SECTION 6. ALLOCATION AND

APPORTIONMENT OF EXPENSES TO SEPARATE CATEGORIES WITH QUALIFYING DIVIDENDS

.01 No New Separate Category

Section 965 does not provide for qualifying dividends to be assigned to a special separate category or otherwise modify the generally applicable look-through rules of section 904(d)(3) for determining the separate category to which dividends and subpart F inclusions from CFCs are assigned. For purposes of allocating expenses on the basis of assets in the election year, stock of CFCs paying qualifying dividends is characterized under the generally applicable rules of Treas. Reg. §1.861–12T(c)(3).

.02 Treatment of CFC Stock and Qualifying Dividends under Section 864(e)

The first sentence of section 864(e)(3) (section 864(e)(3)(A) for transactions before January 1, 2005) provides that, for purposes of allocating and apportioning any deductible expense, any tax-exempt asset (and any income from such an asset) shall not be taken into account. The second sentence of section 864(e)(3) provides that a similar rule applies in the case of the portion of certain dividends equal to the deduction allowable under section 243 or 245(a) with respect to such dividend, and in the case of a like portion of

any stock the dividends on which would be so deductible. A qualifying dividend is not exempt income, and the CFC stock on which qualifying dividends are paid is not an exempt asset, within the meaning of the first sentence of section 864(e)(3). In addition, the similar rule in the second sentence of section 864(e)(3) does not apply to qualifying dividends or the CFC stock on which qualifying dividends are paid, since no deduction is allowed under section 243 or 245 for any dividend for which a deduction is allowed under section 965. Section 965(c)(4). Accordingly, gross income attributable to a qualifying dividend is not considered exempt income, and no portion of the stock of a CFC paying a qualifying dividend is considered an exempt asset, for purposes of allocating and apportioning interest and other expenses in the election year.

.03 Expenses Allocated and Apportioned to Separate Categories that Include Qualifying Dividends

Section 965 does not modify the generally applicable rules of sections 861 through 865 and the regulations thereunder for allocating and apportioning expenses and losses to separate categories described in section 904(d)(1) and Treas. Reg. §1.904–5(m) (separate categories) that include nondeductible CFC dividends. However, the amount of nondeductible CFC dividends in a separate category must be determined for purposes of applying the limitations on the allowable foreign tax credit for the election year under section 904 and section 965(e)(1) and related computations under sections 53 and 55. See sections 7, 8, and 9 of this notice. For this purpose, expenses that are allocated and apportioned to a separate category that includes qualifying dividends will be considered to reduce other foreign source gross income in the separate category before reducing foreign source income attributable to nondeductible CFC dividends. Except as provided in section 7.01 of this notice (relating to the taxable income limitation of section 965(e)(2)(A)), if expenses and other deductions properly allocated and apportioned to foreign source gross income in a separate category exceed the amount of foreign source gross income exclusive of nondeductible CFC dividends in that separate category,

2005–36 I.R.B. 479 September 6, 2005

account in the election year under paragraph 1 of Notice 89–3, 1989–1 C.B. 623.

.02 Examples

The following examples illustrate the application of section 965(e)(2) and this section 7.

Example 1. Taxable income limitation; one in- come category . (i) Facts . USP has the following items of gross income and expense for the election year: $1,000 of foreign source general limitation gross income, including $100 of qualifying dividends, and $1,000 of deductible expenses allocated and apportioned to general limitation income (computed after the disallowance of expenses directly allocable to the deductible portion of the qualifying dividends), including the $85 DRD allowed under section 965(a) and $20 of expenses relating to nondeductible CFC dividends.

(ii) Result . Under section 965(e)(2)(A), USP’s taxable income for the election year cannot be less than $15, the amount of nondeductible CFC dividends received during such year. Because taxable income computed without regard to section 965(e)(2)(A) ($0) is less than the amount of nondeductible CFC dividends ($15), under section 7.01 of this notice the $1,000 of general limitation expenses reduce general limitation income only to the extent of $985 ($1,000 - $15), the excess of general limitation gross income over general limitation nondeductible CFC dividends. Accordingly, USP has $15 of general limitation taxable income, all attributable to nondeductible CFC dividends.

Under section 965(e)(2)(B)(i), the amount of USP’s NOL for the election year is computed without regard to the $15 of nondeductible CFC dividends. Accordingly, USP has general limitation taxable income of $15 and a general limitation loss of ($15) that constitutes a net operating loss of ($15) for the election year.

Example 2. Taxable income limitation; U.S. and foreign source income . (i) Facts . The facts are the same as in Example 1, except that USP has $1,500 rather than $1,000 of deductible expenses allocated and apportioned to general limitation income, and also has $1,000 of U.S. source gross income and $500 of deductible expenses allocated and apportioned to U.S. source income.

(ii) Result . Under section 965(e)(2)(A), USP’s taxable income for the election year cannot be less than $15, the amount of nondeductible CFC dividends received during such year. Because taxable income computed without regard to section 965(e)(2)(A) ($0) is less than the amount of nondeductible CFC dividends ($15), under section 7.01 of this notice the $1,500 of general limitation expenses reduce general limitation income only to the extent of $985 ($1,000 - $15), the excess of general limitation gross income over general limitation nondeductible CFC dividends, and the $515 ($1,500 - $985) excess of general limitation deductions over that amount constitutes a separate limitation loss. Accordingly, prior to the application of section 904(f) USP has $15 of general limitation taxable income, all attributable to nondeductible CFC dividends, a general limitation separate limitation loss of ($515), and U.S. source taxable income of $500 ($1,000 - $500).

income, of which $150 is attributable to nondeductible CFC dividends, and $200 of U.S. source taxable income.

Example 2. Nondeductible CFC dividends exceed separate limitation income; nondeductible CFC divi- dends reduced . (i) Facts . The facts are the same as in Example 1, except that USP has an additional $100 of deductible expenses allocated and apportioned to general limitation income. Accordingly, USP has $300 of taxable income and $150 of nondeductible CFC dividends in the election year, and the taxable income limitation of section 965(e)(2)(A) does not apply.

(ii) Result . Under section 6.03 of this notice, general limitation expenses reduce nondeductible CFC dividends after reducing other general limitation income. Accordingly, USP has $100 of foreign source general limitation income, all attributable to nondeductible CFC dividends, and $200 of U.S. source taxable income.

Example 3. Nondeductible CFC dividends ex- ceed separate limitation income; separate limitation loss with U.S. source taxable income . (i) Facts . The facts are the same as in Example 1, except that USP has an additional $250 of deductible expenses allocated and apportioned to general limitation income. Accordingly, USP has $150 of taxable income and $150 of nondeductible CFC dividends in the election year, and the taxable income limitation of section 965(e)(2)(A) does not apply. (ii) Result . Under section 6.03 of this notice, general limitation expenses reduce nondeductible CFC dividends after reducing other general limitation income, and the excess deductions constitute a separate limitation loss. Accordingly, prior to the application of section 904(f) USP has a ($50) foreign source general limitation separate limitation loss, no general limitation nondeductible CFC dividends, and $200 of U.S. source taxable income.

Example 4. Nondeductible CFC dividends ex- ceed separate limitation income; separate limitation loss with U.S. and foreign source taxable income . (i) Facts . The facts are the same as in Example 3, except that instead of $300 of U.S. source gross income USP has $200 of U.S. source gross income and $100 of foreign source passive gross income. Accordingly, USP has $150 of taxable income and $150 of nondeductible CFC dividends in the election year, and the taxable income limitation of section 965(e)(2)(A) does not apply.

(ii) Result . Under section 6.03 of this notice, general limitation expenses reduce nondeductible CFC dividends after reducing other general limitation income, and the excess deductions constitute a separate limitation loss. Accordingly, prior to the application of section 904(f) USP has a ($50) foreign source general limitation separate limitation loss, no general limitation nondeductible CFC dividends, $100 of foreign source passive taxable income, no passive limitation nondeductible CFC dividends, and $100 of U.S. source taxable income.