Part I. Rulings — Internal Revenue Bulletin 2004-35

Section 42.—Low-Income Housing Credit

26 CFR 1.42–5: Monitoring compliance with low- income housing credit requirements.

Questions are answered pertaining to the vacant unit rule, record retention, and tenant income documentation. See Rev. Rul. 2004-82, page 350.

(Also §§ 1.42–5, 1.42–15, 1.103–8.)

Low-income housing credit. This ruling answers 12 questions about the low-income housing credit provisions under section 42 of the Code.

Rev. Rul. 2004–82

PURPOSE

This revenue ruling answers certain questions about the low-income housing credit under § 42 of the Internal Revenue Code.

LAW AND QUESTIONS AND ANSWERS

A. ELIGIBLE BASIS AND QUALIFIED BASIS ISSUES

Law

Section 42(a) provides for a credit for investment in certain low-income housing buildings. The amount of the low-income housing credit for any taxable year in the credit period is an amount equal to the applicable percentage of the qualified basis of each qualified low-income building (as defined in § 42(c)(2)).

Section 42(c)(1)(A) provides that the qualified basis of any qualified low-income building for any taxable year is an amount equal to (i) the applicable fraction (determined as of the close of the taxable year) of (ii) the eligible basis of the building (determined under § 42(d)).

Section 42(c)(1)(B) defines the applicable fraction as the smaller of the unit fraction or the floor space fraction. Section 42(c)(1)(C) defines the unit fraction as the fraction the numerator of which is the number of low-income units (as defined in § 42(i)(3)(A)) in the building and

the denominator of which is the number of residential rental units (that is, all units in the building which are available to rent as personal residences), whether or not occupied, in the building. Section 42(c)(1)(D) defines the floor space fraction as the fraction the numerator of which is the total floor space of the low-income units in the building and the denominator of which is the total floor space of the residential rental units, whether or not occupied, in the building.

Section 42(d)(1) provides that the eligible basis of a new building is its adjusted basis as of the close of the first taxable year of the credit period. Section 42(d)(4)(A) provides that, except as provided in § 42(d)(4)(B) and (C), the adjusted basis of any building is determined without regard to the adjusted basis of any property that is not residential rental property. Section 42(d)(4)(B) provides that the adjusted basis of any building includes the adjusted basis of property of a character subject to the allowance for depreciation (1) used in common areas or (2) provided as comparable amenities to all residential rental units in the building.

Section 42(d)(4)(C)(i) provides that the adjusted basis of any building located in a qualified census tract is determined by taking into account the adjusted basis of property (of a character subject to the allowance for depreciation and not otherwise taken into account) used throughout the taxable year in providing any community service facility. Section 42(d)(4)(C)(iii) provides that the term “community service facility” means any facility designed to serve primarily individuals whose income is 60 percent or less of area median income (AMGI) (within the meaning of § 42(g)(1)(B)). Section 42(d)(5)(C)(ii)(I) defines the term “qualified census tract” as any census tract (1) which is designated by the Secretary of Housing and Urban Development (HUD), and (2) for the most recent year for which census data are available on household income in the tract, either in which 50 percent or more of the households have an income which is less than 60 percent of the AMGI for the year or which has a poverty rate of at least 25 percent. See

http://www.huduser.org/datasets/qct.html for a listing of census tracts designated by the Secretary of HUD.

Section 42(d)(4)(C)(ii) provides that the increase in the adjusted basis of any building which is taken into account because of a community service facility may not exceed 10 percent of the eligible basis of the qualified low-income housing project (as defined in § 42(g)(1)) of which the community service facility is a part. For this purpose, § 42(d)(4)(C)(ii) provides that all community service facilities which are part of the same qualified low-income housing project are treated as one facility.

Rev. Rul. 2003–77, 2003–29 I.R.B. 75, provides that the requirement that a community service facility must be designed to serve primarily individuals whose income is 60 percent or less of AMGI will be satisfied if the following conditions are met. First, the facility must be used to provide services that will improve the quality of life for community residents. Second, the taxpayer must demonstrate that the services provided at the facility will be appropriate and helpful to individuals in the area of the project whose income is 60 percent or less of AMGI. This may, for example, be demonstrated in the market study required to be conducted under § 42(m)(1)(A)(iii), or another similar study. Third, the facility must be located on the same tract of land as one of the buildings that is part of the qualified lowincome housing project. Finally, if fees are charged for services provided, they must be affordable to individuals whose income is 60 percent or less of AMGI.

The legislative history of § 42 states that residential rental property for purposes of the low-income housing credit has the same meaning as residential rental property for purposes of § 103. The legislative history of § 42 further states that residential rental property includes residential rental units, facilities for use by the tenants, and other facilities reasonably required by the project. H.R. Conf. Rep. No. 841, 99 ^th Cong., 2d Sess. II–89 (1986), 1986–3 (Vol. 4) C.B. 89.

In the Tax Reform Act of 1986 (the “1986 Act”), Congress reorganized §§ 103

2004–35 I.R.B. 350 August 30, 2004

assigned police officers with a local office. The services provided by the police are free of charge. The adjusted basis of the property constituting the Facility (of a character subject to the allowance for depreciation and not otherwise taken into account in the adjusted basis of Building) does not exceed 10 percent of the eligible basis of Building.

As required by § 42(m)(1)(A)(iii), prior to the allocation of low-income housing credit to Building, a comprehensive market study was conducted to assess the housing needs of the low-income individuals in the area to be served by Building. The study found, among other items, that due to the high rate of crime in the community in which Building is located, providing a police substation would be appropriate and helpful to individuals in the area of Building whose income is 60 percent or less of AMGI.

(a) Is the adjusted basis of the Facility includable in Building’s eligible basis under § 42(d)(1)?

(b) If yes, is the Facility includable in Building’s applicable fraction under § 42(c)(1)(B)?

A–2. (a) Yes. The Facility qualifies as a community service facility under § 42(d)(4)(C)(iii). Under the facts presented, the Facility is designed to serve primarily individuals whose income is 60 percent or less of AMGI for the following reasons: (1) the services provided at the Facility are services that will help improve the quality of life for community residents; (2) the market study required to be conducted under § 42(m)(1)(A)(iii) found that the services provided at the Facility would be appropriate and helpful to individuals in the area of Building whose income is 60 percent or less of AMGI; (3) the Facility is located within Building; and (4) the services provided at the Facility are affordable to individuals whose income is 60 percent or less of AMGI. Because the other requirements set forth in § 42(d)(4)(C) are met, the adjusted basis of Building will be determined by taking into account the adjusted basis of the Facility. Thus, the adjusted basis of the Facility is includable in Building’s eligible basis.

(b) No. The Facility is not a residential rental unit for purposes of § 42. Therefore, the Facility is not includable in either the

and 103A of the Internal Revenue Code of 1954 (the “1954 Code”) regarding tax-exempt bonds into §§ 103 and 141 through 150 of the Internal Revenue Code of 1986. Congress intended that to the extent not amended by the 1986 Act, all principles of pre–1986 Act law would continue to apply to the reorganized provisions. H.R. Conf. Rep. No. 841, 99 ^th Cong., 2d Sess. II–686 (1986), 1986–3 (Vol. 4) C.B. 686. Because no regulations have been promulgated relating to residential rental property for purposes of § 103, the regulations relating to residential rental property promulgated pursuant to the 1954 Code continue to apply except as otherwise modified by the 1986 Act and subsequent law.

Under § 1.103–8(b)(4)(i) of the Income Tax Regulations, facilities that are functionally related and subordinate to residential rental projects are considered residential rental property. Section 1.103–8(b)(4)(iii) provides that functionally related and subordinate facilities include facilities for use by the tenants, such as swimming pools and other recreational facilities, parking areas, and other facilities reasonably required for the project. Examples in § 1.103–8(b)(4)(iii) of facilities reasonably required for a project include units for resident managers or maintenance personnel.

Q–1. A new qualified low-income building (Building) is located in an area in which owners of apartment buildings typically employ security officers due to the level of crime in the area.

(a) If a unit in Building is occupied by a full-time security officer for that building and Building’s owner requires the security officer to live in the unit, is the adjusted basis of that unit includable in Building’s eligible basis under § 42(d)(1)?

(b) If yes, is that unit a residential rental unit includable in the numerator and denominator of Building’s applicable fraction under § 42(c)(1)(B)?

A–1. (a) Yes. The legislative history of § 42 indicates that residential rental property includes, in addition to the residential rental units, facilities for use by the tenants and other facilities reasonably required by the project.

Under § 1.103–8(b)(4)(iii), functionally related and subordinate property is property that is reasonably required for the project. Examples of functionally related and subordinate property are units

for resident managers or maintenance personnel. See § 1.103–8(b)(4)(iii). Thus, while units for resident managers or maintenance personnel are not residential rental units, they are treated as part of residential rental property because these units are functionally related and subordinate to the project. The unit occupied by a full-time security officer is similar to the units described in the examples contained in § 1.103–8(b)(4)(iii), and is reasonably required by the project because of the level of crime in the area. Thus, the unit is functionally related and subordinate to Building. As a result, the unit is residential rental property for purposes of § 42 and its adjusted basis is includable in Building’s eligible basis under § 42(d)(1).

(b) No. The term “residential rental unit” has a different meaning than the term “residential rental property” for purposes of § 42. Under § 1.103–8(b)(4)(iii), units for resident managers or maintenance personnel are residential rental property because they are functionally related and subordinate to residential rental projects, not because they are residential rental units. Similarly, a unit occupied by a full-time security officer is not a residential rental unit. Only residential rental units are includable in Building’s applicable fraction under § 42(c)(1)(B).

If in a later year of the credit period, the unit occupied by the full-time security officer is converted to a residential rental unit, the unit will be includable in the denominator of Building’s applicable fraction for that year. If the unit also becomes a low-income unit in a later year, the unit will be includable in the numerator of Building’s applicable fraction for that year.

Q–2. A new qualified low-income building (Building) received a housing credit allocation on June 1, 2003, and was placed in service in 2004. Building is located in a qualified census tract (as defined in § 42(d)(5)(C)). The neighborhood in which Building is located is an area with a high rate of crime. In 2004, the local police department leases a unit in Building to be used as a police substation (Facility). The Facility is part of the police department’s community outreach program. This Facility is intended to serve as a deterrent to crime in the community, assist the community with solving crime-related problems, reduce the response time to area calls for service, and provide the locally

August 30, 2004 351 2004–35 I.R.B.

period will not be less than the applicable fraction specified in the agreement and which prohibits the actions described in subclauses (I) and (II) of § 42(h)(6)(E)(ii) ” (emphasis added).

Section 42(h)(6)(E)(ii) provides that the termination of an extended low-income housing commitment under § 42(h)(6)(E)(i) will not be construed to permit before the close of the 3-year period following the termination (I) the eviction or termination of tenancy (other than for good cause) of an existing tenant of any low-income unit, or (II) any increase in the gross rent with respect to a low-income unit not otherwise permitted under § 42.

Section 42(h)(6)(D) defines the term “extended use period” as the period beginning on the first day in the compliance period on which the building is part of a qualified low-income housing project and ending on the later of (1) the date specified by the agency in the extended low-income housing commitment, or (2) the date which is 15 years after the close of the compliance period.

Section 42(h)(6)(J) provides that if, during a taxable year, there is a determination that a valid extended low-income housing commitment was not in effect as of the beginning of the year, the determination will not apply to any period before that year and § 42(h)(6)(A) will be applied without regard to the determination provided that the failure is corrected within 1 year from the date of the determination.

In the Omnibus Budget Reconciliation Act of 1990, 1991–2 C.B. 481, 531 (the “1990 Act”), Congress amended § 42(h)(6)(B)(i) by adding the language emphasized above, which prohibits the actions described in subclauses (I) and (II) of § 42(h)(6)(E)(ii). At the time of this amendment, however, § 42(h)(6)(E)(ii) was already part of § 42.

The legislative history to § 42 states that the extended low-income housing commitment must prohibit the eviction or termination of tenancy (other than for good cause) of an existing tenant of a low-income unit or any increase in the gross rent inconsistent with the rent restrictions on the unit. H. Rep. No. 894, 101 ^st Cong., 2d Sess. 10, 13 (1990). Q–5. Must the extended low-income housing commitment prohibit the actions described in subclauses (I) and (II) of

numerator or denominator of Building’s applicable fraction.

Q–3. On applying to the housing credit agency for an allocation of § 42 credits for a new building, the housing credit agency requires that the applicant pay a nonrefundable application fee. If the applicant is successful, an allocation fee is payable to the housing credit agency. Are the application fee and allocation fee includable in the eligible basis of the applicant’s low-income housing building?

A–3. No. The application fee and allocation fee are not includable in the eligible basis of the applicant’s low-income housing building because the fees are not capitalizable into the adjusted basis of the building. See § 263 and § 263A. However, depending on the facts and circumstances, all or a portion of these fees may be required to be capitalized as amounts paid to create an intangible asset. See § 1.263(a)–4. Any portion of these fees not required to be capitalized under § 1.263(a)–4 may be deductible as an ordinary and necessary expense under § 162 or § 212, provided the taxpayer satisfies the requirements of those sections.

B. FIRST-YEAR LOW-INCOME UNIT ISSUE

Law

Section 42(i)(3)(A) defines “low-income unit” as any unit in a building if (i) the unit is rent-restricted (as defined in § 42(g)(2)), and (ii) the individuals occupying the unit meet the income limitation applicable under § 42(g)(1) to the project of which the building is a part (individuals that meet the applicable income limitation are referred to as “income-qualified”). Section 42(i)(3)(B) provides that a unit will not be treated as a low-income unit unless the unit is suitable for occupancy and used other than on a transient basis.

Section 42(f)(1) defines the “credit period” for a low-income housing credit building as the period of 10 taxable years beginning with (A) the taxable year in which the building is placed in service or (B) at the election of the taxpayer, the succeeding taxable year, but in either case only if the building is a qualified low-income building as of the close of the first year of the period.

Section 42(f)(2)(A) provides a special rule for determining the amount of the lowincome housing credit allowable for the first year of the credit period. It provides that the credit allowable under § 42(a) with respect to any building for the first taxable year of the credit period must be determined by substituting for the applicable fraction under § 42(c)(1) the fraction (i) the numerator of which is the sum of the applicable fractions determined under § 42(c)(1) as of the close of each full month of the first taxable year of the credit period during which the building was in service, and (ii) the denominator of which is 12.

Q–4. On initial occupancy of a unit in the first year of a newly constructed building’s credit period, an income-qualified tenant moved into the unit on the last day of a month. The unit was rent-restricted in accordance with § 42(g)(2). In determining the low-income housing credit for the building for the first year of the credit period, is the unit treated as a low-income unit for that month for purposes of the fraction calculated under § 42(f)(2)(A)?

A–4. Yes. The unit is treated as a low-income unit eligible for inclusion in the numerator and denominator of the monthly applicable fraction calculated under § 42(f)(2)(A)(i) if the tenant, who meets the income limitation under § 42(g)(1), resides in the rent-restricted unit on the last day of the month. However, in accordance with § 42(f)(2)(A), the building must have been placed in service for a full month for the unit to be includable in the numerator and denominator of the monthly applicable fraction.

C. EXTENDED LOW-INCOME HOUSING COMMITMENT ISSUE

Law

Section 42(h)(6)(A) provides that no credit will be allowed with respect to any building for the taxable year unless an extended low-income housing commitment (as defined in § 42(h)(6)(B)) is in effect as of the end of the taxable year. Section 42(h)(6)(B)(i) provides that the term “extended low-income housing commitment” means any agreement between the taxpayer and the housing credit agency which requires that the applicable fraction (as defined in § 42(c)(1)) for the building for each taxable year in the extended use

2004–35 I.R.B. 352 August 30, 2004

the imputed income limitation applicable to the unit.

Section 42(g)(2)(C) provides that the imputed income limitation applicable to a unit is the income limitation which would apply under § 42(g)(1) to individuals occupying the unit if the number of individuals occupying the unit were: (i) in the case of a unit which does not have a separate bedroom, 1 individual; and (ii) in the case of a unit which has one or more separate bedrooms, 1.5 individuals for each separate bedroom.

Section 42(g)(3)(A) provides that a building will be treated as a qualified low-income building only if the project (of which the building is a part) meets the requirements of § 42(g)(1) not later than the close of the first year of the credit period for the building.

Section 42(i)(2)(A) provides that for purposes of § 42(b)(1), a new building will be treated as federally subsidized for any taxable year if, at any time during the taxable year or any prior taxable year, there is or was outstanding any obligation the interest on which is exempt from tax under § 103, or any below market Federal loan, the proceeds of which are or were used (directly or indirectly) with respect to the building or operation thereof.

Section 42(i)(2)(B) provides that a loan or tax-exempt obligation will not be taken into account under § 42(i)(2)(A) if the taxpayer elects to exclude from eligible basis of the building for purposes of § 42(d), in the case of a loan, the principal amount of the loan, and in the case of a tax-exempt obligation, the proceeds of the obligation.

Section 42(i)(2)(C) provides that § 42(i)(2)(A) will not apply to any tax-exempt obligation or below market Federal loan used to provide construction financing for any building if (i) the obligation or loan (when issued or made) identified the building for which the proceeds of the obligation or loan would be used, and (ii) the obligation is redeemed, and the loan is repaid, before the building is placed in service.

Section 42(i)(2)(D) provides that the term “below market Federal loan” means any loan funded in whole or in part with Federal funds if the interest rate payable on the loan is less than the applicable Federal rate (AFR) in effect under § 1274(d)(1) (as of the date the loan was made).

§ 42(h)(6)(E)(ii) only for the 3-year period described in § 42(h)(6)(E)(ii)?

A–5. No. Section 42(h)(6)(B)(i) requires that an extended low-income housing commitment include a prohibition during the extended use period against (1) the eviction or the termination of tenancy (other than for good cause) of an existing tenant of any low-income unit (no-cause eviction protection) and (2) any increase in the gross rent with respect to the unit not otherwise permitted under § 42. When Congress amended § 42(h)(6)(B)(i) to add the language emphasized above, § 42(h)(6)(E)(ii) was already part of § 42. As a result, Congress must have intended the amendment to § 42(h)(6)(B)(i) to add an additional requirement beyond what was contained in § 42(h)(6)(E)(ii), which already prohibited the actions described in that section for the 3 years following the termination of the extended use period. Because the requirements of § 42(h)(6)(B)(i) otherwise apply for the extended use period, Congress must have intended the addition of the prohibition against the actions described in subclauses (I) and (II) of § 42(h)(6)(E)(ii) to apply throughout the extended use period.

If it is determined by the end of a taxable year that a taxpayer’s extended lowincome housing commitment for a building does not meet the requirements for an extended low-income housing commitment under § 42(h)(6)(B) (for example, it does not provide no-cause eviction protection for the tenants of low-income units throughout the extended use period), the low-income housing credit is not allowable with respect to the building for the taxable year, or any prior taxable year. However, if the failure to have a valid extended low-income housing commitment in effect is corrected within 1 year from the date of the determination, the determination will not apply to the current year of the credit period or any prior year.

Pursuant to this revenue ruling, each housing credit agency is required to review its extended low-income housing commitments for compliance with the interpretation of § 42(h)(6)(B)(i) provided in this question and answer. This review must be completed by December 31, 2004. If during the review period the housing credit agency determines that an extended low-income housing commitment is not

in compliance with the interpretation of § 42(h)(6)(B)(i) provided in this question and answer, the 1-year period described under § 42(h)(6)(J) will commence on the date of that determination.

D. HOME INVESTMENT PARTNERSHIP ACT LOAN ISSUES

Law

Section 42(b)(2)(A) provides that for a qualified low-income building placed in service by the taxpayer after 1987, the term “applicable percentage” means (1) the 70-percent present value credit under § 42(b)(2)(B)(i) for new buildings which are not federally subsidized, and (2) the 30-percent present value credit under § 42(b)(2)(B)(ii) for new buildings which are federally subsidized and for existing buildings.

In general, § 42(d)(5)(C)(i) provides that in the case of any building located in a designated qualified census tract or difficult development area (as defined in § 42(d)(5)(C)(ii) and (iii)), (I) the eligible basis of a new building will be 130 percent of the eligible basis determined without regard to this rule, and (II) in the case of an existing building, the rehabilitation expenditures taken into account under § 42(e) will be 130 percent of the expenditures determined without regard to this rule.

Section 42(g)(1) defines the term “qualified low-income housing project” as any project for residential rental property if the project meets the requirements of § 42(g)(1)(A) or (B), whichever the taxpayer elects. The election is irrevocable. The project meets the requirements of § 42(g)(1)(A) if 20 percent or more of the residential units in the project are rent-restricted and occupied by individuals whose income is 50 percent or less of AMGI. The project meets the requirements of § 42(g)(1)(B) if 40 percent or more of the residential units in the project are rent-restricted and occupied by individuals whose income is 60 percent or less of AMGI. The requirement a taxpayer elects is referred to as the “minimum set-aside” for the project.

Section 42(g)(2)(A) provides that for purposes of § 42(g)(1), a residential unit is rent-restricted if the gross rent with respect to the unit does not exceed 30 percent of

August 30, 2004 353 2004–35 I.R.B.

plicable. Accordingly, Building is eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I).

If the tax-exempt obligation was redeemed before Building was placed in service or the proceeds of the obligation were excluded from Building’s eligible basis, Building would no longer be treated as federally subsidized by the tax-exempt obligation under § 42(i)(2)(A). Therefore, § 42(i)(2)(E)(i) would be applicable, and cause Building not to be treated as federally subsidized by the HOME loan under § 42(i)(2)(A). Accordingly, the prohibition in § 42(i)(2)(E)(i) against using § 42(d)(5)(C) would apply, and Building would not be eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I). The 70-percent value credit under § 42(b) would apply to Building.

(b) Yes. When the HOME loan was made, the interest rate on the loan was not less than the AFR. Therefore, the loan is not described in § 42(i)(2)(D), and the building will not be treated as federally subsidized under § 42(i)(2)(A). The 70-percent present value credit will apply to Building. Because § 42(i)(2)(E)(i) is inapplicable to HOME loans not described in § 42(i)(2)(D), this loan is not subject to § 42(i)(2)(E)(i), and the prohibition in § 42(i)(2)(E)(i) against using § 42(d)(5)(C) does not apply. Accordingly, Building is eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I).

(c) Yes. Although Building meets the exception under § 42(i)(2)(C) with respect to the tax-exempt obligation, Building is treated as federally subsidized under § 42(i)(2)(A) because it received a HOME loan at less than the AFR and does not meet the special set-aside under § 42(i)(2)(E)(i). The 30-percent present value credit will apply to Building as it is treated as federally subsidized. Because Building does not meet the special set-aside under § 42(i)(2)(E)(i), the prohibition in § 42(i)(2)(E)(i) against using § 42(d)(5)(C) does not apply, and Building is eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I).

If Taxpayer elected to exclude the principal amount of the HOME loan from the eligible basis of Building under § 42(i)(2)(B) (whether or not the special set-aside under § 42(i)(2)(E)(i) was met), Building would not be treated as federally subsidized under § 42(i)(2)(A),

Section 42(i)(2)(E)(i) generally provides that assistance provided under the HOME Investment Partnerships Act (HOME) with respect to any building will not be treated as a below market Federal loan under § 42(i)(2)(D) if 40 percent or more of the residential units in the building are occupied by individuals whose income is 50 percent or less of AMGI (the special set-aside). Section 42(d)(5)(C) (the 130 percent eligible basis increase) does not apply to any building to which the preceding sentence applies.

Q–6. Taxpayer owns a new qualified low-income housing project consisting of Buildings 1 and 2, each containing 100 residential rental units. Forty percent of the units in each building are low-income units. Taxpayer elected the minimum set-aside for the project under § 42(g)(1)(B). Also, Taxpayer elected on Form 8609, Low-Income Housing Credit Allocation Certification, to treat the buildings as part of a multiple building project. A HOME loan at less than the AFR was provided with respect to the project.

(a) How does the special set-aside under § 42(i)(2)(E)(i) apply to qualify Buildings 1 and 2 for the 70-percent present value credit under § 42(b)?

(b) What rent restriction applies to the low-income units used to satisfy the special set-aside under § 42(i)(2)(E)(i)?

A–6. (a) To qualify the project for the 70-percent present value credit, Taxpayer must rent at least 40 units in each of Buildings 1 and 2 to tenants whose income is 50 percent or less of AMGI throughout the 15-year compliance period because the rule under § 42(i)(2)(E)(i) applies on a building-by-building basis. Because these units are to be low-income units and Taxpayer elected the minimum set-aside under § 42(g)(1)(B), the same units used to satisfy the special set-aside under § 42(i)(2)(E)(i) will also satisfy the project’s minimum set-aside.

(b) The rent restriction that applies for all of the low-income units in the project, including the units in Buildings 1 and 2 which are used to satisfy the special set-aside under § 42(i)(2)(E)(i), is based on the applicable income limitation under § 42(g)(1)(B) because § 42(g)(2)(C) contains no exception for buildings that satisfy the special set-aside contained in § 42(i)(2)(E)(i). Therefore, the imputed income limitation (as defined in

§ 42(g)(2)(C)) applicable to the units in this project is 60 percent of AMGI. Under § 42(g)(2), rent may not exceed 30 percent of this imputed income limitation.

Q–7. (a) Taxpayer owns a newly constructed qualified low-income housing project consisting of one building located in a qualified census tract (Building). A HOME loan at less than the AFR was provided with respect to Building. Construction of Building was funded in part with an obligation the interest on which is exempt from tax under § 103 that was outstanding after Building was placed in service. Taxpayer did not elect to exclude from eligible basis the principal amount of the HOME loan or the proceeds of the tax-exempt obligation as provided under § 42(i)(2)(B). Forty percent of the residential units in Building are occupied by individuals whose income is 50 percent or less of area median gross income. Is Building eligible for the increase in eligible basis provided under § 42(d)(5)(C)(i)(I)?

(b) The facts are the same as in (a) above except that the interest rate on the HOME loan when made was not less than the AFR in effect under § 1274(d)(1), and the tax-exempt obligation was redeemed before Building was placed in service. Is Building eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I)?

(c) The facts are the same as in (a) above except that the special set-aside under § 42(i)(2)(E)(i) was not met, and the tax-exempt obligation was redeemed before Building was placed in service. Is Building eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I)?

A–7. (a) Yes. Because the tax-exempt obligation is outstanding after Building was placed in service and the proceeds of the obligation were not excluded from Building’s eligible basis under § 42(i)(2)(B), Building is treated as federally subsidized under § 42(i)(2)(A). Inasmuch as the building is treated as federally subsidized, the 30-percent present value credit under § 42(b) will apply to Building. The fact that the tax-exempt obligation caused Building to be federally subsidized makes § 42(i)(2)(E)(i) (which provides that certain HOME loans will not cause a project to be federally subsidized if the special set-aside requirement under that section is satisfied, and whose applicability prohibits the increase in eligible basis under § 42(d)(5)(C)) inap

2004–35 I.R.B. 354 August 30, 2004

placed classified advertisements in two local newspapers, and contacted prospective low-income tenants on a waiting list for the project and on a local public housing authority list of section 8 voucher holders about the low-income unit vacancies. These are customary methods of advertising apartment vacancies in the area of the project for identifying prospective tenants. Subsequent to the low-income unit vacancies, a market-rate unit of comparable size to the low-income units became vacant. Will the owner violate the vacant unit rule if the owner rents the market-rate unit before any of the low-income units?

A–9. No. In accordance with § 1.42–5 (c)(1)(ix), the owner of a qualified low-income housing project has to use reasonable attempts to rent a vacant low-income unit or the next available unit of comparable or smaller size to tenants having a qualifying income before any units in the project are rented to tenants not having a qualifying income. Thus, if the project owner makes reasonable attempts to rent the vacant low-income units to income-qualified tenants, the owner may rent the newly vacated market-rate unit before renting the low-income units and continue to characterize the vacant low-income units as low-income units for purposes of the minimum set-aside requirements in § 42(g)(1) and calculation of the applicable fraction under § 42(c)(1)(B).

What constitutes reasonable attempts to rent a vacant unit is based on facts and circumstances, and may differ from project to project depending on factors such as the size and location of the project, tenant turnover rates, and market conditions. Also, the different advertising methods that are accessible to owners and prospective tenants would affect what is considered reasonable. Under the facts in this situation, the owner used reasonable methods of advertising an apartment vacancy in the area of the project before the owner rented the market-rate unit. Thus, the owner made reasonable attempts to rent the vacant low-income units.

In addition, the available unit rule is not violated by rental of the market-rate unit before the low-income units because there are no over-income units in the building.

Q–10. A building has 10 units of comparable size, consisting of 7 low-income units (none was an over-income unit) and 3 market-rate units. All units in the build

and the 70-percent present value credit would apply to Building. Because the HOME loan would not be taken into account, § 42(i)(2)(D) and § 42(i)(2)(E)(i) do not apply to Building. Therefore, Building would not be described in § 42(i)(2)(E)(i). Accordingly, the prohibition in § 42(i)(2)(E)(i) against using § 42(d)(5)(C) would not apply, and Building would be eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I).

E. VACANT UNIT RULE ISSUES

Law

Section 1.42–5(c)(1)(ix) provides that a housing credit agency must require the owner of a low-income housing project to certify at least annually to the housing credit agency that, for the preceding 12-month period, if a low-income unit in the project became vacant during the year, reasonable attempts were or are being made to rent that unit or the next available unit of comparable or smaller size to tenants having a qualifying income before any units in the project were or will be rented to tenants not having a qualifying income (the “vacant unit rule”).

The legislative history to § 42 indicates that vacant units, formerly occupied by low-income individuals, may continue to be treated as occupied by qualified low-income individuals for purposes of the minimum set-aside requirement (as well as for determining qualified basis) provided reasonable attempts are made to rent the unit. H. R. Conf. Rep. No. 841, supra, at II–94.

Section 42(g)(2)(D)(i) provides that notwithstanding an increase in the income of the occupants of a low-income unit above the income limitation applicable under § 42(g)(1), the unit will continue to be treated as a low-income unit if the income of the occupants initially met the income limitation and the unit continues to be rent-restricted.

Section 42(g)(2)(D)(ii) provides that if the income of the occupants of the unit increases above 140 percent of the income limitation applicable under § 42(g)(1), the unit ceases to be treated as a low-income unit if any available or subsequently available residential rental unit in the building (of a size comparable to, or smaller than, the unit) is occupied by a new resident

whose income exceeds the income limitation (the “available unit rule”).

Under § 1.42–15(a), a low-income unit in which the aggregate income of the occupants of the unit rises above 140 percent of the applicable income limitation under § 42(g)(1) is referred to as an “over-income unit.”

Section 1.42–15(c) provides that a unit is not available for purposes of the available unit rule when the unit is no longer available for rent due to contractual arrangements that are binding under local law (for example, a unit is not available if it is subject to a preliminary reservation that is binding on the owner under local law prior to the date a lease is signed or the unit is occupied).

Q–8. On July 1, 2003, an income-qualified household (Household) initially occupied a rent-restricted residential rental unit in Building 1 of Project. On October 31, 2003, the property manager moved Household (and transferred Household’s lease) to a similar rent-restricted unit in Building 2 of Project that was not previously occupied. Household occupied the Building 2 unit at the end of 2003. The unit Household vacated in Building 1 was unoccupied during November and December. Are both units in Buildings 1 and 2 low-income units at the end of 2003?

A–8. No. While a vacant low-income unit generally retains its character as a low-income unit, where an owner simply moves a tenant from a unit in one building to a unit in another building in the same project, both units may not be treated as low-income units; rather, only the unit that the tenant actually occupies at the end of a month in the first year of the credit period and at the end of each year in subsequent years qualifies as a low-income unit. Thus, in this situation, while the unit in Building 1 vacated by Household was treated as a low-income unit during the months it was occupied by Household, the unit ceased to be treated as a low-income unit when Household vacated the unit. At that time, the vacated unit would be treated as a unit not previously occupied.

Q–9. Ten units previously occupied by income-qualified tenants in a 200-unit mixed-use housing project are vacant. None of the low-income units in the project had been over-income units. The project owner displayed a banner and for rent signs at the entrance to the project,

August 30, 2004 355 2004–35 I.R.B.

provides that records maintained in an electronic storage system that complies with the requirements of this revenue procedure will constitute records within the meaning of § 6001.

Q–11. May a taxpayer comply with the recordkeeping and record retention provisions under § 1.42–5(b) by using an electronic storage system instead of maintaining hardcopy (paper) books and records?

A–11. Yes, provided that the electronic storage system satisfies the requirements of Rev. Proc. 97–22. However, complying with the recordkeeping and record retention requirements of the Service does not exempt an owner from having to satisfy any additional recordkeeping and record retention requirements of the monitoring procedure adopted by the housing credit agency. For example, the housing credit agency may require the taxpayer to maintain hardcopy books and records.

For the basic requirements of maintaining records in an automated data processing system, including electronic storage systems, see Rev. Proc. 98–25, 1998–1 C.B. 689.

G. TENANT INCOME DOCUMENTATION ISSUE

Law

Section 1.42–5(b)(1)(vi) provides that a housing credit agency must require the owner of a low-income housing project to keep records for each qualified low-income building in the project that show, for each year in the compliance period, the annual income certification of each low-income tenant per unit. Under § 1.42–5(b)(1)(vii), the housing credit agency must require the owner to keep documentation to support each low-income tenant’s income certification (for example, a copy of the tenant’s Federal income tax return, Forms W–2, or verifications of income from third parties such as employers or state agencies paying unemployment compensation).

Under § 1.42–5(c)(1)(iii), the housing credit agency must require the owner of a low-income housing project to certify at least annually that, for the preceding 12-month period, the owner has received an annual income certification from each low-income tenant, and documentation to support that certification.

ing were occupied except for one marketrate unit. A low-income unit became vacant on March 15, 2004. Between March 15, 2004, and March 29, 2004, the owner made reasonable attempts to rent this unit to an income-qualified tenant. The vacant low-income unit became subject to a reservation (a contractual arrangement that is binding on the building owner under local law prior to the date a lease is signed or the unit is occupied) on March 29, 2004, under which the owner agreed to rent the unit to A, whose income meets the income limitation elected for the project under § 42(g)(1). Thereafter, the owner ceased any efforts to attempt to rent the unit. On April 30, 2004, A signed a lease for the unit and occupied the unit on May 1, 2004. The vacant market-rate unit was rented to a market-rate tenant on April 15, 2004. Did the owner violate the vacant unit rule?

A–10. No. For purposes of the vacant unit rule, an owner needs to make reasonable attempts to rent an available vacant low-income unit. To determine what constitutes an available unit for purposes of the vacant unit rule, the Internal Revenue Service will adopt the rule under § 1.42–15(c) for when a unit is considered not available. Therefore, a unit is not available for purposes of the vacant unit rule when the unit is no longer available for rent due to contractual arrangements that are binding under local law, such as a reservation entered into between a building owner and a prospective tenant. Thus, in this situation, because the vacant low-income unit was subject to a reservation that was binding under local law prior to the renting of the vacant market-rate unit, the low-income unit was not available when the market-rate unit was rented. Accordingly, the owner no longer needed to make reasonable efforts to rent the low-income unit.

In addition, the available unit rule is not violated by rental of the market-rate unit because there is no over-income unit in the building.

F. RECORDKEEPING AND RECORD RETENTION ISSUE

Law

Section 42(m)(1)(A)(i) requires each housing credit agency to allocate low-in

come housing credits according to a qualified allocation plan. Under § 42(m)(1)(B)(iii), an allocation plan is not qualified unless it contains a procedure that the housing credit agency (or an agent or other private contractor of the agency) will follow in (1) monitoring for noncompliance with the provisions of § 42, (2) notifying the Service of any noncompliance which the agency becomes aware of, and (3) monitoring for noncompliance with habitability standards through regular site visits.

Under § 1.42–5(a)(2)(i)(A), for the procedure to satisfy § 42(m)(1)(B)(iii), the procedure must include the recordkeeping and record retention provisions of § 1.42–5(b). However, a monitoring procedure adopted by a housing credit agency may require additional recordkeeping and record retention provisions beyond those specifically provided in § 1.42–5(b).

Section 1.42–5(b)(1) provides that a housing credit agency must require the owner of a low-income housing project to keep certain specified records for each qualified low-income building in the project for each year in the compliance period. Under § 1.42–5(b)(2), the owner must be required to retain the records described in § 1.42–5(b)(1) for a particular year for at least 6 years after the due date (with extensions) for filing the Federal income tax return for that year. The records for the first year of the credit period, however, must be retained for at least 6 years beyond the due date (with extensions) for filing the Federal income tax return for the last year of the compliance period (as defined in § 42(i)(1)) of the building. Section 1.42–5(b)(3) also specifies that the owner must be required to retain the original local health, safety, or building code violation reports or notices that were issued by the state or local government unit (as described in § 1.42–5(c)(1)(vi)) for inspection by the housing credit agency.

The general requirements for keeping records for purposes of the Code are in § 6001 and the regulations thereunder.

Rev. Proc. 97–22, 1997–1 C.B. 652, provides guidance to taxpayers that maintain books and records by using an electronic storage system that either images their hardcopy (paper) books and records or transfers their computerized books and records to an electronic storage media, such as an optical disk. Rev. Proc. 97–22

2004–35 I.R.B. 356 August 30, 2004

Section 457.—Deferred Compensation Plans of State and Local Governments and Tax-Exempt Organizations

26 CFR 1.457–1: General overviews of section 457.

A revenue procedure provides model amendments that may be used by a State or local government eligible employer (as defined in § 457(e)(1)(A) of the Code) to amend or draft its eligible § 457(b) plan to reflect the requirements of § 457 and the regulations thereunder. See Rev. Proc. 2004-56, page 376.

Section 472.—Last-in, First-out Inventories

26 CFR 1.472–1: Last-in, first-out inventories.

LIFO; price indexes; department stores. The June 2004 Bureau of Labor Statistics price indexes are accepted for use by department stores employing the retail inventory and last-in, first-out inventory methods for valuing inventories for tax years ended on, or with reference to, June 30, 2004.

Rev. Rul. 2004–91

The following Department Store Inventory Price Indexes for June 2004 were issued by the Bureau of Labor Statistics. The indexes are accepted by the Internal Revenue Service, under § 1.472–1(k) of the Income Tax Regulations and Rev. Proc. 86–46, 1986–2 C.B. 739, for appropriate application to inventories of department stores employing the retail inventory and last-in, first-out inventory methods for tax years ended on, or with reference to, June 30, 2004.

The Department Store Inventory Price Indexes are prepared on a national basis and include (a) 23 major groups of departments, (b) three special combinations of the major groups - soft goods, durable goods, and miscellaneous goods, and (c) a store total, which covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco, and contract departments.

Rev. Proc. 94–65, 1994–2 C.B. 798, indicates that an owner may satisfy the documentation requirement of § 1.42–5(b)(1)(vii) for a low-income tenant’s income from assets by obtaining a signed, sworn statement from the tenant or prospective tenant if (1) the tenant’s or prospective tenant’s Net Family assets do not exceed $5,000, and (2) the tenant or prospective tenant provides a signed, sworn statement to this effect to the building owner. The revenue procedure provides that a housing credit agency’s monitoring procedure may not permit an owner to rely on a low-income tenant’s signed, sworn statement of annual income from assets if a reasonable person in the owner’s position would conclude that the tenant’s income is higher than the tenant’s represented annual income. In this case, the owner must obtain other documentation of the low-income tenant’s income from assets to satisfy the documentation requirement. In addition, the revenue procedure indicates that a housing credit agency’s monitoring procedure may continue to require that an owner obtain documentation, other than the signed, sworn statement, to support a low-income tenant’s annual certification of income from assets.

Q–12. On reviewing tenant files of a project, the housing credit agency discovered that for purposes of determining the income of certain tenants, the owner had accepted signed, sworn self-certifications in which the tenants stated that they had not received any child support payments. Is a signed, sworn self-certification by a tenant sufficient documentation under § 1.42–5(b)(1)(vii) to show that the tenant is not receiving child support payments?

A–12. Yes. Consistent with the documentation requirements in Rev. Proc. 94–65, a signed, sworn self-certification by a tenant is sufficient documentation under § 1.42–5(b)(1)(vii) to show that a tenant is not receiving child support payments. In addition to specifying that a tenant is not receiving any child support payments, an annual signed, sworn self-certification should indicate whether the tenant will be seeking or expects to

receive child support payments within the next 12 months. If the tenant possesses a child support agreement but is not presently receiving any child support payments, the tenant should include an explanation of this and all supporting documentation such as a divorce decree and court documents to enforce payment. Also, the self-certification should indicate that the tenant will notify the owner of any changes in the status of child support.

A housing credit agency’s monitoring procedure, however, may not permit an owner to rely on a low-income tenant’s signed, sworn statement indicating that the tenant is not receiving child support payments if a reasonable person in the owner’s position would conclude that the tenant’s income is higher than the tenant’s represented annual income. In this case, the owner must obtain other documentation of the low-income tenant’s annual child support payments to satisfy the documentation requirement in § 1.42–5(b)(1)(vii).

A housing credit agency’s monitoring procedure may continue to require that an owner obtain documentation, other than the statement described above, to support a low-income tenant’s annual certification of child support payments.

DRAFTING INFORMATION

The principal author of this revenue ruling is Gregory N. Doran. For further information regarding this revenue ruling, contact Harold Burghart of the Office of Associate Chief Counsel (Passthroughs and Special Industries) at (202) 622–3040 (not a toll-free call).

Section 142.—Exempt Facility Bond

26 CFR 1.103–8: Interest on bonds to finance certain exempt facilities.

If the full-time security officer for a § 42 low-income housing project occupies a unit in the project, is that unit functionally related and subordinate property and therefore property that is reasonably required for the project? See Rev. Rul. 2004-82, page 350.

August 30, 2004 357 2004–35 I.R.B.

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS

(January 1941 = 100, unless otherwise noted)

Groups June 2003 June 2004

Percent Change from June 2003

to June 2004 ¹

Piece Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464.3 490.9 5.7
Domestics and Draperies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557.0 538.7 -3.3
Women’s and Children’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629.1 631.8 0.4
Men’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 849.5 854.5 0.6
Infants’ Wear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588.9 567.3 -3.7
Women’s Underwear. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516.1 508.4 -1.5
Women’s Hosiery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348.9 329.9 -5.4
Women’s and Girls’ Accessories . . . . . . . . . . . . . . . . . . . . . . . . . . . 547.9 581.5 6.1
Women’s Outerwear and Girls’ Wear . . . . . . . . . . . . . . . . . . . . . . . 362.9 361.9 -0.3
Men’s Clothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541.8 540.3 -0.3
Men’s Furnishings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570.2 578.3 1.4
Boys’ Clothing and Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449.6 431.3 -4.1
Jewelry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 877.8 897.4 2.2
Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 791.4 791.9 0.1
Toilet Articles and Drugs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 990.0 998.9 0.9
Furniture and Bedding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 619.9 624.2 0.7
Floor Coverings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 586.6 592.9 1.1
Housewares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 726.0 712.6 -1.8
Major Appliances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214.1 200.4 -6.4
Radio and Television. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45.4 41.9 -7.7
Recreation and Education ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83.1 80.7 -2.9
Home Improvements ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125.4 129.3 3.1
Automotive Accessories ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111.5 112.4 0.8

Groups 1–15: Soft Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559.5 559.3 0.0 Groups 16–20: Durable Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395.6 384.1 -2.9 Groups 21–23: Misc. Goods ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94.4 93.4 -1.1

Store Total ³ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500.1 496.5 -0.7

1Absence of a minus sign before the percentage change in this column signifies a price increase. 2Indexes on a January 1986 = 100 base. 3The store total index covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco and contract departments.

taxes under section 902. See Announcement 2004-64, page 402.

Section 904.—Limitation on Credit

An announcement withdraws proposed regulations relating to the computation of deemed-paid taxes under section 902. See Announcement 2004-64, page 402.

DRAFTING INFORMATION

The principal author of this revenue ruling is Michael Burkom of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Burkom at (202) 622–7924 (not a toll-free call).

Section 902.—Deemed Paid Credit Where Domestic Corporation Owns 10 Percent or More of Voting Stock of Foreign Corporation

An announcement withdraws proposed regulations relating to the computation of deemed-paid

2004–35 I.R.B. 358 August 30, 2004

ulations would be outweighed by other administrative difficulties, including those associated with redeterminations of deemed-paid foreign taxes under section 905(c). Accordingly, the Treasury Department and the IRS are withdrawing the proposed amendments to §1.902–1(a) in a notice of withdrawal published in this issue of the Bulletin.

II. Separate Categories: §1.904–4

A. The active rents and royalties exception

The proposed regulations would have expanded the exception from passive income for active rents and royalties to include rents and royalties received from related payors. The proposed regulations provide that this change would apply to rents and royalties paid or accrued more than 60 days after the date that the final regulations are published in the Federal Register . Several comments requested that the amendment to the rents and royalties exception apply retroactively. The Treasury Department and the IRS continue to believe this amendment, which modifies existing final regulations, should apply only prospectively. Therefore, the amendment is adopted without change, and the new final regulations are applicable to rents and royalties paid or accrued more than 60 days after the date that the final regulations are published in the Fed- eral Register .

B. Effect of intervening period of noncontrolled or less-than–10%-U.S.-owned status on distributions from a controlled foreign corporation or other look-through corporation

Under section 904(d)(3) and the Treasury regulations thereunder, a U.S. shareholder (as defined in section 951(b)) is allowed look-through treatment for dividends received from a controlled foreign corporation (CFC) if paid out of earnings and profits (E&P) accumulated during periods in which the foreign corporation was a CFC. Section 904(d)(4) allows look-through treatment for dividends paid by a noncontrolled section 902 corporation (10/50 corporation) to a domestic corporation that meets the ownership requirements of section 902(a) from E&P accumulated in a taxable year begin

26 CFR 1.904–4: Separate application of section 904 with respect to certain categories of income.

T.D. 9141

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Application of Section 904 to Income Subject to Separate Limitations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final Income Tax Regulations relating to the section 904(d) foreign tax credit limitation and to the exclusion of certain export financing interest from foreign personal holding company income. Changes to the applicable law were made by the Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the Taxpayer Relief Act of 1997, and the Jobs and Growth Tax Relief Reconciliation Act of 2003. These regulations provide guidance needed to comply with these changes and affect individuals and corporations claiming foreign tax credits and reporting subpart F income.

DATES: Effective Date: These regulations are effective July 20, 2004.

Applicability Dates: These regulations generally apply for taxable years beginning on or after July 20, 2004. Section 1.904–4(b)(2)(i) applies with respect to rents and royalties paid or accrued more than 60 days after July 20, 2004. Taxpayers may choose to apply §1.904(b)–1 and §1.904(b)–2 to taxable years ending after July 20, 2004.

FOR FURTHER INFORMATION CONTACT: Bethany A. Ingwalson (202) 622–3850 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On January 3, 2001, the Treasury Department and the IRS published in the Federal Register (66 FR 319) a notice of

proposed rulemaking (REG–104683–00, 2001–1 C.B. 407) providing guidance with respect to the application of sections 902 and 904. Several comments were received, and a public hearing was held on April 26, 2001. After consideration of the comments, certain portions of the regulations are withdrawn and the remainder of the regulations are finalized substantially as proposed. The discussion below summarizes the comments received and describes the reasons for withdrawing portions of the proposed regulations and the modifications to the remainder of the regulations. A notice of withdrawal (published as Announcement 2004–64) in this issue of the Bulletin withdraws the proposed amendments to §§1.902–0, 1.902–1 and 1.904–4(g).

Summary of Comments Received and Changes Made

I. Effect of Loss of Domestic Corporate Shareholder on Pooling of Earnings and Taxes in Computing Deemed Paid Credits: §1.902–1

Under the proposed amendments to §1.902–1(a), the multi-year pooling of a foreign corporation’s post–1986 undistributed earnings and foreign income taxes would have terminated if the ownership requirements of section 902(c)(3)(B) were not met as of the end of any taxable year, and such earnings and earnings subsequently accumulated in periods during which the stock ownership requirements of section 902 were not met would have been treated as pre–1987 accumulated profits subject to the annual layering rules of section 902(c)(6). Prop. §1.902–1(a)(8), (10) and (13). The proposed amendments also provided for the pooling of earnings and taxes to resume in the first subsequent taxable year as of the end of which the foreign corporation again has a qualifying domestic corporate shareholder. The proposed regulations were intended to alleviate the difficulties of reconstructing accumulated earnings and taxes accounts in connection with a U.S. shareholder’s acquisition of stock in a foreign corporation previously owned by U.S. shareholders after an intervening period of foreign ownership.

The Treasury Department and the IRS have determined that the potential simplification benefits of the proposed reg

August 30, 2004 359 2004–35 I.R.B.

the rate differential adjustments of section 904(b)(2)(B)(i) and paragraph (c)(1) of the regulations to the extent a taxpayer has a net long-term capital loss from sources within the United States that does not reduce long-term capital gains from foreign sources pursuant to the capital gain net income limitation. This can occur when a taxpayer has short-term capital gains. The final regulations clarify the operation of the net capital gain limitation. In addition, because the net capital gain limitation applies solely for purposes of determining the amount of capital gains from foreign sources subject to the rate differential adjustments of section 904(b)(2)(B)(i) and paragraph (c)(1) of the regulations, the provisions addressing the net capital gain limitation have been moved to paragraph (c)(1) in the final regulations.

B. Election for Certain Noncorporate Taxpayers

The proposed regulations also provide guidance concerning the rate differential adjustments required by section 904(b)(2)(B). Prop. §1.904(b)–1(c) and (d). The final regulations add a rule that permits qualifying noncorporate taxpayers to elect not to apply the rate differential adjustments for any taxable year. Under the final regulations, a noncorporate taxpayer that is not subject to tax under section 55 for the taxable year may elect not to apply the rate differential adjustments if the highest rate of tax imposed on the taxpayer’s taxable income (excluding net capital gain and qualified dividend income) for the taxable year under section 1 does not exceed the highest rate of tax in effect under section 1(h) for the taxable year and the amount of the taxpayer’s net capital gain from foreign sources, plus the amount of the taxpayer’s qualified dividend income from foreign sources, is less than $20,000. Under the tax rates currently in effect, an individual with less than $20,000 of net capital gain and qualified dividend income from foreign sources would be eligible to make the election if the highest rate of tax applicable to such individual’s taxable income (excluding net capital gain and qualified dividend income) under section 1 is 28 percent. For example, taxpayers whose filing status is married filing jointly would be eligible to make the election for the 2004 taxable year

ning after December 31, 2002. Section 904(d)(4) provides the Secretary with authority to issue regulations addressing the treatment of dividends paid by a 10/50 corporation out of pre-acquisition E&P.

The proposed regulations would not have provided look-through treatment for a dividend paid by a CFC or 10/50 corporation out of E&P accumulated during a post–2002 period in which the corporation was a CFC or 10/50 corporation if paid after an intervening period during which the corporation was a less-than-10%-U.S.-owned corporation. Prop. §1.904–4(g)(3)(i)(C)(2). Similarly, the proposed regulations would not have provided look-through treatment for a dividend from a CFC out of E&P accumulated during a pre-2003 period in which the corporation was a CFC if paid after an intervening pre-2003 period in which the CFC was a 10/50 corporation or less-than-10%-U.S.-owned corporation. Prop. §1.904–4(g)(3)(i)(C)(1) and (2). The proposed regulations also include a transition year rule that treated E&P accumulated and distributions made during the year in which a CFC or 10/50 corporation loses its look-through status ( i.e., becomes a non-CFC for pre-2003 tax years or a less-than-10%-U.S.-owned corporation for post-2002 tax years) as E&P accumulated or distributions made after the loss of look-through status. Prop. §1.904–4(g)(3)(i)(C). The effect of this transition year rule would be to deny look-through treatment for a dividend or an amount treated as a dividend under section 1248(a) from a CFC or 10/50 corporation out of E&P accumulated while the corporation was a look-through entity.

Several comments suggested that the proposed regulations were inconsistent with section 904(d)(2)(E), which provides that a CFC is not treated as a 10/50 corporation with respect to any distribution out of its E&P for periods during which it was a CFC. Comments also criticized the effect of the transition year rule described above. After consideration of the comments, the Treasury Department and the IRS are withdrawing the proposed amendments to §1.904–4(g) in a notice of withdrawal published in this issue of the Bulletin.

C. High-Taxed Income

The final regulations correct an error in an example relating to the grouping of items of income for purposes of determining whether the items are high-taxed income within the meaning of section 904(d)(2)(F).

III. Capital Gain and Loss Adjustments: §1.904(b)–1

A. In General

The proposed regulations under section 904(b) provide guidance concerning the application of the capital gain net income limitation of section 904(b)(2)(A) and 904(b)(2)(B)(i). Prop. §1.904(b)–1(a). The proposed regulations require a taxpayer to reduce foreign source capital gains to the extent the taxpayer’s capital gain net income from foreign sources (in the aggregate) exceeded the taxpayer’s entire capital gain net income. A taxpayer with a capital gain rate differential for the year and capital gain net income in two or more rate groups within a separate category with capital gain net income would be required to allocate such reduction pro rata to each such rate group in the separate category. The proposed regulations do not provide specific guidance concerning short-term capital gains for these purposes. The final regulations clarify that short-term amounts are treated as a rate group for purposes of §1.904(b)–1. Specifically, the final regulations clarify that a taxpayer with capital gain net income from foreign sources in a separate category attributable to capital gain net income in the short-term rate group and in one or more long-term rate groups allocates any reduction pursuant to the capital gain net income limitation pro rata to the short-term rate group and each applicable long-term rate group. The final regulations add an example involving short-term capital gain to illustrate this rule.

The proposed regulations also contain a rule limiting net capital gain from foreign sources (in the aggregate) to worldwide net capital gain. Prop. §1.904(b)–1(a). This rule is intended to limit the amount of capital gains from foreign sources (remaining after application of the capital gain net income limitation of section 904(b)(2)(A) and (b)(2)(B)(i)) subject to

2004–35 I.R.B. 360 August 30, 2004

tional), within the Office of Chief Counsel, Internal Revenue Service. However, other personnel from the IRS and the Treasury Department participated in their development.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by removing the entries for “1.904–4 through 1.904–7” and the entry for “1.904(b)–3”, and by adding entries in numerical order to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.904–4 also issued under 26 U.S.C. 904(d)(6).

Section 1.904(b)–1 also issued under 26 U.S.C. 1(h)(11)(C)(iv) and 904(b)(2)(C).

Section 1.904(b)–2 also issued under 26 U.S.C. 1(h)(11)(C)(iv) and 904(b)(2)(C).

Section 1.904–5 also issued under 26 U.S.C. 904(d)(6).

Section 1.904–6 also issued under 26 U.S.C. 904(d)(6).

Section 1.904–7 also issued under 26 U.S.C. 904(d)(6). - * *

Par. 2. Section 1.904–0 is amended as follows:

The entries for §1.904–4 are amended by:

a. Revising the entry for paragraph (b)(2)(iii).

b. Removing the entry for paragraph (b)(2)(iv).

c. Adding an entry for paragraph (m). 2. The entries for §§1.904(b)–1 and 1.904(b)–2 are revised. 3. Removing all the entries for §§1.904(b)–3 and 1.904(b)–4.

Adding entries for §1.904(j)–1. The revisions and additions read as follows:

§1.904–0 Outline of regulation provisions for section 904.

if their taxable income (excluding net capital gain and qualified dividend income) for 2004 does not exceed $178,650 and the total of their net capital gain and qualified dividend income, from foreign sources, is less than $20,000. A similar election applies to a noncorporate taxpayer subject to the alternative minimum tax for the taxable year. A qualifying taxpayer is presumed to elect out of the rate differential adjustments unless the taxpayer indicates otherwise on its return for the taxable year. The rule is intended to permit taxpayers to avoid the complexity of computing the rate differential adjustments in cases where the failure to make the adjustments does not result in a significant divergence from the results contemplated by section 904(b)(2)(B). Because capital gains of corporations are not eligible for reduced rates of tax, the eligibility for the election is limited to noncorporate taxpayers.

C. Coordination with Section 904(f)

The proposed regulations contain rules for coordinating the adjustments pursuant to section 904(b)(2) with section 904(f). Prop. §1.904(b)–1(g). The final regulations provide additional guidance concerning the interaction between section 904(b)(2) and (f). First, the final regulations provide that a capital loss from sources within the United States that reduces capital gains from foreign sources pursuant to section 904(b)(2)(A) (or 904(b)(2)(B)(i)) and paragraph (a) of the regulations is disregarded in determining the amount of a taxpayer’s taxable income from sources within the United States for purposes of computing the amount of any additions to the taxpayer’s overall foreign loss accounts. This rule is intended to prevent the double-counting of capital losses from sources within the United States. Second, the final regulations provide that a taxpayer’s loss from sources in the United States (within the meaning of section 904(f)(5)(D)) is the amount by which the taxpayer’s foreign source taxable income (in the aggregate after taking into account adjustments pursuant to section 904(b)(2) and the final regulations) exceeds the taxpayer’s entire taxable income (after taking into account adjustments pursuant to section 904(b)(2)(B) and the final regulations).

The rule is intended to prevent distortions to the foreign tax credit limitation fraction that would otherwise result when a taxpayer has capital gains or losses from sources within the United States. The final regulations add examples to illustrate the operation of these coordination rules.

D. Qualified Dividend Income

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), Public Law 108–27 (117 Stat. 752), extended the capital gain rates under section 1(h) to qualified dividend income of noncorporate taxpayers. JGTRRA provides that rules similar to the rules of section 904(b)(2)(B) (the rate differential adjustment rules) apply with respect to such qualified dividend income. The final regulations implement the coordination rule contained in JGTRRA by requiring a taxpayer to make rate differential adjustments to the taxpayer’s qualified dividend income in a manner similar to the adjustments for a taxpayer’s capital gains. The final regulations contain an election for noncorporate taxpayers, similar to the election for capital gains and losses, allowing a qualifying taxpayer to elect out of the rate differential adjustments with respect to the taxpayer’s qualified dividend income.

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 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 regulations do 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 Code, the notice of proposed rulemaking preceding these regulations was 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 final regulations is Bethany A. Ingwalson of the Office of Associate Chief Counsel (Interna

August 30, 2004 361 2004–35 I.R.B.

The first sentence of paragraph (b)(2)(i) is revised.
Paragraph (b)(2)(ii) is revised.
Paragraph (b)(2)(iii) is removed.
Paragraph (b)(2)(iv) is redesignated as paragraph (b)(2)(iii).
The last three sentences of the Example in newly designated paragraph (b)(2)(iii) are removed and six new sentences are added in their place.
The fifth sentence of Example 4 in paragraph (c)(8) is revised.
The language “and” at the end of paragraph (l)(1)(v) is removed.
The period at the end of paragraph (l)(1)(vi) is removed and “; and” is added in its place.
Paragraph (l)(1)(vii) is added.
Paragraph (m) is added. The revisions and additions read as follows:

§1.904–4 Separate application of section 904 with respect to certain categories of income.

- - - (b) - * (2) * * * (i) * * * For rents and royalties paid or accrued after September 18, 2004, passive income does not include any rents or royalties that are derived in the active conduct of a trade or business, regardless of whether such rents or royalties are received from a related or an unrelated person. - - (ii) Exception for certain rents and roy- alties . Rents and royalties are considered derived in the active conduct of a trade or business by a United States person or by a controlled foreign corporation (or other entity to which the look-through rules apply) for purposes of section 904 (but not for purposes of section 954) if the requirements of section 954(c)(2)(A) are satisfied by one or more corporations that are members of an affiliated group of corporations (within the meaning of section 1504(a), determined without regard to section 1504(b)(3)) of which the recipient is a member. For purposes of this paragraph (b)(2)(ii), an affiliated group includes only domestic corporations and foreign corporations that are controlled foreign corporations in which domestic members of the affiliated group own, directly or indirectly, at least 80 percent of the total voting power and value of the stock. For purposes of

§1.904–4 Separate application of section 904 with respect to certain categories of income.

- - - (b) - - (2) - - (iii) Example.
- - - (m) Income treated as allocable to an additional separate category.

§1.904(b)–1 Special rules for capital gains and losses.

(a) Capital gains and losses included in taxable income from sources outside the United States.

(1) Limitation on capital gain from sources outside the United States when the taxpayer has net capital losses from sources within the United States.

(i) In general. (ii) Allocation of reduction to separate categories or rate groups.

(A) In general. (B) Taxpayer with capital gain rate differential.

(2) Exclusivity of rules; no reduction by reason of net capital loss from sources outside the United States in a different separate category.

(3) Capital losses from sources outside the United States in the same separate category.

(4) Examples. (b) Capital gain rate differential. (1) Application of adjustments only if capital gain rate differential exists.

(2) Determination of whether capital gain rate differential exists.

(3) Special rule for certain noncorporate taxpayers.

(1) Rate differential adjustment of capital gains in foreign source taxable income.

(i) In general. (ii) Special rule for taxpayers with a net long-term capital loss from sources within the United States.

(iii) Examples. (2) Rate differential adjustment of capital gains in entire taxable income.

(d) Rate differential adjustment of capital losses from sources outside the United States.

(1) In general. (2) Determination of which capital gains are offset by net capital losses from sources outside the United States.

(e) Qualified dividend income. (1) In general. (2) Exception. (f) Definitions. (1) Alternative tax rate. (2) Net capital gain. (3) Rate differential portion. (4) Rate group. (i) Short-term capital gains or losses. (ii) Long-term capital gains. (iii) Long-term capital losses. (5) Terms used in sections 1(h), 904(b) or 1222.

(g) Examples. (h) Coordination with section 904(f). (1) In general. (2) Examples. (i) Effective date.

§1.904(b)–2 Special rules for application of section 904(b) to alternative minimum tax foreign tax credit.

(a) Application of section 904(b)(2)(B) adjustments.

(b) Use of alternative minimum tax rates.

(1) Taxpayers other than corporations. (2) Corporate taxpayers. (c) Effective date.

§1.904(j)–1 Certain individuals exempt from foreign tax credit limitation.

(a) Election available only if all foreign taxes are creditable foreign taxes.

(b) Coordination with carryover rules. (1) No carryovers to or from election year.

(2) Carryovers to and from other years determined without regard to election years.

(3) Determination of amount of creditable foreign taxes.

Paragraph (a) is amended by removing the period at the end and adding the language “, or in §1.904–4(m) (additional separate categories).”

2004–35 I.R.B. 362 August 30, 2004

Par. 6. Section 1.904(b)–1 is revised to read as follows:

§1.904(b)–1 Special rules for capital gains and losses.

(a) Capital gains and losses included in taxable income from sources outside the United States —(1) Limitation on cap- ital gain from sources outside the United States when the taxpayer has net capi- tal losses from sources within the United States —(i) In general . Except as otherwise provided in this section, for purposes of section 904 and this section, taxable income from sources outside the United States (in all of the taxpayer’s separate categories in the aggregate) shall include capital gain net income from sources outside the United States (determined by considering all of the capital gain and loss items in all of the taxpayer’s separate categories in the aggregate) only to the extent of capital gain net income from all sources. Thus, capital gain net income from sources outside the United States (determined by considering all of the capital gain and loss items in all of the taxpayer’s separate categories in the aggregate) shall be reduced to the extent such amount exceeds capital gain net income from all sources.

(ii) Allocation of reduction to separate categories or rate groups —(A) In general . If capital gain net income from sources outside the United States exceeds capital gain net income from all sources, and the taxpayer has capital gain net income from sources outside the United States in only one separate category, such excess is allocated as a reduction to that separate category. If a taxpayer has capital gain net income from foreign sources in two or more separate categories, such excess must be apportioned on a pro rata basis as a reduction to each such separate category. For purposes of the preceding sentence, pro rata means based on the relative amounts of the capital gain net income from sources outside the United States in each separate category.

(B) Taxpayer with capital gain rate dif- ferential . If a taxpayer with a capital gain rate differential for the year (within the meaning of paragraph (b) of this section) has capital gain net income from foreign sources in only one rate group within a separate category, any reduction to such separate category pursuant to paragraph

this paragraph (b)(2)(ii), indirect ownership shall be determined under section 318 and the regulations under that section.

(iii) * - Example . - * * Some of the franchisees are unrelated to S and P. Other franchisees are related to S or P and use the licensed property outside of S’s country of incorporation. S does not satisfy, but P does satisfy, the active trade or business requirements of section 954(c)(2)(A) and the regulations thereunder. The royalty income earned by S with regard to both its related and unrelated franchisees is foreign personal holding company income because S does not satisfy the active trade or business requirements of section 954(c)(2)(A) and, in addition, the royalty income from the related franchisees does not qualify for the same country exception of section 954(c)(3). However, all of the royalty income earned by S is general limitation income to S under §1.904–4(b)(2)(ii) because P, a member of S’s affiliated group (as defined therein), satisfies the active trade or business test (which is applied without regard to whether the royalties are paid by a related person). S’s royalty income that is taxable to P under subpart F and the royalties paid to P are general limitation income to P under the look-through rules of §1.904–5(c)(1)(i) and (c)(3), respectively.

- - - (c) - * (8) - * Example 4 . - - - The royalty income is not subject to a withholding tax, and is not taxed by Country X, and the interest and the rental income are subject to a 4 percent and 10 percent withholding tax, respectively. - * *
- (l) * * * (1) * * * (vii) Income that meets the definitions of a separate category described in paragraph (m) of this section and of any other category of separate limitation income described in section 904(d)(1)(A) through (H) will be subject to the separate limitation described in paragraph (m) of this section and will not be treated as general limitation income described in section 904(d)(1)(I).
- - - (m) Income treated as allocable to an additional separate category . If section 904(a), (b), and (c) are applied separately to any category of income under the Internal Revenue Code (for example, under section 56(g)(4)(C)(iii)(IV), 245(a)(10), 865(h), 901(j), or 904(g)(10)), that category of income will be treated for all purposes of the Internal Revenue Code and regulations as if it were a separate

category listed in section 904(d)(1) and (d)(3)(F)(i).

Par. 4. In §1.904–5, paragraph (a)(1) is revised to read as follows:

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

(a) - - (1) The term separate category means, as the context requires, any category of income described in section 904(d)(1)(A), (B), (C), (D), (E), (F), (G), (H), or (I) and in §1.904–4(b), (d), (e), (f), and (g), any category of income described in §1.904–4(m), or any category of earnings and profits to which income described in such provisions is attributable.

- - - Par. 5. In §1.904–6, paragraph (a)(1)(ii) is amended by adding two sentences at the end to read as follows:

§1.904–6 Allocation and apportionment of taxes.

(a) * * * (1) * * * (ii) * * * If the taxpayer applies the principles of §§1.861–8 through 1.861–14T for purposes of allocating expenses at the level of the taxpayer (or at the level of the qualified business unit, foreign subsidiary, or other entity that paid or accrued the foreign taxes) under this paragraph (a)(1)(ii), such principles shall be applied (for such purposes) in the same manner as the taxpayer applies such principles in determining the income or earnings and profits for United States tax purposes of the taxpayer (or of the qualified business unit, foreign subsidiary, or other entity that paid or accrued the foreign taxes, as the case may be). For example, a taxpayer must use the modified gross income method under §1.861–9T when applying the principles of that section for purposes of this paragraph (a)(1)(ii) to determine the amount of a controlled foreign corporation’s income, in each separate category, that is taxed by a foreign country, if the taxpayer applies the modified gross income method under §1.861–9T(f)(3) when applying §1.861–9T to determine the income and earnings and profits of the controlled foreign corporation for United States tax purposes.

August 30, 2004 363 2004–35 I.R.B.

(a)(1)(ii)(A) of this section must be allocated to such rate group. If a taxpayer with a capital gain rate differential for the year (within the meaning of paragraph (b) of this section) has capital gain net income from foreign sources in two or more rate groups within a separate category, any reduction to such separate category pursuant to paragraph (a)(1)(ii)(A) of this section must be apportioned on a pro rata basis among such rate groups. For purposes of the preceding sentence, pro rata means based on the relative amounts of the capital gain net income from sources outside the United States in each rate group within the applicable separate category.

(2) Exclusivity of rules; no reduction by reason of net capital losses from sources outside the United States in a different sep- arate category . Capital gains from sources outside the United States in any separate category shall be limited by reason of section 904(b)(2)(A) and the comparable limitation of section 904(b)(2)(B)(i) only to the extent provided in paragraph (a)(1) of this section (relating to limitation on capital gain from sources outside the United States when taxpayer has net capital losses from sources within the United States).

(3) Capital losses from sources outside the United States in the same separate category . Except as otherwise provided in paragraph (d) of this section, taxable income from sources outside the United States in each separate category shall be reduced by any capital loss that is allocable or apportionable to income from sources outside the United States in such separate category to the extent such loss is allowable in determining taxable income for the taxable year.

(4) Examples . The following examples illustrate the application of this paragraph (a) to taxpayers that do not have a capital gain rate differential for the taxable year. See paragraph (g) of this section for examples that illustrate the application of this paragraph (a) to taxpayers that have a capital gain rate differential for the year. The examples are as follows:

Example 1 . Taxpayer A, a corporation, has a $3,000 capital loss from sources outside the United States in the general limitation category, a $6,000 capital gain from sources outside the United States in the passive category, and a $2000 capital loss from sources within the United States. A’s capital gain net income from sources outside the United States in the aggregate, from all separate categories, is $3000 ($6,000 - $3,000). A’s capital gain net income from

all sources is $1000 ($6000 - $3000 - $2000). Thus, for purposes of section 904, A’s taxable income from sources outside the United States in all of A’s separate categories in the aggregate includes only $1000 of capital gain net income from sources outside the United States. See paragraph (a)(1)(i) of this section. Pursuant to paragraphs (a)(1)(i) and (a)(1)(ii)(A) of this section, A must reduce the $6000 of capital gain net income from sources outside the United States in the passive category by $2000 ($3000 of capital gain net income from sources outside the United States $1000 of capital gain net income from all sources). After the adjustment, A has $4000 of capital gain from sources outside the United States in the passive category and $3000 of capital loss from sources outside the United States in the general limitation category.

Example 2 . Taxpayer B, a corporation, has a $300 capital gain from sources outside the United States in the general limitation category and a $200 capital gain from sources outside the United States in the passive category. B’s capital gain net income from sources outside the United States is $500 ($300 + $200). B also has a $150 capital loss from sources within the United States and a $50 capital gain from sources within the United States. Thus, B’s capital gain net income from all sources is $400 ($300 + $200 - $150 + $50). Pursuant to paragraph (a)(1)(ii)(A) of this section, the $100 excess of capital gain net income from sources outside the United States over capital gain net income from all sources ($500 - $400) must be apportioned, as a reduction, three-fifths ($300/$500 of $100, or $60) to the general limitation category and two-fifths ($200/$500 of $100, or $40) to the passive category. Therefore, for purposes of section 904, the general limitation category includes $240 ($300 - $60) of capital gain net income from sources outside the United States and the passive category includes $160 ($200 - $40) of capital gain net income from sources outside the United States.

Example 3 . Taxpayer C, a corporation, has a $10,000 capital loss from sources outside the United States in the general limitation category, a $4,000 capital gain from sources outside the United States in the passive category, and a $2,000 capital gain from sources within the United States. C’s capital gain net income from sources outside the United States is zero, since losses exceed gains. C’s capital gain net income from all sources is also zero. C’s capital gain net income from sources outside the United States does not exceed its capital gain net income from all sources, and therefore paragraph (a)(1) of this section does not require any reduction of C’s passive category capital gain. For purposes of section 904, C’s passive category includes $4,000 of capital gain net income. C’s general limitation category includes a capital loss of $6,000 because only $6,000 of capital loss is allowable as a deduction in the current year. The entire $4,000 of capital loss in excess of the $6,000 of capital loss that offsets capital gain in the taxable year is carried back or forward under section 1212(a), and none of such $4,000 is taken into account under section 904(a) or (b) for the current taxable year.

(b) Capital gain rate differential —(1) Application of adjustments only if capi- tal gain rate differential exists . Section 904(b)(2)(B) and paragraphs (c) and (d) of

this section apply only for taxable years in which the taxpayer has a capital gain rate differential.

(2) Determination of whether capital gain rate differential exists . For purposes of section 904(b) and this section, a capital gain rate differential is considered to exist for the taxable year only if the taxpayer has taxable income (excluding net capital gain and qualified dividend income) for the taxable year, a net capital gain for the taxable year and—

(i) In the case of a taxpayer other than a corporation, tax is imposed on the net capital gain at a reduced rate under section 1(h) for the taxable year; or (ii) In the case of a corporation, tax is imposed under section 1201(a) on the taxpayer at a rate less than any rate of tax imposed on the taxpayer by section 11, 511, or 831(a) or (b), whichever applies (determined without regard to the last sentence of section 11(b)(1)), for the taxable year.

(3) Special rule for certain noncorpo- rate taxpayers . A taxpayer that has a capital gain rate differential for the taxable year under paragraph (b)(2)(i) of this section and is not subject to alternative minimum tax under section 55 for the taxable year may elect not to apply the rate differential adjustments contained in section 904(b)(2)(B) and paragraphs (c) and (d) of this section if the highest rate of tax imposed on such taxpayer’s taxable income (excluding net capital gain and any qualified dividend income) for the taxable year under section 1 does not exceed the highest rate of tax in effect under section 1(h) for the taxable year and the amount of the taxpayer’s net capital gain from sources outside the United States, plus the amount of the taxpayer’s qualified dividend income from sources outside the United States, is less than $20,000. A taxpayer that has a capital gain rate differential for the taxable year under paragraph (b)(2)(i) of this section and is subject to alternative minimum tax under section 55 for the taxable year may make such election if the rate of tax imposed on such taxpayer’s alternative minimum taxable income (excluding net capital gain and any qualified dividend income) under section 55 does not exceed 26 percent, the highest rate of tax imposed on such taxpayer’s taxable income (excluding net capital gain and any qualified dividend income) for the taxable year under section 1 does not exceed the highest rate of tax

2004–35 I.R.B. 364 August 30, 2004

require any reduction of M’s capital gain net income in the passive category.

(iii) Because M has a net long-term capital loss from sources within the United States ($100) and also has a short-term capital gain from U.S. sources ($150), M must apply the provisions of paragraph (c)(1)(ii) of this section to determine the amount of the $300 of capital gain net income in the passive category that is subject to a rate differential adjustment. Under Step 1, the U.S. long-term capital loss adjustment amount is $100 ($100 - $0). Under Step 2, M must apportion this amount to each rate group in the passive category pro rata based on the amount of capital gain net income in each rate group. Thus, $66.67 ($200/$300 of $100) is apportioned to the 15 percent rate group and $33.33 ($100/$300 of $100) is apportioned to the 28 percent rate group. The applicable rate differential amount for the 15 percent rate group is $133.33 ($200 - $66.67). Thus, $133.33 of the $200 of capital gain net income in the 15 percent rate group is subject to a rate differential adjustment pursuant to paragraph (c)(1) of this section. The remaining $66.67 is not subject to a rate differential adjustment. The applicable rate differential amount for the 28 percent rate group is $66.67 ($100 - $33.33). Thus, $66.67 of the $100 of capital gain net income in the 28 percent rate group is subject to a rate differential adjustment pursuant to paragraph (c)(1) of this section. The remaining $33.33 is not subject to a rate differential adjustment.

Example 2 . (i) N, an individual, has $300 of longterm capital gain from foreign sources in the passive category, all of which is subject to tax at a rate of 15 percent under section 1(h). N has $50 of short-term capital gain from sources within the United States. N has a $100 long-term capital loss from sources within the United States.

(ii) N’s capital gain net income from sources outside the United States ($300) exceeds N’s capital gain net income from all sources ($250). Pursuant to paragraph (a)(1) of this section, N must reduce the $300 capital gain in the passive category by $50. N has $250 of capital gain remaining in the passive category.

(iii) Because N has a net long-term capital loss from sources within the United States ($100) and also has a short-term capital gain from U.S. sources ($50), N must apply the provisions of paragraph (c)(1)(ii) of this section to determine the amount of the $250 of capital gain in the passive category that is subject to a rate differential adjustment. Under Step 1, the U.S. long-term capital loss adjustment amount is $50 ($100 - $50). Under Step 2, the applicable rate differential amount is $200 ($250 - $50). Thus, $200 of the capital gain in the passive category is subject to a rate differential adjustment under paragraph (c)(1) of this section. The remaining $50 is not subject to a rate differential adjustment.

Example 3 . (i) O, an individual, has a $100 shortterm capital gain from foreign sources in the passive category. O has $300 of long-term capital gain from foreign sources in the passive category, all of which is subject to tax at a rate of 15 percent under section 1(h). O has a $100 long-term capital loss from sources within the United States.

(ii) O’s capital gain net income from sources outside the United States ($400) exceeds O’s capital gain net income from all sources ($300). Pursuant to paragraph (a)(1) of this section, O must reduce the

in effect under section 1(h) for the taxable year and the amount of the taxpayer’s net capital gain from sources outside the United States, plus the amount of the taxpayer’s qualified dividend income from sources outside the United States, is less than $20,000. A taxpayer who makes this election shall apply paragraph (a) of this section as if such taxpayer does not have a capital gain rate differential for the taxable year. An eligible taxpayer shall be presumed to have elected not to apply the rate differential adjustments, unless such taxpayer applies the rate differential adjustments contained in section 904(b)(2)(B) and paragraphs (c) and (d) of this section in determining its foreign tax credit limitation for the taxable year.

(c) Rate differential adjustment of capi- tal gains —(1) Rate differential adjustment of capital gains in foreign source taxable income —(i) In general . Subject to paragraph (c)(1)(ii) of this section, in determining taxable income from sources outside the United States for purposes of section 904 and this section, capital gain net income from sources outside the United States in each long-term rate group in each separate category (separate category longterm rate group), shall be reduced by the rate differential portion of such capital gain net income. For purposes of paragraph (c)(1) of this section, references to capital gain net income are references to capital gain net income remaining after any reduction to such income pursuant to paragraph (a)(1) of this section ( i.e., paragraph (a)(1) of this section applies before paragraphs (c) and (d) of this section).

(ii) Special rule for taxpayers with a net long-term capital loss from sources within the United States . If a taxpayer has a net long-term capital loss from sources within the United States ( i.e., the taxpayer’s longterm capital losses from sources within the United States exceed the taxpayer’s longterm capital gains from sources within the United States) and also has any short-term capital gains from sources within or without the United States, then capital gain net income from sources outside the United States in each separate category long-term rate group shall be reduced by the rate differential portion of the applicable rate differential amount. The applicable rate differential amount is determined as follows:

(A) Step 1 : Determine the U.S. long-term capital loss adjustment amount .

The U.S. long-term capital loss adjustment amount is the excess, if any, of the net long-term capital loss from sources within the United States over the amount, if any, by which the taxpayer reduced long-term capital gains from sources without the United States pursuant to paragraph (a)(1) of this section.

(B) Step 2 : Determine the applicable rate differential amount . If a taxpayer has capital gain net income from sources outside the United States in only one separate category long-term rate group, the applicable rate differential amount is the excess of such capital gain net income over the U.S. long-term capital loss adjustment amount. If a taxpayer has capital gain net income from sources outside the United States in more than one separate category long-term rate group, the U.S. long-term capital loss adjustment amount shall be apportioned on a pro rata basis to each separate category long-term rate group with capital gain net income. For purposes of the preceding sentence, pro rata means based on the relative amounts of capital gain net income from sources outside the United States in each separate category long-term rate group. The applicable rate differential amount for each separate category long-term rate group with capital gain net income is the excess of such capital gain net income over the portion of the U.S. long-term capital loss adjustment amount apportioned to the separate category long-term rate group pursuant to this Step 2.

(iii) Examples . The following examples illustrate the provisions of paragraph (c)(1)(ii) of this section. The taxpayers in the examples are assumed to have taxable income (excluding net capital gain and qualified dividend income) subject to a rate of tax under section 1 greater than the highest rate of tax in effect under section 1(h) for the applicable taxable year. The examples are as follows:

Example 1 . (i) M, an individual, has $300 of longterm capital gain from foreign sources in the passive category, $200 of which is subject to tax at a rate of 15 percent under section 1(h) and $100 of which is subject to tax at a rate of 28% under section 1(h). M has $150 of short-term capital gain from sources within the United States. M has a $100 long-term capital loss from sources within the United States.

(ii) M’s capital gain net income from sources outside the United States ($300) does not exceed M’s capital gain net income from all sources ($350). Therefore, paragraph (a)(1) of this section does not

August 30, 2004 365 2004–35 I.R.B.

to the extent netted against capital gains in any other separate category under paragraph (d)(2)(i) of this section or against capital gains in the same or any other rate group under paragraph (d)(2)(iii) of this section, shall be treated as coming pro rata from each separate category that contains a net capital loss from sources outside the United States in that rate group. For example, assume that the taxpayer has $20 of net capital losses in the 15 percent rate group in the passive category and $40 of net capital losses in the 15 percent rate group in the general limitation category, both from sources outside the United States. Further assume that $50 of the total $60 net capital losses from sources outside the United States are netted against capital gain net income in the 28 percent rate group (from other separate categories or from sources within the United States). One-third of the $50 of such capital losses would be treated as coming from the passive category, and two-thirds of such $50 would be treated as coming from the general limitation category.

(v) In determining the capital gain net income offset by a net capital loss from sources outside the United States pursuant to this paragraph (d)(2), a taxpayer shall take into account any reduction to capital gain net income from sources outside the United States pursuant to paragraph (a) of this section and shall disregard any adjustments to such capital gain net income pursuant to paragraph (c)(1) of this section.

(vi) If at any time during a taxable year, tax is imposed under section 1(h) at a rate other than a rate of tax specified in this paragraph (d)(2), the principles of this paragraph (d)(2) shall apply to determine the capital gain net income offset by any net capital loss in a separate category rate group.

(vii) The determination of which capital gains are offset by capital losses from sources outside the United States under this paragraph (d)(2) is made solely in order to determine the appropriate rate-differential-based adjustments to such capital losses under this section and section 904(b), and does not change the source, allocation, or separate category of any such capital gain or loss for purposes of computing taxable income from sources within or outside the United States or for any other purpose.

$400 capital gain net income in the passive category by $100. Because C has capital gain net income in two or more rate groups in the passive category, O must apportion such amount, as a reduction, to each rate group on a pro rata basis pursuant to paragraph (a)(1)(ii)(B) of this section. Thus, $25 ($100/$400 of $100) is apportioned to the short-term capital gain and $75 ($300/$400 of $100) is apportioned to the long-term capital gain in the 15 percent rate group. After application of paragraph (a)(1) of this section, O has $75 of short-term capital gain in the passive category and $225 of long-term capital gain in the 15 percent rate group in the passive category.

(iii) Because O has a net long-term capital loss from sources within the United States ($100) and also has a short-term capital gain from foreign sources ($100), O must apply the provisions of paragraph (c)(1)(ii) of this section to determine the amount of the $225 of long-term capital gain in the 15 percent rate group that is subject to a rate differential adjustment. Under Step 1, the U.S. long-term capital loss adjustment amount is $25 ($100 - $75). Under Step 2, the applicable rate differential amount is $200 ($225 $25). Thus, $200 of the long-term capital gain is subject to a rate differential adjustment under paragraph (c)(1) of this section. The remaining $25 of long-term capital gain is not subject to a rate differential adjustment.

(2) Rate differential adjustment of cap- ital gains in entire taxable income . For purposes of section 904 and this section, entire taxable income shall include gains from the sale or exchange of capital assets only to the extent of capital gain net income reduced by the sum of the rate differential portions of each rate group of net capital gain.

(d) Rate differential adjustment of cap- ital losses from sources outside the United States —(1) In general . In determining taxable income from sources outside the United States for purposes of section 904 and this section, a taxpayer with a net capital loss in a separate category rate group shall reduce such net capital loss by the sum of the rate differential portions of the capital gain net income in each long-term rate group offset by such net capital loss. A net capital loss in a separate category rate group is the amount, if any, by which capital losses in a rate group from sources outside the United States included in a separate category exceed capital gains from sources outside the United States in the same rate group and the same separate category.

(2) Determination of which capital gains are offset by net capital losses from sources outside the United States . For purposes of paragraph (d)(1) of this section, in order to determine the capital gain net income offset by net capital losses from

sources outside the United States, the following rules shall apply in the following order:

(i) Net capital losses from sources outside the United States in each separate category rate group shall be netted against capital gain net income from sources outside the United States from the same rate group in other separate categories.

(ii) Capital losses from sources within the United States shall be netted against capital gains from sources within the United States in the same rate group.

(iii) Net capital losses from sources outside the United States in excess of the amounts netted against capital gains under paragraph (d)(2)(i) of this section shall be netted against the taxpayer’s remaining capital gains from sources within and outside the United States in the following order, and without regard to any net capital losses, from any rate group, from sources within the United States—

(A) First against capital gain net income from sources within the United States in the same rate group;

(B) Next, against capital gain net income in other rate groups, in the order in which capital losses offset capital gains for purposes of determining the taxpayer’s taxable income and without regard to whether such capital gain net income derives from sources within or outside the United States, as follows:

( 1 ) A net capital loss in the short-term rate group is used first to offset any capital gain net income in the 28 percent rate group, then to offset capital gain net income in the 25 percent rate group, then to offset capital gain net income in the 15 percent rate group, and finally to offset capital gain net income in the 5 percent rate group.

( 2 ) A net capital loss in the 28 percent rate group is used first to offset capital gain net income in the 25 percent rate group, then to offset capital gain net income in the 15 percent rate group, and finally to offset capital gain net income in the 5 percent rate group.

( 3 ) A net capital loss in the 15 percent rate group is used first to offset capital gain net income in the 5 percent rate group, and then to offset capital gain net income in the 28 percent rate group, and finally to offset capital gain net income in the 25 percent rate group.

(iv) Net capital losses from sources outside the United States in any rate group,

2004–35 I.R.B. 366 August 30, 2004

taxed at each applicable rate. For example, under the section 1(h) rates in effect for tax years beginning in 2004, a long-term capital gain (other than a long-term capital gain described in section 1(h)(4)(A) or (h)(6)) may be subject to tax at 5 percent or 15 percent.

(iii) Long-term capital losses . With respect to a long-term capital loss, a loss described in section 1(h)(4)(B)(i) (collectibles loss) or (iii) (long-term capital loss carryover) is a loss in the 28 percent rate group. All other long-term capital losses shall be treated as losses in the highest rate group in effect under section 1(h) for the tax year with respect to long-term capital gains other than long-term capital gains described in section 1(h)(4)(A) or (h)(6). For example, under the section 1(h) rates in effect for tax years beginning in 2004, a long-term capital loss not described in section 1(h)(4)(B)(i) or (iii) shall be treated as a loss in the 15 percent rate group.

(5) Terms used in sections 1(h), 904(b) or 1222 . For purposes of this section, any term used in this section and also used in section 1(h), section 904(b) or section 1222 shall have the same meaning given such term by section 1(h), 904(b) or 1222, respectively, except as otherwise provided in this section.

(g) Examples . The following examples illustrate the provisions of this section. In these examples, the rate differential adjustment is shown as a fraction, the numerator of which is the alternative tax rate percentage and the denominator of which is 35 percent (assumed to be the highest applicable tax rate for individuals under section 1). Finally, all dollar amounts in the examples are abbreviated from amounts in the thousands (for example, $50 represents $50,000). The examples are as follows:

Example 1 . (i) AA, an individual, has items from sources outside the United States only in the passive category for the taxable year. AA has $1000 of longterm capital gains from sources outside the United States that are subject to tax at a rate of 15 percent under section 1(h). AA has $700 of long-term capital losses from sources outside the United States, which are not described in section 1(h)(4)(B)(i) or (iii). For the same taxable year, AA has $800 of long-term capital gains from sources within the United States that are taxed at a rate of 28 percent under section 1(h). AA also has $100 of long-term capital losses from sources within the United States, which are not described in section 1(h)(4)(B)(i) or (iii). AA also has $500 of ordinary income from sources within the United States. The highest tax rate in effect under section 1(h) for the taxable year with respect to long-term

(e) Qualified dividend income —(1) In general . A taxpayer that has taxable income (excluding net capital gain and qualified dividend income) for the taxable year and that qualifies for a reduced rate of tax under section 1(h) on its qualified dividend income (as defined in section 1(h)(11)) for the taxable year shall adjust the amount of such qualified dividend income in a manner consistent with the rules of paragraphs (c)(1)(i) (first sentence) and (c)(2) of this section irrespective of whether such taxpayer has a net capital gain for the taxable year. For purposes of making adjustments pursuant to this paragraph (e), the special rule in paragraph (c)(1)(ii) of this section for taxpayers with a net long-term capital loss from sources within the United States shall be disregarded.

(2) Exception . A taxpayer that makes the election provided for in paragraph (b)(3) of this section shall not make adjustments pursuant to paragraph (e)(1) of this section. Additionally, a taxpayer other than a corporation that does not have a capital gain rate differential for the taxable year within the meaning of paragraph (b)(2) of this section may elect not to apply paragraph (e)(1) of this section if such taxpayer would have qualified for the election provided for in paragraph (b)(3) of this section had such taxpayer had a capital gain rate differential for the taxable year. Such a taxpayer shall be presumed to make the election provided for in the preceding sentence unless such taxpayer applies the rate differential adjustments provided for in paragraph (e)(1) of this section to the qualified dividend income in determining its foreign tax credit limitation for the taxable year.

(f) Definitions . For purposes of section 904(b) and this section, the following definitions apply:

(1) Alternative tax rate . The term alter- native tax rate means, with respect to any rate group, the rate applicable to that rate group under section 1(h) (for taxpayers other than corporations) or section 1201(a) (for corporations). For example, the alternative tax rate for unrecaptured section 1250 gain is 25 percent. (2) Net capital gain . For purposes of this section, net capital gain shall not include any qualified dividend income (as defined in section 1(h)(11)). See paragraph (e) of this section for rules relating to qualified dividend income.

(3) Rate differential portion . The term rate differential portion with respect to capital gain net income from sources outside the United States in a separate category long-term rate group (or the applicable portion of such amount), net capital gain in a rate group, or capital gain net income in a long-term rate group, as the case may be, means the same proportion of such amount as—

(i) The excess of the highest applicable tax rate (as defined in section 904(b)(3)(E)(ii)) over the alternative tax rate; bears to

(ii) the highest applicable tax rate (as defined in section 904(b)(3)(E)(ii)).

(4) Rate group . For purposes of this section, the term rate group means:

(i) Short-term capital gains or losses . With respect to a short-term capital gain or loss, the rate group is the short-term rate group.

(ii) Long-term capital gains . With respect to a long-term capital gain, the rate group is the particular rate of tax to which such gain is subject under section 1(h). Such a rate group is a long-term rate group. For example, the 28 percent rate group of capital gain net income from sources outside the United States consists of the capital gain net income from sources outside the United States that is subject to tax at a rate of 28 percent under section 1(h). Such 28 percent rate group is a long-term rate group. If a taxpayer has long-term capital gains that may be subject to tax at more than one rate under section 1(h) and the taxpayer’s net capital gain attributable to such long-term capital gains and any qualified dividend income are taxed at one rate of tax under section 1(h), then all of such long-term capital gains shall be treated as long-term capital gains in that one rate group. If a taxpayer has long-term capital gains that may be subject to tax at more than one rate of tax under section 1(h) and the taxpayer’s net capital gain attributable to such long-term capital gains and any qualified dividend income are taxed at more than one rate pursuant to section 1(h), the taxpayer shall determine the rate group for such long-term capital gains from sources within or outside the United States (and, to the extent from sources outside the United States, from each separate category) ratably based on the proportions of net capital gain and any qualified dividend income

August 30, 2004 367 2004–35 I.R.B.

capital gains other than long-term capital gains described in section 1(h)(4)(A) or (h)(6) is 15 percent.

Accordingly, AA’s long-term capital losses are in the (ii) AA’s items of ordinary income, capital gain 15 percent rate group. and capital loss for the taxable year are summarized in the following table:

	U.S. source	foreign source: passive
15% rate group	($100)	$1,000 ($700)
28% rate group	$800
Ordinary income	$500

(iii) AA’s capital gain net income from sources outside the United States ($300) does not exceed AA’s capital gain net income from all sources ($1,000). Therefore, paragraph (a)(1) of this section does not require any reduction of AA’s capital gain net income in the passive category.

(iv) In computing AA’s taxable income from sources outside the United States in the numerator of the section 904(a) foreign tax credit limitation fraction for the passive category, AA’s $300 of capital gain net income in the 15 rate group in the passive category must be adjusted as required under

Example 2 . (i) BB, an individual, has the following items of ordinary income, capital gain, and capital loss for the taxable year:

paragraph (c)(1) of this section. AA adjusts the $300 of capital gain net income using 15 percent as the alternative tax rate, as follows: $300(15%/35%).

(v) In computing AA’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fraction, AA combines the $300 of capital gain net income from sources outside the United States and the $100 net capital loss from sources within the United States in the same rate group (15 percent). AA must adjust the resulting $200 ($300 - $100) of net capital gain in the 15 percent rate group as required under paragraph (c)(2)

$300(15%/35%)

$500 + $200(15%/35%) + $800(28%/35%)

of this section, using 15 percent as the alternative tax rate, as follows: $200(15%/35%). AA must also adjust the $800 of net capital gain in the 28 percent rate group, using 28 percent as the alternative tax rate, as follows: $800(28%/35%). AA must also include ordinary income from sources outside the United States in the numerator, and ordinary income from all sources in the denominator, of the foreign tax credit limitation fraction.

(vi) AA’s passive category foreign tax credit limitation fraction is $128.58/$1225.72, computed as follows:

	U.S. source	foreign general	source: passive
15% rate group	$300	($500)	$100
25% rate group	$200
28% rate group	$500	($300)
Ordinary income	$1,000	$500	$500

(ii) BB’s capital gain net income from sources outside the United States in the aggregate (zero, since losses exceed gains) does not exceed BB’s capital gain net income from all sources ($300). Therefore, paragraph (a)(1) of this section does not require any reduction of BB’s capital gain net income in the passive category.

(iii) In computing BB’s taxable income from sources outside the United States in the numerators of the section 904(a) foreign tax credit limitation fractions for the passive and general limitation categories, BB must adjust capital gain net income from sources outside the United States in each separate category long-tem rate group and net capital losses from sources outside the United States in each separate category rate group as provided in paragraphs (c)(1) and (d) of this section.

(A) The $100 of capital gain net income in the 15 percent rate group in the passive category is adjusted under paragraph (c)(1) of this section as follows: $100(15%/35%).

(B) BB must adjust the net capital losses in the 15 percent and 28 percent rate groups in the general lim

itation category in accordance with the ordering rules contained in paragraph (d)(2) of this section. Under paragraph (d)(2)(i) of this section, BB’s net capital loss in the 15 percent rate group is netted against capital gain net income from sources outside the United States in other separate categories in the same rate group. Thus, $100 of the $500 net capital loss in the 15 percent rate group in the general limitation category offsets $100 of capital gain net income in the 15 percent rate group in the passive category. Accordingly, $100 of the $500 net capital loss is adjusted under paragraph (d)(1) of this section as follows: $100(15%/35%).

(C) Next, under paragraph (d)(2)(iii)(A) of this section, BB’s net capital losses from sources outside the United States in any separate category rate group are netted against capital gain net income in the same rate group from sources within the United States. Thus, $300 of the $500 net capital loss in the 15 percent rate group in the general limitation category offsets $300 of capital gain net income in the 15 percent rate group from sources within the United States. Accordingly, $300 of the $500 net capital loss

is adjusted under paragraph (d)(1) of this section as follows: $300(15%/35%). Similarly, the $300 of net capital loss in the 28 percent rate group in the general limitation category offsets $300 of capital gain net income in the 28 percent rate group from sources within the United States. The $300 net capital loss is adjusted under paragraph (d)(1) of this section as follows: $300(28%/35%).

(D) Finally, under paragraph (d)(2)(iii)(B) of this section, the remaining net capital losses in a separate category rate group are netted against capital gain net income from other rate groups from sources within and outside the United States. Thus, the remaining $100 of the $500 net capital loss in the 15 percent rate group in the general limitation category offsets $100 of the remaining capital gain net income in the 28 percent rate group from sources within the United States. Accordingly, the remaining $100 of net capital loss is adjusted under paragraph (d)(1) of this section as follows: $100(28%/35%).

(iv) In computing BB’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fractions, BB must adjust net

2004–35 I.R.B. 368 August 30, 2004

capital gain by netting all of BB’s capital gains and losses, from sources within and outside the United States, and adjusting any remaining net capital gains, based on rate group, under paragraph (c)(2) of this section. BB must also include foreign source ordinary income in the numerators, and ordinary income

from all sources in the denominator, of the foreign tax credit limitation fractions. The denominator of BB’s foreign tax credit limitation fractions reflects $2,000 of ordinary income from all sources, $100 of net capital gain taxed at the 28% rate and adjusted as follows: $100(28%/35%), and $200 of net capital

gain taxed at the 25% rate and adjusted as follows: $200(25%/35%).

(v) BB’s foreign tax credit limitation fraction for the general limitation category is $8.56/$2222.86, computed as follows:

$500 - $100(15%/35%) - $300(15%/35%) - $300(28%/35%) - $100(28%/35%)

$1,000 + $500 + $500 + $100(28%/35%) + $200(25%/35%)

(vi) BB’s foreign tax credit limitation fraction for the passive category is $542.86/$2222.86, computed as follows:

$500 + $100(15%/35%)

$1,000 + $500 + $500 + $100(28%/35%) + $200(25%/35%)

Example 3. (i) CC, an individual, has the following items of ordinary income, capital gain, and capital loss for the taxable year:

	U.S. source	foreign general	source: passive
15% rate group	$300	($720)	($80)
25% rate group	$200
28% rate group	$500	($150)	$50
Ordinary income	$1,000	$1,000	$500

(ii) CC’s capital gain net income from sources outside the United States (zero, since losses exceed gains) does not exceed CC’s capital gain net income from all sources ($100). Therefore, paragraph (a)(1) of this section does not require any adjustment.

(iii) In computing CC’s taxable income from sources outside the United States in the numerators of the section 904(a) foreign tax credit limitation fractions for the passive and general limitation categories, CC must adjust capital gain net income from sources outside the United States in each separate category long-tem rate group and net capital losses from sources outside the United States in each separate category rate group as provided in paragraphs (c)(1) and (d) of this section.

(A) CC must adjust the $50 of capital gain net income in the 28 percent rate group in the passive category pursuant to paragraph (c)(1) of this section as follows: $50(28%/35%).

(B) Under paragraph (d)(2)(i) of this section, $50 of CC’s $150 net capital loss in the 28 percent rate group in the general limitation category offsets $50 of capital gain net income in the 28 percent rate group in the passive category. Thus, $50 of the $150 net capital loss is adjusted as follows: $50(28%/35%). Next, under paragraph (d)(2)(iii)(A) of this section, the remaining $100 of net capital loss in the 28 percent rate

group in the general limitation category offsets $100 of capital gain net income in the 28 percent rate group from sources within the United States. Thus, the remaining $100 of net capital loss is adjusted as follows: $100(28%/35%).

(C) Under paragraphs (d)(2)(iii)(A) and (d)(2)(iv) of this section, the net capital losses in the 15 percent rate group in the passive and general limitation categories offset on a pro rata basis the $300 of capital gain net income in the 15 percent rate group from sources within the United States. The proportionate amount of the $720 net capital loss ($720/$800 of $300, or $270) is adjusted as follows: $270(15%/35%). The proportionate amount of the $80 net capital loss ($80/$800 of $300, or $30) is adjusted as follows $30(15%/35%).

(D) Of the remaining $500 of net capital loss in the 15 percent rate group in the general limitation and passive categories, $400 offsets the remaining $400 of capital gain net income in the 28 percent rate group from sources within the United States under paragraph (d)(2)(iii)(B)( 3 ) of this section. The proportionate amount of the $720 net capital loss ($720/$800 of $400, or $360) is adjusted as follows: $360(28%/35%). The proportionate amount of the $80 net capital loss ($80/$800 of $400, or $40) is adjusted as follows: $40(28%/35%).

(E) Under paragraph (d)(2)(iii)(B)( 3 ) of this section, the remaining $100 of net capital loss in the 15 percent rate group in the general limitation and passive limitation categories offsets $100 of capital gain net income in the 25 percent rate group from sources within the United States. The proportionate amount of the $720 net capital loss ($720/$800 of $100, or $90) is adjusted as follows: $90(25%/35%). The proportionate amount of the $80 net capital loss ($80/$800 of $100 of $10) is adjusted as follows: $10(25%/35%).

(iv) In computing CC’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fractions, CC must adjust capital gain net income by netting all of CC’s capital gains and losses, from sources within and outside the United States, and adjusting any remaining net capital gains, based on rate group, under paragraph (c)(2) of this section. The denominator of CC’s foreign tax credit limitation fractions reflects $2,500 of ordinary income from all sources and $100 of net capital gain taxed at the 25% rate and adjusted as follows: $100(25%/35%).

(v) CC’s foreign tax credit limitation fraction for the general limitation category is $424.87/$2571.42, computed as follows:

$1,000 - $50 (28%/35%) - $100(28%/35%) - $270(15%/35%) - $360(28%/35%) - $90(25%/35%)

$1,000 + $1,000 + $500 + $100(25%/35%)

August 30, 2004 369 2004–35 I.R.B.

(vi) CC’s foreign tax credit limitation fraction for the passive category is $488.00/$2571.42, computed as follows:

$500 + $50(28%/35%) - $30(15%/35%) - $40(28%/35%) - $10(25%/35%)

$1,000 + $1,000 + $500 + $100(25%/35%)

Example 4 . (i) DD, an individual, has the following items of ordinary income, capital gain and capital loss for the taxable year:

	U.S. source	foreign general	source: passive
15% rate group	($80)	($100)	$300
Short-term		$500	$100
Ordinary income	$500

(ii) DD’s capital gain net income from outside the United States ($800) exceeds DD’s capital gain net income from all sources ($720). Pursuant to paragraph (a)(1)(ii)(A) of this section, DD must apportion the $80 of excess of capital gain net income from sources outside the United States between the general limitation and passive categories based on the amount of capital gain net income in each separate category. Thus, one-half ($400/$800 of $100, or $40) is apportioned to the general limitation category and one-half ($400/$800 of $80, or $40) is apportioned to the passive category. The $40 apportioned to the general limitation category reduces DD’s $500 short-term capital gain in the general limitation category to $460. Pursuant to paragraph (a)(1)(ii)(B) of this section, the $40 apportioned to the passive category must be apportioned further between the capital gain net income in the short-term rate group and the 15 percent rate group based on the relative amounts of capital gain net income in each rate group. Thus, onefourth ($100/$400 of $40 or $10) is apportioned to the short-term rate group and three-fourths ($300/$400 of $40 or $30) is apportioned to the 15 percent rate group. DD’s passive category includes $90 of short

(vii) DD’s foreign tax credit limitation fraction for the passive category is $234.29/$1151.43, computed as follows:

Example 5 . (i) EE, an individual, has the following items of ordinary income, capital gain and capital loss for the taxable year:

term capital gain and $270 of capital gain net income in the 15% rate group.

(iii) Because DD has a net long-term capital loss from sources within the United States ($80) and also has short-term capital gains, DD must apply the provisions of paragraph (c)(1)(ii) of this section to determine the amount of DD’s $270 of capital gain net income in the 15% rate group that is subject to a rate differential adjustment under paragraph (c)(1) of this section. Under Step 1, the U.S. long-term capital loss adjustment amount is $50 ($80 - $30). Under Step 2, the applicable rate differential amount is the excess of the remaining capital gain net income over the U.S. long-term adjustment amount. Thus, the applicable rate differential amount is $220 ($270 - $50). In computing DD’s taxable income from sources outside the United States in the numerator of the section 904(a) foreign tax credit limitation fraction for the passive category, DD must adjust this amount as follows: $220(15%/35). DD does not adjust the remaining $50 of capital gain net income in the 15% rate group.

(iv) The amount of capital gain net income in the 15% rate group in the passive category, taking into

$460 - $100(15%/35%)

$500 + $600 + $120(15%/35%)

$90 + $220(15%/35%) + $50

$500 + $600 + $120(15%/35%)

account the adjustment pursuant to paragraph (a)(1) of this section and disregarding the adjustment pursuant to paragraph (c)(1) of this section, is $270. Under paragraphs (d)(2)(i) and (d)(2)(v) of this section, DD’s $100 net capital loss in the 15% rate group in the general limitation category offsets capital gain net income in the 15% rate group in the passive category. Accordingly, the $100 of net capital loss is adjusted as follows: $100(15%/35%).

(v) In computing DD’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fractions, DD must adjust capital gain net income by netting all of DD’s capital gains and losses from sources within and outside the United States, and adjusting the remaining net capital gain in each rate group pursuant to paragraph (c)(2) of this section. The denominator of DD’s foreign tax credit limitation fraction reflects $500 of ordinary income from all sources, $600 of short-term capital gain and $120 of net capital gain in the 15 percent rate group adjusted as follows: $120(15%/35%).

(vi) DD’s foreign tax credit limitation fraction for the general limitation category is $417.14/$1151.43, computed as follows:

2004–35 I.R.B. 370 August 30, 2004

	U.S. source	foreign source: passive
15% rate group	($150)	$300
28% rate group		$200
Short-term	$30	$100
Ordinary income	$500

(ii) EE’s capital gain net income from sources outside the United States ($600) exceeds EE’s capital gain net income from all sources ($480). Pursuant to paragraph (a)(1)(ii) of this section, the $120 of excess capital gain net income from sources outside the United States is allocated as a reduction to the passive category and must be apportioned pro rata to each rate group within the passive category with capital gain net income. Thus, $20 ($100/$600 of $120) is apportioned to the short-term rate group, $60 ($300/$600 of $120) is apportioned to the 15 percent rate group and $40($200/$600 of $120) is apportioned to the 28 percent rate group. After application of paragraph (a)(1) of this section, EE has $80 of capital gain net income in the short-term rate group, $240 of capital gain net income in the 15 percent rate group and $160 of capital gain net income in the 28 percent rate group.

(iii) Because EE has a net long-term capital loss from sources within the United States ($150) and also has short-term capital gains, EE must apply the pro

(h) Coordination with section 904(f) —(1) In general . Section 904(b) and this section shall apply before the provisions of section 904(f) as follows:

(i) The amount of a taxpayer’s separate limitation income or loss in each separate category, the amount of overall foreign loss, and the amount of any additions to or recapture of separate limitation loss or overall foreign loss accounts pursuant to section 904(f) shall be determined after applying paragraphs (a), (c)(1), (d) and (e) of this section to adjust capital gains and losses and qualified dividend income from sources outside the United States in each separate category.

(ii) To the extent a capital loss from sources within the United States reduces a

visions of paragraph (c)(1)(ii) of this section to determine the amount of EE’s remaining $400 ($240

$160) of capital gain net income in long-term rate groups in the passive category that is subject to a rate differential adjustment. Under Step 1, the U.S. longterm capital loss adjustment amount is $50 ($150 $100). Under Step 2, EE must apportion this amount pro rata to each long-tem rate group within the passive category with capital gain net income. Thus, $30 ($240/$400 of $50) is apportioned to the 15 percent rate group and $20 ($160/$400 of $50) is apportioned to the 28 percent rate group. The applicable rate differential amount for the 15 percent rate group is $210 ($240 - $30). The applicable rate differential amount for the 28 percent rate group is $140 ($160 - $20).

(iv) Pursuant to paragraph (c)(1)(ii) of this section, EE must adjust $210 of the $240 capital gain in the 15 percent rate group as follows: $210 (15%/35%). EE does not adjust the remaining $30. Pursuant to paragraph (c)(1)(ii) of this section, EE must adjust $140 of the $160 capital gain in the 28

$80 + $210 (15%/35%) + $30 + $140 (28%/35%) + $20

$500 + $130 + $150 (15%/35%) + $200 (28%/35%)

taxpayer’s foreign source taxable income under paragraph (a)(1) of this section, such capital loss shall be disregarded in determining the amount of a taxpayer’s taxable income from sources within the United States for purposes of computing the amount of any additions to the taxpayer’s overall foreign loss accounts.

(iii) In determining the amount of a taxpayer’s loss from sources in the United States under section 904(f)(5)(D) (section 904(f)(5)(D) amount), the taxpayer shall make appropriate adjustments to capital gains and losses from sources within the United States to reflect adjustments pursuant to section 904(b)(2) and this section. Therefore, for purposes of section 904, a taxpayer’s section 904(f)(5)(D) amount

percent rate group as follows: $140 (28%/35%). EE does not adjust the remaining $20.

(v) In computing EE’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fractions, EE must adjust capital gain net income by netting all of EE’s capital gains and losses from sources within and outside the United States, and adjusting the remaining net capital gain in each rate group pursuant to paragraph (c)(2) of this section. The denominator of EE’s foreign tax credit limitation fraction reflects $500 of ordinary income from all sources, $130 of short-term capital gain, $150 of net capital gain in the 15 percent rate group adjusted as follows: $150(15%/35%), and $200 of net capital gain in the 28 percent rate group adjusted as follows: $200(28%/35%).

(vi) EE’s foreign tax credit limitation fraction for the passive category is $332/$854.29, computed as follows:

shall be equal to the excess of the taxpayer’s foreign source taxable income in all separate categories in the aggregate for the taxable year (taking into account any adjustments pursuant to paragraphs (a)(1), (c)(1), (d) and (e) of this section) over the taxpayer’s entire taxable income for the taxable year (taking into account any adjustments pursuant to paragraphs (c)(2) and (e) of this section).

(2) Examples . The following examples illustrate the application of paragraph (h) of this section:

Example 1 . (i) W, an individual, has the following items of ordinary income, capital gain, and capital loss for the taxable year:

August 30, 2004 371 2004–35 I.R.B.

	U.S. source	foreign general	source: passive
15% rate group	$500	$100	($400)
Ordinary income	$900	$100

limitation loss account for the passive category. The remaining $28.57 of the separate limitation loss reduces income from sources within the United States. See section 904(f)(5)(A). Thus, W adds $28.57 to the overall foreign loss account for the passive category.

Example 2 . (i) X, a corporation, has the following items of ordinary income, ordinary loss, capital gain and capital loss for the taxable year:

(ii) In computing W’s taxable income from sources outside the United States for purposes of section 904 and this section, W must adjust the capital gain net income and net capital loss in each separate category as provided in paragraphs (c)(1) and (d) of this section. Thus, W must adjust the $100 of capital gain net income in the general limitation category and the $400 of net capital loss in the passive category as follows: $100(15%/35%) and $400(15%/35%).

(iii) After the adjustment to W’s net capital loss in the passive category, W has a $171.43 separate limitation loss in the passive category. After the adjustment to W’s capital gain in the general limitation category, W has $142.86 of foreign source taxable income in the general limitation category. Thus, $142.86 of the separate limitation loss reduces foreign source taxable income in the general limitation category. See section 904(f)(5)(B). W adds $142.86 to the separate

	U.S. source	foreign source: general
Capital gain	($550)	$700
Ordinary income	$1100	($1000)

(ii) X’s capital gain net income from sources outside the United States ($700) exceeds X’s capital gain net income from all sources ($200). Pursuant to paragraph (a)(1) of this section, X must reduce the $700 capital gain in the general limitation category by $500. After the adjustment, X has $200 of capital gain net income remaining in the general limitation

category. Thus, X has an overall foreign loss attributable to the general limitation category of $800.

(iii) For purposes of computing the amount of the addition to X’s overall foreign loss account for the general limitation category, the $500 capital loss from sources within the United States is disregarded and X’s taxable income from sources within the United

States is $1100. Accordingly, X must increase its overall foreign loss account for the general limitation category by $800.

Example 3 . (i) Y, a corporation, has the following items of ordinary income, ordinary loss, capital gain and capital loss for the taxable year:

	U.S. source	foreign source: general
Capital gain	($100)	$200
Ordinary income	($200)	$500

(ii) Y’s capital gain net income from sources outside the United States ($200) exceeds Y’s capital gain net income from all sources ($100). Pursuant to paragraph (a)(1) of this section, Y must reduce the $200 capital gain in the passive category by $100. Y has $100 of capital gain net income remaining in the passive category.

(iii) Y is not required to make adjustments pursuant to paragraph (c), (d) or (e) of this section. See paragraphs (b) and (e) of this section. Y’s foreign

source taxable income in the passive category after the adjustment pursuant to paragraph (a)(1) of this section is $600. Y’s entire taxable income for the taxable year is $400.

(iv) Y’s section 904(f)(5)(D) amount is the excess of Y’s foreign source taxable income in all separate categories in the aggregate for the taxable year after taking into account the adjustment pursuant to paragraph (a)(1) of this section ($600) over Y’s entire taxable income for the taxable year ($400). Therefore,

Y’s section 904(f)(5)(D) amount is $200 and Y’s foreign source taxable income in the passive category is reduced to $400. See section 904(f)(5)(D).

Example 4 . (i) Z, an individual, has the following items of ordinary income, ordinary loss and capital gain for the taxable year:

	U.S. source	foreign general	source: passive
15% rate group	$100
Ordinary income	($200)	$300	$300

(ii) Z’s foreign source taxable income in all of Z’s separate categories in the aggregate for the taxable year is $600. (There are no adjustments to Z’s foreign source taxable income pursuant to paragraph (a)(1), (c)(1), (d) or (e) of this section.)

(iii) In computing Z’s entire taxable income in the denominator of the section 904(d) foreign tax credit limitation fractions, Z must adjust the $100 of net capital gain in the 15 percent rate group pursuant to paragraph (c)(2) of this section as follows:

$100(15%/35%). Thus, Z’s entire taxable income for the taxable year, taking into account the adjustment pursuant to paragraph (c)(2) of this section, is $442.86.

(iv) Z’s section 904(f)(5)(D) amount is the excess of Z’s foreign source taxable income in all separate categories in the aggregate for the taxable year ($600) over Z’s entire taxable income for the taxable year after the adjustment pursuant to paragraph (c)(2) of this section ($442.86). Therefore, Z’s sec

tion 904(f)(5)(D) amount is $157.32. This amount must be allocated pro rata to the passive and general limitation categories in accordance with section 904(f)(5)(D). Example 5 . (i) O, an individual, has the following items of ordinary income, ordinary loss and capital gain for the taxable year:

2004–35 I.R.B. 372 August 30, 2004

	U.S. source	foreign general	source: passive
15% rate group	$1100	($500)
Ordinary income	($1000)	$1000	$500

(2) Carryovers to and from other years determined without regard to election years . The amount of the foreign taxes paid or accrued, and the amount of the foreign source taxable income, in any year for which the taxpayer elects to apply section 904(j) shall not be taken into account in determining the amount of any carryover to or from any other taxable year. However, an election to apply section 904(j) to any year does not extend the number of taxable years to which unused foreign taxes may be carried under section 904(c) and §1.904–2(b). Therefore, in determining the number of such carryover years, the taxpayer must take into account years to which a section 904(j) election applies.

(3) Determination of amount of cred- itable foreign taxes . Otherwise allowable carryovers of foreign tax credits from other taxable years shall not be taken into account in determining whether the amount of creditable foreign taxes paid or accrued by an individual during a taxable year exceeds $300 ($600 in the case of a joint return) for purposes of section 904(j)(2)(B).

Example 1 . In 2006, X, a single individual using the cash basis method of accounting for income and foreign tax credits, pays $100 of foreign taxes with respect to general limitation income that was earned and included in income for United States tax purposes in 2005. The foreign taxes would be creditable under section 901 but are not shown on a payee statement furnished to X. X’s only income for 2006 from sources outside the United States is qualified passive income, with respect to which X pays $200 of creditable foreign taxes shown on a payee statement. X may not elect to apply section 904(j) for 2006 because some of X’s foreign taxes are not creditable foreign taxes within the meaning of section 904(j)(3)(B).

Example 2 . (i) In 2009, A, a single individual using the cash basis method of accounting for income and foreign tax credits, pays creditable foreign taxes of $250 attributable to passive income. Under section 904(c), A may also carry forward to 2009 $100 of unused foreign taxes paid in 2005 with respect to passive income, $300 of unused foreign taxes paid in 2005 with respect to general limitation income, $400 of unused foreign taxes paid in 2006 with respect to passive income, and $200 of unused foreign taxes paid in 2006 with respect to general limitation income. In 2009, A’s only foreign source income is passive income described in section 904(j)(3)(A)(i), and this income is reported to A on a payee state

(ii) In determining O’s taxable income from sources outside the United States, O must reduce the $500 capital loss in the general limitation category to $214.29 ($500 x 15%/35%) pursuant to paragraph (d) of this section. Taking this adjustment into account, O’s foreign source taxable income in all of O’s separate categories in the aggregate is $1285.71 ($1000 - $214.29 + $500).

(iii) In computing O’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fraction, O must reduce the $600 of net capital gain for the year to $257.14 ($600 x 15%/35%) pursuant to paragraph (c)(2) of this section. Taking this adjustment into account, O’s entire taxable income for the year is $757.14 ($500

$257.14).

(iv) Therefore, O’s section 904(f)(5)(D) amount is $528.57 ($1285.71 - $757.14). This amount must be allocated pro rata to O’s $500 of income in the passive category and O’s $785.71 of adjusted income in the general limitation category in accordance with section 904(f)(5)(D).

(i) Effective date . This section shall apply to taxable years beginning after July 20, 2004. Taxpayers may choose to apply this section and §1.904(b)–2 to taxable years ending after July 20, 2004.

Par. 7. Section 1.904(b)–2 is revised to read as follows:

§1.904(b)–2 Special rules for application of section 904(b) to alternative minimum tax foreign tax credit.

(a) Application of section 904(b)(2)(B) adjustments . Section 904(b)(2)(B) shall apply for purposes of determining the alternative minimum tax foreign tax credit under section 59 (regardless of whether or not the taxpayer has made an election under section 59(a)(4)).

(b) Use of alternative minimum tax rates —(1) Taxpayers other than corpora- tions . In the case of a taxpayer other than a corporation, for purposes of determining the alternative minimum tax foreign tax credit under section 59—

(i) Section 904(b)(3)(D)(i) shall be applied by using the language “section 55(b)(3)” instead of “subsection (h) of section 1”;

(ii) Section 904(b)(3)(E)(ii)(I) shall be applied by using the language “section 55(b)(1)(A)(i)” instead of “subsection (a),

(b), (c), (d), or (e) of section 1 (whichever applies)”; and

(iii) Section 904(b)(3)(E)(iii)(I) shall be applied by using the language “the alternative rate of tax determined under section 55(b)(3)” instead of “the alternative rate of tax determined under section 1(h)”.

(2) Corporate taxpayers . In the case of a corporation, for purposes of determining the alternative minimum tax foreign tax credit under section 59, section 904(b)(3)(E)(ii)(II) shall be applied by using the language “section 55(b)(1)(B)” instead of “section 11(b)”.

(c) Effective date . This section shall apply to taxable years beginning after July 20, 2004. See §1.904(b)–1(i) for a rule permitting taxpayers to choose to apply §1.904(b)–1(i) and this §1.904(b)–2 to taxable years ending after July 20, 2004.

§§1.904(b)–3 and 1.904(b)–4 [Removed]

Par. 8. Sections 1.904(b)–3 and 1.904(b)–4 are removed. Par. 9. Section 1.904(j)–1 is added to read as follows:

§1.904(j)–1 Certain individuals exempt from foreign tax credit limitation.

(a) Election available only if all foreign taxes are creditable foreign taxes . A taxpayer may elect to apply section 904(j) for a taxable year only if all of the taxes for which a credit is allowable to the taxpayer under section 901 for the taxable year (without regard to carryovers) are creditable foreign taxes (as defined in section 904(j)(3)(B)). (b) Coordination with carryover rules —(1) No carryovers to or from elec- tion year . If the taxpayer elects to apply section 904(j) for any taxable year, then no taxes paid or accrued by the taxpayer during such taxable year may be deemed paid or accrued under section 904(c) in any other taxable year, and no taxes paid or accrued in any other taxable year may be deemed paid or accrued under section 904(c) in such taxable year.

August 30, 2004 373 2004–35 I.R.B.

ment (within the meaning of section 6724(d)(2)). If A elects to apply section 904(j) for the 2009 taxable year, the unused foreign taxes paid in 2005 and 2006 are not deemed paid in 2009, and A therefore cannot claim a foreign tax credit for those taxes in 2009.

(ii) In 2010, A again is eligible for and elects the application of section 904(j). The carryforwards from 2005 expire in 2010. The carryforward period established under section 904(c) is not extended by A’s election under section 904(j). In 2011, A does not elect the application of section 904(j). The $600 of unused foreign taxes paid in 2006 on passive and general limitation income are deemed paid in 2011, under section 904(c), without any adjustment for any portion of those taxes that might have been used as a foreign tax credit in 2009 or 2010 if A had not elected to apply section 904(j) to those years.

(d) Effective date . Section 1.904(j)–1 applies to taxable years beginning after July 20, 2004.

Par. 10. Section 1.954–2 is amended by:

Revising paragraph (b)(2)(iv), Ex- ample 2 .
Removing paragraph (b)(2)(iv), Ex- ample 3 .

The revision reads as follows:

§1.954–2 Foreign personal holding company income.

- - - (b) - * (2) - * (iv) - * Example 2 . (i) DS, a domestic corporation, wholly owns two controlled foreign corporations organized in Country A, CFC1 and CFC2. CFC1 purchases from DS property that DS manufactures in the United States. CFC1 uses the purchased property as a component part of property that CFC1 manufactures in Country A within the meaning of §1.954–3(a)(4). CFC2 provides loans described in section 864(d)(6) to unrelated persons in Country A for the purchase of the property that CFC1 manufactures in Country A.

(ii) The interest accrued from the loans by CFC2 is not export financing interest as defined in section 904(d)(2)(G) because the property sold by CFC1 is not manufactured in the United States under §1.927(a)–1T(c). No portion of the interest is export financing interest as defined in this paragraph (b)(2). The full amount of the interest is, therefore, included in foreign personal holding company income under paragraph (b)(1)(ii) of this section.

Mark E. Matthews, Deputy Commissioner for Services and Enforcement .

Approved June 16, 2004.

Gregory F. Jenner, Acting Assistant Secretary for Tax Policy .

(Filed by the Office of the Federal Register on July 19, 2004, 8:45 a.m., and published in the issue of the Federal Register for July 20, 2004, 69 F.R. 43304)

Section 954.—Foreign Base Company Income

Final regulations provide guidance on the exclusion of certain export financing interest from foreign personal holding company income. See T.D. 9141, page 359.

2004–35 I.R.B. 374 August 30, 2004