SECTION 7. REDUCTION OF

BENEFIT FOR INCREASES IN RELATED PARTY INDEBTEDNESS

.01 Background

(a) General . Section 965(b)(3) provides that a U.S. shareholder reduces the amount of dividends otherwise eligible for the deduction under section 965(a) by any increase in the indebtedness of its CFC to any related person (as defined in section 954(d)(3)) between October 3, 2004, and the close of the taxable year for which the election under section 965 is in effect. For purposes of section 965(b)(3), all CFCs with respect to which the taxpayer is a U.S. shareholder are treated as a single CFC.

(b) Definitions . For purposes of section 965(b)(3) and this section 7, the following definitions apply:

(i) The term “CFC” means all CFCs with respect to which the taxpayer is a U.S. shareholder, treating such CFCs as a single CFC pursuant to section 965(b)(3).

(ii) The term “individual CFC” is used to refer to a single CFC (for example, to identify a single CFC that is acquired or disposed of by a consolidated group U.S. shareholder).

(iii) The term “U.S. shareholder” as used in this section 7 is defined in section 951(b). (iv) The term “related person” means a person that is related to a CFC within the meaning of section 954(d)(3).

(v) The term “related party indebtedness” means the amount of indebtedness of a CFC to a related person. However, indebtedness between individual CFCs of a U.S. shareholder is disregarded for purposes of section 965(b)(3).

(vi) The term “initial measurement date” means the close of October 3, 2004 or, if the U.S. shareholder so chooses, an alternative date which is provided as a matter of administrative convenience for taxpayers and the IRS. The alternative date is either: (i) the close of September 30, 2004, if such shareholder used a calendar year or a fiscal year as its taxable year; or (2) the close of the last day of such shareholder’s fiscal-year month ending nearest October 3, 2004, if such shareholder used a 52–53 week taxable year. However, the U.S. shareholder uses the same date as its initial measurement date for all purposes of section 965.

(vii) The term “last measurement date” means the close of a U.S. shareholder’s taxable year for which an election is in effect.

.02 Definition of Indebtedness

(a) In general . Except as provided in this section, for purposes of section 965(b)(3), “indebtedness” is defined under general Federal income tax principles. Further, the amount of indebtedness of a CFC to any related person pursuant to section 965(b)(3) is not reduced or otherwise offset by indebtedness of any related person to the CFC. Thus, for example, if on the initial measurement date or the last measurement date, there is $100x of indebtedness of a CFC to its U.S. shareholder, and $10x of indebtedness from such U.S. shareholder to the CFC, the amount of indebtedness under section 965(b)(3)(A) as of such date is $100x (and not $90x).

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otherwise eligible for the section 965(a) DRD in the order that those dividends are received. If such dividends are received by more than one U.S. shareholder on the same day, each U.S. shareholder takes into account the remaining amount of the increase in related party indebtedness of such CFC based on the relative amount of cash dividends received on such day. The overall reduction in dividends of all U.S. shareholders eligible for the section 965(a) DRD under this rule may not exceed the total increase in related party indebtedness under section 965(b)(3). See Examples 8 and 9 of section 7.08 of this notice.

.07 Translation of Foreign Currency-Denominated Related Party Indebtedness

The initial measurement date RPI and the last measurement date RPI of a U.S. shareholder is determined in U.S. dollars. The amount of any indebtedness on both the initial measurement date and the last measurement date is translated into U.S. dollars using the spot rate (as defined in Treas. Reg. §1.988–1(d)(1)) on the initial measurement date. See Example 7 of section 7.08 of this notice.

.08 Examples

The following examples illustrate the application of section 965(b)(3) and this section 7. Unless otherwise indicated, the following facts are assumed for purposes of these examples. USP, a domestic corporation and the common parent of the USP consolidated group that uses the calendar year as its taxable year, wholly owns US1. US1 is a domestic corporation and a member of the USP consolidated group. US1 wholly owns CFC1, a foreign corporation that owes US1 $100x at the close of September 30, 2004, evidenced by a note ($100x note). USP wholly owns CFC2, a foreign corporation with no indebtedness owed to persons described in section 954(d)(3). The USP group chooses September 30, 2004, as its initial measurement date and it elects to apply section 965 to its 2005 calendar year tax year.

Example 1 . Determination of the amount of initial measurement date RPI . (i) Facts . The general facts apply.

(ii) Result . US1 and USP are each U.S. shareholders with respect to CFC1 and CFC2 and are considered one U.S. shareholder for purposes of section 965(b)(3). Further, CFC1 and CFC2 are considered

section 965(b)(3) attributable to the same CFC indebtedness, such shareholders take into account such indebtedness under the rules of 7.06 of this section.

(b) Indirect Financing of Cash Div- idend by a U.S. Shareholder . Section 965(b)(3) is intended to prevent a U.S. shareholder from directly or indirectly financing a cash dividend qualifying under section 965(a). In addition to the application of the related party indebtedness rule under section 965(b)(3), general tax law principles such as the substance-over-form doctrine and circular cash-flow principles may apply to various financing structures. However, a related party guarantee of CFC indebtedness is not considered to be an indirect financing of a cash dividend for purposes of section 965(b)(3), provided that the CFC is treated as the obligor on the indebtedness for Federal income tax purposes. See Plantation Patterns, Inc. v. Comm’r, 462 F.2d 712 (5 ^th Cir. 1972), cert. denied, 409 U.S. 1076 (1972).

.05 Amount of Related Party Indebtedness on the Initial Measurement Date and the Last Measurement Date

(a) Initial Measurement Date RPI General Rule . A U.S. shareholder determines the amount of the related party indebtedness of its CFC on the initial measurement date and such amount is the “initial measurement date RPI” of such U.S. shareholder. The amount of the initial measurement date RPI is adjusted pursuant to section 7.05(c) of this notice in certain instances. See Example 1 of section 7.08 of this notice.

(b) Last Measurement Date RPI General Rule . A U.S. shareholder determines the amount of the related party indebtedness of its CFC on the last measurement date and such amount is the “last measurement date RPI” of such U.S. shareholder. Thus, to the extent that a CFC pays all or a portion of the principal on the related party indebtedness before the last measurement date and does not incur any new related party indebtedness before such date, the U.S. shareholder’s last measurement date RPI will be less than its initial measurement date RPI. See Examples 4 and 6 of section 7.08 of this notice.

(c) Special Adjustments to Initial Mea- surement Date RPI . A U.S. shareholder

reduces its initial measurement date RPI to the extent the U.S. shareholder’s initial measurement date RPI is attributable to any individual CFC with respect to which such shareholder ceases to be a U.S. shareholder or a related person as the result of a transaction before the last measurement date. However, the prior sentence does not apply to the extent, before or as a result of such transaction, all or a portion of the principal on the indebtedness is paid by the debtor (for example, as a result of the liquidation of an individual CFC).

A domestic corporation that becomes a U.S. shareholder and a related person with respect to an individual CFC after such corporation’s initial measurement date, but before the last day of its election year (or a U.S. shareholder that files a separate return for its short taxable year immediately after a transaction during the same period), and that remains a U.S. shareholder and a related person with respect to such individual CFC on its last measurement date, increases its initial measurement date RPI by the amount of related party indebtedness of such individual CFC immediately after the transaction, excluding any indebtedness arising in connection with or as a result of the transaction (for example, as a result of the incorporation of a branch). See Examples 3, 4, and 10 of section 7.08 of this notice.

If two or more U.S. shareholders may otherwise be considered to have an amount that is considered under section 965(b)(3) attributable to the same CFC indebtedness, such shareholders take into account such indebtedness under the rules of section 7.06 of this notice.

.06 Related Party Indebtedness — Multiple U.S. Shareholders

An increase in a CFC’s related party indebtedness may not reduce the total amount of dividends otherwise eligible for the section 965(a) DRD on anything but a dollar-for-dollar basis. Consequently, if more than one U.S. shareholder is a related person with respect to a CFC, then the effect of the increase in the related party indebtedness of the CFC pursuant to section 965(b)(3) is allocated among and between such U.S. shareholders. For this purpose, such increase is allocated on a dollar-for-dollar basis to cash dividends received by such U.S. shareholders that are

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one CFC for purposes of section 965(b)(3). The USP group’s CFC (CFC1 and CFC2) has indebtedness of $100x owed to the USP group (and directly to US1 as a member of that group), a related party. Therefore, the USP group has initial measurement date RPI of $100x.

Example 2 . Determination of initial and last mea- surement date RPI when CFC transferred or sold . (i) Facts . On December 31, 2004, US1 sells all the stock of CFC1 and the $100x note to USB, an unrelated U.S. corporation that is the common parent of a consolidated group. Immediately after the transaction, CFC1 owes $100x to USB. USB makes an election under section 965 for its calendar year ending December 31, 2005. As of USB’s last measurement date, it is a U.S. shareholder and related person with respect to CFC1.

(ii) Result . Under section 965(b)(3) all CFCs of a U.S. shareholder are treated as one CFC. Moreover, for purposes of section 965(b)(3), all U.S. shareholders that are members of a consolidated group are considered one U.S. shareholder. Therefore, CFC1 and CFC2 are considered one CFC and US1 and USP are considered one U.S. shareholder (the USP group). Only the relationship between CFC1, CFC2 and the USP group is taken into account for purposes of determining the initial measurement date RPI of the USP group, while only the relationship between CFC1 and USB is taken into account for purposes of determining the last measurement date RPI of the USB group.

As of the initial measurement date the USP group’s CFC (CFC1 and CFC2) owes $100x to related parties. Therefore, under section 7.05(a), and without regard to the disposition of CFC1, the USP group’s initial measurement date RPI is $100x. Under section 7.05(c), however, the USP group reduces its initial measurement date RPI to account for the disposition of CFC1. Therefore, the USP group’s initial measurement date RPI is $0. As of the last measurement date, CFC1 is not related to the USP group. Accordingly, the USP group’s last measurement date RPI is $0.

With respect to the USB group, CFC1 is not related to the USB group on the USB group’s initial measurement date. Therefore, the USB group’s initial measurement date RPI, without consideration of the acquisition of CFC1 is $0. Under section 7.05(c), however, the USB group increases its initial measurement date RPI by $100x, the amount of the CFC1’s related party indebtedness immediately after the acquisition. Therefore, the USB group has initial measurement date RPI of $100x. Further, as of its last measurement date, CFC1 owes USB, a related party, $100x. Therefore, the USB group’s last measurement date RPI is $100x.

(iii) Alternative facts . The facts are the same as in (i), except that USB does not purchase the $100x note due from CFC1. Under section 7.05(c), the USP group reduces its initial measurement date RPI from $100x to $0, to account for the disposition of CFC1 (the same result reached in (ii)). Under section 7.05, the USP group’s last measurement date RPI is $0 (the same result reached in (ii)). Under the alternative facts, however, the USB group does not adjust its initial measurement date RPI to take into account the acquisition of CFC1 because immediately after the acquisition CFC1 will owe an indebtedness to US1, which is not a related person. As a result, the USB group has an initial measurement date RPI of $0. Fur

ther, the USB group has a last measurement date RPI of $0.

(iv) Alternative facts . The facts are the same as in (i) except that CFC1 liquidates (whether by reason of an actual liquidation or by reason of an election under Treas. Reg. §301.7701–3) into US1 instead of being sold to USB. Under section 7.05(c), the USP group does not decrease its initial measurement date RPI to account for the liquidation. Consequently, the USP group’s initial measurement date RPI is $100x. Under section 7.05(b), the USP group’s last measurement date RPI is $0.

Example 3 . Determination of initial and last mea- surement date RPI when a U.S. shareholder is trans- ferred to an unrelated person . (i) Facts . The facts are the same as in Example 1, except that on December 31, 2004, all the stock of US1 (and indirectly CFC1), is sold to an unrelated U.S. shareholder, USB. US1 joins the USB consolidated group and USB makes an election under section 965 for the taxable year ending December 31, 2005. As of its last measurement date, USB is a U.S. shareholder and related person with respect to CFC1.

(ii) Result . Without regard to the disposition of US1, the USP group’s initial measurement date RPI is $100x. Under section 7.05(c), the USP group’s initial measurement date RPI is decreased by $100x, resulting in the USP group having initial measurement date RPI of $0.

USP computes its last measurement date RPI under section 7.05(b) of this notice. As of the last measurement date, CFC1 owes an indebtedness to US1, a party that is not related within the meaning of section 954(d)(3) to USP. Therefore, the USP group’s last measurement date RPI is $0.

Without regard to the acquisition of US1, the USB group’s initial measurement date RPI is $0. However, under section 7.05(c), the USB group increases its initial measurement date RPI by $100x, the amount of the related party indebtedness of its CFC (CFC1) immediately after the transaction. Further, the USB group’s last measurement date RPI is $100x because as of its last measurement date, CFC1 owed $100x to US1, a related person.

(iii) Alternative facts . Assume that the stock of US1 is sold to USB on March 31, 2005, which is during the USP group’s and the USB group’s election year. The results are the same as set forth in (ii), above.

Example 4 . Determination of initial and last mea- surement date RPI when a new CFC is formed . (i) Facts . The facts are the same as in Example 1, except that USP incorporates CFC2 on November 1, 2004, and during the USP election year USP acquires all the stock of USB (and indirectly all of USB’s individual CFCs), an unrelated U.S. shareholder. Further, USB is a member of the USP consolidated group on the last day of the USP election year. In part, CFC2 is capitalized with $100x of related party indebtedness and USP is a U.S. shareholder and a related person with respect to CFC2 on its last measurement date. USB has initial measurement date RPI of $400x, attributable to its CFCs. Immediately after the acquisition, USB’s CFCs continue to have indebtedness owed to USB in the amount of $400x.

(ii) Result . Without regard to the acquisition of USB or the formation of CFC2, under section 7.05(a), the USP group has initial measurement date RPI of $100x. Under section 7.05(c), the USP group in

creases its initial measurement date RPI by the related party indebtedness of the USB CFCs immediately after the transaction. Note, however, that no adjustment is made to the USP group’s initial measurement date RPI to account for CFC2’s related party indebtedness under section 7.05(c). Thus, after adjustment, the USP group’s initial measurement date RPI is $500x. Under section 7.05(b), the USP group’s last measurement date RPI is $600x, which includes the indebtedness of CFC1 ($100x), CFC2 ($100x), and the acquired CFCs of USB ($400x).

(iii) Alternative facts . The facts are the same as in Example 6 (i), except that CFC1 pays US1 $70x of the $100x indebtedness on November 1, 2005. The USP group’s initial measurement date RPI is $500, the same as in (ii). Under section 7.05(b), the USP group’s last measurement date RPI is $530x, which includes the indebtedness of CFC1 ($30x), CFC2 ($100x), and the acquired CFCs of USB ($400x). Under section 7.04 of this notice and section 965(b)(3), USP group reduces its dividends otherwise eligible for the section 965(a) DRD by $30x.

Example 5 . Determination of initial and last mea- surement date RPI when a U.S. shareholder and its CFC are transferred but the note due from the CFC is left behind . (i) Facts . The facts are the same as in Example 1, except that all the stock of US1 (and indirectly CFC1) is sold to an unrelated U.S. shareholder, USB, on December 31, 2004, before USP group’s election year ending December 31, 2005. Assume that CFC1’s related party indebtedness on the initial measurement date ($100x) was the result of the indebtedness being owed to USP instead of US1. US1 is a member of the USB group on the USB group’s last measurement date.

(ii) Result . Without regard to acquisitions and dispositions, the USP group has initial measurement date RPI of $100x. Because USP was a U.S. shareholder and a related person with respect to CFC1 on the USP group’s initial measurement date, but is not a U.S. shareholder or a related person on its last measurement date, section 7.05(c) requires the USP group to reduce its initial measurement date RPI from $100x to $0.

On the USP group’s last measurement date, CFC1 is not a related person. Therefore, the USP group’s last measurement date RPI is $0.

USB has initial measurement date RPI of $0, without regard to the acquisition of US1 (and CFC1). No adjustment is made to this amount under section 7.05(c) because immediately after the acquisition CFC1 owed an indebtedness to USP, an unrelated party. Further, the USB group’s last measurement date RPI is $0 because its CFC (CFC1) does not have an indebtedness to a related party on the last measurement date.

Example 6 . Determination of initial and last mea- surement date RPI when a U.S. shareholder is trans- ferred without the debtor CFC . (i) Facts . The facts are the same as in Example 1, except that on December 31, 2004, before the USP group’s election year, US1 distributed CFC1 to USP, and then US1 was sold to USB. In addition, CFC1’s related party indebtedness on the USP group’s initial measurement date was owed to USP instead of US1. Finally, USB has initial measurement date RPI of $0.

(ii) Result . Without regard to the distribution of CFC1 or the disposition of US1, the USP group

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has initial measurement date RPI of $100x. No adjustment is made under section 7.05(c) to the USP group’s initial measurement date RPI as a result of the distribution of CFC1 because after the distribution the USP group is a U.S. shareholder and related person with respect to CFC1. Further, under section 7.05(c), the sale of US1 does not require the USP group to reduce its initial measurement date RPI because after the disposition USP is still a U.S. shareholder and related person with respect to CFC1. Therefore, USP has initial measurement date RPI of $100x. The USP group’s last measurement date RPI is also $100x because on the last measurement date CFC1’s indebtedness is owed to USP, a related party.

USB acquires US1, but US1 has no CFCs when it enters the USB consolidated group. Therefore, under section 7.05(c), the USB consolidated group does not increase its initial measurement date RPI. In addition, USB’s last measurement date RPI is $0.

(iii) Alternative facts . The facts are the same as in (i), except that the CFC1 indebtedness is owed to US1. Under the alternative facts, the USP group would still have initial measurement date RPI in the amount of $100x. No adjustment is made to this amount under section 7.05(c) because on the USP group’s initial measurement date and last measurement date the USP group was a U.S. shareholder and a related person with respect to CFC1. However, as of the last measurement date, CFC1 will owe an indebtedness to US1, an unrelated party. Therefore, the USP group’s last measurement date RPI is $0. The results with respect to the USB group are the same as set forth in (ii).

Example 7 . Translating RPI denominated in a non-U.S. dollar currency . (i) Facts . CFC1’s indebtedness to US1 is denominated in currency u. As of the close of September 30, 2004 (the initial measurement date), CFC1 owed 100u to US1. As of the close of December 31, 2005, CFC1 continued to owe 100u to US1. As of September 30, 2004, the spot rate is 1u/$1. As of December 31, 2005, the spot rate is 1u/$1.5. (ii) Result . Pursuant to section 7.05 of this notice, the indebtedness of CFC1 to US1 on the initial measurement date and the last measurement date is converted into U.S. dollars on the spot rate on the initial measurement date. As a result, the indebtedness of CFC1 to US1 on both dates is $100x.

Example 8 . U.S. shareholder not related to CFC (i) Facts . FP, a foreign corporation, wholly owns US1, a domestic corporation. US1 owns 60% of CFC. US2, a domestic corporation that is unrelated to FP or US1, owns the remaining 40% of CFC. As of the initial measurement date of US1 and US2, CFC has related party indebtedness in the amount of $100x that is owed to FP.

(ii) Result . US1 is a related person with respect to CFC on its initial measurement date. As a result, US1 takes into account the related party indebtedness of CFC for purposes of section 965(b)(3). Because US2 is not a related person with respect to CFC, the $100x of related party indebtedness is not taken into account by US2 for purposes of section 965(b)(3).

Example 9 . Application of Section 965(b)(3) re- duction to multiple U.S. shareholders (i) Facts . USP is a domestic corporation and the common parent of a consolidated group. USP wholly owns US1, a domestic corporation that is not a member of the USP group because an election under section 936 is in ef

fect with respect to US1. USP and US1 wholly own CFC1 and CFC2, respectively. The USP group and US1 both maintain a calendar taxable year and elect to apply section 965 to the taxable year ending December 31, 2005. USP receives a cash dividend of $200x from CFC1 on February 1, 2005. US1 receives a cash dividend from CFC2 of $300x on March 1, 2005. Both cash dividends received by USP and US1 during 2005 are otherwise eligible for the deduction under section 965(a). There is a $300x increase in CFC1’s related party indebtedness pursuant to section 965(b)(3). CFC2 does not have related party indebtedness at any time.

(ii) Result . Under section 965(d)(3), the USP group and US1 are both U.S. shareholders and related persons with respect to CFC1. Thus, both the USP group and US1 are required to take into account CFC1’s increase in related party indebtedness. Based upon the rules set forth in section 7.06, above, CFC1’s $300x increase in related party indebtedness reduces the amount of the USP group’s and US1’s dividends eligible for the deduction under section 965(a) based on the earliest cash dividends eligible for the section 965(a) DRD received by the USP group and US1 during the election year. As a result, the USP group takes into account $200x of the $300x increase in RPI because it received a cash dividend of $200x on February 1, 2005. US1 takes into account the remaining $100x of such increase because it received its cash dividend on March 1, 2005.

(iii) Alternative Facts . The facts are the same as Example 2, except that USP and US1 received the cash dividends from CFC1 and CFC2, respectively, on the same day during the election year. Under section 7.06, the USP group and US1 take into account the $300x increase in RPI attributable to CFC1 in proportion to their receipt of cash dividends on such date. Thus, the USP group takes into account $120x of the increase (($200x/($200x + $300x)) x $300x). US1 takes into account the remaining $180x of the increase (($300x/($200x + $300x)) x $300x).

Example 10 . Determination of initial and last measurement date RPI when related party indebted- ness arises in connection with or as a result of a trans- action . (i) Facts . The facts are the same as in Exam- ple 3, except that in connection with or as a result of USB’s purchase of the stock of US1 (and indirectly CFC1), US1 lends CFC1 $50x.

(ii) Result . With respect to the USP group, the initial measurement date RPI and the last measurement date RPI are the same as in Example 3 . The USB group’s initial measurement date RPI and last measurement RPI are affected. Without regard to the acquisition of US1, the USB group’s initial measurement date RPI is $0. However, under section 7.05(c), the USB group increases its initial measurement date RPI by $100x, the amount of the related party indebtedness of its CFC (CFC1) immediately after the transaction, but excluding the indebtedness arising in connection with, or as a result of, the transaction. The USB group’s last measurement date RPI, however, is $150x because as of its last measurement date, CFC1 owes $150x to US1, a related person. Therefore, under section 7.04 of this notice and section 965(b)(3), the USB group reduces its dividends otherwise eligible for the section 965(a) DRD by $50x.