SECTION 4. DISALLOWANCE OF

CREDIT OR DEDUCTION FOR FOREIGN TAXES ON DEDUCTIBLE PORTION OF QUALIFYING DIVIDENDS

.01 Identification of Foreign Income Taxes Paid or Accrued with Respect to the Deductible Portion of Qualifying Dividends

Under section 965(d)(1), no credit or deduction is allowed for foreign taxes described in section 901 that are paid or accrued (or treated as paid or accrued) with respect to the deductible portion of each qualifying dividend, including distributions of PTI that are treated as cash dividends under section 965(a)(2). This disallowance applies to 85 percent of the U.S. dollar amount of (1) foreign taxes paid or accrued by the U.S. shareholder with respect to the qualifying dividend (including the U.S. shareholder’s distributive share of foreign taxes that are paid or accrued by a partnership with respect to the dividend and that are properly allocated to the U.S. shareholder-partner under the rules of sections 702 and 704 and the regulations thereunder and separately stated to the partner under Treas. Reg. §1.702–1(a)(6)); (2) foreign taxes deemed paid under section 902 with respect to a qualifying dividend described in section 965(a)(1); and (3) foreign taxes deemed paid under section 960, including taxes described in section 960(a)(3), with respect to a subpart F inclusion resulting from a CFC-to-CFC dividend and the associated PTI distribution described in section 965(a)(2).

Section 965 does not modify the computation of foreign taxes deemed paid under sections 902 and 960. As a result, for purposes of section 902 the post-1986 undistributed earnings, post-1986 foreign income taxes, pre-1987 accumulated profits, pre-1987 foreign income taxes, and previously-taxed earnings and profits and

tax accounts of CFCs paying qualifying dividends are reduced by the full amount of earnings distributed and the full amount of foreign taxes attributable to the distributed earnings, without regard to the amount of the DRD or the amount of foreign tax for which section 965(d)(1) disallows a credit or deduction.

.02 Section 78 Gross-Up

Under section 78, an amount equal to the taxes deemed paid under section 902(a) or section 960(a)(1) by a domestic corporation generally is included in income as a dividend if the domestic corporation chooses the benefits of the foreign tax credit for the taxable year. Section 78 does not apply to any tax which is not allowable as a credit under section 901 by reason of section 965(d). See also section 9.01 of Notice 2005–38.

.03 Examples

The following examples illustrate the application of section 965(d)(1) and this section 4. Unless otherwise indicated, the following facts are assumed for purposes of these examples. All corporations use calendar taxable years for U.S. tax purposes. USP is a domestic corporation that elects to apply section 965 to its 2005 taxable year and meets all applicable requirements to claim the section 965(a) DRD with respect to the qualifying dividends described in the examples. All the earnings and profits and creditable foreign taxes of each CFC constitute general limitation post-1986 undistributed earnings and general limitation post-1986 foreign income taxes, and no exceptions apply to prevent USP from including in income its pro rata share of any CFC’s subpart F income in the election year. Except as specifically provided, a CFC has no other items of gross income or expense for the election year, has no previously-taxed earnings and profits described in section 959(c)(1) or (2), and makes no distributions in the election year.

Example 1. Qualifying dividend under section 965(a)(1) from first-tier CFC . (i) Facts . USP owns all the stock of CFC1, a foreign corporation that uses the “u” as its functional currency. On June 30, 2005, CFC1 pays a cash dividend of 80u, equal to $100 translated at the spot rate on that date of 0.8u = $1, out of its post-1986 undistributed earnings to USP. The dividend is subject to a 10 percent withholding tax of 8u = $10, so USP receives cash of $90. USP

has a base period amount of $0 and its total amount of qualifying dividends is $100. As of the close of 2005, computed without regard to the June 30 distribution to USP, CFC1 has post-1986 undistributed earnings of 800u and post-1986 foreign income taxes of $200.

(ii) Result . Under section 902(a), $20 ((80u/800u) x $200) of foreign income taxes are deemed paid by USP with respect to the $100 dividend from CFC1. Subject to other applicable limitations, USP may claim a foreign tax credit or deduction for $1.50 (15 percent of the $10 withholding tax), and may also claim a credit for $3 (15 percent of the $20 of deemed-paid taxes). Under section 965(d)(1), no credit or deduction is allowed for the remaining $8.50 of withholding tax or $17 of deemed-paid tax, which represent the taxes paid or deemed paid with respect to the 85 percent deductible portion of the $100 dividend. USP includes $100 in gross income and claims an $85 DRD under section 965(a) with respect to the qualifying dividend of $100 described in section 965(a)(1). If USP elects to credit foreign taxes in 2005, USP also includes $3 in income under section 78. No gross-up is required under section 78 for the $17 of deemed-paid tax which is not allowed as a credit. CFC1’s post-1986 undistributed earnings and post-1986 foreign income taxes are reduced by the full amount of earnings distributed and foreign taxes deemed paid in 2005, without regard to the amount of the DRD under section 965(a) or the disallowance under section 965(d)(1) of a credit for taxes deemed paid with respect to the deductible portion of the qualifying dividend. Accordingly, CFC1’s post-1986 undistributed earnings and post-1986 foreign income taxes, computed as of January 1, 2006, are 720u (800u - 80u) and $180 ($200 - $20), respectively.

Example 2. Qualifying dividend under section 965(a)(1) from first-tier CFC to disregarded entity . (i) Facts . USP is the sole owner of DE, a disregarded entity organized in Country X. DE owns all the stock of CFC1, which is incorporated in Country Y. Each of DE and CFC1 uses the U.S. dollar as its functional currency. On June 30, 2005, CFC1 pays a cash dividend of $135 to DE, with respect to which USP is deemed under section 902(a) to pay $20 of foreign income tax paid by CFC1. DE pays Country Y withholding tax of $20 and Country X net income tax of $15 with respect to the dividend from CFC1. Also on June 30, 2005, DE distributes $135 to USP. The distribution from DE is not subject to Country X withholding tax. USP has a base period amount of $0 and qualifying dividends of $135.

(ii) Result . USP is entitled to a DRD of $114.75 (.85 x $135) under section 965(a) with respect to the $135 dividend paid by CFC1 to DE and distributed in cash to USP in 2005. Subject to other applicable limitations, USP may claim a foreign tax credit or deduction for $5.25 (15 percent of the $35 of foreign tax paid by DE), and may also claim a credit for $3 (15 percent of the $20 of foreign taxes paid by CFC1 that are deemed paid by USP with respect to the dividend paid by CFC1). If USP elects to credit foreign taxes in 2005, USP includes $3 in income under section 78. No gross-up is required under section 78 for the $17 of deemed-paid tax which is not allowed as a credit. Under section 965(d)(1), no credit or deduction is allowed for the remaining $29.75 of tax paid under section 901 or $17 of tax deemed paid under section 902, which represent the taxes paid or deemed

September 6, 2005 476 2005–36 I.R.B.

paid with respect to the 85 percent deductible portion of the $135 qualifying dividend. CFC1’s post-1986 undistributed earnings and post-1986 foreign income taxes, computed as of January 1, 2006, are reduced by $135 and $20, respectively.

Example 3. Qualifying dividend under section 965(a)(2) attributable to dividend from second-tier CFC, subpart F inclusion, and PTI distribution from first-tier CFC to USP . (i) Facts . USP owns all the stock of CFC1, which owns all the stock of CFC2. CFC1 is incorporated in Country X, and CFC2 is incorporated in Country Y. Each of CFC1 and CFC2 uses the U.S. dollar as its functional currency. On June 30, 2005, CFC2 pays a cash dividend of $135 to CFC1. CFC1 pays Country Y withholding tax of $20 and Country X net income tax of $15 with respect to the dividend from CFC2. CFC1 has no other items of income or expense in 2005, so its subpart F income and earnings and profits for 2005 are $100, all attributable to the dividend from CFC2, and USP includes $100 in income under section 951(a)(1)(A) with respect to CFC1 for 2005. Also on June 30, 2005, CFC1 distributes $100 of cash to USP. The PTI distribution is subject to Country X withholding tax of $10. As of the close of 2005, including taxes paid and deemed paid under section 902(b) by CFC1 with respect to the distribution from CFC2 but before accounting for the effect of the subpart F inclusion or distribution to USP, CFC1 has post-1986 undistributed earnings of $1,000 and post-1986 foreign income taxes of $200. USP has a base period amount of $0 and qualifying dividends of $100.

(ii) Result . Under sections 960(a)(1) and 902(a), $20 (($100/$1,000) x $200) of foreign income taxes are deemed paid by USP with respect to the $100 subpart F inclusion attributable to CFC1. Under section 965(a)(2), the cash distribution of PTI from CFC1 is a qualifying dividend to the extent of $100, the amount USP included in income under section 951(a)(1)(A) in 2005 as a result of the cash dividend paid from CFC2 to CFC1 in 2005. USP is entitled to a DRD of $85 under section 965(a) with respect to the $100 subpart F inclusion and associated PTI distribution. Subject to other applicable limitations, USP may claim a foreign tax credit or deduction for 15 percent of the $10 withholding tax, or $1.50, and may claim a credit for 15 percent of the $20 of deemed-paid taxes, or $3. If USP elects to credit foreign taxes in 2005, USP includes $3 in income under section 78. No gross-up is required under section 78 for the $17 of deemed-paid tax which is not allowed as a credit. Under section 965(d)(1), no credit or deduction is allowed for the remaining $8.50 of withholding tax or $17 of deemed-paid tax, which represent the taxes paid or deemed paid with respect to the 85 percent deductible portion of the $100 qualifying dividend. CFC1’s post-1986 undistributed earnings and post-1986 foreign income taxes, computed as of January 1, 2006, are $900 ($1,000 - $100) and $180 ($200 - $20), respectively.

Example 4. Qualifying dividend under section 965(a)(2) attributable to multiple dividends from sec- ond-tier CFCs, subpart F inclusion, and distribution from first-tier CFC to USP . (i) Facts . USP owns all the stock of CFC1, which owns all the stock of CFC2 and CFC3. CFC1, CFC2, and CFC3 are organized under the laws of different foreign countries, and each uses the “u” as its functional currency. In 2005, CFC2 and CFC3 each pays an 80u cash divi

dend to CFC1 that is subpart F income of CFC1 under sections 952(a) and 954(c)(1)(A) that results in an income inclusion to USP under section 951(a)(1)(A). Under section 902(b)(1), CFC1 is deemed to pay foreign taxes of $8 with respect to the 80u dividend from CFC2, and CFC1 is deemed to pay foreign taxes of $40 with respect to the 80u dividend from CFC3.

Also in 2005, CFC1 makes two distributions of 80u, totaling 160u, to USP, all of which constitutes previously-taxed earnings and profits of CFC1 described in section 959(c)(2). The first 80u distribution has a value of $100 at the 0.8u = $1 spot exchange rate on the date of distribution, and the second 80u distribution has a value of $80 at the 1u = $1 spot exchange rate on the date of distribution. Under section 3.04 of this notice, USP’s subpart F inclusion attributable to CFC1’s 160u of foreign personal holding company income attributable to cash dividends paid by CFC2 and CFC3 is translated into dollars at the spot rate on the dates an equivalent amount of cash is distributed to USP, rather than at the average exchange rate for the year. Accordingly, USP includes $180 ($100 + $80) in income under section 951(a)(1)(A), and neither of the 80u PTI distributions results in exchange gain or loss under section 986(c). USP’s total cash dividends are $180. USP has a base period amount of $80 and qualifying dividends of $100.

As of the close of 2005, taking into account the dividends received from CFC2 and CFC3 and the associated deemed-paid taxes but before giving effect to the subpart F inclusion to USP, CFC1 has post-1986 undistributed earnings of 1,600u and post-1986 foreign income taxes of $400.

(ii) Result . Under sections 960(a)(1) and 902(a), $40 ((160u/1,600u) x $400) of foreign income taxes are deemed paid by USP with respect to the 160u subpart F inclusion attributable to CFC1. Of this amount, $20 is attributable to the first cash dividend of 80u = $100, and $20 is attributable to the second cash dividend of 80u = $80. If USP identifies the first distribution in its entirety as the qualifying dividend, USP is entitled to a DRD of $85 under section 965(a) with respect to the $100 subpart F inclusion and associated PTI distribution. Subject to other applicable limitations, USP may claim a foreign tax credit for $23, equal to the sum of $3 (.15 x $20) of deemed-paid taxes attributable to the qualifying dividend and $20 of deemed-paid taxes attributable to the remaining $80 of the subpart F inclusion. If USP elects to credit foreign taxes in 2005, USP includes $23 in income under section 78. Under section 965(d)(1), no credit is allowed for the remaining $17 of deemed-paid taxes, which are attributable to the 85 percent deductible portion of the $100 qualifying dividend. No gross-up is required under section 78 for the $17 of deemed-paid tax which is not allowed as a credit.

If, instead, USP identifies $20 of the $100 first cash dividend and the entire $80 of the second cash dividend as the qualifying dividends, USP is entitled to a DRD of $17 (.85 x $20) with respect to the first qualifying dividend and $68 (.85 x $80) with respect to the second qualifying dividend, for a total DRD of $85. Subject to other applicable limitations, USP may claim a foreign tax credit for $19.60, equal to the sum of $0.60 (.15 x ($20/$100) x $20) of deemed-paid taxes attributable to the $20 qualifying dividend, $16 (($80/$100) x $20) of deemed-paid

taxes attributable to the remaining $80 of the subpart F inclusion associated with the first cash dividend, and $3 (.15 x $20) of deemed-paid taxes attributable to the $80 qualifying dividend. If USP elects to credit foreign taxes in 2005, USP includes $19.60 in income under section 78. Under section 965(d)(1), no credit is allowed for the remaining $20.40 ($3.40 + $17) of deemed-paid taxes, which are attributable to the 85 percent deductible portion of the $20 and $80 qualifying dividends. No gross-up is required under section 78 for the $20.40 of deemed-paid tax which is not allowed as a credit.

Because under sections 960(a)(1) and 902(a) USP’s foreign taxes deemed paid with respect to the subpart F inclusion underlying the qualifying dividends described in section 965(a)(2) are computed on the basis of CFC1’s year-end post-1986 undistributed earnings and post-1986 foreign income taxes, a ratable portion of CFC1’s post-1986 foreign income taxes, and not the specific taxes associated with the underlying dividends from CFC2 and CFC3, are considered attributable to the qualifying dividends.

Example 5. Qualifying dividend under section 965(a)(2) attributable to dividend from third-tier CFC, subpart F inclusion from second-tier CFC, and distribution through first-tier CFC to USP . (i) Facts . USP owns all the stock of CFC1, which owns all the stock of CFC2, which owns all the stock of CFC3. CFC1 is incorporated in Country X, CFC2 is incorporated in Country Y, and CFC3 is incorporated in Country Z. Each of CFC1, CFC2, and CFC3 uses the U.S. dollar as its functional currency. On June 30, 2005, CFC3 pays a dividend of $150 to CFC2. CFC2 pays Country Z withholding tax of $20 and Country Y net income tax of $15 with respect to the dividend from CFC3. CFC2 has no other items of income or expense in 2005, so its subpart F income and earnings and profits for 2005 are $115, all attributable to the dividend from CFC3, and USP includes $115 in income under section 951(a)(1)(A) with respect to CFC2 for 2005. Also on June 30, 2005, CFC2 distributes $115 of cash to CFC1 that is PTI excluded from CFC1’s gross income under section 959(b). The distribution is subject to $10 of Country Y withholding tax and $5 of Country X income tax in the hands of CFC1, which are taxes on PTI excluded from CFC1’s post-1986 foreign income taxes and accounted for under section 960(a)(3). Later in 2005, CFC1 distributes $100 of PTI to USP. USP pays $10 of withholding tax to Country X with respect to the $100 PTI distribution, receiving cash of $90. As of the close of 2005, including taxes paid and deemed paid under section 902(b) by CFC2 with respect to the distribution from CFC3 but before accounting for the effect of the subpart F inclusion or distribution to CFC1, CFC2 has post-1986 undistributed earnings of $1,150 and post-1986 foreign income taxes of $200. USP has a base period amount of $0.

(ii) Result . Under sections 960(a)(1) and 902(a), $20 (($115/$1,150) x $200) of foreign income taxes paid by CFC2 are deemed paid by USP with respect to the $115 subpart F inclusion attributable to CFC2. Under section 960(a)(3), $15 of foreign taxes ($10 of withholding tax and $5 of income tax) paid by CFC1 with respect to the $115 distribution of PTI from CFC2 are deemed paid by USP with respect to the $100 of remaining PTI distributed from CFC1 to USP. However, under section 965(a)(2), the $100 PTI distribution from CFC1 is a cash dividend and, there

2005–36 I.R.B. 477 September 6, 2005

fore, a qualifying dividend only to the extent of $100, the lesser of the amount USP included in income under section 951(a)(1)(A) in 2005 as a result of the cash dividend paid from CFC3 to CFC2 in 2005 ($115) or the amount of the PTI distribution from CFC1 to USP ($100). The amount of foreign taxes deemed paid under section 960(a)(1) with respect to the $100 section 965(a)(2) dividend is $17.39 (($100/$115) x $20), and the amount of foreign taxes deemed paid under section 960(a)(3) with respect to the $100 PTI distribution is $15.

USP is entitled to a DRD of $85 under section 965(a) with respect to $100 of the $115 subpart F inclusion and associated PTI distribution. Subject to other applicable limitations, USP may claim a foreign tax credit or deduction for $1.50 (15 percent of the $10 withholding tax imposed on the $100 PTI distribution), and may claim a credit for $2.61 (15 percent of the $17.39 of taxes deemed paid under section 960(a)(1) with respect to the $100 qualifying portion of the subpart F inclusion from CFC2), plus $2.25 (15 percent of the $15 of tax deemed paid under section 960(a)(3) with respect to the $100 PTI distribution). USP may also claim a credit for the $2.61 of foreign tax deemed paid under section 960(a)(1) with respect to the $15 of USP’s subpart F inclusion that does not result in a qualifying dividend. If USP elects to credit foreign taxes in 2005, USP includes $5.22 in income under section 78 with respect to the $2.61 of foreign tax deemed paid under section 902 with respect to the $15 nondeductible CFC dividend and the $2.61 of foreign tax deemed paid under section 960(a)(1) with respect to the $15 of USP’s subpart F inclusion that does not result in a qualifying dividend. No gross-up is required under section 78 with respect to the $2.25 of taxes deemed paid under section 960(a)(3), equal to 15 percent of the $15 of the taxes paid by CFC1 on the $115 PTI distribution from CFC2, which was included in USP’s income under section 951(a)(1)(A). Under section 965(d)(1), no credit or deduction is allowed for the remaining $8.50 of withholding tax, $14.78 of tax deemed paid under section 960(a)(1), or $12.75 of tax deemed paid under section 960(a)(3), which represent the taxes paid or deemed paid with respect to the 85 percent deductible portion of the $100 qualifying dividend. No gross-up is required under section 78 for the $14.78 of tax deemed paid under section 960(a)(1) which is not allowed as a credit or for any portion of the taxes deemed paid under section 960(a)(3). CFC2’s post-1986 undistributed earnings and post-1986 foreign income taxes, computed as of January 1, 2006, are $1,035 ($1,150 - $115) and $180 ($200 - $20), respectively.

Example 6. Qualifying dividend under section 965(a)(2) attributable to dividend from third-tier CFC, subpart F inclusion from second-tier CFC, distribution through first-tier CFC to USP, and addi- tional PTI distribution . (i) Facts . The facts are the same as Example 5, except that CFC1 distributes an additional $15 of PTI described in section 959(c)(2) to USP in the election year, subject to Country X withholding tax of $1.50. The additional $15 of PTI is attributable to subpart F income of CFC1 that was included in USP’s income in a year prior to the election year.

(ii) Result . The additional $15 of PTI distributed is a cash dividend that is eligible to be treated as a qualifying dividend described in section 965(a)(2)

because during the election year USP included $115 in income under section 951(a)(1)(A) attributable to the cash dividend paid from CFC3 to CFC2, and CFC2 made cash distributions described in section 959(b) of $115 to CFC1. USP may identify the additional $15 PTI distribution as a qualifying dividend and claim an 85 percent DRD of $12.75 with respect to the remaining $15 of the subpart F inclusion resulting from the dividend paid by CFC3 to CFC2. The amount of foreign taxes deemed paid under section 960(a)(1) with respect to the $115 of section 965(a)(2) dividends is $20 (($115/$115) x $20), and the amount of foreign taxes deemed paid under section 960(a)(3) with respect to the $115 of PTI distributions is $15 ($15 of foreign taxes paid by CFC1 with respect to the $115 distribution of PTI from CFC2). Subject to other applicable limitations, USP may claim a foreign tax credit or deduction for $1.73 (15 percent of the $11.50 withholding tax imposed on the $115 PTI distribution), and may claim a credit for $3 (15 percent of the $20 of taxes deemed paid under section 960(a)(1) with respect to the $115 subpart F inclusion from CFC2), plus $2.25 (15 percent of the $15 of tax deemed paid under section 960(a)(3) with respect to the $115 PTI distribution). If USP elects to credit foreign taxes in 2005, USP includes $3 in income under section 78. Under section 965(d)(1), no credit or deduction is allowed for the remaining $9.77 of withholding tax, $17 of tax deemed paid under section 960(a)(1), or $12.75 of tax deemed paid under section 960(a)(3), which represent the taxes paid or deemed paid with respect to the 85 percent deductible portion of the $115 qualifying dividend. No gross-up is required under section 78 for the $17 of tax deemed paid under section 960(a)(1) which is not allowed as a credit or for any portion of the taxes deemed paid under section 960(a)(3). The adjustments to CFC2’s post-1986 undistributed earnings and post-1986 foreign income taxes are the same as in Example 5 .