SECTION 7. LIMITATION ON — Internal Revenue Bulletin 2005-36

REDUCTION IN TAXABLE INCOME BELOW AMOUNT OF NONDEDUCTIBLE CFC DIVIDENDS PURSUANT TO SECTION 965(e)(2)

.01 In General

Under section 965(e)(2)(A), taxable income for the election year cannot be less than the amount of nondeductible CFC dividends received during such year. In addition, section 965(e)(2)(B)(i) provides that nondeductible CFC dividends are not taken into account under section 172 in determining the amount of any NOL for the election year. Accordingly, if deductible expenses and losses for the election year (including the DRD allowed under section 965(a) but not including expenses for which section 965(d)(2) disallows a deduction) exceed the taxpayer’s gross income exclusive of the amount of nondeductible CFC dividends, taxable income will be equal to the amount of nondeductible CFC dividends, and the excess deductions will constitute an NOL for the taxable year. If, determined without regard to section 965(e)(2)(A), taxable income for the election year would be less than the amount of nondeductible CFC dividends received during such year, the excess of the deductions allocated and apportioned to a separate category over the amount of gross income in the separate category exclusive of the nondeductible CFC dividends will constitute a separate limitation loss with respect to that separate category for the election year. Such separate limitation loss is allocated in accordance with section 904(f) and section 8 of this notice.

Section 965(e)(2)(B)(ii) provides that nondeductible CFC dividends are not taken into account in determining taxable income for the election year for purposes of the second sentence of section 172(b)(2), which applies in determining the allowable NOL carryover or carryback to other years. Therefore, the amount of the allowable NOL deduction that is absorbed in the election year is limited to the excess of taxable income over the amount of nondeductible CFC dividends. However, taxable income attributable to nondeductible CFC dividends is taken into account in determining the source and allocation of NOL deductions taken into

September 6, 2005 480 2005–36 I.R.B.

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 taxable income of $15 and a net operating loss of ($15) for the election year.

Example 3. Taxable income limitation; U.S. loss and foreign source income . (i) Facts . The facts are the same as in Example 2, except that instead of $1,000 of U.S. source gross income USP has $400 of U.S. source gross income and $600 of foreign source passive gross 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), foreign source passive income of $600, and U.S. source loss of ($100) ($400 - $500).

Example 4. Net operating loss absorption . (i) Facts . Before taking into account the NOL deduction or applying section 904(f) in the election year, USP has $100 of general limitation taxable income, all attributable to nondeductible CFC dividends, $200 of passive limitation taxable income, and a $100 NOL from prior years, all attributable to general limitation income.

(ii) Result . Because USP’s available NOL ($100) does not exceed the amount of taxable income exclusive of nondeductible CFC dividends for the election year ($200), the taxable income limitation of section 965(e)(2)(A) does not apply to limit USP’s NOL deduction for the election year. Under section 965(e)(2)(B)(ii) and section 7.01 of this notice, USP’s $100 of nondeductible CFC dividends is not taken into account in determining the amount of USP’s allowable NOL deduction absorbed in the election year, but is taken into account in determining the source and allocation of NOL deductions absorbed in the election year. Accordingly, under paragraph (1)(b)(ii) of Notice 89–3, the $100 general limitation NOL deduction reduces USP’s $100 of general limitation income to zero. After allocation of the NOL deduction but before application of section 904(f), USP has $200 of passive limitation taxable income and no general limitation or passive limitation nondeductible CFC dividends in the election year.

Example 5. Net operating loss limitation . (i) Facts . Before taking into account the NOL deduction or applying section 904(f), USP has $500 of general limitation foreign source taxable income, including $15 of nondeductible CFC dividends, $500 of passive

limitation foreign source taxable income, and $1,000 of U.S. source taxable income for the election year. USP also has a net operating loss carryover of $2,000, consisting of $1,000 of U.S. loss, $600 of general limitation loss, and $400 of passive limitation loss.

(ii) Result . Under section 965(e)(2)(A), the amount of USP’s NOL deduction absorbed in the election year is limited to $1,985, the amount of USP’s taxable income exclusive of nondeductible CFC dividends. Under paragraph (1)(b)(i) of Notice 89–3, the $1,000 U.S. loss component of the NOL carryover is absorbed first, and $985 of the NOL carryover is available to offset foreign source income. Under paragraph (1)(b)(ii) of Notice 89–3, separate limitation losses that are part of the NOL carryover are tentatively carried over to the extent of separate limitation income in the same category. Pursuant to section 965(e)(2)(B)(ii) and section 7.01 of this notice, the $15 of nondeductible CFC dividends is not taken into account in determining the amount of the allowable NOL deduction absorbed in the election year, but is taken into account in determining the amount of general limitation income available to be absorbed by the allowable NOL. Accordingly, $500 of the $600 general limitation component of the NOL and $400 of the passive limitation component of the NOL are tentatively carried over to the election year, eliminating the $500 of general limitation income (including the $15 of nondeductible CFC dividends) and $400 of the $500 of passive income.

Under paragraph (1)(b)(iii) of Notice 89–3, a proportionate part of the remaining loss from each separate limitation category is next carried over, to the extent of the remaining NOL carryover amount of $85, and allocated in accordance with section 904(f)(5). Accordingly, an additional $85 of the general limitation component of the NOL is carried over to the election year and allocated to passive income in accordance with section 904(f)(5). At the conclusion of these steps, USP has $15 of passive income in the election year and a remaining NOL carryover to other years of ($15), all attributable to general limitation loss.

.03 Other Deduction Limitations

For purposes of applying other Code provisions that contain limitations based on the amount of the taxpayer’s gross income or taxable income for the taxable year, gross income includes qualifying dividends, and taxable income includes nondeductible CFC dividends.

.04 Examples

The following examples illustrate the application of section 7.03 of this notice.

Example 1. No taxable income limitation under section 965(e)(2)(A) . (i) Facts . Before calculating its allowable charitable contribution deduction under section 170, USP has the following items of gross income and expense for the election year: $1,000 of foreign source general limitation gross income, including $200 of qualifying dividends, $500 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 $170 DRD allowed under section 965(a) and $20 of expenses relating to nondeductible CFC dividends, $1,000 of U.S. source gross income, and $500 of deductible expenses allocated and apportioned to U.S. source income. Under section 7.01 of this notice, without regard to the charitable deduction USP has $500 of general limitation taxable income, including $30 of nondeductible CFC dividends, and $500 of U.S. source taxable income for the election year.

(ii) Result . Section 170(b)(2), which limits a corporation’s charitable contribution deduction to 10 percent of taxable income computed without regard to section 170 and certain other provisions not relevant on these facts, limits USP’s allowable deduction to $100, 10 percent of USP’s taxable income of $1,000 for the election year. If USP claims the $100 deduction, USP has $900 of taxable income for the election year.

Example 2. Section 965(e)(2)(A) taxable income limitation . (i) Facts . Before calculating its allowable charitable contribution deduction under section 170, USP has the following items of gross income and expense for the election year: $1,000 of foreign source general limitation gross income, including $200 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 $170 DRD allowed under section 965(a) and $20 of expenses relating to nondeductible CFC dividends. Under section 965(e)(2)(A) and section 7.01 of this notice, without regard to the charitable contribution deduction, USP’s current year deductions are limited to $970 and USP has $30 of general limitation taxable income, all attributable to nondeductible CFC dividends. Under section 965(e)(2)(B)(i) and section 7.01 of this notice, USP has a general limitation loss of $30 that constitutes a net operating loss of $30 for the election year.

(ii) Result . Section 170(b)(2), which limits a corporation’s charitable contribution deduction to 10 percent of taxable income computed without regard to section 170 and certain other provisions not relevant on these facts, limits USP’s allowable deduction to $3, 10 percent of USP’s taxable income of $30 for the election year. If USP claims the $3 deduction, USP has $30 of taxable income and a $33 NOL for the election year.

.05 No Other Limits on Use of Deductions to Reduce Taxable Income

Section 965(e)(2) limits the use of deductions to reduce taxable income below the amount of nondeductible CFC dividends, but does not restrict the use of deductions to offset income in excess of the amount of nondeductible CFC dividends. Therefore, deductions may offset income in excess of the amount of nondeductible CFC dividends, including income attributable to the section 78 gross-up that is required with respect to foreign taxes

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recharacterization of income operates to recapture the prior year separate limitation loss or overall foreign loss. See section 904(f)(1), section 904(f)(5)(C), and Notice 89–3. Separate limitation losses and overall foreign losses may be recaptured in the election year out of income in any separate category with separate limitation income, including income attributable to nondeductible CFC dividends, whether or not the taxable income limitation of section 965(e)(2)(A) applies in the election year.

Separate limitation losses and overall foreign losses with respect to a separate category that includes nondeductible CFC dividends will be considered recaptured first out of other income in the separate category before any income attributable to nondeductible CFC dividends is recharacterized. See Example 5 in section 8.05 of this notice. If nondeductible CFC dividends are recharacterized as U.S. source income or income in a different separate category, the recharacterized income is not treated as nondeductible CFC dividends. See Examples 6 and 7 in section 8.05 of this notice.

.04 Treatment of Foreign Taxes Imposed with Respect to Nondeductible CFC Dividends

The recharacterization of income under the overall foreign loss or separate limitation loss recapture rules does not result in the recharacterization of any tax. Section 904(f)(5)(C). Accordingly, foreign tax attributable to nondeductible CFC dividends in a separate category remains in that separate category even if the income attributable to the nondeductible CFC dividends is recharacterized. See section 9.02 of this notice for rules relating to the application of section 965(e)(1) to foreign taxes attributable to nondeductible CFC dividends when a portion of nondeductible CFC dividends is recharacterized under section 904(f) and this section 8.

.05 Examples

The following examples illustrate the application of the rules of section 904(f) and this section 8.

Example 1. No taxable income limitation; allo- cation of separate limitation loss . (i) Facts . After the allocation and apportionment of expenses but before the application of section 904(f), USP has the following items of taxable income for the election year:

deemed paid with respect to nondeductible CFC dividends.