SECTION 4. NETTING OF

FOREIGN TAXES IN REFUND YEAR

.01 Eligibility to Use Netting

The regulations described in this section 4 are expected to apply if a RIC receives in a taxable year (the “refund year”) a refund of foreign tax that had been paid in a taxable year in which the RIC made an election under section 853(a). These regulations are expected to provide a netting method that such RICs may apply in lieu of the general rules under section 905(c), if the following requirements are met:

(a) The economic benefit of the refund and any related interest payment received by the RIC primarily inures to the RIC’s refund-year shareholders (as opposed to, if different, shareholders in the year or years in which the RIC paid the refunded foreign taxes);

(b) The RIC was not held predominantly by entities described in section 817(h)(4)(A) or (B) in the year in which the RIC paid the refunded foreign taxes;

(c) The RIC makes a valid election under section 853(a) for the refund year; and

(d) The RIC paid an amount of foreign taxes in the refund year that is equal to or greater than the amount of the foreign tax adjustment described in section 4.03 for that year.

.02 Netting Procedure

The regulations are expected to provide that, if a RIC applies the method described in this section 4, then for purposes of section 853, the RIC must reduce the amount of foreign taxes reported by the RIC to its shareholders for the refund year by the amount of the foreign tax adjustment defined in section 4.03.

.03 Foreign Tax Adjustment

(a) Components of the Foreign Tax Ad- justment

The foreign tax adjustment for a refund year is equal to the sum of:

(1) All foreign tax refunds received by the RIC in the refund year; and

(2) All interest adjustments, as defined in section 4.03(b).

(b) Interest Adjustment Defined

An interest adjustment period begins on the date on which the RIC made a payment of foreign tax related to the refund and ends on the date on which the RIC receives the refund. Each payment of foreign tax that relates to a refund produces one or more separate interest adjustment periods. (Foreign tax amounts paid in the same taxable year may have been refunded on different dates during the refund year at issue, and foreign taxes refunded on a single date may have been paid on different dates and in different taxable years.)

The amount of the interest adjustment, calculated for each interest adjustment period, is an amount equal to the lesser of:

(1) The amount of interest that would be calculated for that period under section 6601 with respect to an underpayment of tax equal to the amount of the associated foreign tax refund; or

(2) The amount of interest paid by a foreign country or possession of the United States to the RIC with respect to the associated foreign tax refund for that period.

.04 Effects of Netting

(a) The RIC shall not include as income from sources without the United States the amount of the foreign tax adjustment.

(b) The shareholders of the RIC shall not include in their gross income under section 853(b)(2)(A) and § 1.853–2(b) the amount of the current year foreign taxes that are offset by the foreign tax refund component of the foreign tax adjustment, and that amount shall be excluded from the amount of income reported to the shareholders under § 1.853–3. The shareholders of the RIC shall include in their gross income under section 853(b)(2)(A) and § 1.853–2(b) the amount of the current year foreign taxes that are offset by the interest adjustment component of the foreign tax adjustment, and that amount shall be included in the amount of income reported to shareholders under § 1.853–3.

(c) To determine the dividends paid deduction, the amount of the foreign taxes paid in the refund year for which an addition to the dividends paid deduction otherwise would be allowed under section 853(b)(1)(B) shall be reduced by the amount of the foreign tax adjustment as

defined in section 4.03 for that taxable year.

.05 Notification Requirement for RICs Utilizing Netting

The regulations are expected to provide that, if a RIC applies the netting method described in this section 4, the RIC must notify the IRS of each refund on a statement attached to a Form 1118, or its successor, for the refund year. This statement must include the following information:

(a) The amount of each refund; (b) The date on which each refund was received;

(c) The date or dates on which the RIC paid the foreign tax to which each refund relates;

(d) The taxable year or years with respect to which the foreign tax to which each refund relates was reported to shareholders;

(e) The amount of interest paid by the foreign country or possession of the United States with respect to each refunded amount;

(f) The exchange rates used to translate any foreign currency amounts into dollars; and

(g) With respect to each refunded amount, the amounts included in the foreign tax adjustment as defined in section 4.03.

.06 Example: Netting Refunds Against Foreign Taxes Paid

(a) Facts . Corporation L, a RIC, invests in country P stocks in each of taxable years 1 through 6 and makes a valid election under section 853(a) for all years. In each of years 1 through 5, Corporation L earned 1,000u of dividend income from country P stocks and paid 100u in foreign tax. In each of years 1 through 5, the applicable exchange rate is 1u � $1. With respect to years 1 through 5, Corporation L distributed $900 to shareholders and reported to shareholders their aggregate proportionate shares of foreign source income and foreign taxes paid of $1,000 and $100, respectively. Corporation L also reported $1,000 of dividend income and claimed $1,000 in dividends paid deductions ($900 from the distribution made to shareholders and $100 under section

Bulletin No. 2016–6 309 February 8, 2016

853(b)(1)(B) for the foreign taxes paid) with respect to each of years 1 through 5.

In year 6, Corporation L receives dividend income of 1,000u, pays 100u in foreign taxes, and also receives a refund of 55u of the foreign tax it paid in year 1. In year 6, the applicable exchange rate is 1u � $2. Country P paid to Corporation L interest of 1u on the foreign tax refund, which was less than the amount of interest adjustment that would be calculated for the interest adjustment period under section 6601 with respect to an underpayment of tax equal to $55 (55u translated at the applicable exchange rate for year 1). Corporation L exchanges the 956u (900u dividends received, net of withholding tax, plus 55u received as a refund of foreign tax and 1u received as interest on the foreign tax refund) for $1,912 and distributes $1,912 to its shareholders with respect to year 6 ($1,800 from dividends received that year, net of withholding tax, plus $110 received as a refund of foreign tax and $2 received as interest on the foreign tax refund). Assume that Corporation L has no expenses allocated and apportioned to the dividend income and that it meets the requirements for netting under section 4.01 of this notice.

(b) Results . Corporation L received a refund and applies netting under section 4. For purposes of furnishing statements to shareholders, Corporation L must reduce the $200 of foreign tax paid in year 6 by the foreign tax adjustment as determined under section 4.03 of this notice. The foreign tax adjustment is the sum of the refund and the interest adjustment, or $57 (a $55 refund and a $2 interest adjustment).

The exchange of the refunded amount for dollars results in $55 of foreign currency gain under section 988 ($110 value of refunded foreign currency in year 6 less $55 basis from year 1). Corporation L must report $2,000 of dividend income and $55 of foreign currency gain but does not include as additional income the amount of the foreign tax adjustment.

Corporation L may claim $2,055 in dividends-paid deductions ($1,912 from the actual distribution to year 6 shareholders, plus $143 ($200 foreign taxes paid less $57 foreign tax adjustment) of foreign taxes paid under section 853(b)(1)(B). See section 4.04 of this notice.

Corporation L must attach a statement to its Form 1118 for year 6 that includes the information listed in section 4.05 of this notice. After netting, Corporation L’s shareholders are deemed to have paid foreign taxes in year 6 of $143 ($200 foreign taxes paid less $57 foreign tax adjustment). Corporation L must report to its year 6 shareholders $2,057 of gross foreign source income ($1,912 from the distribution plus $145 from the foreign taxes paid in year 6 ($200 foreign taxes paid in year 6 less $55 foreign tax refund under section 4.04(b) of this notice)) and $143 of foreign tax, and Corporation L’s year 6 shareholders must include such income in their gross income and treat such foreign tax as paid by them.