SECTION 8. OVERALL FOREIGN

LOSS AND SEPARATE LIMITATION LOSS RULES

.01 In General

Section 965 does not modify the operation of the overall foreign loss and separate limitation loss allocation and recapture rules or the U.S. loss allocation rules of section 904(f). Accordingly, except in situations where the taxable income limitation of section 965(e)(2)(A) applies, as provided in paragraph .02 of this section, section 904(f) may operate to reduce amounts of foreign source income, which may include nondeductible CFC dividends in a separate category, or recharacterize such amount as U.S. source income or foreign source income in a different separate category for purposes of applying the limitations on the allowable foreign tax credit under sections 904(d) and 965(e)(1).

The amount of taxable income and the amount of the allowable NOL deduction for the election year are determined prior to the application of section 904(f). Therefore, the amount of the section 965(a) DRD, the amount of foreign taxes and expenses for which a credit or deduction is disallowed under section 965(d), the amount of taxable income determined under section 965(e)(2)(A), and the allowable NOL deduction determined under section 965(e)(2)(B) are not affected if nondeductible CFC dividends are reduced or recharacterized as U.S. source income or foreign source income in another separate category pursuant to section 904(f).

.02 Loss Allocation

To the extent a separate limitation loss or U.S. loss is allocated under section 904(f)(5)(B) or 904(f)(5)(D) to reduce foreign source taxable income in a separate category that includes nondeductible CFC dividends, such loss will be considered first to reduce other foreign source income in the separate category before foreign source income attributable to nondeductible CFC dividends is reduced. Even if nondeductible CFC dividends are reduced as a result of a separate limitation loss or U.S. loss allocation, income in a

later year in the separate category that is recharacterized under section 904(f)(5)(C) or section 904(f)(1) as income in the loss category or as U.S. source income, as the case may be, will not be considered nondeductible CFC dividends.

If the taxable income limitation of section 965(e)(2)(A) applies in the election year, taxable income equals the amount of nondeductible CFC dividends. In this case, after the allocation and apportionment of expenses and the determination and allocation of the allowable NOL deduction for the election year described in sections 6 and 7 of this notice, but prior to the application of section 904(f), a taxpayer may have separate limitation income attributable to nondeductible CFC dividends with or without a separate limitation loss in the same separate category, and may have separate limitation income or separate limitation losses in other separate categories as well as U.S. source taxable income or loss. Because separate limitation losses and U.S. losses in the aggregate may not reduce the sum of separate limitation income and U.S. source income below the amount of nondeductible CFC dividends in the election year, the excess of such losses over the amount of such income exclusive of the amount of nondeductible CFC dividends will constitute a net operating loss for the election year. For purposes of determining which losses are absorbed in the election year and which losses make up the net operating loss in the election year if the taxable income limitation of section 965(e)(2)(A) applies, separate limitation losses and U.S. losses are allocated under section 904(f)(5)(B) and (D) without regard to nondeductible CFC dividends. See Examples 3 and 4 in section 8.05 of this notice.

.03 Loss Recapture

After separate limitation losses for the taxable year are allocated to reduce separate limitation income in other separate categories, any remaining separate limitation income may be recharacterized as income in another separate category or as U.S. source income, if the taxpayer had separate limitation losses in that same separate category in a prior taxable year that were allocated to reduce separate limitation income in that other separate category or U.S. source income. This

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$100 of general limitation income, all attributable to nondeductible CFC dividends, ($100) of passive limitation loss, and $200 of U.S. source taxable income.

(ii) Result . Because USP’s taxable income in the election year ($200) exceeds the amount of nondeductible CFC dividends ($100), the taxable income limitation of section 965(e)(2)(A) does not apply. Under section 904(f)(5)(B), paragraph (2) of Notice 89–3, and section 8.02 of this notice, USP’s $100 passive limitation loss is allocated to reduce the $100 of general limitation income to zero. After allocation of the separate limitation loss, USP has no general limitation or passive income, no general limitation or passive limitation nondeductible CFC dividends, and $200 of U.S. source taxable income. USP has a passive limitation loss recapture account of $100 with respect to general limitation income.

Example 2. Taxable income limitation; allocation of separate limitation loss . (i) Facts . The facts are the same as in Example 1, except that USP has $40, rather than $200, of U.S. source taxable income in the election year.

(ii) Result . Because USP’s taxable income computed without regard to section 965(e)(2)(A) ($40) is less than the amount of nondeductible CFC dividends ($100), the taxable income limitation of section 965(e)(2)(A) applies. Therefore, under section 8.02 of this notice the loss allocation rules of section 904(f)(5) and Notice 89–3 are applied without regard to the nondeductible CFC dividends. Accordingly, under section 904(f)(5)(A) and section 8.02 of this notice $40 of USP’s $100 passive limitation loss is allocated to reduce U.S. source taxable income to zero, and the remaining $60 passive loss constitutes an NOL for the election year. After allocation of the separate limitation loss, USP has $100 of general limitation income, all attributable to nondeductible CFC dividends, a $60 passive limitation loss that constitutes an NOL, and no U.S. source taxable income. USP has a $40 overall foreign loss account in the passive category.

Example 3. Taxable income limitation; allocation of U.S. 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: $750 of general limitation income, of which $500 is attributable to nondeductible CFC dividends, and $750 of U.S. source loss.

(ii) Result . Because USP’s taxable income computed without regard to section 965(e)(2)(A) ($0) is less than the amount of nondeductible CFC dividends ($500), the taxable income limitation of section 965(e)(2)(A) applies. Therefore, under section 8.02 of this notice the loss allocation rules of section 904(f)(5) and Notice 89–3 are applied without regard to the nondeductible CFC dividends. Accordingly, under section 904(f)(5)(D) and section 8.02 of this notice $250 of USP’s $750 U.S. loss is allocated to reduce general limitation income to $500, and the remaining $500 U.S. loss constitutes an NOL for the election year. After allocation of the U.S. loss, USP has $500 of general limitation income, all attributable to nondeductible CFC dividends, and a $500 U.S. loss that constitutes an NOL.

Example 4. Taxable income limitation; allocation of separate limitation loss and U.S. 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: $100 of general limitation income attributable to nondeductible CFC dividends, ($100) of general limitation loss, $100 of passive income, and ($100) of U.S. source loss.

(ii) Result . Because USP’s taxable income computed without regard to section 965(e)(2)(A) ($0) is less than the amount of nondeductible CFC dividends ($100), the taxable income limitation of section 965(e)(2)(A) applies. Therefore, under section 8.02 of this notice the loss allocation rules of section 904(f)(5) and Notice 89–3 are applied without regard to the nondeductible CFC dividends. Accordingly, under section 904(f)(5)(B) and section 8.02 of this notice USP’s $100 general limitation loss is allocated to reduce passive income to zero, and the $100 U.S. loss constitutes an NOL for the election year. After allocation of the separate limitation loss, USP has $100 of general limitation income, all attributable to nondeductible CFC dividends, and a $100 U.S. loss that constitutes an NOL. USP has a $100 general limitation loss recapture account with respect to passive income.

Example 5. OFL recapture from other income . (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: $150 of general limitation income attributable to nondeductible CFC dividends and $190 of other general limitation income. USP has a pre2005 general limitation OFL account of $400. (ii) Result . Under section 904(f)(1), 50 percent or $170 of USP’s general limitation income is recharacterized as U.S. source income. Since the recapture amount does not exceed USP’s foreign source general limitation income exclusive of nondeductible CFC dividends, after OFL recapture USP has $150 of nondeductible CFC dividends and $20 of other income in the general limitation category, and $170 of U.S. source income. USP’s general limitation OFL recapture account is reduced by $170.

Example 6. OFL recapture from nondeductible CFC dividends . (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: $150 of general limitation income, all attributable to nondeductible CFC dividends. USP has a pre-2005 general limitation OFL account of $200.

(ii) Result . Under section 904(f)(1), unless USP elects to recapture a larger percentage of the OFL account, 50 percent or $75 of USP’s general limitation income is recharacterized as U.S. source income. After OFL recapture USP has $75 of nondeductible CFC dividends in the general limitation category, and $75 of U.S. source income. USP’s OFL recapture account is reduced by $75.

Example 7. Separate limitation loss recapture from nondeductible CFC dividends . (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: $240 of general limitation income, of which $150 is attributable to nondeductible CFC dividends. USP has a general limitation separate limitation loss recapture account with respect to passive income of $200.

(ii) Result . Since the $200 recapture amount exceeds $90, USP’s foreign source general limitation income exclusive of nondeductible CFC dividends

($240 - $150), a portion of the nondeductible CFC dividends is recaptured after all other general limitation income is recaptured under section 904(f)(5)(C). Accordingly, $200 of USP’s general limitation income, equal to $90 of other income plus $110 of nondeductible CFC dividends, is recharacterized as passive income. After recapture of the separate limitation loss, USP has $40 of general limitation income, all attributable to nondeductible CFC dividends, and $200 of passive income. USP’s general limitation separate limitation loss recapture account with respect to passive income is reduced by $200 to 0.