchange rates for fixed assets while applying the current year’s spot rate for other balance sheet accounts, the proposed regulations provide for income adjustments in the case of a controlled foreign corporation (CFC) and a branch that reflect amounts that would have been included in income under DASTM.

In the case of a CFC, the proposed regulations provide for a shareholder level income adjustment to the extent subpart F income realized during the period after 1986 until the taxable year of change differs from subpart F income that would have been realized if the CFC had used DASTM throughout this period. In the case of a branch, the regulations provide that any difference between the branch’s local currency equity translated into dollars at the spot exchange rate on the last day prior to the taxable year of change and the taxpayer’s dollar basis pool on that day is included in income over three taxable years beginning with the taxable year of change. For purposes of translating the balance sheet of noncontrolled section 902 corporations, the proposed regulations apply historic exchange rates for fixed assets. In such case, no shareholder level income adjustments are required.

Recognizing the administrative burden of making income adjustments for all post1986 tax years in the case of a CFC, the preamble to the proposed regulations requested comments regarding three alternative transition rules as follows: (1) requiring shareholder level adjustments for the three-year base period used to determine the hyperinflationary status of the local currency, (in which case the general rule of §1.985–5 would be applied in preparing the balance sheet for the first year of the base period); (2) treating a portion of retained earnings as subpart F income based on an average historical rate of subpart F income to total earnings and profits, and (3) using the spot rate on the last day prior to the taxable year of change to translate balance sheet items with special rules to allow historical exchange rates to translate fixed assets to the extent of unrealized exchange loss on paid-in capital.

Reasons for change The IRS is concerned that the approach of the proposed regulations could create a significant administrative burden for shareholders of CFCs. The administrative burden results from the requirement that shareholders recompute subpart F income for all of the CFC’s post 1986 taxable years. If the functional currency of a CFC becomes hyperinflationary in a year that is significantly distant from the CFC’s first post-1986 taxable year, records supporting the required recomputation may be unavailable.

Further, the required recomputation under the proposed regulations is generally inconsistent with the policy of sections 986 and 987 that the income of branches with a functional currency different than that of the taxpayer and the earnings and profits of foreign corporations be computed under a profit and loss method, except in the case of hyperinflation. See S. Rep. No. 99–313, 99th Cong., 2d Sess., 454 (1986). The recomputation under the proposed regulation would put the CFC on DASTM for nonhyperinflationary years. Accordingly, the rules in the proposed regulations have been modified as described below.

II. Final Regulations for Changing From P&L to DASTM (§1.985–7)

General Rule The approach employed in the final

April 20, 1998 12 1998–16 I.R.B.

regulations has the general effect of treating a QBU as if it had applied §1.985–5 on the last day of the last taxable year prior to the base period for determining whether a currency is hyperinflationary (transition date) and had applied DASTM during the taxable years beginning after the transition date until the taxable year of change (look-back period). This approach addresses the problems of applying §1.985–5 in the taxable year of change for purposes of translating fixed assets by applying the historical exchange rate to the extent fixed assets were acquired during the look-back period. Assets acquired prior to the look-back period are translated by applying the spot rate on the transition date. This approach also corrects distortions in income and expense (generally interest income and expense) that occur during the look-back period.

The final regulations respond to taxpayers’ comments and provide an appropriate rule for translating the adjusted basis of fixed assets into dollars by applying an exchange rate in effect prior to the hyperinflationary period. Moreover, this method more accurately reflects Congressional intent for QBUs to apply the profit and loss method except in the case of hyperinflation. In addition, this approach decreases the administrative burden of changing to DASTM.

Foreign Corporations In the case of a foreign corporation which is either required or elects to use DASTM, four basic corporate level adjustments are required as follows. (1) The balance sheet is translated by treating the corporation as if it had changed its functional currency to the dollar for the first post-transition date taxable year and had applied the rules of §1.985–5(c) on the transition date. Assets acquired and liabilities incurred in the functional currency during the look-back period are translated by applying the rules of §1.985–3. (2) The unrealized gain or loss on dollar denominated section 988 transactions as determined on the transition date are treated as if recognized on that date (and actual gain or loss recognized on dollar denominated section 988 transactions during the look-back period is reversed). (3) The dollar value of the pre-1987 E&P of the corporation as stated on the transition date in the functional currency is translated

into U.S. dollars at the spot rate in effect on the transition date. (4) The dollar value of the post-1986 E&P is computed by translating the post-1986 E&P as stated on the transition date in the functional currency at the spot rate on such date and adding to it the E&P for the years during the look-back period as computed under DASTM.

In the case of a CFC, there are three shareholder level adjustments as follows: (1) The U.S. shareholders must take into income exchange gain or loss on the deemed recognition of the section 988 transactions as determined at the corporate level to the extent such gain or loss is subpart F income. (2) The U.S. shareholders must recognize foreign currency gain or loss as computed under section 986(c) as if all previously taxed earnings and profits were distributed on the transition date (however, any actual 986(c) gain or loss recognized during the look-back period is reversed). (3) The subpart F income of the CFC is recomputed during the look-back period under DASTM and compared to the subpart F income as computed under the P&L method. The difference (positive or negative) is taken into account in the taxable year of change and spread over four years. Similar rules apply to United States persons who have made an election under section 1295 to treat a passive foreign investment company as a qualified electing fund. In the case of other foreign corporations, no shareholder level income adjustments are necessary.

Branches In accord with the general approach articulated above, the regulations treat a branch changing to DASTM as applying the principles of §1.985–5 on the transition date. Thus, the balance sheet is translated by treating the branch as if it had changed its functional currency to the dollar for the first post-transition date taxable year and had applied the rules of §1.985– 5(c) on the transition date. Unrealized gain or loss on dollar denominated section 988 transactions as stated on the transition date are treated as if recognized on that date (and any actual gain or loss realized with respect to section 988 transactions during the look-back period is reversed). Further, the regulations require that the taxpayer recognize gain or loss attributable to the branch’s equity pool (as stated

on the transition date) under the principles of section 987, computed as if the branch terminated on the transition date. Such gain or loss is reduced by any section 987 gain and increased by any section 987 loss that was recognized by the taxpayer with respect to remittances during the look-back period. Finally, branch income shall be determined under §1.985–3 for each look-back year and compared to the amount that was taken into account for each year. The sum of the difference (positive or negative) is taken into account in the taxable year of change and spread over four years.

III. Rules for Changing from DASTM to

P&L (§1.985–1)

Under the proposed regulation, a QBU that has been required or had elected to use DASTM must change functional currency to the currency of its economic environment in a year in which the currency is no longer hyperinflationary pursuant to the three-year test under §1.985–1(b). These rules provide that when a taxpayer changes from DASTM to the P&L method of accounting, §1.985–5 shall apply for purposes of translating a QBU’s balance sheet and for making certain income adjustments. Because these rules generally do not create distortions and are administrable, the final regulations adopt these regulations as proposed.

IV. Other Changes

Various conforming changes have been made to §§1.985–1 and 1.985–5 to account for the addition of §1.985–7. In addition, the definition of hyperinflation has been liberalized to provide that for purposes of determining whether a currency is hyperinflationary for income tax purposes, United States generally accepted accounting principles will be accepted provided that the determination is based on criteria that is substantially similar to the general rules provided in the regulations, the method of determination is applied consistently from year to year, and the same method is applied to all related persons.

Special Analysis

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866.

1998–16 I.R.B. 13 April 20, 1998

Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the notice of proposed rulemaking preceding the regulations was issued prior to March 29, 1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Accordingly, a regulatory flexibility analysis is not required. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Howard A. Wiener of the Office of the Associate Chief Counsel (International). Other personnel from the IRS and Treasury Department also participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.985–1 is amended by:

Revising paragraph (b)(2)(ii)(C).
Adding a sentence to the end of paragraph (b)(2)(ii)(D).
Adding paragraph (b)(2)(ii)(E). The additions and revision reads as follows:

§1.985–1. Functional currency.

(b) * * * (2) * * * (ii) * * * (C) Change in functional currency. If a QBU is required to change its functional currency to the dollar under paragraph (b)(2)(ii)(A) of this section, or chooses or is required to change its functional currency to the dollar for any open taxable year (and all subsequent taxable years) under §1.985–3(a)(2)(ii), the change is

considered to be made with the consent of the Commissioner for purposes of §1.985–4. A QBU changing functional currency must make adjustments described in §1.985–7 if the year of change (as defined in §1.481–1(a)(1)) begins after 1987, or the adjustments described in §1.985–6 if the year of change begins in 1987. No adjustments under section 481 are required solely because of a change in functional currency described in this paragraph (b)(2)(ii)(C).

(D) * * * In making the determination whether a currency is hyperinflationary, the determination for purposes of United States generally accepted accounting principles may be used for income tax purposes provided the determination is based on criteria that is substantially similar to the rules previously set forth in this paragraph (b)(2)(ii)(D), the method of determination is applied consistently from year to year, and the same method is applied to all related persons as defined in §1.985–3(e)(2)(vi).

(E) Change in functional currency when currency ceases to be hyperinfla- tionary –(1) In general. A QBU that has been required to use the dollar as its functional currency under paragraph (b)(2) of this section, or has elected to use the dollar as its functional currency under paragraph (b)(2)(ii)(B)(2) of this section or §1.985–2, must change its functional currency as of the first day of the first taxable year that follows three consecutive taxable years in which the currency of its economic environment, determined under paragraph (c)(2) of this section, is not a hyperinflationary currency. The functional currency of the QBU for such year shall be determined in accordance with paragraph (c) of this section. For purposes of §1.985–4, the change is considered to be made with the consent of the Commissioner. See §1.985–5 for adjustments that are required upon a change in functional currency.

(2) Effective Date. This paragraph (b)(2)(ii)(E) of this section applies to taxable years beginning after April 6, 1998.

Par. 3. Section 1.985–5(a) is amended by adding the following sentence to the end of the paragraph:

§1.985–5 Adjustments required upon change in functional currency.

(a) * * *

However, a QBU that changes to the dollar pursuant to §1.985–1(b)(2) after 1987 shall apply §1.985–7.

Par. 4. Section 1.985–7 is added as follows:

1.985–7 Adjustments required in connection with a change to DASTM.

(a) In general. If a QBU begins to use the dollar approximate separate transactions method of accounting set forth in §1.985–3 (DASTM) in a taxable year beginning after April 6, 1998, adjustments shall be made as provided by this section. For the rules with respect to foreign corporations, see paragraph (b) of this section. For the rules with respect to adjustments to the income of United States shareholders of controlled foreign corporations, see paragraph (c) of this section. For the rules with respect to adjustments relating to QBU branches, see paragraph (d) of this section. For the effective date of this section, see paragraph (e). For purposes of applying this section, the look-back period shall be the period beginning with the first taxable year after the transition date and ending on the last day prior to the taxable year of change. The term transition date means the later of the last day of the last taxable year ending before the base period as defined in §1.985–1(b)(2)(ii)(D) or the last day of the taxable year in which the QBU last applied DASTM. The taxable year of change shall mean the taxable year of change as defined in §1.481–1(a)(1). The application of this paragraph may be illustrated by the following examples:

Example 1. A calendar year QBU that has not previously used DASTM operates in a country in which the functional currency of the country is hyperinflationary as defined under §1.985–1(b)(2)(ii)(D) for the QBU’s 1999 tax year. The lookback period is the period from January 1, 1996 through December 31, 1998, the transition date is December 31, 1995, and the taxable year of change is the taxable year beginning January 1, 1999.

Example 2. A QBU that has not previously used DASTM with a taxable year ending June 30, operates in a country in which the functional currency of the country is hyperinflationary for the QBU’s tax year beginning July 1, 1999 as defined under §1.985–1(b)(2)(ii)(D)(where the base period is the thirty-six calendar months immediately preceding the first day of the current calendar year 1999). The look-back period is the period from July 1, 1995 through June 30, 1999, the transition date is June 30, 1995, and the taxable year of change is the taxable year beginning July 1, 1999.

April 20, 1998 14 1998–16 I.R.B.

(b) Adjustments to foreign corpora- tions —(1) In general. In the case of a foreign corporation, the corporation shall make the adjustments set forth in paragraphs (b)(2) through (4) of this section. The adjustments shall be made on the first day of the taxable year of change.

(2) Treatment of certain section 988 transactions —(i) Exchange gain or loss from section 988 transactions unrealized as of the transition date. A foreign corporation shall adjust earnings and profits by the amount of any unrealized exchange gain or loss that was attributable to a section 988 transaction (as defined in sections 988(c)(1)(A), (B), and (C)) that was denominated in terms of (or determined by reference to) the dollar and was held by the corporation on the transition date. Such gain or loss shall be computed as if recognized on the transition date and shall be reduced by any gain and increased by any loss recognized by the corporation with respect to such transaction during the look-back period. The amount of such gain or loss shall be determined without regard to the limitations of section 988(b) (i.e., whether any gain or loss would be realized on the transaction as a whole). The character and source of such gain or loss shall be determined under section 988. Proper adjustments shall be made to account for gain or loss taken into account by reason of this paragraph (b)(2). See §1.985–5(f) Example 1, footnote 1.

(ii) Treatment of a section 988 transac- tion entered into and terminated during the look-back period. A foreign corporation shall reduce earnings and profits by the amount of any gain, and increase earnings and profits by the amount of any loss, that was recognized with respect to any dollar denominated section 988 transactions entered into and terminated during the look-back period.

(3) Opening balance sheet. The opening balance sheet of a foreign corporation for the taxable year of change shall be determined as if the corporation had changed its functional currency to the dollar by applying § 1.985–5(c) on the transition date and had translated its assets and liabilities under §1.985–3 during the look-back period.

(4) Earnings and profits adjust- ments —(i) Pre-1987 accumulated profits. The foreign income taxes and accumulated profits or deficits in accumulated

profits of a foreign corporation that are attributable to taxable years beginning before January 1, 1987, as stated on the transition date, and that were maintained for purposes of section 902 in the old functional currency, shall be translated into dollars at the spot rate in effect on the transition date. The applicable accumulated profits shall be reduced on a last-in, first-out basis by the aggregate dollar amount (translated from functional currency in accordance with the rules of section 989(b)) attributable to earnings and profits that were distributed (or treated as distributed) during the look-back period to the extent such amounts distributed exceed the earnings and profits calculated under (b)(4)(ii) or (b)(4)(iii), as applicable. See §1.902–1(b)(2)(ii). Once translated into dollars, these pre-1987 taxes and accumulated profits or deficits in accumulated profits shall (absent a change in functional currency) remain in dollars for all federal income tax purposes.

(ii) Post-1986 undistributed earnings of a CFC. In the case of a controlled foreign corporation (within the meaning of section 957 or section 953(c)(1)(B))(CFC) or a foreign corporation subject to the rules of §1.904–6(a)(2), the corporation’s post-1986 undistributed earnings in each separate category as defined in §1.904–5(a)(1) as of the first day of the taxable year of change (and prior to adjustment under paragraph (c)(1) of this section) shall equal the sum of—

(A) The corporation’s post-1986 undistributed earnings and profits (or deficit in earnings and profits) in each separate category as defined in §1.904– 5(a)(1) as stated on the transition date translated into dollars at the spot rate in effect on the transition date; and

(B) The sum of the earnings and profits (or deficit in earnings and profits) in each separate category determined under §1.985–3 for each post-transition date taxable year prior to the taxable year of change. Such amount shall be reduced by the aggregate dollar amount (translated from functional currency in accordance with the rules of section 989(b)) attributable to earnings and profits that were distributed (or treated as distributed) during the lookback period out of post-1986 earnings and profits in such separate category. For purposes of applying this paragraph

(b)(4)(ii)(B), the opening balance sheet for calculating earnings and profits under §1.985–3 for the first post-transition year shall be translated into dollars pursuant to §1.985–5(c).

(iii) Post-1986 undistributed earnings of other foreign corporations. In the case of a foreign corporation that is not a CFC or subject to the rules of §1.904–6(a)(2), the corporation’s post-1986 undistributed earnings shall equal the sum of—

(A) The corporation’s post-1986 undistributed earnings (or deficit) on the transition date translated into dollars at the spot rate in effect on the transition date; and

(B) The sum of the earnings and profits (or deficit in earnings and profits) determined under §1.985–3 for each posttransition date taxable year (or such later year determined under section 902(c)(3)(A)) prior to the taxable year of change. Such amount shall be reduced by the aggregate dollar amount (translated from functional currency in accordance with the rules of section 989(b)) that was distributed (or treated as distributed) during the look-back period out of post-1986 earnings and profits. For purposes of applying this paragraph (b)(4)(iii)(B), the opening balance sheet for calculating earnings and profits under §1.985-3 for the first post-transition year shall be translated into dollars pursuant to §1.985–5(c).

(c) United States shareholders of con- trolled foreign corporations —(1) In gen- eral. A United States shareholder (within the meaning of section 951(b) or section 953(c)(1)(B)) of a CFC that changes to DASTM shall make the adjustments set forth in paragraphs (c)(2) through (5) of this section on the first day of the taxable year of change. Adjustments under this section shall be taken into account by the shareholder (or such shareholder’s successor in interest) ratably over four taxable years beginning with the taxable year of change. Similar rules shall apply in determining adjustments to income of United States persons who have made an election under section 1295 to treat a passive foreign investment company as a qualified electing fund.

(2) Treatment under subpart F of in- come recognized on section 988 transac- tions. The character of amounts taken into account under paragraph (b)(2) of

1998–16 I.R.B. 15 April 20, 1998

the look-back period. A QBU branch shall reduce income by the amount of any gain, and increase income by the amount of any loss, that was recognized with respect to any dollar denominated section 988 transactions entered into and terminated during the look-back period.

(3) Deemed termination income ad- justment. The taxpayer shall realize gain or loss attributable to the QBU branch’s equity pool (as stated on the transition date) under the principles of section 987, computed as if the branch terminated on the transition date. Such amount shall be reduced by section 987 gain and increased by section 987 loss that was recognized by such taxpayer with respect to remittances during the look-back period.

(4) Branch income adjustment. Branch income in a separate category shall be determined under §1.985–3 for each look-back year. For this purpose, the opening DASTM balance sheet shall be determined under §1.985–5. The sum of the difference (positive or negative) between the amount computed pursuant to §1.985–3 and amount taken into account for each year shall be taken into account in the taxable year of change pursuant to paragraph (d)(1) of this section. Such amounts shall retain their character for all federal income tax purposes.

(5) Opening balance sheet. The opening balance sheet of a QBU branch for the taxable year of change shall be determined as if the branch had changed its functional currency to the dollar by applying § 1.985–5(c) on the transition date and had translated its assets and liabilities under §1.985–3 during the look-back period.

(e) Effective date. This section is effective for taxable years beginning after April 6, 1998. However, a taxpayer may choose to apply this section to all open taxable years beginning after December 31, 1986, provided each person, and each QBU branch of a person, that is related (within the meaning of §1.985–2(d)(3)) to the taxpayer also applies this section rules.

Approved February 11, 1998.

Donald C. Lubick, Assistant Secretary of

the Treasury.

this section for purposes of sections 951 through 964, shall be determined on the transition date and to the extent characterized as subpart F income shall be taken into account in accordance with the rules of paragraph (c)(1) of this section. Such amounts shall retain their character for all federal income tax purposes (including sections 902, 959, 960, 961, 1248, and 6038). (3) Recognition of foreign currency gain or loss on previously taxed earnings and profits on the transition date. Gain or loss is recognized under section 986(c) as if all previously taxed earnings and profits as determined on the transition date, if any, were distributed on such date. Such gain or loss shall be reduced by any foreign currency gain and increased by any foreign currency loss that was recognized under section 986(c) with respect to distributions of previously taxed earnings and profits during the look-back period. Such amount shall be characterized in accordance with section 986(c) and taken into account in accordance with the rules of paragraph (c)(1) of this section.

(4) Subpart F income adjustment. Subpart F income in a separate category shall be determined under §1.985–3 for each look-back year. For this purpose, the opening DASTM balance sheet shall be determined under §1.985–5. The sum of the difference (positive or negative) between the amount computed pursuant to §1.985–3 and amount that was included in income for each year shall be taken into account in the taxable year of change pursuant to paragraph (c)(1) of this section. Such amounts shall retain their character for all federal income tax purposes (including sections 902, 959, 960, 961, 1248, and 6038). For rules applicable if an adjustment under this section results in a loss for the taxable year in a separate category, see section 904(f) and the regulations thereunder. The amount of previously taxed earnings and profits as determined under section 959(c)(2) shall be adjusted (positively or negatively) by the amount taken into account under this paragraph (c)(4) as of the first day of the taxable year of change.

(5) Foreign tax credit. A United States shareholder of a CFC shall compute an amount of foreign taxes deemed paid under section 960 with respect to any positive adjustments determined under para

graph (c) of this section. The amount of foreign tax deemed paid shall be computed with reference to the full amount of the adjustment and to the post-1986 undistributed earnings determined under paragraph (b)(4)(i) and (ii) of this section and the post-1986 foreign income taxes of the CFC on the first day of the taxable year of change (i.e., without taking into account earnings and taxes for the taxable year of change.) For purposes of section 960, the associated taxes in each separate category shall be allocated pro rata among, and deemed paid in, the shareholder’s taxable years in which the income is taken into account. (No adjustment to foreign taxes deemed paid in prior years is required solely by reason of a negative adjustment to income under paragraph (c)(1) of this section.)

(d) QBU branches —(1) In general. In the case of a QBU branch, the taxpayer shall make the adjustments set forth in paragraphs (d)(2) through (d)(4) of this section. Adjustments under this section shall be taken into account by the taxpayer ratably over four taxable years beginning with the taxable year of change.

(2) Treatment of certain section 988 transactions —(i) Exchange gain or loss from section 988 transactions unrealized as of the transition date. A QBU branch shall adjust income by the amount of any unrealized exchange gain or loss that was attributable to a section 988 transaction (as defined in sections 988(c)(1)(A), (B), and (C)) that was denominated in terms of (or determined by reference to) the dollar and was held by the QBU branch on the transition date. Such gain or loss shall be computed as if recognized on the transition date and shall be reduced by any gain and increased by any loss recognized by the QBU branch with respect to such transaction during the look-back period. The amount of such gain or loss shall be determined without regard to the limitations of section 988(b) (i.e., whether any gain or loss would be realized on the transaction as a whole). The character and source of such gain or loss shall be determined under section 988. Proper adjustments shall be made to account for gain or loss taken into account by reason of this paragraph (d)(2). See §1.985–5(f) Example 1, footnote 1.

(ii) Treatment of a section 988 transac- tion entered into and terminated during

Michael P. Dolan, Deputy Commissioner of

Internal Revenue.

April 20, 1998 16 1998–16 I.R.B.

separate return limitation years. Available data indicates that many consolidated return filers are large companies (not small businesses). In addition, the data indicates that an insubstantial number of consolidated return filers that are smaller companies have credit carryovers or carrybacks, and thus even fewer of these filers have credit carryovers or carrybacks that are subject to the separate return limitation year rules. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. It has also been determined that under section 553(d) of the Administrative Procedure Act (5 U.S.C. chapter 5) these regulations should be effective immediately because they involve the applicability of regulations that modify the limitations on the use of certain tax attributes for taxable years beginning on or after January 1, 1997. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking accompanying these regulations is being sent to the Small Business Administration for comment on their impact on small businesses.

Drafting Information

The principal author of these regulations is Roy A. Hirschhorn of the Office of Assistant Chief Counsel (Corporate). Other personnel from the IRS and Treasury participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.1502–3 is amended by revising paragraphs (c)(3), (d)(2) and (e)(3) to read as follows:

§1.1502–3 Consolidated investment credit.

(Filed by the Office of the Federal Register on March 4, 1998, 8:45 a.m., and published in the issue of the Federal Register for March 5, 1998, 63 F.R. 10772)

Section 1.1502–3: Regulations

26 CFR 1.1502–3: Consolidated investment credit.

T.D. 8766

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Consolidated Returns— Limitations on the Use of Certain Credits; Overall Foreign Loss Accounts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains temporary amendments to the consolidated return regulations. The temporary amendments modify the date temporary regulations apply as published in the Fed- eral Register on January 12, 1998, relating to the use of tax credits of a consolidated group and its members. The amendments provide guidance to consolidated groups that have a taxable year beginning on or after January 1, 1997, for which the income tax return is due on or before March 13, 1998. The text of the temporary regulations also serves as the text of REG–104062–97, page 20 of this Bulletin.

DATES: Effective dates: These amendments are effective March 13, 1998.

Applicability dates: For dates of application, see the Effective Dates portion of the preamble under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Roy A. Hirschhorn, (202) 6227770.

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

On January 12, 1998, the IRS and Treasury published in the Federal Register

final, temporary and proposed regulations (the January 12, 1998, regulations) relating to limitations on the use of certain tax credits and related attributes by corporations filing consolidated income tax returns. In general, the January 12, 1998, regulations relate to the separate return limitation year provisions (and certain consolidated return changes in ownership) for general business credits, alternative minimum tax credits, foreign tax credits and overall foreign loss accounts. The January 12, 1998, regulations were generally applicable to consolidated return years beginning on or after January 1, 1997. IRS and Treasury have determined that the appropriate effective date of those regulations should be for consolidated return years for which the due date (without extensions) of the income tax return is after March 13, 1998. In lieu of applying this effective date, a consolidated group may choose to apply the effective date provisions as published in the January 12, 1998, regulations. Taxpayers making this choice must apply all of those effective date provisions for all relevant years. Thus, such taxpayers may not choose to apply one provision of the January 12, 1998, regulations and not another.

Effective Dates

The temporary amendments are applicable to consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998. As explained in the Background portion of this preamble, taxpayers may instead choose to apply the effective date provisions of the January 12, 1998, regulations (i.e., generally taxable years beginning on or after January 1, 1997).

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It is hereby certified that these regulations do not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that these regulations principally affect corporations filing consolidated federal income tax returns that have carryover or carryback of credits from

1998–16 I.R.B. 17 April 20, 1998

tive date rule (generally making the rules of this paragraph (f) inapplicable to a consolidated return year beginning after December 31, 1996, if the due date of the income tax return (without extensions) for such year is on or before March 13, 1998.

(g) * * * (3) Special effective date for CRCO limitation. See §1.1502–4T(g)(3) for the rule that ends the CRCO limitation with respect to a consolidated return change of ownership that occurs on or after the first day of a taxable year for which the due date of the income tax return (without extensions) is after March 13, 1998. See also §1.1502–3T(c)(4) for an optional effective date rule (generally making the rules of this paragraph (g) inapplicable if the consolidated return change of ownership occurred on or after January 1, 1997, and during a consolidated return year for which the due date of the income tax return (without extensions) is on or before March 13, 1998).

Par. 5. Section 1.1502–4T is amended by revising paragraphs (f) and (g)(3) to read as follows:

§1.1502–4T Consolidated foreign tax credit (temporary).

(f) Limitation on unused foreign tax carryover or carryback from separate re- turn limitation years. Section 1.1502– 4(f) does not apply for consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998. For consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998, a group shall include an unused foreign tax of a member arising in a SRLY without regard to the contribution of the member to consolidated tax liability for the consolidated return year. See also §1.1502–3T(c)(4) for an optional effective date rule (generally making the rules of this paragraph (f) applicable to a consolidated return year beginning after December 31, 1996, if the due date of the income tax return (without extensions) for such year is on or before March 13, 1998).

years for which the due date of the income tax return (without extensions) is on or before March 13, 1998. See §1.1502– 3T(c) for the rule that limits the group’s use of a section 38 credit carryover or carryback from a SRLY for a consolidated return year for which the due date of the income tax return (without extensions) is after March 13, 1998. For taxable years not subject to §1.1502–3T(c), prior law applies. See §1.1502–3(c) in effect prior to January 12, 1998 (§1.1502–3(c) as contained in the 26 CFR part 1 edition revised April 1, 1997) for prior law. See also §1.1502–3T(c)(4) for an optional effective date rule (generally making the rules of this paragraph (c) inapplicable to a consolidated return year beginning after December 31, 1996, if the due date of the income tax return (without extensions) for such year is on or before March 13, 1998).

(d) Examples. - * * (2) Example (2) and Example (3) of this paragraph (d) do not apply to consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998. For consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998, see §1.1502–3T(d).

(e) * * * (3) Special effective date. This paragraph (e) applies only to a consolidated return change of ownership that occurred during a consolidated return year for which the due date of the income tax return (without extensions) is on or before March 13, 1998. See §1.1502–3T(c)(4) for an optional effective date rule (generally making the rules of this paragraph (e) inapplicable if the consolidated return change of ownership occurred on or after January 1, 1997, and during a consolidated return year for which the due date of the income tax return (without extensions) is on or before March 13, 1998).

Par. 3. Section 1.1502–3T is amended by revising paragraphs (c)(3) and (d)(2) and adding a new paragraph (c)(4) to read as follows:

§1.1502–3T Consolidated investment credit (temporary).

(c) * * * (3) Effective date. This paragraph (c) applies to consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998. However, a group does not take into account a consolidated taxable year for which the due date of the income tax return (without extensions) is on or before March 13, 1998, in determining a member’s (or subgroup’s) contributions to the consolidated section 38(c) limitation under this paragraph (c). See also §1.1502–3(c).

(4) Optional effective date of January 1, 1997. In lieu of paragraphs (c)(3) and (d)(2) of this section and §§1.1502– 3(c)(3), (d)(2) and (e)(3) (relating to the general business credit), 1.1502–4(f)(3) and (g)(3), 1.1502–4T(f) and (g)(3) (relating to the foreign tax credit), 1.1502–9(a) (the next to last sentence), 1.1502–9T(b)(1)(v) (relating to overall foreign losses), and 1.1502–55T(h)(4)(iii)(C) (relating to the alternative minimum tax credit), a consolidated group may apply such paragraphs as they appear in 1998–10 I.R.B. 23 (see §601.601(d)(2) of this chapter). A consolidated group making this choice must apply all such paragraphs for all relevant years.

(d) * * * (2) This paragraph (d) applies to consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998. See also §1.1502–3(d) for years for which the due date of the income tax return (without extensions) is on or before March 13, 1998.

Par. 4. Section 1.1502–4 is amended by revising paragraphs (f)(3) and (g)(3) to read as follows:

§1.1502–4 Consolidated foreign tax credit.

(f) * * * (3) Special effective date ending SRLY limitation. See §1.1502–4T(f) for the rule that ends the SRLY limitation with respect to foreign tax credits for consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998. See also §1.1502–3T(c)(4) for an optional effec

April 20, 1998 18 1998–16 I.R.B.

(g)(3) Special effective date for CRCO limitation. Section 1.1502–4(g) applies only to a consolidated return change of ownership that occurred during a consolidated return year for which the due date of the income tax return (without extensions) is on or before March 13, 1998. See also §1.1502–3T(c)(4) for an optional effective date rule (generally making the rules of this paragraph (g)(3) applicable if the consolidated return change of ownership occurred on or after January 1, 1997, and during a consolidated return year for which the due date of the income tax return (without extensions) is on or before March 13, 1998).

Par. 6. In §1.1502–9, paragraph (a) is amended by removing the last sentence and adding two sentences in its place to read as follows:

§1.1502–9 Application of overall foreign loss recapture rules to corporations filing consolidated returns.

(a) * * * See §1.1502–9T(b)(1)(v) for the rule that ends the separate return limitation year limitation for consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998. See also §1.1502– 3T(c)(4) for an optional effective date rule (generally making the rules of paragraphs (b)(1)(iii) and (iv) of this section inapplicable for a consolidated return year beginning after December 31, 1996, if the due date of the income tax return (without extensions) for such year is on or before March 13, 1998).

Par. 7. Section 1.1502–9T is amended by revising paragraph (b)(1)(v) to read as follows:

§1.1502–9T Application of overall foreign loss recapture rules to corporations filing consolidated returns (temporary).

(b)(1)(v) Special effective date for SRLY limitation. Sections 1.1502– 9(b)(1)(iii) and (iv) apply only to consolidated return years for which the due date of the income tax return (without extensions) is on or before March 13, 1998. For consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998, the rules of §1.1502–9(b)(1)(ii) shall apply to overall foreign losses from separate return years that are separate return limitation years. For purposes of applying §1.1502–9(b)(1)(ii) in such years, the group treats a member with a balance in an overall foreign loss account from a separate return limitation year on the first day of the first consolidated return year for which the due date of the income tax return (without extensions) is after March 13, 1998, as a corporation joining the group on such first day. An overall foreign loss that is part of a net operating loss or net capital loss carryover from a separate return limitation year of a member that is absorbed in a consolidated return year for which the due date of the income tax return (without extensions) is after March 13, 1998, shall be added to the appropriate consolidated overall foreign loss account in the year that it is absorbed. For consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998, similar principles apply to overall foreign losses when there has been a consolidated return change of ownership (regardless of when the change of ownership occurred). See also §1.1502–3T(c)(4) for an optional effective date rule (generally making this paragraph (b)(1)(v) applicable to a consolidated return year beginning after December 31, 1996, if the due date of the income tax return (without extensions) for such year is on or before March 13, 1998).

Par. 8. Section 1.1502–55T is amended by revising paragraph (h)(4)(iii)(C) to read as follows:

§1.1502–55T Computation of alternative minimum tax of consolidated groups (temporary).

(h)(4) * * * (iii) * * * (C) Effective date. This paragraph (h)(4)(iii) applies to consolidated return years for which the due date of the income tax return (without extensions) is after March 13, 1998. However, a group does not take into account a consolidated taxable year for which the due date of the income tax return (without extensions) is on or before March 13, 1998, in determining a member’s (or subgroup’s) contributions to the consolidated section 53(c) limitation under paragraph (h)(4)(iii) of this section. See §1.1502–3T(c)(4) for an optional effective date rule (generally making this paragraph (h)(4)(iii) applicable to a consolidated return year beginning after December 31, 1996, if the due date of the income tax return (without extensions) for such year is on or before March 13, 1998).

Michael P. Dolan, Deputy Commissioner of

Internal Revenue.

Approved March 9, 1998.

Donald C. Lubick, Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on March 13, 1998, at 8:45 a.m., and published in the Federal Register for March 16, 1998, 63 F.R. 12641)

1998–16 I.R.B. 19 April 20, 1998