Allocation of Loss with Respect to Stock &
Other Personal Property; Application of
Section 904 to Income Subject to Separate Limitations

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8805] RIN 1545-AQ43;
1545-AT41

TITLE: Allocation of Loss with Respect to Stock and Other Personal
Property; Application of Section 904 to Income Subject to Separate
Limitations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains final and temporary Income Tax
Regulations relating to the allocation of loss recognized on the
disposition of stock and other personal property and the computation
of the foreign tax credit limitation. The loss allocation
regulations primarily will affect taxpayers that claim the foreign
tax credit and that incur losses with respect to personal property
and are necessary to modify existing guidance with respect to loss
allocation. The foreign tax credit limitation regulations will
affect taxpayers claiming foreign tax credits that have passive
income or losses and are necessary to modify existing guidance with
respect to the computation of the limitation.

DATES: Effective dates: These regulations are effective January 11,
1999, except that �1.904-4(c)(2)(ii)(A) and (B) are effective March
12, 1999 and �1.904-4(c)(3)(iv) is effective December 31, 1998.

Dates of applicability: For dates of applicability of ��1.865-1T,
1.865-2, and 1.865-2T, see ��1.865-1T(f), 1.865-2(e), and
1.865-2T(e), respectively. For dates of applicability of
�1.904-4(c), see �1.904-4(c)(2)(i).

FOR FURTHER INFORMATION CONTACT: Seth B. Goldstein, (202) 622- 3810,
regarding section 865(j); and Rebecca Rosenberg, (202) 622- 3850,
regarding section 904(d) (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

On May 14, 1992, the IRS published a notice of proposed rulemaking
in the Federal Register (REG-209527-92, formerly INTL-1- 92 (1992-1
C.B. 1209), 57 FR 20660), proposing amendments to the Income Tax
Regulations (26 CFR part 1) under section 904(d).

The regulations included proposed amendments to the grouping rules
under �1.904-4(c)(3) for purposes of determining whether passive
income is high taxed. The amendments were proposed to be effective
for taxable years beginning after December 31, 1991. A public
hearing was held on September 24, 1992, but no written or oral
comments were received with respect to these provisions.

These regulations are finalized as proposed. However, as described
below, the effective date of the regulations has been modified.

On July 8, 1996, the IRS published proposed amendments (REG-209750-
95, formerly INTL-4-95 (1996-2 C.B. 484), 61 FR 35696) to the Income
Tax Regulations (26 CFR part 1) under sections 861, 865, and 904 of
the Internal Revenue Code in the Federal Register. The regulations
addressed the allocation of loss on the disposition of stock
(�1.865-2) and other personal property (�1.865-1) and also contained
proposed amendments to the grouping rules under �1.904-4(c). The
proposed regulations generally allocate loss with respect to stock
based upon the residence of the seller (reciprocal to gain), but
allocate loss on other personal property based upon the income
generated by the property. A public hearing was held on November 6,
1996, and several written comments were received. The written
comments endorsed the regulations' general approach with respect to
the allocation of stock loss. In addition, on June 18, 1997, the Tax
Court held in International Multifoods Corporation v.

Commissioner, 108 T.C. 579 (1997), that loss on the disposition of
stock is generally allocated based on the residence of the seller,
consistent with the approach of the proposed regulations.

After consideration of all the comments, the regulations proposed by
INTL-4-95 with respect to stock loss and with respect to the
grouping rules are adopted as amended by this Treasury decision.

The principal changes to these regulations, as well as the major
comments and suggestions, are discussed below. An additional anti-
abuse rule, not previously proposed, is issued as a proposed and
temporary regulation.

The written comments criticized the proposed regulation concerning
the allocation of loss on other personal property (�1.865-1). This
proposed regulation is withdrawn and replaced with a new proposed
and temporary regulation that is more consistent with the approach
of the stock loss allocation rules.

The new rules are issued as a temporary regulation because of the
need for immediate guidance following the International Multifoods
opinion.

Explanation of Provisions

Section 1.861-8T(e)(8): Net Operating Loss

Section 1.861-8T(e)(8) clarifies that a net operating loss deduction
allowed under section 172 is allocated and apportioned in the same
manner as the deductions giving rise to the net operating loss
deduction.

Section 1.865-1T: Loss With Respect to Personal Property Other Than
Stock

Section 1.865-1T(a) provides the general rule that loss with respect
to personal property is allocated in the same manner in which gain
on the sale of the property would be sourced. Thus, for example,
loss on the sale or worthlessness of a foreign bond held by a U.S.
resident generally would be allocated against U.S. source income.
Notice 89-58 (1989-1 C.B. 699), which addressed the allocation of
loss with respect to certain bank loans, is revoked as inconsistent
with this approach. Taxpayers may rely on the Notice for loss
recognized prior to the effective date of the temporary regulations
(see discussion of effective dates, below). Following the general
rule, loss attributable to a foreign office of a U.S. resident is
allocated against foreign source income where gain would be foreign
source under the foreign branch rule of section 865(e)(1).

Section 1.865-1T(b) provides special rules of application.

Loss on depreciable property generally is allocated based upon the
allocation of depreciation deductions taken with respect to the
property, consistent with the depreciation-recapture source rule of
section 865(c)(1). Similarly, loss with respect to a contingent
payment debt instrument subject to Reg. �1.1275-4(b) is allocated
against interest income because gain on the instrument generally is
treated as interest income.

Section 1.865-1T(c) provides exceptions from the reciprocal-to- gain
rule. The regulations do not apply to certain financial products (to
be addressed in a future guidance project), loss governed by section
988, inventory (which is not governed by section 865), or trade
receivables and certain interest equivalents (which are governed by
�1.861-9T(b)). When Prop.

�1.863-3(h) (the global dealing sourcing regulation) is finalized,
�1.865-1T will not apply to any loss sourced under that regulation.
Loss attributable to accrued-but-unpaid interest income is allocated
against interest income. Also, loss on a debt instrument is
allocated against interest income to the extent the taxpayer did not
amortize bond premium to the full extent permitted by the Code.
Anti-abuse exceptions are also provided. Section 1.865-1T(c)(6)(i),
which prevents taxpayers from manipulating loss allocation through
related-party transfers, reorganizations, or similar transactions,
and �1.865- 1T(c)(6)(ii), which addresses offsetting positions, are
similar to the anti-abuse rules previously proposed with respect to
stock losses. In addition, section 1.865-1T(c)(6)(iii) has been.6
included to prevent taxpayers from accelerating foreign source
income with respect to property and claiming an offsetting U.S.
loss.

The temporary regulations are effective for loss recognized on or
after January 11, 1999. A taxpayer may apply the regulations,
however, to loss recognized in any taxable year beginning on or
after January 1, 1987, subject to certain conditions.

Section 1.865-2: Stock Loss

The proposed regulations issued in 1996 provide that generally loss
with respect to stock is allocated to the residence of the seller,
but contain three major exceptions: an exclusion for dispositions of
portfolio stock and stock in regulated investment companies (RICs)
and S corporations, a dividend recapture rule, and a consistency
rule for certain dispositions of foreign affiliates. The final
regulations modify these exceptions. The principal comments and
changes to the regulations are discussed below.

Section 1.865-2(a): General Rule for Allocation of Stock Loss
Commentators criticized the exclusion of portfolio stock and RIC
stock from the general residence-based rule, arguing that the
rationale for residence-based allocation applies equally to these
classes of stock. The final regulations eliminate the exception for
portfolio stock and RIC stock.

In response to a comment, the final regulations clarify that
�1.865-2 does not apply to stock that constitutes inventory.

The proposed regulations allocate loss recognized on the A sale or
other disposition @ of stock. Proposed �1.865-2(c)(2) provides that
worthlessness giving rise to a deduction under section 165(g)(3)
with respect to stock is treated as a disposition. Questions have
been raised as to whether the regulations apply to other recognized
losses that are not the result of a sale or disposition (for
example, loss recognized under the mark-to-market rules of section
475). The final regulations are intended to apply to all recognized
stock losses.

To avoid confusion, the reference to sales or other dispositions has
been deleted in the final regulations. The special reference to
worthlessness deductions is therefore unnecessary and also has been
deleted.

Section 1.865-2(b)(1): Dividend Recapture Exception Some
commentators questioned the dividend recapture rule of �1.865-2(b)
(1) and suggested that the rule should be limited to cases in which
the dividends were fully sheltered from U.S. tax by foreign tax
credits or the taxpayer did not meet a minimum holding period.
Others suggested that the two-year recapture period defined in
�1.865-2(d)(5) of the proposed regulations should be shortened.
Sections 1.865-2(b)(1)(i) and 1.865-2(d)(3) of the final regulations
retain the two-year rule.

Section 1.865-2(b)(1)(iii) of the final regulations provides an
exception from dividend recapture for passive-basket dividends. This
new exception will exempt most portfolio investors (other than
financial services entities) from the dividend recapture rule. The
rule, which will reduce administrative burdens, reflects the fact
that passive income is generally subject to residual U.S. tax and
the high-tax kick-out of section 904(d)(2)(A)(iii)(III) limits the
potential for cross-crediting in the passive basket, thus reducing
the need for recapture. In addition, allocation of loss to the
passive basket may lead to investment incentives that violate the
policies underlying the passive basket. For example, where a loss
allocated to the passive basket creates a separate limitation loss
under section 904(f)(5) that reduces high-taxed income in other
baskets, this creates an incentive in subsequent years for the
taxpayer to earn low-taxed foreign passive income to utilize the
foreign tax credits in the high-taxed basket (due to the
recharacterization rules of section 904(f)(5)(C)).

Commentators also suggested alternatives to the de minimis rule of
�1.865-2(b)(1)(ii), which exempts from recapture dividends that are
less than 10 percent of the recognized loss.

The proposed de minimis rule is retained in the final regulations.
The de minimis rule is intended to exempt from recapture, as a
matter of administrative convenience, dividends that are relatively
insignificant in comparison to the loss.

Two commentators questioned why the dividend recapture rule and the
definition of the recapture period in �1.865-2(d)(5) of the proposed
regulations refer to realized, rather than recognized, loss. The
wording was intended to avoid confusion over the application of the
rule to loss that is deferred under section 267(f). The final
regulation refers to "recognized" loss, but examples have been added
in �1.865-2(b)(1)(iv) of the final regulations to illustrate the
application of the dividend recapture rule in the context of section
267(f) and how the result differs in the context of a consolidated
group.

Proposed �1.865-2(b)(2): Consistency Rule

Proposed �1.865-2(b)(2) requires a taxpayer to allocate loss on the
sale of a foreign affiliate to passive-basket foreign source income
if the taxpayer recognized foreign source gain under section 865(f)
at any time during the 5-year period preceding the loss sale.
Commentators criticized this rule as producing disproportionate
results where the foreign source gain is small in comparison to the
subsequent loss. Furthermore, even where the gain and loss are of
similar magnitude, the results may be disproportionate because
sourcing the gain foreign may provide the taxpayer with minimal tax
benefits (because the gain is assigned to the passive basket) but
the loss may reduce (sometimes as a separate limitation loss) income
that is otherwise sheltered by foreign tax credits. In addition,
allocating loss to the passive basket raises the policy concerns
described above with respect to passive-basket dividend recapture.
After consideration of the comments, the consistency rule has been
eliminated from the final regulations.

Section 1.865-2(b)(2): Anti-abuse Rules

The anti-abuse rules of �1.865-2(b)(3) of the proposed regulations,
finalized as �1.865-2(b)(4), have been refined and modified. One
commentator requested examples illustrating the anti-abuse rules.
Examples have been provided. An additional rule is provided in
�1.865-2T, discussed below.

Section 1.865-2(e): Effective Date and Retroactive Election The
proposed regulations are proposed to be effective for taxable years
beginning 61 days after final regulations are promulgated. Because
of the immediate need for guidance following the International
Multifoods opinion, the final regulations are effective for losses
recognized on or after January 11, 1999.

Several commentators requested that the regulations clarify the
scope of the retroactive election and reduce the administrative
burden of making the election. In response to these comments,
�1.865-2(e)(2) is amended to provide that a taxpayer need not make a
formal election to retroactively apply the regulations to losses
recognized in any post-1986 year and all subsequent pre-effective
date years. An amended return will be required only if retroactive
application results in a change in tax liability.

One commentator urged that the overall foreign loss transition rule
in �1.904(f)-12 be modified to provide that an overall foreign loss
account attributable to a stock loss recognized in a pre-1987 year
be recomputed under the new regulations in the first election year.
This suggestion was rejected because the allocation of a stock loss
is governed by the rules in effect in the year the loss is
recognized, and the retroactive election is available only with
respect to post-1986 years. Section 1.865-2(e)(3) provides examples
to illustrate the effect of the retroactive application of the
regulations on overall foreign loss accounts, capital loss
carryovers, and foreign tax credit carryovers.

Section 1.865-2T: Stock Loss Matching Rule

Section 1.865-2T(b)(4)(iii) provides a rule intended to prevent
taxpayers from avoiding the dividend recapture rule of �1.865-2(b)
(1) or from accelerating foreign source income and recognizing an
offsetting U.S. loss. This rule is substantially the same as the
matching rule of �1.865-1T(c)(6)(iii). The rule is promulgated as a
temporary regulation because it is necessary to prevent abuse of the
residence-based general allocation rule.

Section 1.904-4(c): Grouping Rules

The high-tax kick-out grouping rules of �1.904-4(c) provide rules
for determining when particular groups of passive income are high-
taxed and, therefore, treated as general limitation income under
sections 904(d)(2)(A)(iii)(III) and 904(d)(2)(F).

As described above, the proposed amendments to these rules that were
proposed in 1992 are finalized as proposed, but taxpayers are
afforded some flexibility with respect to the effective date.

The amendments were proposed to be effective for taxable years
beginning after December 31, 1991. The final regulations are
effective for taxable years ending on or after December 31, 1998,
but taxpayers may apply the amended regulations to any taxable year
beginning after December 31, 1991 and all subsequent years.

An example is also added to clarify that foreign taxes that are not
creditable (e.g., under section 901(k)) are not withholding taxes
for purposes of the grouping rules.

The proposed amendments to the grouping rules that were proposed in
1996 are finalized with two clarifications. Proposed �1.904-4(c)(2)
(ii)(B) provides guidance where deductions allocated to a group of
passive income exceed the income in that group (i.e., a loss group).
A question has been raised as to the proper treatment of foreign
taxes in a group that has no taxable income or loss (either because
the deductions allocated to the group exactly equal the income in
the group or because the foreign taxes assigned to the group are
imposed on U.S. source income or income that is not currently taken
into account under U.S. tax principles). Consistent with the
approach taken in the proposed regulations with respect to loss
groups, the final regulations clarify that foreign taxes allocated
to a group with no foreign source income are A kicked out @ and
treated as related to general limitation income.

Proposed �1.904-4(c)(2)(ii)(A) provides that foreign tax imposed on
sales that result in loss for U.S. tax purposes is allocated to the
group of passive income to which the loss is allocated. While this
correctly states the result where loss on the disposition of
property is allocated to passive income under a reciprocal-to-gain
rule, under the temporary and final regulations loss may be
allocated to reduce the group of passive income where income from
the property was assigned (for example, dividends or interest under
the anti-abuse rules or the accrued-but- unpaid interest rule) or a
separate category of income other than passive income. Accordingly,
�1.904-4(c)(2)(ii)(A) of the final regulations is clarified to state
that foreign tax imposed on a loss sale is allocated to the group of
passive income to which a gain would have been assigned. The
examples in �1.904- 4(c)(8) of the final regulations are modified to
reflect the fact that the consistency rule of �1.865-2(b)(2) of the
proposed regulations has been deleted.

One commentator inquired whether the rule of �1.904- 4(c)(2)(ii)(A)
allocating foreign tax on a loss sale to a group of passive income
is consistent with the tax allocation rule of �1.904-6(a)(1)(iv).
The latter rule provides that a foreign tax imposed on an item of
income that does not constitute income under U.S. tax principles (a
base difference) shall be treated as imposed with respect to general
limitation income, whereas a foreign tax imposed on an item that
would be income under U.S. tax principles in another year (a timing
difference) will be allocated to the appropriate separate category
as if the U.S. recognized the income in the same year. Treasury and
the Service believe that a base difference exists within the meaning
of �1.904-6(a)(1)(iv) only when a foreign country taxes items that
the United States would never treat as taxable income, for example,
gifts or life insurance proceeds. A sale that results in gain under
foreign law but in loss for U.S. tax purposes is attributable to
differences in basis calculations rather than to a difference in the
concept of taxable income and, therefore, does not constitute a base
difference. The tax allocation rule of �1.904-4(c)(2)(ii)(A),
allocating foreign taxes on a loss sale to the same group of passive
income to which gain would have been assigned had the United States
recognized gain on the sale, is conceptually consistent with the
treatment of timing differences in �1.904-6(a)(1)(iv).

Effect on Other Documents

The following document is obsolete as of January 11, 1999:

Notice 89-58, 1989-1 C.B. 699.

Special Analyses

It has been determined that this Treasury Decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required.

This Treasury Decision finalizes notices of proposed rulemaking
published May 14, 1992 (57 FR 20660) and July 8, 1996 (61 FR 35696).
It has been determined that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does not apply to the final
regulations issued pursuant to the notice of proposed rulemaking
published on May 14, 1992. Furthermore, the Regulatory Flexibility
Act (5 U.S.C. chapter 6) does not apply to those regulations,
because the notice of proposed rulemaking was issued prior to March
29, 1996.

It also has been determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to
the portion of the notice of proposed rulemaking published on July
8, 1996, relating to section 904 of the Internal Revenue Code.
Because the regulation does not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter
6) does not apply.

A final regulatory flexibility analysis under 5 U.S.C. � 604 has
been prepared for the final regulations portion of this Treasury
Decision with respect to the regulations issued under section 865 of
the Internal Revenue Code. A summary of the analysis is set forth
below under the heading 'Summary of Regulatory Flexibility
Analysis.' Because no preceding notice of proposed rulemaking is
required for the temporary regulations portion of this Treasury
Decision relating to sections 861 and 865 of the Code, the
provisions of the Regulatory Flexibility Act do not apply. However,
an initial Regulatory Flexibility Analysis was prepared for the
proposed regulations published elsewhere in this issue of the
Federal Register.

Pursuant to section 7805(f) of the Internal Revenue Code, the
notices of proposed rulemaking preceding these regulations were
submitted to the Small Business Administration for comment on their
impact on small business.

Summary of Regulatory Flexibility Analysis

It has been determined that a final regulatory flexibility analysis
is required under 5 U.S.C. � 604 with respect to the final
regulations portion of this Treasury Decision with respect to the
regulations issued under section 865 of the Internal Revenue Code.
These regulations will affect small entities such as small
businesses but not other small entities, such as local government or
tax exempt organizations, which do not pay taxes.

The IRS and Treasury Department are not aware of any federal rules
that duplicate, overlap or conflict with these regulations.

The final regulations address the allocation of loss with respect to
stock. These regulations are necessary primarily for the proper
computation of the foreign tax credit limitation under section 904
of the Internal Revenue Code. With respect to U.S. resident
taxpayers, the regulations generally allocate losses against U.S.
source income. Generally, this allocation simplifies the computation
of the foreign tax credit limitation.

None of the significant alternatives considered in drafting the
regulations would have significantly altered the economic impact of
the regulations on small entities. There are no alternative rules
that are less burdensome to small entities but that accomplish the
purposes of the statute.

Drafting Information

The principal author of these regulations is Seth B.

Goldstein, of the Office of the Associate Chief Counsel
(International), IRS. However, other personnel from the IRS and
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1 Income taxes, Reporting and
recordkeeping requirements.

Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.865-1T also issued under
26 U.S.C. 865(j)(1).

Section 1.865-2 also issued under 26 U.S.C. 865(j)(1).

Section 1.865-2T also issued under 26 U.S.C. 865(j)(1). * * * Par.
2. Section 1.861-8 is amended by adding paragraph (e)(7)(iii) and
revising paragraph (e)(8) to read as follows:

�1.861-8 Computation of taxable income from sources within the
United States and from other sources and activities.

* * * * *

(e) * * *

(7) * * *

(iii) Allocation of loss recognized in taxable years after 1986. See
��1.865-1T, 1.865-2, and 1.865-2T for rules regarding the allocation
of certain loss recognized in taxable years beginning after December
31, 1986.

(8) Net operating loss deduction. [Reserved.] For guidance, see
�1.861-8T(e)(8).

* * * * *

Par. 3. Section 1.861-8T is amended by adding paragraph (e)(8) and a
sentence at the end of paragraph (h) to read as follows:

�1.861-8T Computation of taxable income from sources within the
United States and from other sources and activities (Temporary).

* * * * *

(e) * * *

(8) Net operating loss deduction. A net operating loss deduction
allowed under section 172 shall be allocated and apportioned in the
same manner as the deductions giving rise to the net operating loss
deduction.

* * * * *

(h) * * * Paragraph (e)(8) of this section shall cease to be
effective January 8, 2002.

Par. 4. Section 1.865-1T is added immediately following �1.864-8T,
to read as follows:

�1.865-1T Loss with respect to personal property other than stock
(Temporary).

(a) General rules for allocation of loss--(1) Allocation against
gain. Except as otherwise provided in ��1.865-2 and 1.865-2T and
paragraph (c) of this section, loss recognized with respect to
personal property shall be allocated to the class of gross income
and, if necessary, apportioned between the statutory grouping of
gross income (or among the statutory groupings) and the residual
grouping of gross income, with respect to which gain from a sale of
such property would give rise in the hands of the seller. Thus, for
example, loss recognized by a United States resident on the sale of
a bond generally is allocated to reduce United States source income.

(2) Loss attributable to foreign office. Except as otherwise
provided in ��1.865-2 and 1.865-2T and paragraph (c) of this
section, and except with respect to loss subject to paragraph (b) of
this section, in the case of loss recognized by a United States
resident with respect to property that is attributable to an office
or other fixed place of business in a foreign country within the
meaning of section 865(e)(3), the loss shall be allocated to reduce
foreign source income if a gain on the sale of the property would
have been taxable by the foreign country and the highest marginal
rate of tax imposed on such gains in the foreign country is at least
10 percent. However, paragraph (a)(1) of this section and not this
paragraph (a)(2) will apply if gain on the sale of such property
would be sourced under section 865(c), (d)(1)(B), or (d)(3).

(3) Loss recognized by United States citizen or resident alien with
foreign tax home. Except as otherwise provided in ��1.865-2 and
1.865-2T and paragraph (c) of this section, and except with respect
to loss subject to paragraph (b) of this section, in the case of
loss with respect to property recognized by a United States citizen
or resident alien that has a tax home (as defined in section 911(d)
(3)) in a foreign country, the loss shall be allocated to reduce
foreign source income if a gain on the sale of such property would
have been taxable by a foreign country and the highest marginal rate
of tax imposed on such gains in the foreign country is at least 10
percent.

(4) Allocation for purposes of section 904. For purposes of section
904, loss recognized with respect to property that is allocated to
foreign source income under this paragraph (a) shall be allocated to
the separate category under section 904(d) to which gain on the sale
of the property would have been assigned (without regard to section
904(d)(2)(A)(iii)(III)). For purposes of �1.904-4(c)(2)(ii)(A), any
such loss allocated to passive income shall be allocated (prior to
the application of �1.904- 4(c)(2)(ii)(B)) to the group of passive
income to which gain on a sale of the property would have been
assigned had a sale of the property resulted in the recognition of a
gain under the law of the relevant foreign jurisdiction or
jurisdictions.

(5) Loss recognized by partnership. A partner's distributive share
of loss recognized by a partnership with respect to personal
property shall be allocated and apportioned in accordance with this
section as if the partner had recognized the loss. If loss is
attributable to an office or other fixed place of business of the
partnership within the meaning of section 865(e)(3), such office or
fixed place of business shall be considered to be an office of the
partner for purposes of this section.

(b) Special rules of application--(1) Depreciable property.

In the case of a loss recognized with respect to depreciable
personal property, the gain referred to in paragraph (a)(1) of this
section is the gain that would be sourced under section 865(c)(1)
(depreciation recapture).

(2) Contingent payment debt instrument. Except to the extent
provided in �1.1275-4(b)(9)(iv), loss recognized with respect to a
contingent payment debt instrument to which �1.1275- 4(b) applies
(instruments issued for money or publicly traded property) shall be
allocated to the class of gross income and, if necessary,
apportioned between the statutory grouping of gross income (or among
the statutory groupings) and the residual grouping of gross income,
with respect to which interest income from the instrument (in the
amount of the loss subject to this paragraph (b)(2)) would give
rise.

(c) Exceptions--(1) Foreign currency and certain financial
instruments. This section does not apply to loss governed by section
988 and loss recognized with respect to options contracts or
derivative financial instruments, including futures contracts,
forward contracts, notional principal contracts, or evidence of an
interest in any of the foregoing.

(2) Inventory. This section does not apply to loss recognized with
respect to property described in section 1221(1).

(3) Interest equivalents and trade receivables. Loss subject to
�1.861-9T(b) (loss equivalent to interest expense and loss on trade
receivables) shall be allocated and apportioned under the rules of
�1.861-9T and not under the rules of this section.

(4) Unamortized bond premium. To the extent a taxpayer recognizing
loss with respect to a bond (within the meaning of �1.171-1(b)) did
not amortize bond premium to the full extent permitted by ��1.171-2
or 1.171-3 (or �1.171-1, as contained in the 26 CFR part 1 edition
revised as of April 1, 1997)(as applicable), loss recognized with
respect to the bond shall be allocated to the class of gross income
and, if necessary, apportioned between the statutory grouping of
gross income (or among the statutory groupings) and the residual
grouping of gross income, with respect to which interest income from
the bond was assigned.

(5) Accrued interest. Loss attributable to accrued but unpaid
interest on a debt obligation shall be allocated to the class of
gross income and, if necessary, apportioned between the statutory
grouping of gross income (or among the statutory groupings) and the
residual grouping of gross income, with respect to which interest
income from the obligation was assigned. For purposes of this
section, whether loss is attributable to accrued but unpaid interest
(rather than to principal) shall be determined under the principles
of ��1.61- 7(d) and 1.446-2(e).

(6) Anti-abuse rules--(i) Transactions involving built-in losses. If
one of the principal purposes of a transaction is to change the
allocation of a built-in loss with respect to personal property by
transferring the property to another person, qualified business
unit, office or other fixed place of business, or branch that
subsequently recognizes the loss, the loss shall be allocated by the
transferee as if it were recognized by the transferor immediately
prior to the transaction. If one of the principal purposes of a
change of residence is to change the allocation of a built-in loss
with respect to personal property, the loss shall be allocated as if
the change of residence had not occurred. If one of the principal
purposes of a transaction is to change the allocation of a built-in
loss on the disposition of personal property by converting the
original property into other property and subsequently recognizing
loss with respect to such other property, the loss shall be
allocated as if it were recognized with respect to the original
property immediately prior to the transaction. Transactions subject
to this paragraph shall include, without limitation, reorganizations
within the meaning of section 368(a), liquidations under section
332, transfers to a corporation under section 351, transfers to a
partnership under section 721, transfers to a trust, distributions
by a partnership, distributions by a trust, transfers to or from a
qualified business unit, office or other fixed place of business, or
branch, or exchanges under section 1031. A person may have a
principal purpose of affecting loss allocation even though this
purpose is outweighed by other purposes (taken together or
separately).

(ii) Offsetting positions. If a taxpayer recognizes loss with
respect to personal property and the taxpayer (or any person
described in section 267(b) (after application of section 267(c)),
267(e), 318 or 482 with respect to the taxpayer) holds (or held)
offsetting positions with respect to such property with a principal
purpose of recognizing foreign source income and United States
source loss, the loss shall be allocated and apportioned against
such foreign source income. For purposes of this paragraph (c)(6)
(ii), positions are offsetting if the risk of loss of holding one or
more positions is substantially diminished by holding one or more
other positions.

(iii) Matching rule. To the extent a taxpayer (or a person described
in section 1059(c)(3)(C) with respect to the taxpayer) recognizes
foreign source income for tax purposes that results in the creation
of a corresponding loss with respect to personal property, the loss
shall be allocated and apportioned against such income. For examples
illustrating a similar rule with respect to stock loss, see Examples
3 through 6 of �1.865- 2T(b)(4)(iv).

(d) Definitions--(1) Contingent payment debt instrument. A
contingent payment debt instrument is any debt instrument that is
subject to �1.1275-4.

(2) Depreciable personal property. Depreciable personal property is
any property described in section 865(c)(4)(A).

(3) Terms defined in �1.861-8. See �1.861-8 for the meaning of class
of gross income, statutory grouping of gross income, and residual
grouping of gross income.

(e) Examples. The application of this section may be illustrated by
the following examples:

Example 1. On January 1, 1997, A, a domestic corporation, purchases
for $1,000 a machine that produces widgets, which A sells in the
United States and throughout the world. Throughout A's holding
period, the machine is located and used in Country X.

During A's holding period, A incurs depreciation deductions of $400
with respect to the machine. Under �1.861-8, A allocates and
apportions depreciation deductions of $250 against foreign source
general limitation income and $150 against U.S. source income. On
December 12, 1999, A sells the machine and recognizes a loss of
$500. Because the machine was used predominantly outside the United
States, under section 865(c)(1)(B) and.25 (c)(3)(B)(ii), gain on the
disposition of the machine would be foreign source general
limitation income to the extent of the depreciation adjustments.
Therefore, under paragraph (b)(1) of this section, the entire $500
loss is allocated against foreign source general limitation income.

Example 2. On January 1, 1997, A, a domestic corporation, loans
$2,000 to N, its wholly-owned controlled foreign corporation, in
exchange for a contingent payment debt instrument subject to
�1.1275-4(b). During 1997 through 1999, A accrues and receives
interest income of $630, $150 of which is foreign source general
limitation income and $480 of which is foreign source passive income
under section 904(d)(3). Assume there are no positive or negative
adjustments pursuant to �1.1275-4(b)(6) in 1997 through 1999. On
January 1, 2000, A disposes of the debt instrument and recognizes a
$770 loss. Under �1.1275- 4(b)(8)(ii), $630 of the loss is treated
as ordinary loss and $140 is treated as capital loss. Assume that
$140 of interest income earned in 2000 with respect to the debt
instrument would be foreign source passive income under section
904(d)(3). Under �1.1275-4(b)(9)(iv), $150 of the ordinary loss is
allocated against foreign source general limitation income and $480
of the ordinary loss is allocated against foreign source passive
income.

Under paragraph (b)(2) of this section, the $140 capital loss is
allocated against foreign source passive income.

Example 3. On January 1, 1997, A, a domestic corporation, purchases
for $1,000 a bond maturing January 1, 2009, with a stated principal
amount of $1,000, payable at maturity. The bond provides for
unconditional payments of interest of $100, payable December 31 of
each year. The issuer of the bond is a foreign corporation and
interest on the bond is thus foreign source.

Between 1997 and 2001, A accrues and receives foreign source
interest income of $500 with respect to the bond. On January 1,
2002, A sells the bond and recognizes a $500 loss. Under paragraph
(a)(1) of this section, the $500 loss is allocated against U.S.
source income. Paragraph (c)(6)(iii) of this section is not
applicable because A's recognition of the foreign source income did
not result in the creation of a corresponding loss with respect to
the bond.

Example 4. On January 1, 1999, A, a domestic corporation on the
accrual method of accounting, purchases for $1,000 a bond maturing
January 1, 2009, with a stated principal amount of $1,000, payable
at maturity. The bond provides for unconditional payments of
interest of $100, payable December 31 of each year.

The issuer of the bond is a foreign corporation and interest on the
bond is thus foreign source. On June 10, 1999, after A has accrued
$44 of interest income, but before any interest has been paid, the
issuer suddenly becomes insolvent and declares bankruptcy. A sells
the bond (including the accrued interest) for $20. Assuming that A
properly accrued $44 interest income, A treats the $20 proceeds from
the sale of the bond as payment of interest previously accrued and
recognizes a $1000 loss with respect to the bond principal and a $24
loss with respect to the accrued interest. See �1.61-7(d). Under
paragraph (a)(1) of this section, the $1000 loss with respect to the
principal is allocated against U.S. source income. Under paragraph
(c)(5) of this section, the $24 loss with respect to accrued but
unpaid interest is allocated against foreign source interest income.

(f) Effective date--(1) In general. Except as provided in paragraph
(f)(2) of this section, this section is effective for loss
recognized on or after January 11, 1999. For purposes of this
paragraph (f), loss that is recognized but deferred (for example,
under section 267 or 1092) shall be treated as recognized at the
time the loss is taken into account. This section shall cease to be
effective January 8, 2002.

(2) Application to prior periods. A taxpayer may apply the rules of
this section to losses recognized in any taxable year beginning on
or after January 1, 1987, and all subsequent years, provided that--

(i) The taxpayer's tax liability as shown on an original or amended
tax return is consistent with the rules of this section for each
such year for which the statute of limitations does not preclude the
filing of an amended return on June 30, 1999; and

(ii) The taxpayer makes appropriate adjustments to eliminate any
double benefit arising from the application of this section to years
that are not open for assessment.

(3) Examples. See �1.865-2(e)(3) for examples illustrating an
effective date provision similar to the effective date provided in
this paragraph (f).

Par. 5. Section 1.865-2 is added immediately after �1.865- 1T, to
read as follows:

�1.865-2 Loss with respect to stock.

(a) General rules for allocation of loss with respect to stock--(1)
Allocation against gain. Except as otherwise provided in paragraph
(b) of this section, loss recognized with respect to stock shall be
allocated to the class of gross income and, if necessary,
apportioned between the statutory grouping of gross income (or among
the statutory groupings) and the residual grouping of gross income,
with respect to which gain (other than gain treated as a dividend
under section 964(e)(1) or 1248) from a sale of such stock would
give rise in the hands of the seller (without regard to section
865(f)). Thus, for example, loss recognized by a United States
resident on the sale of stock generally is allocated to reduce
United States source income.

(2) Stock attributable to foreign office. Except as otherwise
provided in paragraph (b) of this section, in the case of loss
recognized by a United States resident with respect to stock that is
attributable to an office or other fixed place of business in a
foreign country within the meaning of section 865(e)(3), the loss
shall be allocated to reduce foreign source income if a gain on the
sale of the stock would have been taxable by the foreign country and
the highest marginal rate of tax imposed on such gains in the
foreign country is at least 10 percent.

(3) Loss recognized by United States citizen or resident alien with
foreign tax home--(i) In general. Except as otherwise provided in
paragraph (b) of this section, in the case of loss with respect to
stock that is recognized by a United States citizen or resident
alien that has a tax home (as defined in section 911(d)(3)) in a
foreign country, the loss shall be allocated to reduce foreign
source income if a gain on the sale of the stock would have been
taxable by a foreign country and the highest marginal rate of tax
imposed on such gains in the foreign country is at least 10 percent.

(ii) Bona fide residents of Puerto Rico. Except as otherwise
provided in paragraph (b) of this section, in the case of loss with
respect to stock in a corporation described in section 865(g)(3)
recognized by a United States citizen or resident alien that is a
bona fide resident of Puerto Rico during the entire taxable year,
the loss shall be allocated to reduce foreign source income.

(4) Stock constituting a United States real property interest. Loss
recognized by a nonresident alien individual or a foreign
corporation with respect to stock that constitutes a United States
real property interest shall be allocated to reduce United States
source income. For additional rules governing the treatment of such
loss, see section 897 and the regulations thereunder.

(5) Allocation for purposes of section 904. For purposes of section
904, loss recognized with respect to stock that is allocated to
foreign source income under this paragraph (a) shall be allocated to
the separate category under section 904(d) to which gain on a sale
of the stock would have been assigned (without regard to section
904(d)(2)(A)(iii)(III)). For purposes of �1.904-4(c)(2)(ii)(A), any
such loss allocated to passive income shall be allocated (prior to
the application of �1.904- 4(c)(2)(ii)(B)) to the group of passive
income to which gain on a sale of the stock would have been assigned
had a sale of the stock resulted in the recognition of a gain under
the law of the relevant foreign jurisdiction or jurisdictions.

(b) Exceptions--(1) Dividend recapture exception--(i) In general. If
a taxpayer recognizes a loss with respect to shares of stock, and
the taxpayer (or a person described in section 1059(c)(3)(C) with
respect to such shares) included in income a dividend recapture
amount (or amounts) with respect to such shares at any time during
the recapture period, then, to the extent of the dividend recapture
amount (or amounts), the loss shall be allocated and apportioned on
a proportionate basis to the class or classes of gross income or the
statutory or residual grouping or groupings of gross income to which
the dividend recapture amount was assigned.

(ii) Exception for de minimis amounts. Paragraph (b)(1)(i) of this
section shall not apply to a loss recognized by a taxpayer on the
disposition of stock if the sum of all dividend recapture amounts
(other than dividend recapture amounts eligible for the exception
described in paragraph (b)(1)(iii) of this section (passive
limitation dividends)) included in income by the taxpayer (or a
person described in section 1059(c)(3)(C)) with respect to such
stock during the recapture period is less than 10 percent of the
recognized loss.

(iii) Exception for passive limitation dividends. Paragraph (b)(1)
(i) of this section shall not apply to the extent of a dividend
recapture amount that is treated as income in the separate category
for passive income described in section 904(d)(2)(A) (without regard
to section 904(d)(2)(A)(iii)(III)).

The exception provided for in this paragraph (b)(1)(iii) shall not
apply to any dividend recapture amount that is treated as income in
the separate category for financial services income described in
section 904(d)(2)(C).

(iv) Examples. The application of this paragraph (b)(1) may be
illustrated by the following examples:

Example 1. (i) P, a domestic corporation, is a United States
shareholder of N, a controlled foreign corporation. N has never had
any subpart F income and all of its earnings and profits are
described in section 959(c)(3). On May 5, 1998, N distributes a
dividend to P in the amount of $100. The dividend gives rise to a $5
foreign withholding tax, and P is deemed to have paid an additional
$45 of foreign income tax with respect to the dividend under section
902. Under the look-through rules of section 904(d)(3) the dividend
is general limitation income described in section 904(d)(1)(I).

(ii) On February 6, 2000, P sells its shares of N and recognizes a
$110 loss. In 2000, P has the following taxable income, excluding
the loss on the sale of N:

(A) $1,000 of foreign source income that is general limitation
income described in section 904(d)(1)(I);

(B) $1,000 of foreign source capital gain from the sale of stock in
a foreign affiliate that is sourced under section 865(f) and is
passive income described in section 904(d)(1)(A); and

(C) $1,000 of U.S. source income.

(iii) The $100 dividend paid in 1998 is a dividend recapture amount
that was included in P's income within the recapture.31 period
preceding the disposition of the N stock. The de minimis exception
of paragraph (b)(1)(ii) of this section does not apply because the
$100 dividend recapture amount exceeds 10 percent of the $110 loss.
Therefore, to the extent of the $100 dividend recapture amount, the
loss must be allocated under paragraph (b)(1)(i) of this section to
the separate limitation category to which the dividend was assigned
(general limitation income).

(iv) P's remaining $10 loss on the disposition of the N stock is
allocated to U.S. source income under paragraph (a)(1) of this
section.

(v) After allocation of the stock loss, P's foreign source taxable
income in 2000 consists of $900 of foreign source general limitation
income and $1,000 of foreign source passive income.

Example 2. (i) P, a domestic corporation, owns all of the stock of
N1, which owns all of the stock of N2, which owns all of the stock
of N3. N1, N2, and N3 are controlled foreign corporations. All of
the corporations use the calendar year as their taxable year. On
February 5, 1997, N3 distributes a dividend to N2. The dividend is
foreign personal holding company income of N2 under section 954(c)
(1)(A) that results in an inclusion of $100 in P's income under
section 951(a)(1)(A)(i) as of December 31, 1997. Under section
904(d)(3)(B) the inclusion is general limitation income described in
section 904(d)(1)(I).

The income inclusion to P results in a corresponding increase in P's
basis in the stock of N1 under section 961(a).

(ii) On March 5, 1999, P sells its shares of N1 and recognizes a
$110 loss. The $100 1997 subpart F inclusion is a dividend recapture
amount that was included in P's income within the recapture period
preceding the disposition of the N1 stock.

The de minimis exception of paragraph (b)(1)(ii) of this section
does not apply because the $100 dividend recapture amount exceeds 10
percent of the $110 loss. Therefore, to the extent of the $100
dividend recapture amount, the loss must be allocated under
paragraph (b)(1)(i) of this section to the separate limitation
category to which the dividend recapture amount was assigned
(general limitation income). The remaining $10 loss is allocated to
U.S. source income under paragraph (a)(1) of this section.

Example 3. (i) P, a domestic corporation, owns all of the stock of
N1, which owns all of the stock of N2. N1 and N2 are controlled
foreign corporations. All the corporations use the calendar year as
their taxable year and the U.S. dollar as their functional currency.
On May 5, 1998, N2 pays a dividend of $100 to N1 out of general
limitation earnings and profits.

(ii) On February 5, 2000, N1 sells its N2 stock to an unrelated
purchaser. The sale results in a loss to N1 of $110 for U.S. tax
purposes. In 2000, N1 has the following current earnings and
profits, excluding the loss on the sale of N2:

(A) $1,000 of non-subpart F foreign source general limitation
earnings and profits described in section 904(d)(1)(I);

(B) $1,000 of foreign source gain from the sale of stock that is
taken into account in determining foreign personal holding company
income under section 954(c)(1)(B)(i) and which is passive limitation
earnings and profits described in section 904(d)(1)(A);

(C) $1,000 of foreign source interest income received from an
unrelated person that is foreign personal holding company income
under section 954(c)(1)(A) and which is passive limitation earnings
and profits described in section 904(d)(1)(A).

(iii) The $100 dividend paid in 1998 is a dividend recapture amount
that was included in N1's income within the recapture period
preceding the disposition of the N2 stock. The de minimis exception
of paragraph (b)(1)(ii) of this section does not apply because the
$100 dividend recapture amount exceeds 10 percent of the $110 loss.
Therefore, to the extent of the $100 dividend recapture amount, the
loss must be allocated under paragraph (b)(1)(i) of this section to
the separate limitation category to which the dividend was assigned
(general limitation earnings and profits).

(iv) N1's remaining $10 loss on the disposition of the N2 stock is
allocated to foreign source passive limitation earnings and profits
under paragraph (a)(1) of this section.

(v) After allocation of the stock loss, N1's current earnings and
profits for 1998 consist of $900 of foreign source general
limitation earnings and profits and $1,990 of foreign source passive
limitation earnings and profits.

(vi) After allocation of the stock loss, N1's subpart F income for
2000 consists of $1,000 of foreign source interest income that is
foreign personal holding company income under section 954(c)(1)(A)
and $890 of foreign source net gain that is foreign personal holding
company income under section 954(c)(1)(B)(i). P includes $1,890 in
income under section 951(a)(1)(A)(i) as passive income under
sections 904(d)(1)(A) and 904(d)(3)(B).

Example 4. P, a foreign corporation, has two wholly-owned
subsidiaries, S, a domestic corporation, and B, a foreign
corporation. On January 1, 2000, S purchases a one-percent interest
in N, a foreign corporation, for $100. On January 2, 2000, N
distributes a $20 dividend to S. The $20 dividend is foreign source
financial services income. On January 3, 2000, S sells its N stock
to B for $80 and recognizes a $20 loss that is deferred under
section 267(f). On June 10, 2008, B sells its N stock to an
unrelated person for $55. Under section 267(f) and �1.267(f)-1(c)
(1), S's $20 loss is deferred until 2008. Under this paragraph (b)
(1), the $20 loss is allocated to reduce foreign source financial
services income in 2008 because the loss was recognized (albeit
deferred) within the 24-month recapture period following the receipt
of the dividend. See ��1.267(f)-1( a)(2)(i)(B) and 1.267(f)-1(c)(2).

Example 5. The facts are the same as in Example 4, except P, S, and
B are domestic corporations and members of the P consolidated group.
Under the matching rule of �1.1502-13(c)(1), the separate entity
attributes of S's intercompany items and B's corresponding items are
redetermined to the extent necessary to produce the same effect on
consolidated taxable income as if S and B were divisions of a single
corporation and the intercompany transaction was a transaction
between divisions. If S and B were divisions of a single
corporation, the transfer of N stock on January 3, 2000 would be
ignored for tax purposes, and the corporation would be treated as
selling that stock only in 2008.

Thus, the corporation's entire $45 loss would have been allocated
against U.S. source income under paragraph (a)(1) of this section
because a dividend recapture amount was not received during the
corporation's recapture period. Accordingly, S's $20 loss and B's
$25 loss are allocated to reduce U.S. source income.

(2) Exception for inventory. This section does not apply to loss
recognized with respect to stock described in section 1221(1).

(3) Exception for stock in an S corporation. This section does not
apply to loss recognized with respect to stock in an S corporation
(as defined in section 1361).

(4) Anti-abuse rules--(i) Transactions involving built-in losses. If
one of the principal purposes of a transaction is to change the
allocation of a built-in loss with respect to stock by transferring
the stock to another person, qualified business unit (within the
meaning of section 989(a)), office or other fixed place of business,
or branch that subsequently recognizes the loss, the loss shall be
allocated by the transferee as if it were recognized with respect to
the stock by the transferor immediately prior to the transaction. If
one of the principal purposes of a change of residence is to change
the allocation of a built-in loss with respect to stock, the loss
shall be allocated as if the change of residence had not occurred.
If one of the principal purposes of a transaction is to change the
allocation of a built-in loss with respect to stock (or other
personal property) by converting the original property into other
property and subsequently recognizing loss with respect to such
other property, the loss shall be allocated as if it were recognized
with respect to the original property immediately prior to the
transaction. Transactions subject to this paragraph shall include,
without limitation, reorganizations within the meaning of section
368(a), liquidations under section 332, transfers to a corporation
under section 351, transfers to a partnership under section 721,
transfers to a trust, distributions by a partnership, distributions
by a trust, or transfers to or from a qualified business unit,
office or other fixed place of business. A person may have a
principal purpose of affecting loss allocation even though this
purpose is outweighed by other purposes (taken together or
separately).

(ii) Offsetting positions. If a taxpayer recognizes loss with
respect to stock and the taxpayer (or any person described in
section 267(b) (after application of section 267(c)), 267(e), 318 or
482 with respect to the taxpayer) holds (or held).35 offsetting
positions with respect to such stock with a principal purpose of
recognizing foreign source income and United States source loss, the
loss will be allocated and apportioned against such foreign source
income. For purposes of this paragraph (b)(4)(ii), positions are
offsetting if the risk of loss of holding one or more positions is
substantially diminished by holding one or more other positions.

(iii) Matching rule. [Reserved] For further guidance, see
�1.865-2T(b)(4)(iii).

(iv) Examples. The application of this paragraph (b)(4) may be
illustrated by the following examples. No inference is intended
regarding the application of any other Internal Revenue Code section
or judicial doctrine that may apply to disallow or defer the
recognition of loss. The examples are as follows:

Example 1. (i) Facts. On January 1, 2000, P, a domestic corporation,
owns all of the stock of N1, a controlled foreign corporation, which
owns all of the stock of N2, a controlled foreign corporation. N1's
basis in the stock of N2 exceeds its fair market value, and any loss
recognized by N1 on the sale of N2 would be allocated under
paragraph (a)(1) of this section to reduce foreign source passive
limitation earnings and profits of N1. In contemplation of the sale
of N2 to an unrelated purchaser, P causes N1 to liquidate with
principal purposes of recognizing the loss on the N2 stock and
allocating the loss against U.S. source income. P sells the N2 stock
and P recognizes a loss.

(ii) Loss allocation. Because one of the principal purposes of the
liquidation was to transfer the stock to P in order to change the
allocation of the built-in loss on the N2 stock, under paragraph (b)
(4)(i) of this section the loss is allocated against P's foreign
source passive limitation income.

Example 2. (i) Facts. On January 1, 2000, P, a domestic corporation,
forms N and F, foreign corporations, and contributes $1,000 to the
capital of each. N and F enter into offsetting positions in
financial instruments that produce financial services income.
Holding the N stock substantially diminishes P's risk of loss with
respect to the F stock (and vice versa). P holds N and F with a
principal purpose of recognizing foreign source income and U.S.
source loss. On March 31, 2000, when the financial instrument held
by N is worth $1,200 and the financial instrument held by F is worth
$800, P sells its F stock and recognizes a $200 loss.

(ii) Loss allocation. Because P held an offsetting position with
respect to the F stock with a principal purpose of recognizing
foreign source income and U.S. source loss, the $200 loss is
allocated against foreign source financial services income under
paragraph (b)(4)(ii) of this section.

(c) Loss recognized by partnership. A partner's distributive share
of loss recognized by a partnership shall be allocated and
apportioned in accordance with this section as if the partner had
recognized the loss. If loss is attributable to an office or other
fixed place of business of the partnership within the meaning of
section 865(e)(3), such office or fixed place of business shall be
considered to be an office of the partner for purposes of this
section.

(d) Definitions--(1) Terms defined in �1.861-8. See �1.861- 8 for
the meaning of class of gross income, statutory grouping of gross
income, and residual grouping of gross income.

(2) Dividend recapture amount. A dividend recapture amount is a
dividend (except for an amount treated as a dividend under section
78), an inclusion described in section 951(a)(1)(A)(i) (but only to
the extent attributable to a dividend (including a dividend under
section 964(e)(1)) included in the earnings of a controlled foreign
corporation (held directly or indirectly by the person recognizing
the loss) that is included in foreign personal holding company
income under section 954(c)(1)(A)) and an inclusion described in
section 951(a)(1)(B).

(3) Recapture period. A recapture period is the 24-month period
preceding the date on which a taxpayer recognizes a loss with
respect to stock, increased by any period of time in which the
taxpayer has diminished its risk of loss in a manner described in
section 246(c)(4) and the regulations thereunder and by any period
in which the assets of the corporation are hedged against risk of
loss with a principal purpose of enabling the taxpayer to hold the
stock without significant risk of loss until the recapture period
has expired.

(4) United States resident. See section 865(g) and the regulations
thereunder for the definition of United States resident.

(e) Effective date--(1) In general. This section is effective for
loss recognized on or after January 11, 1999. For purposes of this
paragraph (e), loss that is recognized but deferred (for example,
under section 267 or 1092) shall be treated as recognized at the
time the loss is taken into account.

(2) Application to prior periods. A taxpayer may apply the rules of
this section to losses recognized in any taxable year beginning on
or after January 1, 1987, and all subsequent years, provided that--

(i) The taxpayer's tax liability as shown on an original or amended
tax return is consistent with the rules of this section and
�1.865-2T for each such year for which the statute of limitations
does not preclude the filing of an amended return on June 30, 1999;
and

(ii) The taxpayer makes appropriate adjustments to eliminate any
double benefit arising from the application of this section to years
that are not open for assessment.

(3) Examples. The rules of this paragraph (e) may be illustrated by
the following examples:

Example 1. (i) P, a domestic corporation, has a calendar taxable
year. On March 10, 1985, P recognizes a $100 capital loss on the
sale of N, a foreign corporation. Pursuant to sections 1211(a) and
1212(a), the loss is not allowed in 1985 and is carried over to the
1990 taxable year. The loss is allocated against foreign source
income under �1.861-8(e)(7). In 1999, P chooses to apply this
section to all losses recognized in its 1987 taxable year and in all
subsequent years.

(ii) Allocation of the loss on the sale of N is not affected by the
rules of this section because the loss was recognized in a taxable
year that did not begin after December 31, 1986.

Example 2. (i) P, a domestic corporation, has a calendar taxable
year. On March 10, 1988, P recognizes a $100 capital loss on the
sale of N, a foreign corporation. Pursuant to sections 1211(a) and
1212(a), the loss is not allowed in 1988 and is carried back to the
1985 taxable year. The loss is allocated against foreign source
income under �1.861-8(e)(7) on P's federal income tax return for
1985 and increases an overall foreign loss account under
�1.904(f)-1.

(ii) In 1999, P chooses to apply this section to all losses
recognized in its 1987 taxable year and in all subsequent years.

Consequently, the loss on the sale of N is allocated against U.S.
source income under paragraph (a)(1) of this section. Allocation of
the loss against U.S. source income reduces P's overall foreign loss
account and increases P's tax liability in 2 years:

1990, a year that will not be open for assessment on June 30, 1999,
and 1997, a year that will be open for assessment on June 30, 1999.
Pursuant to paragraph (e)(2)(i) of this section, P must file an
amended federal income tax return that reflects the rules of this
section for 1997, but not for 1990.

Example 3. (i) P, a domestic corporation, has a calendar taxable
year. On March 10, 1989, P recognizes a $100 capital loss on the
sale of N, a foreign corporation. The loss is allocated against
foreign source income under �1.861-8(e)(7) on P's federal income tax
return for 1989 and results in excess foreign tax credits for that
year. The excess credit is carried back to 1988, pursuant to section
904(c). In 1999, P chooses to apply this section to all losses
recognized in its 1989 taxable year and in all subsequent years. On
June 30, 1999, P's 1988 taxable year is closed for assessment, but
P's 1989 taxable year is open with respect to claims for refund.

(ii) Because P chooses to apply this section to its 1989 taxable
year, the loss on the sale of N is allocated against U.S. source
income under paragraph (a)(1) of this section. Allocation of the
loss against U.S. source income would have permitted the foreign tax
credit to be used in 1989, reducing P's tax liability in 1989.
Nevertheless, under paragraph (e)(2)(ii) of this section, because
the credit was carried back to 1988, P may not claim the foreign tax
credit in 1989.

Par. 6. Section 1.865-2T is added immediately after �1.865- 2, to
read as follows:

�1.865-2T Loss with respect to stock (Temporary).

(a) through (b)(4)(ii) [Reserved] For further guidance, see
�1.865-2(a) through (b)(4)(ii).

(b)(4)(iii) Matching rule. To the extent a taxpayer (or a person
described in section 1059(c)(3)(C) with respect to the taxpayer)
recognizes foreign source income for tax purposes that results in
the creation of a corresponding loss with respect to stock, the loss
shall be allocated and apportioned against such income. This
paragraph (b)(4)(iii) shall not apply to the extent a loss is
related to a dividend recapture amount and �1.865- 2(b)(1)(ii) (de
minimis exception) or (b)(1)(iii) (passive dividend exception)
exempts the loss from �1.865-2(b)(1)(i) (dividend recapture rule),
unless the stock is held with a principal purpose of producing
foreign source income and corresponding loss.

(iv) Examples. The application of this paragraph (b)(4) may be
illustrated by the following examples. No inference is intended
regarding the application of any other Internal Revenue Code section
or judicial doctrine that may apply to disallow or defer the
recognition of loss. The examples are as follows:

Examples 1 and 2. [Reserved] For further guidance, see �1.865-2(b)
(4)(iv).

Example 3. (i) Facts. On January 1, 1999, P and Q, domestic
corporations, form R, a domestic partnership. The corporations and
partnership use the calendar year as their taxable year. P
contributes $900 to R in exchange for a 90- percent partnership
interest and Q contributes $100 to R in exchange for a 10-percent
partnership interest. R purchases a dance studio in country X for
$1,000. On January 2, 1999, R enters into contracts to provide dance
lessons in Country X for a 5-year period beginning January 1, 2000.
These contracts are prepaid by the dance studio customers on
December 31, 1999, and R recognizes foreign source taxable income of
$500 from the prepayments (R's only income in 1999). P takes into
income its $450 distributive share of partnership taxable income. On
January 1, 2000, P's basis in its partnership interest is $1,350
($900 from its contribution under section 722, increased by its $450
distributive share of partnership income under section 705).

On September 22, 2000, P contributes its R partnership interest to
S, a newly-formed domestic corporation, in exchange for all the
stock of S. Under section 358, P's basis in S is $1,350. On December
1, 2000, P sells S to an unrelated party for $1050 and recognizes a
$300 loss.

(ii) Loss allocation. Because P recognized foreign source income for
tax purposes that resulted in the creation of a corresponding loss
with respect to the S stock, the $300 loss is allocated against
foreign source income under paragraph (b)(4)(iii) of this section.

Example 4. (i) Facts. On January 1, 2000, P, a domestic corporation
that uses the calendar year as its taxable year forms N, a foreign
corporation. P contributes $1,000 to the capital of N in exchange
for 100 shares of common stock. P contributes an additional $1,000
to the capital of N in exchange for 100 shares of preferred stock.
Each preferred share is entitled to 15- percent dividend but is
redeemable by N on or after January 1, 2010, for $1. Prior to
January 10, 2005, P receives a total of $750 of distributions from N
with respect to its preferred shares, which P treats as foreign
source general limitation dividends. On January 10, 2005, P sells
its 100 preferred shares in N to an unrelated purchaser for $600.
Assume that this arrangement is not recharacterized under Notice
97-21 (1997-1 C.B. 407).

(ii) Loss allocation. Because P recognized foreign source income for
tax purposes that resulted in the creation of a corresponding loss
with respect to the N stock, the $400 loss is allocated against
foreign source general limitation income under paragraph (b)(4)(iii)
of this section.

Example 5. (i) Facts. On January 1, 2000, P, a domestic corporation
that uses the calendar year as its taxable year, and F, a newly-
formed controlled foreign corporation wholly-owned by P, form N, a
foreign corporation. P contributes $1,000 to the capital of N in
exchange for 100 shares of common stock and $1,000 to the capital of
F in exchange for 100 shares of common stock. F contributes LC1,000
to the capital of N in exchange for 100 shares of preferred stock.
Each preferred share is entitled to a 65-percent LC dividend. At the
time of the contributions, $1=LC1. The LC is expected to depreciate
significantly in relation to the U.S. dollar. Prior to June 10,
2005, P receives a total of $1,900 of distributions from F, which it
treats as foreign source general limitation dividends. On June 10,
2005, the N preferred stock has a fair market value of $25 and P
sells F for $25 to an unrelated person. Assume that this arrangement
is not recharacterized under Notice 97-21 (1997-1 C.B. 407).

(ii) Loss allocation. Because P recognized foreign source income for
tax purposes that resulted in the creation of a corresponding loss
with respect to the F stock, the $975 loss is allocated against
foreign source general limitation income under paragraph (b)(4)(iii)
of this section.

Example 6. (i) Facts. On January 1, 1998, P, a domestic corporation,
purchases N, a foreign corporation, for $1000. On March 1, 1998, N
sells its operating assets, distributes a $400 general limitation
dividend to P, and invests its remaining $600 in short term
government securities. N earns interest income from the securities.
The income constitutes subpart F income that is included in P's
income under section 951, increasing P's basis in the N stock under
section 961(a). On March 1, 2002, P sells N and recognizes a $400
loss.

(ii) Loss allocation. The $400 dividend received by P resulted in a
$400 built-in loss in the N stock, which was locked in for P's four-
year holding period. Because P recognized foreign source income for
tax purposes that resulted in the creation of a corresponding loss
with respect to the N stock, under paragraph (b)(4)(iii) of this
section the $400 loss is allocated against foreign source general
limitation income.

(e) Effective date--(1) In general. This section is effective for
loss recognized on or after January 11, 1999. For purposes of this
paragraph (e), loss that is recognized but deferred (for example,
under section 267 or 1092) shall be treated as recognized at the
time the loss is taken into account.

This section shall cease to be effective January 8, 2002.

(2) Application to prior periods. A taxpayer may apply the rules of
this section to losses recognized in any taxable year beginning on
or after January 1, 1987, and all subsequent years, provided that--
(i) The taxpayer's tax liability as shown on an original or amended
tax return is consistent with the rules of this section and �1.865-2
for each such year for which the statute of limitations does not
preclude the filing of an amended return on June 30, 1999; and (ii)
The taxpayer makes appropriate adjustments to eliminate any double
benefit arising from the application of this section to years that
are not open for assessment.

Par. 7. Section 1.904-0 is amended by revising the entry for
�1.904-4(c)(2)(i) and (ii) and adding entries for paragraphs (c)(2)
(i)(A), (c)(2)(i)(B), (c)(2)(ii)(A) and (c)(2)(ii)(B) to read as
follows:

�1.904-0 Outline of regulation provisions for section 904.

* * * * *

�1.904-4 Separate application of section 904 with respect to certain
categories of income.

* * * * *

(c) * * *

(2) * * *

(i) Effective dates.

(A) In general.

(B) Application to prior periods.

(ii) Grouping rules.

(A) Initial allocation and apportionment of deductions and taxes.

(B) Reallocation of loss groU.S.

* * * * *

Par. 8. Section 1.904-4 is amended by:

1. Revising paragraphs (c)(1) and (c)(2),

2. Revising paragraph (c)(3)(iii),

3. Adding paragraph (c)(3)(iv), and

4. Amending paragraph (c)(8) by adding Example 11, Example 12 and
Example 13.

5. The additions and revisions read as follows:

�1.904-4 Separate application of section 904 with respect to certain
categories of income.

* * * * *

(c) High-taxed income--(1) In general. Income received or accrued by
a United States person that would otherwise be passive income shall
not be treated as passive income if the income is determined to be
high-taxed income. Income shall be considered to be high-taxed
income if, after allocating expenses, losses and other deductions of
the United States person to that income under paragraph (c)(2)(ii)
of this section, the sum of the foreign income taxes paid or accrued
by the United States person with respect to such income and the
foreign taxes deemed paid or accrued by the United States person
with respect to such income under section 902 or section 960 exceeds
the highest rate of tax specified in section 1 or 11, whichever
applies (and with reference to section 15 if applicable), multiplied
by the amount of such income (including the amount treated as a
dividend under section 78). If, after application of this paragraph
(c), income that would otherwise be passive income is determined to
be high-taxed income, such income shall be treated as general
limitation income, and any taxes imposed on that income shall be
considered related to general limitation income under �1.904-6.

If, after application of this paragraph (c), passive income is zero
or less than zero, any taxes imposed on the passive income shall be
considered related to general limitation income. For additional
rules regarding losses related to passive income, see paragraph (c)
(2) of this section. Income and taxes shall be translated at the
appropriate rates, as determined under sections 986, 987 and 989 and
the regulations under those sections, before application of this
paragraph (c). For purposes of allocating taxes to groups of income,
United States source passive income is treated as any other passive
income. In making the determination whether income is high-taxed,
however, only foreign source income, as determined under United
States tax principles, is relevant. See paragraph (c)(8) Examples 10
through 13 of this section for examples illustrating the application
of this paragraph (c)(1) and paragraph (c)(2) of this section.

(2) Grouping of items of income in order to determine whether
passive income is high-taxed income--(i) Effective dates--(A) In
general. For purposes of determining whether passive income is high-
taxed income, the grouping rules of paragraphs (c)(3)(i) and (ii),
(c)(4), and (c)(5) of this section apply to taxable years beginning
after December 31, 1987. Except as provided in paragraph (c)(2)(i)
(B) of this section, the rules of paragraph (c)(3)(iii) apply to
taxable years beginning after December 31, 1987, and ending before
December 31, 1998, and the rules of paragraph (c)(3)(iv) apply to
taxable years ending on or after December 31, 1998. See Notice 87-6
(1987-1 C.B.417) for the grouping rules applicable to taxable years
beginning after December 31, 1986 and before January 1, 1988. The
fourth sentence of paragraph (c)(2)(ii)(A) and paragraph (c)(2)(ii)
(B) of this section are effective for taxable years beginning after
March 12, 1999.

(B) Application to prior periods. A taxpayer may apply the rules of
paragraph (c)(3)(iv) to any taxable year beginning after December
31, 1991, and all subsequent years, provided that--

(1) The taxpayer's tax liability as shown on an original or amended
tax return is consistent with the rules of this section for each
such year for which the statute of limitations does not preclude the
filing of an amended return on June 30, 1999; and

(2) The taxpayer makes appropriate adjustments to eliminate any
double benefit arising from the application of this section to years
that are not open for assessment.

(ii) Grouping rules--(A) Initial allocation and apportionment of
deductions and taxes. For purposes of determining whether passive
income is high-taxed, expenses, losses and other deductions shall be
allocated and apportioned initially to each of the groups of passive
income (described in paragraphs (c)(3), (4), and (5) of this
section) under the rules of ��1.861-8 through 1.861-14T and 1.865-1T
through 1.865-2T.

Taxpayers that allocate and apportion interest expense on an asset
basis may nevertheless apportion passive interest expense among the
groups of passive income on a gross income basis.

Foreign taxes are allocated to groups under the rules of �1.904-
6(a)(iii). If a loss on a disposition of property gives rise to
foreign tax (i.e., the transaction giving rise to the loss is
treated under foreign law as having given rise to a gain), the
foreign tax shall be allocated to the group of passive income to
which gain on the sale would have been assigned under paragraph (c)
(3) or (4) of this section. A determination of whether passive
income is high-taxed shall be made only after application of
paragraph (c)(2)(ii)(B) of this section (if applicable).

(B) Reallocation of loss groups. If, after allocation and
apportionment of expenses, losses and other deductions under
paragraph (c)(2)(ii)(A) of this section, the sum of the allocable
deductions exceeds the gross income in one or more groups, the
excess deductions shall proportionately reduce income in the other
groups (but not below zero).

(3) * * *

(iii) For taxable years ending before December 31, 1998 (except as
provided in paragraph (c)(2)(i)(B) of this section), all passive
income received during the taxable year that is subject to no
withholding tax shall be treated as one item of income.

(iv) For taxable years ending on or after December 31, 1998, all
passive income received during the taxable year that is subject to
no withholding tax or other foreign tax shall be treated as one item
of income, and all passive income received during the taxable year
that is subject to no withholding tax but is subject to a foreign
tax other than a withholding tax shall be treated as one item of
income.

* * * * *

(8) * * *

Example 11. In 2001, P, a U.S. citizen with a tax home in Country X,
earns the following items of gross income: $400 of foreign source,
passive limitation interest income not subject to foreign
withholding tax but subject to Country X income tax of $100, $200 of
foreign source, passive limitation royalty income subject to a 5
percent foreign withholding tax (foreign tax paid is $10), $1,300 of
foreign source, passive limitation rental income subject to a 25
percent foreign withholding tax (foreign tax paid is $325), $500 of
foreign source, general limitation income that gives rise to a $250
foreign tax, and $2,000 of U.S. source capital gain that is not
subject to any foreign tax. P has a $900 deduction allocable to its
passive rental income. P's only other deduction is a $700 capital
loss on the sale of stock that is allocated to foreign source
passive limitation income under �1.865-2(a)(3)(i). The $700 capital
loss is initially allocated to the group of passive income subject
to no withholding tax but subject to foreign tax other than
withholding tax. The $300 amount by which the capital loss exceeds
the income in the group must be reapportioned to the other groups
under paragraph (c)(2)(ii)(B) of this section. The royalty income is
thus reduced by $100 to $100 ($200 - ($300 x (200/600))) and the
rental income is thus reduced by $200 to $200 ($400 - ($300 x
(400/600))). The $100 royalty income is not high-taxed and remains
passive income because the foreign taxes do not exceed the highest
United States rate of tax on that income. Under the high-tax kick-
out, the $200 of rental income and the $325 of associated foreign
tax are assigned to the general limitation category.

Example 12. The facts are the same as in Example 11 except the
amount of the capital loss that is allocated under �1.865- 2(a)(3)
(i) and paragraph (c)(2) of this section to the group of foreign
source passive income subject to no withholding tax but subject to
foreign tax other than withholding tax is $1,200.

Under paragraph (c)(2)(ii)(B) of this section, the excess deductions
of $800 must be reapportioned to the $200 of net royalty income
subject to a 5 percent withholding tax and the $400 of net rental
income subject to a 15 percent or greater withholding tax. The
income in each of these groups is reduced to zero, and the foreign
taxes imposed on the rental and royalty income are considered
related to general limitation income. The remaining loss of $200
constitutes a separate limitation loss with respect to passive
income.

Example 13. In 2001, P, a domestic corporation, earns a $100
dividend that is foreign source passive limitation income subject to
a 30-percent withholding tax. A foreign tax credit for the
withholding tax on the dividend is disallowed under section 901(k).
A deduction for the tax is allowed, however, under sections 164 and
901(k)(7). In determining whether P's passive income is high-taxed,
the $100 dividend and the $30 deduction are allocated to the first
group of income described in paragraph (c)(3)(iv) of this section
(passive income subject to no withholding tax or other foreign tax).

* * * * *

Robert E. Wenzel
Deputy Commissioner of Internal Revenue
Approved: December 15, 1998
Donald C. Lubick
Assistant Secretary of the Treasury

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