Section 42(a) provides for a credit for investment in certain low-income housing buildings. The amount of the low-income housing credit for any taxable year in the credit period is an amount equal to the applicable percentage of the qualified basis of each qualified low-income building (as defined in § 42(c)(2)).

Section 42(c)(1)(A) provides that the qualified basis of any qualified low-income building for any taxable year is an amount equal to (i) the applicable fraction (determined as of the close of the taxable year) of (ii) the eligible basis of the building (determined under § 42(d)).

Section 42(c)(1)(B) defines the applicable fraction as the smaller of the unit fraction or the floor space fraction. Section 42(c)(1)(C) defines the unit fraction as the fraction the numerator of which is the number of low-income units (as defined in § 42(i)(3)(A)) in the building and the denominator of which is the number of residential rental units (that is, all units in the building which are available to rent as personal residences), whether or not occupied, in the building. Section 42(c)(1)(D) defines the floor space fraction as the fraction the numerator of which is the total floor space of the low-income units in the building and the denominator of which is the total floor space of the residential rental units, whether or not occupied, in the building.

Section 42(d)(1) provides that the eligible basis of a new building is its adjusted basis as of the close of the first taxable year of the credit period. Section 42(d)(4)(A) provides that, except as provided in § 42(d)(4)(B) and (C), the adjusted basis of any building is determined without regard to the adjusted basis of any property that is not residential rental property. Section 42(d)(4)(B) provides that the adjusted basis of any building includes the adjusted basis of property of a character subject to the allowance for depreciation (1) used in common areas or (2) provided as comparable amenities to all residential rental units in the building.

Section 42(d)(4)(C)(i) provides that the adjusted basis of any building located in a qualified census tract is determined by taking into account the adjusted basis of property (of a character subject to the allowance for depreciation and not otherwise taken into account) used throughout the taxable year in providing any community service facility. Section 42(d)(4)(C)(iii) provides that the term “community service facility” means any facility designed to serve primarily individuals whose income is 60 percent or less of area median income (AMGI) (within the meaning of § 42(g)(1)(B)). Section 42(d)(5)(C)(ii)(I) defines the term “qualified census tract” as any census tract (1) which is designated by the Secretary of Housing and Urban Development (HUD), and (2) for the most recent year for which census data are available on household income in the tract, either in which 50 percent or more of the households have an income which is less than 60 percent of the AMGI for the year or which has a poverty rate of at least 25 percent. See http://www.huduser.org/datasets/qct.html for a listing of census tracts designated by the Secretary of HUD.

Section 42(d)(4)(C)(ii) provides that the increase in the adjusted basis of any building which is taken into account because of a community service facility may not exceed 10 percent of the eligible basis of the qualified low-income housing project (as defined in § 42(g)(1)) of which the community service facility is a part. For this purpose, § 42(d)(4)(C)(ii) provides that all community service facilities which are part of the same qualified low-income housing project are treated as one facility.

Rev. Rul. 2003-77, 2003-29 I.R.B. 75, provides that the requirement that a community service facility must be designed to serve primarily individuals whose income is 60 percent or less of AMGI will be satisfied if the following conditions are met. First, the facility must be used to provide services that will improve the quality of life for community residents. Second, the taxpayer must demonstrate that the services provided at the facility will be appropriate and helpful to individuals in the area of the project whose income is 60 percent or less of AMGI. This may, for example, be demonstrated in the market study required to be conducted under § 42(m)(1)(A)(iii), or another similar study. Third, the facility must be located on the same tract of land as one of the buildings that is part of the qualified low-income housing project. Finally, if fees are charged for services provided, they must be affordable to individuals whose income is 60 percent or less of AMGI.

The legislative history of § 42 states that residential rental property for purposes of the low-income housing credit has the same meaning as residential rental property for purposes of § 103. The legislative history of § 42 further states that residential rental property includes residential rental units, facilities for use by the tenants, and other facilities reasonably required by the project. H.R. Conf. Rep. No. 841, 99^th Cong., 2d Sess. II-89 (1986), 1986-3 (Vol. 4) C.B. 89.

In the Tax Reform Act of 1986 (the “1986 Act”), Congress reorganized §§ 103 and 103A of the Internal Revenue Code of 1954 (the “1954 Code”) regarding tax-exempt bonds into §§ 103 and 141 through 150 of the Internal Revenue Code of 1986. Congress intended that to the extent not amended by the 1986 Act, all principles of pre-1986 Act law would continue to apply to the reorganized provisions. H.R. Conf. Rep. No. 841, 99^th Cong., 2d Sess. II-686 (1986), 1986-3 (Vol. 4) C.B. 686. Because no regulations have been promulgated relating to residential rental property for purposes of § 103, the regulations relating to residential rental property promulgated pursuant to the 1954 Code continue to apply except as otherwise modified by the 1986 Act and subsequent law.

Under § 1.103-8(b)(4)(i) of the Income Tax Regulations, facilities that are functionally related and subordinate to residential rental projects are considered residential rental property. Section 1.103-8(b)(4)(iii) provides that functionally related and subordinate facilities include facilities for use by the tenants, such as swimming pools and other recreational facilities, parking areas, and other facilities reasonably required for the project. Examples in § 1.103-8(b)(4)(iii) of facilities reasonably required for a project include units for resident managers or maintenance personnel.

Q-1. A new qualified low-income building (Building) is located in an area in which owners of apartment buildings typically employ security officers due to the level of crime in the area.

(a) If a unit in Building is occupied by a full-time security officer for that building and Building’s owner requires the security officer to live in the unit, is the adjusted basis of that unit includable in Building’s eligible basis under § 42(d)(1)?

(b) If yes, is that unit a residential rental unit includable in the numerator and denominator of Building’s applicable fraction under § 42(c)(1)(B)?

A-1. (a) Yes. The legislative history of § 42 indicates that residential rental property includes, in addition to the residential rental units, facilities for use by the tenants and other facilities reasonably required by the project.

Under § 1.103-8(b)(4)(iii), functionally related and subordinate property is property that is reasonably required for the project. Examples of functionally related and subordinate property are units for resident managers or maintenance personnel. See § 1.103-8(b)(4)(iii). Thus, while units for resident managers or maintenance personnel are not residential rental units, they are treated as part of residential rental property because these units are functionally related and subordinate to the project. The unit occupied by a full-time security officer is similar to the units described in the examples contained in § 1.103-8(b)(4)(iii), and is reasonably required by the project because of the level of crime in the area. Thus, the unit is functionally related and subordinate to Building. As a result, the unit is residential rental property for purposes of § 42 and its adjusted basis is includable in Building’s eligible basis under § 42(d)(1).

(b) No. The term “residential rental unit” has a different meaning than the term “residential rental property” for purposes of § 42. Under § 1.103-8(b)(4)(iii), units for resident managers or maintenance personnel are residential rental property because they are functionally related and subordinate to residential rental projects, not because they are residential rental units. Similarly, a unit occupied by a full-time security officer is not a residential rental unit. Only residential rental units are includable in Building’s applicable fraction under § 42(c)(1)(B).

If in a later year of the credit period, the unit occupied by the full-time security officer is converted to a residential rental unit, the unit will be includable in the denominator of Building’s applicable fraction for that year. If the unit also becomes a low-income unit in a later year, the unit will be includable in the numerator of Building’s applicable fraction for that year.

Q-2. A new qualified low-income building (Building) received a housing credit allocation on June 1, 2003, and was placed in service in 2004. Building is located in a qualified census tract (as defined in § 42(d)(5)(C)). The neighborhood in which Building is located is an area with a high rate of crime. In 2004, the local police department leases a unit in Building to be used as a police substation (Facility). The Facility is part of the police department’s community outreach program. This Facility is intended to serve as a deterrent to crime in the community, assist the community with solving crime-related problems, reduce the response time to area calls for service, and provide the locally assigned police officers with a local office. The services provided by the police are free of charge. The adjusted basis of the property constituting the Facility (of a character subject to the allowance for depreciation and not otherwise taken into account in the adjusted basis of Building) does not exceed 10 percent of the eligible basis of Building.

As required by § 42(m)(1)(A)(iii), prior to the allocation of low-income housing credit to Building, a comprehensive market study was conducted to assess the housing needs of the low-income individuals in the area to be served by Building. The study found, among other items, that due to the high rate of crime in the community in which Building is located, providing a police substation would be appropriate and helpful to individuals in the area of Building whose income is 60 percent or less of AMGI.

(a) Is the adjusted basis of the Facility includable in Building’s eligible basis under § 42(d)(1)?

(b) If yes, is the Facility includable in Building’s applicable fraction under § 42(c)(1)(B)?

A-2. (a) Yes. The Facility qualifies as a community service facility under § 42(d)(4)(C)(iii). Under the facts presented, the Facility is designed to serve primarily individuals whose income is 60 percent or less of AMGI for the following reasons: (1) the services provided at the Facility are services that will help improve the quality of life for community residents; (2) the market study required to be conducted under § 42(m)(1)(A)(iii) found that the services provided at the Facility would be appropriate and helpful to individuals in the area of Building whose income is 60 percent or less of AMGI; (3) the Facility is located within Building; and (4) the services provided at the Facility are affordable to individuals whose income is 60 percent or less of AMGI.

Because the other requirements set forth in § 42(d)(4)(C) are met, the adjusted basis of Building will be determined by taking into account the adjusted basis of the Facility. Thus, the adjusted basis of the Facility is includable in Building’s eligible basis.

(b) No. The Facility is not a residential rental unit for purposes of § 42. Therefore, the Facility is not includable in either the numerator or denominator of Building’s applicable fraction.

Q-3. On applying to the housing credit agency for an allocation of § 42 credits for a new building, the housing credit agency requires that the applicant pay a nonrefundable application fee. If the applicant is successful, an allocation fee is payable to the housing credit agency. Are the application fee and allocation fee includable in the eligible basis of the applicant’s low-income housing building?

A-3. No. The application fee and allocation fee are not includable in the eligible basis of the applicant’s low-income housing building because the fees are not capitalizable into the adjusted basis of the building. See § 263 and § 263A. However, depending on the facts and circumstances, all or a portion of these fees may be required to be capitalized as amounts paid to create an intangible asset. See § 1.263(a)-4. Any portion of these fees not required to be capitalized under § 1.263(a)-4 may be deductible as an ordinary and necessary expense under § 162 or § 212, provided the taxpayer satisfies the requirements of those sections.

Section 42(i)(3)(A) defines “low-income unit” as any unit in a building if (i) the unit is rent-restricted (as defined in § 42(g)(2)), and (ii) the individuals occupying the unit meet the income limitation applicable under § 42(g)(1) to the project of which the building is a part (individuals that meet the applicable income limitation are referred to as “income-qualified”). Section 42(i)(3)(B) provides that a unit will not be treated as a low-income unit unless the unit is suitable for occupancy and used other than on a transient basis.

Section 42(f)(1) defines the “credit period” for a low-income housing credit building as the period of 10 taxable years beginning with (A) the taxable year in which the building is placed in service or (B) at the election of the taxpayer, the succeeding taxable year, but in either case only if the building is a qualified low-income building as of the close of the first year of the period.

Section 42(f)(2)(A) provides a special rule for determining the amount of the low-income housing credit allowable for the first year of the credit period. It provides that the credit allowable under § 42(a) with respect to any building for the first taxable year of the credit period must be determined by substituting for the applicable fraction under § 42(c)(1) the fraction (i) the numerator of which is the sum of the applicable fractions determined under § 42(c)(1) as of the close of each full month of the first taxable year of the credit period during which the building was in service, and (ii) the denominator of which is 12.

Q-4. On initial occupancy of a unit in the first year of a newly constructed building’s credit period, an income-qualified tenant moved into the unit on the last day of a month. The unit was rent-restricted in accordance with § 42(g)(2). In determining the low-income housing credit for the building for the first year of the credit period, is the unit treated as a low-income unit for that month for purposes of the fraction calculated under § 42(f)(2)(A)?

A-4. Yes. The unit is treated as a low-income unit eligible for inclusion in the numerator and denominator of the monthly applicable fraction calculated under § 42(f)(2)(A)(i) if the tenant, who meets the income limitation under § 42(g)(1), resides in the rent-restricted unit on the last day of the month. However, in accordance with § 42(f)(2)(A), the building must have been placed in service for a full month for the unit to be includable in the numerator and denominator of the monthly applicable fraction.

Section 42(h)(6)(A) provides that no credit will be allowed with respect to any building for the taxable year unless an extended low-income housing commitment (as defined in § 42(h)(6)(B)) is in effect as of the end of the taxable year. Section 42(h)(6)(B)(i) provides that the term “extended low-income housing commitment” means any agreement between the taxpayer and the housing credit agency which requires that the applicable fraction (as defined in § 42(c)(1)) for the building for each taxable year in the extended use period will not be less than the applicable fraction specified in the agreement and which prohibits the actions described in subclauses (I) and (II) of § 42(h)(6)(E)(ii)” (emphasis added).

Section 42(h)(6)(E)(ii) provides that the termination of an extended low-income housing commitment under § 42(h)(6)(E)(i) will not be construed to permit before the close of the 3-year period following the termination (I) the eviction or termination of tenancy (other than for good cause) of an existing tenant of any low-income unit, or (II) any increase in the gross rent with respect to a low-income unit not otherwise permitted under § 42.

Section 42(h)(6)(D) defines the term “extended use period” as the period beginning on the first day in the compliance period on which the building is part of a qualified low-income housing project and ending on the later of (1) the date specified by the agency in the extended low-income housing commitment, or (2) the date which is 15 years after the close of the compliance period.

Section 42(h)(6)(J) provides that if, during a taxable year, there is a determination that a valid extended low-income housing commitment was not in effect as of the beginning of the year, the determination will not apply to any period before that year and § 42(h)(6)(A) will be applied without regard to the determination provided that the failure is corrected within 1 year from the date of the determination.

In the Omnibus Budget Reconciliation Act of 1990, 1991-2 C.B. 481, 531 (the “1990 Act”), Congress amended § 42(h)(6)(B)(i) by adding the language emphasized above, which prohibits the actions described in subclauses (I) and (II) of § 42(h)(6)(E)(ii). At the time of this amendment, however, § 42(h)(6)(E)(ii) was already part of § 42.

The legislative history to § 42 states that the extended low-income housing commitment must prohibit the eviction or termination of tenancy (other than for good cause) of an existing tenant of a low-income unit or any increase in the gross rent inconsistent with the rent restrictions on the unit. H. Rep. No. 894, 101^st Cong., 2d Sess. 10, 13 (1990).

Q-5. Must the extended low-income housing commitment prohibit the actions described in subclauses (I) and (II) of § 42(h)(6)(E)(ii) only for the 3-year period described in § 42(h)(6)(E)(ii)?

A-5. No. Section 42(h)(6)(B)(i) requires that an extended low-income housing commitment include a prohibition during the extended use period against (1) the eviction or the termination of tenancy (other than for good cause) of an existing tenant of any low-income unit (no-cause eviction protection) and (2) any increase in the gross rent with respect to the unit not otherwise permitted under § 42. When Congress amended § 42(h)(6)(B)(i) to add the language emphasized above, § 42(h)(6)(E)(ii) was already part of § 42. As a result, Congress must have intended the amendment to § 42(h)(6)(B)(i) to add an additional requirement beyond what was contained in § 42(h)(6)(E)(ii), which already prohibited the actions described in that section for the 3 years following the termination of the extended use period. Because the requirements of § 42(h)(6)(B)(i) otherwise apply for the extended use period, Congress must have intended the addition of the prohibition against the actions described in subclauses (I) and (II) of § 42(h)(6)(E)(ii) to apply throughout the extended use period.

If it is determined by the end of a taxable year that a taxpayer’s extended low-income housing commitment for a building does not meet the requirements for an extended low-income housing commitment under § 42(h)(6)(B) (for example, it does not provide no-cause eviction protection for the tenants of low-income units throughout the extended use period), the low-income housing credit is not allowable with respect to the building for the taxable year, or any prior taxable year. However, if the failure to have a valid extended low-income housing commitment in effect is corrected within 1 year from the date of the determination, the determination will not apply to the current year of the credit period or any prior year.

Pursuant to this revenue ruling, each housing credit agency is required to review its extended low-income housing commitments for compliance with the interpretation of § 42(h)(6)(B)(i) provided in this question and answer. This review must be completed by December 31, 2004. If during the review period the housing credit agency determines that an extended low-income housing commitment is not in compliance with the interpretation of § 42(h)(6)(B)(i) provided in this question and answer, the 1-year period described under § 42(h)(6)(J) will commence on the date of that determination.

Section 42(b)(2)(A) provides that for a qualified low-income building placed in service by the taxpayer after 1987, the term “applicable percentage” means (1) the 70-percent present value credit under § 42(b)(2)(B)(i) for new buildings which are not federally subsidized, and (2) the 30-percent present value credit under § 42(b)(2)(B)(ii) for new buildings which are federally subsidized and for existing buildings.

In general, § 42(d)(5)(C)(i) provides that in the case of any building located in a designated qualified census tract or difficult development area (as defined in § 42(d)(5)(C)(ii) and (iii)), (I) the eligible basis of a new building will be 130 percent of the eligible basis determined without regard to this rule, and (II) in the case of an existing building, the rehabilitation expenditures taken into account under § 42(e) will be 130 percent of the expenditures determined without regard to this rule.

Section 42(g)(1) defines the term “qualified low-income housing project” as any project for residential rental property if the project meets the requirements of § 42(g)(1)(A) or (B), whichever the taxpayer elects. The election is irrevocable. The project meets the requirements of § 42(g)(1)(A) if 20 percent or more of the residential units in the project are rent-restricted and occupied by individuals whose income is 50 percent or less of AMGI. The project meets the requirements of § 42(g)(1)(B) if 40 percent or more of the residential units in the project are rent-restricted and occupied by individuals whose income is 60 percent or less of AMGI. The requirement a taxpayer elects is referred to as the “minimum set-aside” for the project.

Section 42(g)(2)(A) provides that for purposes of § 42(g)(1), a residential unit is rent-restricted if the gross rent with respect to the unit does not exceed 30 percent of the imputed income limitation applicable to the unit.

Section 42(g)(2)(C) provides that the imputed income limitation applicable to a unit is the income limitation which would apply under § 42(g)(1) to individuals occupying the unit if the number of individuals occupying the unit were: (i) in the case of a unit which does not have a separate bedroom, 1 individual; and (ii) in the case of a unit which has one or more separate bedrooms, 1.5 individuals for each separate bedroom.

Section 42(g)(3)(A) provides that a building will be treated as a qualified low-income building only if the project (of which the building is a part) meets the requirements of § 42(g)(1) not later than the close of the first year of the credit period for the building.

Section 42(i)(2)(A) provides that for purposes of § 42(b)(1), a new building will be treated as federally subsidized for any taxable year if, at any time during the taxable year or any prior taxable year, there is or was outstanding any obligation the interest on which is exempt from tax under § 103, or any below market Federal loan, the proceeds of which are or were used (directly or indirectly) with respect to the building or operation thereof.

Section 42(i)(2)(B) provides that a loan or tax-exempt obligation will not be taken into account under § 42(i)(2)(A) if the taxpayer elects to exclude from eligible basis of the building for purposes of § 42(d), in the case of a loan, the principal amount of the loan, and in the case of a tax-exempt obligation, the proceeds of the obligation.

Section 42(i)(2)(C) provides that § 42(i)(2)(A) will not apply to any tax-exempt obligation or below market Federal loan used to provide construction financing for any building if (i) the obligation or loan (when issued or made) identified the building for which the proceeds of the obligation or loan would be used, and (ii) the obligation is redeemed, and the loan is repaid, before the building is placed in service.

Section 42(i)(2)(D) provides that the term “below market Federal loan” means any loan funded in whole or in part with Federal funds if the interest rate payable on the loan is less than the applicable Federal rate (AFR) in effect under § 1274(d)(1) (as of the date the loan was made).

Section 42(i)(2)(E)(i) generally provides that assistance provided under the HOME Investment Partnerships Act (HOME) with respect to any building will not be treated as a below market Federal loan under § 42(i)(2)(D) if 40 percent or more of the residential units in the building are occupied by individuals whose income is 50 percent or less of AMGI (the special set-aside). Section 42(d)(5)(C) (the 130 percent eligible basis increase) does not apply to any building to which the preceding sentence applies.

Q-6. Taxpayer owns a new qualified low-income housing project consisting of Buildings 1 and 2, each containing 100 residential rental units. Forty percent of the units in each building are low-income units. Taxpayer elected the minimum set-aside for the project under § 42(g)(1)(B). Also, Taxpayer elected on Form 8609, Low-Income Housing Credit Allocation Certification, to treat the buildings as part of a multiple building project. A HOME loan at less than the AFR was provided with respect to the project.

(a) How does the special set-aside under § 42(i)(2)(E)(i) apply to qualify Buildings 1 and 2 for the 70-percent present value credit under § 42(b)?

(b) What rent restriction applies to the low-income units used to satisfy the special set-aside under § 42(i)(2)(E)(i)?

A-6. (a) To qualify the project for the 70-percent present value credit, Taxpayer must rent at least 40 units in each of Buildings 1 and 2 to tenants whose income is 50 percent or less of AMGI throughout the 15-year compliance period because the rule under § 42(i)(2)(E)(i) applies on a building-by-building basis. Because these units are to be low-income units and Taxpayer elected the minimum set-aside under § 42(g)(1)(B), the same units used to satisfy the special set-aside under § 42(i)(2)(E)(i) will also satisfy the project’s minimum set-aside.

(b) The rent restriction that applies for all of the low-income units in the project, including the units in Buildings 1 and 2 which are used to satisfy the special set-aside under § 42(i)(2)(E)(i), is based on the applicable income limitation under § 42(g)(1)(B) because § 42(g)(2)(C) contains no exception for buildings that satisfy the special set-aside contained in § 42(i)(2)(E)(i).Therefore, the imputed income limitation (as defined in § 42(g)(2)(C)) applicable to the units in this project is 60 percent of AMGI. Under § 42(g)(2), rent may not exceed 30 percent of this imputed income limitation.

Q-7. (a) Taxpayer owns a newly constructed qualified low-income housing project consisting of one building located in a qualified census tract (Building). A HOME loan at less than the AFR was provided with respect to Building. Construction of Building was funded in part with an obligation the interest on which is exempt from tax under § 103 that was outstanding after Building was placed in service. Taxpayer did not elect to exclude from eligible basis the principal amount of the HOME loan or the proceeds of the tax-exempt obligation as provided under § 42(i)(2)(B). Forty percent of the residential units in Building are occupied by individuals whose income is 50 percent or less of area median gross income. Is Building eligible for the increase in eligible basis provided under § 42(d)(5)(C)(i)(I)?

(b) The facts are the same as in (a) above except that the interest rate on the HOME loan when made was not less than the AFR in effect under § 1274(d)(1), and the tax-exempt obligation was redeemed before Building was placed in service. Is Building eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I)?

(c) The facts are the same as in (a) above except that the special set-aside under § 42(i)(2)(E)(i) was not met, and the tax-exempt obligation was redeemed before Building was placed in service. Is Building eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I)?

A-7. (a) Yes. Because the tax-exempt obligation is outstanding after Building was placed in service and the proceeds of the obligation were not excluded from Building’s eligible basis under § 42(i)(2)(B), Building is treated as federally subsidized under § 42(i)(2)(A). Inasmuch as the building is treated as federally subsidized, the 30-percent present value credit under § 42(b) will apply to Building. The fact that the tax-exempt obligation caused Building to be federally subsidized makes § 42(i)(2)(E)(i) (which provides that certain HOME loans will not cause a project to be federally subsidized if the special set-aside requirement under that section is satisfied, and whose applicability prohibits the increase in eligible basis under § 42(d)(5)(C)) inapplicable. Accordingly, Building is eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I).

If the tax-exempt obligation was redeemed before Building was placed in service or the proceeds of the obligation were excluded from Building’s eligible basis, Building would no longer be treated as federally subsidized by the tax-exempt obligation under § 42(i)(2)(A). Therefore, § 42(i)(2)(E)(i) would be applicable, and cause Building not to be treated as federally subsidized by the HOME loan under § 42(i)(2)(A). Accordingly, the prohibition in § 42(i)(2)(E)(i) against using § 42(d)(5)(C) would apply, and Building would not be eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I). The 70-percent value credit under § 42(b) would apply to Building.

(b) Yes. When the HOME loan was made, the interest rate on the loan was not less than the AFR. Therefore, the loan is not described in § 42(i)(2)(D), and the building will not be treated as federally subsidized under § 42(i)(2)(A). The 70-percent present value credit will apply to Building. Because § 42(i)(2)(E)(i) is inapplicable to HOME loans not described in § 42(i)(2)(D), this loan is not subject to § 42(i)(2)(E)(i), and the prohibition in § 42(i)(2)(E)(i) against using § 42(d)(5)(C) does not apply. Accordingly, Building is eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I).

(c) Yes. Although Building meets the exception under § 42(i)(2)(C) with respect to the tax-exempt obligation, Building is treated as federally subsidized under § 42(i)(2)(A) because it received a HOME loan at less than the AFR and does not meet the special set-aside under § 42(i)(2)(E)(i). The 30-percent present value credit will apply to Building as it is treated as federally subsidized. Because Building does not meet the special set-aside under § 42(i)(2)(E)(i), the prohibition in § 42(i)(2)(E)(i) against using § 42(d)(5)(C) does not apply, and Building is eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I).

If Taxpayer elected to exclude the principal amount of the HOME loan from the eligible basis of Building under § 42(i)(2)(B) (whether or not the special set-aside under § 42(i)(2)(E)(i) was met), Building would not be treated as federally subsidized under § 42(i)(2)(A), and the 70-percent present value credit would apply to Building. Because the HOME loan would not be taken into account, § 42(i)(2)(D) and § 42(i)(2)(E)(i) do not apply to Building. Therefore, Building would not be described in § 42(i)(2)(E)(i). Accordingly, the prohibition in § 42(i)(2)(E)(i) against using § 42(d)(5)(C) would not apply, and Building would be eligible for the increase in eligible basis under § 42(d)(5)(C)(i)(I).

Section 1.42-5(c)(1)(ix) provides that a housing credit agency must require the owner of a low-income housing project to certify at least annually to the housing credit agency that, for the preceding 12-month period, if a low-income unit in the project became vacant during the year, reasonable attempts were or are being made to rent that unit or the next available unit of comparable or smaller size to tenants having a qualifying income before any units in the project were or will be rented to tenants not having a qualifying income (the “vacant unit rule”).

The legislative history to § 42 indicates that vacant units, formerly occupied by low-income individuals, may continue to be treated as occupied by qualified low-income individuals for purposes of the minimum set-aside requirement (as well as for determining qualified basis) provided reasonable attempts are made to rent the unit. H. R. Conf. Rep. No. 841, supra, at II-94.

Section 42(g)(2)(D)(i) provides that notwithstanding an increase in the income of the occupants of a low-income unit above the income limitation applicable under § 42(g)(1), the unit will continue to be treated as a low-income unit if the income of the occupants initially met the income limitation and the unit continues to be rent-restricted.

Section 42(g)(2)(D)(ii) provides that if the income of the occupants of the unit increases above 140 percent of the income limitation applicable under § 42(g)(1), the unit ceases to be treated as a low-income unit if any available or subsequently available residential rental unit in the building (of a size comparable to, or smaller than, the unit) is occupied by a new resident whose income exceeds the income limitation (the “available unit rule”).

Under § 1.42-15(a), a low-income unit in which the aggregate income of the occupants of the unit rises above 140 percent of the applicable income limitation under § 42(g)(1) is referred to as an “over-income unit.”

Section 1.42-15(c) provides that a unit is not available for purposes of the available unit rule when the unit is no longer available for rent due to contractual arrangements that are binding under local law (for example, a unit is not available if it is subject to a preliminary reservation that is binding on the owner under local law prior to the date a lease is signed or the unit is occupied).

Q-8. On July 1, 2003, an income-qualified household (Household) initially occupied a rent-restricted residential rental unit in Building 1 of Project. On October 31, 2003, the property manager moved Household (and transferred Household’s lease) to a similar rent-restricted unit in Building 2 of Project that was not previously occupied. Household occupied the Building 2 unit at the end of 2003. The unit Household vacated in Building 1 was unoccupied during November and December. Are both units in Buildings 1 and 2 low-income units at the end of 2003?

A-8. No. While a vacant low-income unit generally retains its character as a low-income unit, where an owner simply moves a tenant from a unit in one building to a unit in another building in the same project, both units may not be treated as low-income units; rather, only the unit that the tenant actually occupies at the end of a month in the first year of the credit period and at the end of each year in subsequent years qualifies as a low-income unit. Thus, in this situation, while the unit in Building 1 vacated by Household was treated as a low-income unit during the months it was occupied by Household, the unit ceased to be treated as a low-income unit when Household vacated the unit. At that time, the vacated unit would be treated as a unit not previously occupied.

Q-9. Ten units previously occupied by income-qualified tenants in a 200-unit mixed-use housing project are vacant. None of the low-income units in the project had been over-income units. The project owner displayed a banner and for rent signs at the entrance to the project, placed classified advertisements in two local newspapers, and contacted prospective low-income tenants on a waiting list for the project and on a local public housing authority list of section 8 voucher holders about the low-income unit vacancies. These are customary methods of advertising apartment vacancies in the area of the project for identifying prospective tenants. Subsequent to the low-income unit vacancies, a market-rate unit of comparable size to the low-income units became vacant. Will the owner violate the vacant unit rule if the owner rents the market-rate unit before any of the low-income units?

A-9. No. In accordance with § 1.42-5 (c)(1)(ix), the owner of a qualified low-income housing project has to use reasonable attempts to rent a vacant low-income unit or the next available unit of comparable or smaller size to tenants having a qualifying income before any units in the project are rented to tenants not having a qualifying income. Thus, if the project owner makes reasonable attempts to rent the vacant low-income units to income-qualified tenants, the owner may rent the newly vacated market-rate unit before renting the low-income units and continue to characterize the vacant low-income units as low-income units for purposes of the minimum set-aside requirements in § 42(g)(1) and calculation of the applicable fraction under § 42(c)(1)(B).

What constitutes reasonable attempts to rent a vacant unit is based on facts and circumstances, and may differ from project to project depending on factors such as the size and location of the project, tenant turnover rates, and market conditions. Also, the different advertising methods that are accessible to owners and prospective tenants would affect what is considered reasonable. Under the facts in this situation, the owner used reasonable methods of advertising an apartment vacancy in the area of the project before the owner rented the market-rate unit. Thus, the owner made reasonable attempts to rent the vacant low-income units.

In addition, the available unit rule is not violated by rental of the market-rate unit before the low-income units because there are no over-income units in the building.

Q-10. A building has 10 units of comparable size, consisting of 7 low-income units (none was an over-income unit) and 3 market-rate units. All units in the building were occupied except for one market-rate unit. A low-income unit became vacant on March 15, 2004. Between March 15, 2004, and March 29, 2004, the owner made reasonable attempts to rent this unit to an income-qualified tenant. The vacant low-income unit became subject to a reservation (a contractual arrangement that is binding on the building owner under local law prior to the date a lease is signed or the unit is occupied) on March 29, 2004, under which the owner agreed to rent the unit to A, whose income meets the income limitation elected for the project under § 42(g)(1). Thereafter, the owner ceased any efforts to attempt to rent the unit. On April 30, 2004, A signed a lease for the unit and occupied the unit on May 1, 2004. The vacant market-rate unit was rented to a market-rate tenant on April 15, 2004. Did the owner violate the vacant unit rule?

A-10. No. For purposes of the vacant unit rule, an owner needs to make reasonable attempts to rent an available vacant low-income unit. To determine what constitutes an available unit for purposes of the vacant unit rule, the Internal Revenue Service will adopt the rule under § 1.42-15(c) for when a unit is considered not available. Therefore, a unit is not available for purposes of the vacant unit rule when the unit is no longer available for rent due to contractual arrangements that are binding under local law, such as a reservation entered into between a building owner and a prospective tenant. Thus, in this situation, because the vacant low-income unit was subject to a reservation that was binding under local law prior to the renting of the vacant market-rate unit, the low-income unit was not available when the market-rate unit was rented. Accordingly, the owner no longer needed to make reasonable efforts to rent the low-income unit.

In addition, the available unit rule is not violated by rental of the market-rate unit because there is no over-income unit in the building.

Section 42(m)(1)(A)(i) requires each housing credit agency to allocate low-income housing credits according to a qualified allocation plan. Under § 42(m)(1)(B)(iii), an allocation plan is not qualified unless it contains a procedure that the housing credit agency (or an agent or other private contractor of the agency) will follow in (1) monitoring for noncompliance with the provisions of § 42, (2) notifying the Service of any noncompliance which the agency becomes aware of, and (3) monitoring for noncompliance with habitability standards through regular site visits.

Under § 1.42-5(a)(2)(i)(A), for the procedure to satisfy § 42(m)(1)(B)(iii), the procedure must include the recordkeeping and record retention provisions of § 1.42-5(b). However, a monitoring procedure adopted by a housing credit agency may require additional recordkeeping and record retention provisions beyond those specifically provided in § 1.42-5(b).

Section 1.42-5(b)(1) provides that a housing credit agency must require the owner of a low-income housing project to keep certain specified records for each qualified low-income building in the project for each year in the compliance period. Under § 1.42-5(b)(2), the owner must be required to retain the records described in § 1.42-5(b)(1) for a particular year for at least 6 years after the due date (with extensions) for filing the Federal income tax return for that year. The records for the first year of the credit period, however, must be retained for at least 6 years beyond the due date (with extensions) for filing the Federal income tax return for the last year of the compliance period (as defined in § 42(i)(1)) of the building. Section 1.42-5(b)(3) also specifies that the owner must be required to retain the original local health, safety, or building code violation reports or notices that were issued by the state or local government unit (as described in § 1.42-5(c)(1)(vi)) for inspection by the housing credit agency.

The general requirements for keeping records for purposes of the Code are in § 6001 and the regulations thereunder.

Rev. Proc. 97-22, 1997-1 C.B. 652, provides guidance to taxpayers that maintain books and records by using an electronic storage system that either images their hardcopy (paper) books and records or transfers their computerized books and records to an electronic storage media, such as an optical disk. Rev. Proc. 97-22 provides that records maintained in an electronic storage system that complies with the requirements of this revenue procedure will constitute records within the meaning of § 6001.

Q-11. May a taxpayer comply with the recordkeeping and record retention provisions under § 1.42-5(b) by using an electronic storage system instead of maintaining hardcopy (paper) books and records?

A-11. Yes, provided that the electronic storage system satisfies the requirements of Rev. Proc. 97-22. However, complying with the recordkeeping and record retention requirements of the Service does not exempt an owner from having to satisfy any additional recordkeeping and record retention requirements of the monitoring procedure adopted by the housing credit agency. For example, the housing credit agency may require the taxpayer to maintain hardcopy books and records.

For the basic requirements of maintaining records in an automated data processing system, including electronic storage systems, see Rev. Proc. 98-25, 1998-1 C.B. 689.

Section 1.42-5(b)(1)(vi) provides that a housing credit agency must require the owner of a low-income housing project to keep records for each qualified low-income building in the project that show, for each year in the compliance period, the annual income certification of each low-income tenant per unit. Under § 1.42-5(b)(1)(vii), the housing credit agency must require the owner to keep documentation to support each low-income tenant’s income certification (for example, a copy of the tenant’s Federal income tax return, Forms W-2, or verifications of income from third parties such as employers or state agencies paying unemployment compensation).

Under § 1.42-5(c)(1)(iii), the housing credit agency must require the owner of a low-income housing project to certify at least annually that, for the preceding 12-month period, the owner has received an annual income certification from each low-income tenant, and documentation to support that certification.

Rev. Proc. 94-65, 1994-2 C.B. 798, indicates that an owner may satisfy the documentation requirement of § 1.42-5(b)(1)(vii) for a low-income tenant’s income from assets by obtaining a signed, sworn statement from the tenant or prospective tenant if (1) the tenant’s or prospective tenant’s Net Family assets do not exceed $5,000, and (2) the tenant or prospective tenant provides a signed, sworn statement to this effect to the building owner. The revenue procedure provides that a housing credit agency’s monitoring procedure may not permit an owner to rely on a low-income tenant’s signed, sworn statement of annual income from assets if a reasonable person in the owner’s position would conclude that the tenant’s income is higher than the tenant’s represented annual income. In this case, the owner must obtain other documentation of the low-income tenant’s income from assets to satisfy the documentation requirement. In addition, the revenue procedure indicates that a housing credit agency’s monitoring procedure may continue to require that an owner obtain documentation, other than the signed, sworn statement, to support a low-income tenant’s annual certification of income from assets.

Q-12. On reviewing tenant files of a project, the housing credit agency discovered that for purposes of determining the income of certain tenants, the owner had accepted signed, sworn self-certifications in which the tenants stated that they had not received any child support payments. Is a signed, sworn self-certification by a tenant sufficient documentation under § 1.42-5(b)(1)(vii) to show that the tenant is not receiving child support payments?

A-12. Yes. Consistent with the documentation requirements in Rev. Proc. 94-65, a signed, sworn self-certification by a tenant is sufficient documentation under § 1.42-5(b)(1)(vii) to show that a tenant is not receiving child support payments. In addition to specifying that a tenant is not receiving any child support payments, an annual signed, sworn self-certification should indicate whether the tenant will be seeking or expects to receive child support payments within the next 12 months. If the tenant possesses a child support agreement but is not presently receiving any child support payments, the tenant should include an explanation of this and all supporting documentation such as a divorce decree and court documents to enforce payment. Also, the self-certification should indicate that the tenant will notify the owner of any changes in the status of child support.

A housing credit agency’s monitoring procedure, however, may not permit an owner to rely on a low-income tenant’s signed, sworn statement indicating that the tenant is not receiving child support payments if a reasonable person in the owner’s position would conclude that the tenant’s income is higher than the tenant’s represented annual income. In this case, the owner must obtain other documentation of the low-income tenant’s annual child support payments to satisfy the documentation requirement in § 1.42-5(b)(1)(vii).

A housing credit agency’s monitoring procedure may continue to require that an owner obtain documentation, other than the statement described above, to support a low-income tenant’s annual certification of child support payments.

Under the proposed amendments to §1.902-1(a), the multi-year pooling of a foreign corporation’s post-1986 undistributed earnings and foreign income taxes would have terminated if the ownership requirements of section 902(c)(3)(B) were not met as of the end of any taxable year, and such earnings and earnings subsequently accumulated in periods during which the stock ownership requirements of section 902 were not met would have been treated as pre-1987 accumulated profits subject to the annual layering rules of section 902(c)(6). Prop. §1.902-1(a)(8), (10) and (13). The proposed amendments also provided for the pooling of earnings and taxes to resume in the first subsequent taxable year as of the end of which the foreign corporation again has a qualifying domestic corporate shareholder. The proposed regulations were intended to alleviate the difficulties of reconstructing accumulated earnings and taxes accounts in connection with a U.S. shareholder’s acquisition of stock in a foreign corporation previously owned by U.S. shareholders after an intervening period of foreign ownership.

The Treasury Department and the IRS have determined that the potential simplification benefits of the proposed regulations would be outweighed by other administrative difficulties, including those associated with redeterminations of deemed-paid foreign taxes under section 905(c). Accordingly, the Treasury Department and the IRS are withdrawing the proposed amendments to §1.902-1(a) in a notice of withdrawal published in this issue of the Bulletin.

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* * * * *

(b) * * *

(2) * * *

(iii) Example.

* * * * *

(m) Income treated as allocable to an additional separate category.

* * * * *

(a) Capital gains and losses included in taxable income from sources outside the United States.

(1) Limitation on capital gain from sources outside the United States when the taxpayer has net capital losses from sources within the United States.

(i) In general.

(ii) Allocation of reduction to separate categories or rate groups.

(A) In general.

(B) Taxpayer with capital gain rate differential.

(2) Exclusivity of rules; no reduction by reason of net capital loss from sources outside the United States in a different separate category.

(3) Capital losses from sources outside the United States in the same separate category.

(4) Examples.

(b) Capital gain rate differential.

(1) Application of adjustments only if capital gain rate differential exists.

(2) Determination of whether capital gain rate differential exists.

(3) Special rule for certain noncorporate taxpayers.

(c) Rate differential adjustment of capital gains.

(1) Rate differential adjustment of capital gains in foreign source taxable income.

(i) In general.

(ii) Special rule for taxpayers with a net long-term capital loss from sources within the United States.

(iii)Examples.

(2) Rate differential adjustment of capital gains in entire taxable income.

(d) Rate differential adjustment of capital losses from sources outside the United States.

(1) In general.

(2) Determination of which capital gains are offset by net capital losses from sources outside the United States.

(e) Qualified dividend income.

(1) In general.

(2) Exception.

(f) Definitions.

(1) Alternative tax rate.

(2) Net capital gain.

(3) Rate differential portion.

(4) Rate group.

(i) Short-term capital gains or losses.

(ii) Long-term capital gains.

(iii) Long-term capital losses.

(5) Terms used in sections 1(h), 904(b) or 1222.

(g) Examples.

(h) Coordination with section 904(f).

(1) In general.

(2) Examples.

(i) Effective date.

(a) Application of section 904(b)(2)(B) adjustments.

(b) Use of alternative minimum tax rates.

(1) Taxpayers other than corporations.

(2) Corporate taxpayers.

(c) Effective date.

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(a) Election available only if all foreign taxes are creditable foreign taxes.

(b) Coordination with carryover rules.

(1) No carryovers to or from election year.

(2) Carryovers to and from other years determined without regard to election years.

(3) Determination of amount of creditable foreign taxes.

(c) Examples.

(d) Effective date.

Par. 3. Section 1.904-4 is amended as follows:

1. Paragraph (a) is amended by removing the period at the end and adding the language “, or in §1.904-4(m) (additional separate categories).”

2. The first sentence of paragraph (b)(2)(i) is revised.

3. Paragraph (b)(2)(ii) is revised.

4. Paragraph (b)(2)(iii) is removed.

5. Paragraph (b)(2)(iv) is redesignated as paragraph (b)(2)(iii).

6. The last three sentences of the Example in newly designated paragraph (b)(2)(iii) are removed and six new sentences are added in their place.

7. The fifth sentence of Example 4 in paragraph (c)(8) is revised.

8. The language “and” at the end of paragraph (l)(1)(v) is removed.

9. The period at the end of paragraph (l)(1)(vi) is removed and “; and” is added in its place.

10. Paragraph (l)(1)(vii) is added.

11. Paragraph (m) is added.

The revisions and additions read as follows:

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(b) * * *

(2) * * * (i) * * * For rents and royalties paid or accrued after September 18, 2004, passive income does not include any rents or royalties that are derived in the active conduct of a trade or business, regardless of whether such rents or royalties are received from a related or an unrelated person. * * *

(ii) Exception for certain rents and royalties. Rents and royalties are considered derived in the active conduct of a trade or business by a United States person or by a controlled foreign corporation (or other entity to which the look-through rules apply) for purposes of section 904 (but not for purposes of section 954) if the requirements of section 954(c)(2)(A) are satisfied by one or more corporations that are members of an affiliated group of corporations (within the meaning of section 1504(a), determined without regard to section 1504(b)(3)) of which the recipient is a member. For purposes of this paragraph (b)(2)(ii), an affiliated group includes only domestic corporations and foreign corporations that are controlled foreign corporations in which domestic members of the affiliated group own, directly or indirectly, at least 80 percent of the total voting power and value of the stock. For purposes of this paragraph (b)(2)(ii), indirect ownership shall be determined under section 318 and the regulations under that section.

(iii) * * *

Example. * * * Some of the franchisees are unrelated to S and P. Other franchisees are related to S or P and use the licensed property outside of S’s country of incorporation. S does not satisfy, but P does satisfy, the active trade or business requirements of section 954(c)(2)(A) and the regulations thereunder. The royalty income earned by S with regard to both its related and unrelated franchisees is foreign personal holding company income because S does not satisfy the active trade or business requirements of section 954(c)(2)(A) and, in addition, the royalty income from the related franchisees does not qualify for the same country exception of section 954(c)(3). However, all of the royalty income earned by S is general limitation income to S under §1.904-4(b)(2)(ii) because P, a member of S’s affiliated group (as defined therein), satisfies the active trade or business test (which is applied without regard to whether the royalties are paid by a related person). S’s royalty income that is taxable to P under subpart F and the royalties paid to P are general limitation income to P under the look-through rules of §1.904-5(c)(1)(i) and (c)(3), respectively.

* * * * *

(c) * * *

(8) * * *

Example 4. * * * The royalty income is not subject to a withholding tax, and is not taxed by Country X, and the interest and the rental income are subject to a 4 percent and 10 percent withholding tax, respectively. * * *

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(l) * * * (1) * * *

(vii) Income that meets the definitions of a separate category described in paragraph (m) of this section and of any other category of separate limitation income described in section 904(d)(1)(A) through (H) will be subject to the separate limitation described in paragraph (m) of this section and will not be treated as general limitation income described in section 904(d)(1)(I).

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(m) Income treated as allocable to an additional separate category. If section 904(a), (b), and (c) are applied separately to any category of income under the Internal Revenue Code (for example, under section 56(g)(4)(C)(iii)(IV), 245(a)(10), 865(h), 901(j), or 904(g)(10)), that category of income will be treated for all purposes of the Internal Revenue Code and regulations as if it were a separate category listed in section 904(d)(1) and (d)(3)(F)(i).

Par. 4. In §1.904-5, paragraph (a)(1) is revised to read as follows:

(a) * * *

(1) The term separate category means, as the context requires, any category of income described in section 904(d)(1)(A), (B), (C), (D), (E), (F), (G), (H), or (I) and in §1.904-4(b), (d), (e), (f), and (g), any category of income described in §1.904-4(m), or any category of earnings and profits to which income described in such provisions is attributable.

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Par. 5. In §1.904-6, paragraph (a)(1)(ii) is amended by adding two sentences at the end to read as follows:

(a) * * * (1) * * *

(ii) * * * If the taxpayer applies the principles of §§1.861-8 through 1.861-14T for purposes of allocating expenses at the level of the taxpayer (or at the level of the qualified business unit, foreign subsidiary, or other entity that paid or accrued the foreign taxes) under this paragraph (a)(1)(ii), such principles shall be applied (for such purposes) in the same manner as the taxpayer applies such principles in determining the income or earnings and profits for United States tax purposes of the taxpayer (or of the qualified business unit, foreign subsidiary, or other entity that paid or accrued the foreign taxes, as the case may be). For example, a taxpayer must use the modified gross income method under §1.861-9T when applying the principles of that section for purposes of this paragraph (a)(1)(ii) to determine the amount of a controlled foreign corporation’s income, in each separate category, that is taxed by a foreign country, if the taxpayer applies the modified gross income method under §1.861-9T(f)(3) when applying §1.861-9T to determine the income and earnings and profits of the controlled foreign corporation for United States tax purposes.

* * * * *

Par. 6. Section 1.904(b)-1 is revised to read as follows:

(a) Capital gains and losses included in taxable income from sources outside the United States—(1) Limitation on capital gain from sources outside the United States when the taxpayer has net capital losses from sources within the United States—(i) In general. Except as otherwise provided in this section, for purposes of section 904 and this section, taxable income from sources outside the United States (in all of the taxpayer’s separate categories in the aggregate) shall include capital gain net income from sources outside the United States (determined by considering all of the capital gain and loss items in all of the taxpayer’s separate categories in the aggregate) only to the extent of capital gain net income from all sources. Thus, capital gain net income from sources outside the United States (determined by considering all of the capital gain and loss items in all of the taxpayer’s separate categories in the aggregate) shall be reduced to the extent such amount exceeds capital gain net income from all sources.

(ii) Allocation of reduction to separate categories or rate groups—(A) In general. If capital gain net income from sources outside the United States exceeds capital gain net income from all sources, and the taxpayer has capital gain net income from sources outside the United States in only one separate category, such excess is allocated as a reduction to that separate category. If a taxpayer has capital gain net income from foreign sources in two or more separate categories, such excess must be apportioned on a pro rata basis as a reduction to each such separate category. For purposes of the preceding sentence, pro rata means based on the relative amounts of the capital gain net income from sources outside the United States in each separate category.

(B) Taxpayer with capital gain rate differential. If a taxpayer with a capital gain rate differential for the year (within the meaning of paragraph (b) of this section) has capital gain net income from foreign sources in only one rate group within a separate category, any reduction to such separate category pursuant to paragraph (a)(1)(ii)(A) of this section must be allocated to such rate group. If a taxpayer with a capital gain rate differential for the year (within the meaning of paragraph (b) of this section) has capital gain net income from foreign sources in two or more rate groups within a separate category, any reduction to such separate category pursuant to paragraph (a)(1)(ii)(A) of this section must be apportioned on a pro rata basis among such rate groups. For purposes of the preceding sentence, pro rata means based on the relative amounts of the capital gain net income from sources outside the United States in each rate group within the applicable separate category.

(2) Exclusivity of rules; no reduction by reason of net capital losses from sources outside the United States in a different separate category. Capital gains from sources outside the United States in any separate category shall be limited by reason of section 904(b)(2)(A) and the comparable limitation of section 904(b)(2)(B)(i) only to the extent provided in paragraph (a)(1) of this section (relating to limitation on capital gain from sources outside the United States when taxpayer has net capital losses from sources within the United States).

(3) Capital losses from sources outside the United States in the same separate category. Except as otherwise provided in paragraph (d) of this section, taxable income from sources outside the United States in each separate category shall be reduced by any capital loss that is allocable or apportionable to income from sources outside the United States in such separate category to the extent such loss is allowable in determining taxable income for the taxable year.

(4) Examples. The following examples illustrate the application of this paragraph (a) to taxpayers that do not have a capital gain rate differential for the taxable year. See paragraph (g) of this section for examples that illustrate the application of this paragraph (a) to taxpayers that have a capital gain rate differential for the year. The examples are as follows:

Example 1. Taxpayer A, a corporation, has a $3,000 capital loss from sources outside the United States in the general limitation category, a $6,000 capital gain from sources outside the United States in the passive category, and a $2000 capital loss from sources within the United States. A’s capital gain net income from sources outside the United States in the aggregate, from all separate categories, is $3000 ($6,000 - $3,000). A’s capital gain net income from all sources is $1000 ($6000 - $3000 - $2000). Thus, for purposes of section 904, A’s taxable income from sources outside the United States in all of A’s separate categories in the aggregate includes only $1000 of capital gain net income from sources outside the United States. See paragraph (a)(1)(i) of this section. Pursuant to paragraphs (a)(1)(i) and (a)(1)(ii)(A) of this section, A must reduce the $6000 of capital gain net income from sources outside the United States in the passive category by $2000 ($3000 of capital gain net income from sources outside the United States - $1000 of capital gain net income from all sources). After the adjustment, A has $4000 of capital gain from sources outside the United States in the passive category and $3000 of capital loss from sources outside the United States in the general limitation category.

Example 2. Taxpayer B, a corporation, has a $300 capital gain from sources outside the United States in the general limitation category and a $200 capital gain from sources outside the United States in the passive category. B’s capital gain net income from sources outside the United States is $500 ($300 + $200). B also has a $150 capital loss from sources within the United States and a $50 capital gain from sources within the United States. Thus, B’s capital gain net income from all sources is $400 ($300 + $200 - $150 + $50). Pursuant to paragraph (a)(1)(ii)(A) of this section, the $100 excess of capital gain net income from sources outside the United States over capital gain net income from all sources ($500 - $400) must be apportioned, as a reduction, three-fifths ($300/$500 of $100, or $60) to the general limitation category and two-fifths ($200/$500 of $100, or $40) to the passive category. Therefore, for purposes of section 904, the general limitation category includes $240 ($300 - $60) of capital gain net income from sources outside the United States and the passive category includes $160 ($200 - $40) of capital gain net income from sources outside the United States.

Example 3. Taxpayer C, a corporation, has a $10,000 capital loss from sources outside the United States in the general limitation category, a $4,000 capital gain from sources outside the United States in the passive category, and a $2,000 capital gain from sources within the United States. C’s capital gain net income from sources outside the United States is zero, since losses exceed gains. C’s capital gain net income from all sources is also zero. C’s capital gain net income from sources outside the United States does not exceed its capital gain net income from all sources, and therefore paragraph (a)(1) of this section does not require any reduction of C’s passive category capital gain. For purposes of section 904, C’s passive category includes $4,000 of capital gain net income. C’s general limitation category includes a capital loss of $6,000 because only $6,000 of capital loss is allowable as a deduction in the current year. The entire $4,000 of capital loss in excess of the $6,000 of capital loss that offsets capital gain in the taxable year is carried back or forward under section 1212(a), and none of such $4,000 is taken into account under section 904(a) or (b) for the current taxable year.

(b) Capital gain rate differential—(1) Application of adjustments only if capital gain rate differential exists. Section 904(b)(2)(B) and paragraphs (c) and (d) of this section apply only for taxable years in which the taxpayer has a capital gain rate differential.

(2) Determination of whether capital gain rate differential exists. For purposes of section 904(b) and this section, a capital gain rate differential is considered to exist for the taxable year only if the taxpayer has taxable income (excluding net capital gain and qualified dividend income) for the taxable year, a net capital gain for the taxable year and—

(i) In the case of a taxpayer other than a corporation, tax is imposed on the net capital gain at a reduced rate under section 1(h) for the taxable year; or

(ii) In the case of a corporation, tax is imposed under section 1201(a) on the taxpayer at a rate less than any rate of tax imposed on the taxpayer by section 11, 511, or 831(a) or (b), whichever applies (determined without regard to the last sentence of section 11(b)(1)), for the taxable year.

(3) Special rule for certain noncorporate taxpayers. A taxpayer that has a capital gain rate differential for the taxable year under paragraph (b)(2)(i) of this section and is not subject to alternative minimum tax under section 55 for the taxable year may elect not to apply the rate differential adjustments contained in section 904(b)(2)(B) and paragraphs (c) and (d) of this section if the highest rate of tax imposed on such taxpayer’s taxable income (excluding net capital gain and any qualified dividend income) for the taxable year under section 1 does not exceed the highest rate of tax in effect under section 1(h) for the taxable year and the amount of the taxpayer’s net capital gain from sources outside the United States, plus the amount of the taxpayer’s qualified dividend income from sources outside the United States, is less than $20,000. A taxpayer that has a capital gain rate differential for the taxable year under paragraph (b)(2)(i) of this section and is subject to alternative minimum tax under section 55 for the taxable year may make such election if the rate of tax imposed on such taxpayer’s alternative minimum taxable income (excluding net capital gain and any qualified dividend income) under section 55 does not exceed 26 percent, the highest rate of tax imposed on such taxpayer’s taxable income (excluding net capital gain and any qualified dividend income) for the taxable year under section 1 does not exceed the highest rate of tax in effect under section 1(h) for the taxable year and the amount of the taxpayer’s net capital gain from sources outside the United States, plus the amount of the taxpayer’s qualified dividend income from sources outside the United States, is less than $20,000. A taxpayer who makes this election shall apply paragraph (a) of this section as if such taxpayer does not have a capital gain rate differential for the taxable year. An eligible taxpayer shall be presumed to have elected not to apply the rate differential adjustments, unless such taxpayer applies the rate differential adjustments contained in section 904(b)(2)(B) and paragraphs (c) and (d) of this section in determining its foreign tax credit limitation for the taxable year.

(c) Rate differential adjustment of capital gains—(1) Rate differential adjustment of capital gains in foreign source taxable income—(i) In general. Subject to paragraph (c)(1)(ii) of this section, in determining taxable income from sources outside the United States for purposes of section 904 and this section, capital gain net income from sources outside the United States in each long-term rate group in each separate category (separate category long-term rate group), shall be reduced by the rate differential portion of such capital gain net income. For purposes of paragraph (c)(1) of this section, references to capital gain net income are references to capital gain net income remaining after any reduction to such income pursuant to paragraph (a)(1) of this section (i.e., paragraph (a)(1) of this section applies before paragraphs (c) and (d) of this section).

(ii) Special rule for taxpayers with a net long-term capital loss from sources within the United States. If a taxpayer has a net long-term capital loss from sources within the United States (i.e., the taxpayer’s long-term capital losses from sources within the United States exceed the taxpayer’s long-term capital gains from sources within the United States) and also has any short-term capital gains from sources within or without the United States, then capital gain net income from sources outside the United States in each separate category long-term rate group shall be reduced by the rate differential portion of the applicable rate differential amount.The applicable rate differential amount is determined as follows:

(A) Step 1: Determine the U.S. long-term capital loss adjustment amount. The U.S. long-term capital loss adjustment amount is the excess, if any, of the net long-term capital loss from sources within the United States over the amount, if any, by which the taxpayer reduced long-term capital gains from sources without the United States pursuant to paragraph (a)(1) of this section.

(B) Step 2: Determine the applicable rate differential amount. If a taxpayer has capital gain net income from sources outside the United States in only one separate category long-term rate group, the applicable rate differential amount is the excess of such capital gain net income over the U.S. long-term capital loss adjustment amount. If a taxpayer has capital gain net income from sources outside the United States in more than one separate category long-term rate group, the U.S. long-term capital loss adjustment amount shall be apportioned on a pro rata basis to each separate category long-term rate group with capital gain net income. For purposes of the preceding sentence, pro rata means based on the relative amounts of capital gain net income from sources outside the United States in each separate category long-term rate group. The applicable rate differential amount for each separate category long-term rate group with capital gain net income is the excess of such capital gain net income over the portion of the U.S. long-term capital loss adjustment amount apportioned to the separate category long-term rate group pursuant to this Step 2.

(iii) Examples. The following examples illustrate the provisions of paragraph (c)(1)(ii) of this section. The taxpayers in the examples are assumed to have taxable income (excluding net capital gain and qualified dividend income) subject to a rate of tax under section 1 greater than the highest rate of tax in effect under section 1(h) for the applicable taxable year. The examples are as follows:

Example 1. (i) M, an individual, has $300 of long-term capital gain from foreign sources in the passive category, $200 of which is subject to tax at a rate of 15 percent under section 1(h) and $100 of which is subject to tax at a rate of 28% under section 1(h). M has $150 of short-term capital gain from sources within the United States. M has a $100 long-term capital loss from sources within the United States.

(ii) M’s capital gain net income from sources outside the United States ($300) does not exceed M’s capital gain net income from all sources ($350). Therefore, paragraph (a)(1) of this section does not require any reduction of M’s capital gain net income in the passive category.

(iii) Because M has a net long-term capital loss from sources within the United States ($100) and also has a short-term capital gain from U.S. sources ($150), M must apply the provisions of paragraph (c)(1)(ii) of this section to determine the amount of the $300 of capital gain net income in the passive category that is subject to a rate differential adjustment. Under Step 1, the U.S. long-term capital loss adjustment amount is $100 ($100 - $0). Under Step 2, M must apportion this amount to each rate group in the passive category pro rata based on the amount of capital gain net income in each rate group. Thus, $66.67 ($200/$300 of $100) is apportioned to the 15 percent rate group and $33.33 ($100/$300 of $100) is apportioned to the 28 percent rate group. The applicable rate differential amount for the 15 percent rate group is $133.33 ($200 - $66.67). Thus, $133.33 of the $200 of capital gain net income in the 15 percent rate group is subject to a rate differential adjustment pursuant to paragraph (c)(1) of this section. The remaining $66.67 is not subject to a rate differential adjustment. The applicable rate differential amount for the 28 percent rate group is $66.67 ($100 - $33.33). Thus, $66.67 of the $100 of capital gain net income in the 28 percent rate group is subject to a rate differential adjustment pursuant to paragraph (c)(1) of this section. The remaining $33.33 is not subject to a rate differential adjustment.

Example 2. (i) N, an individual, has $300 of long-term capital gain from foreign sources in the passive category, all of which is subject to tax at a rate of 15 percent under section 1(h). N has $50 of short-term capital gain from sources within the United States. N has a $100 long-term capital loss from sources within the United States.

(ii) N’s capital gain net income from sources outside the United States ($300) exceeds N’s capital gain net income from all sources ($250). Pursuant to paragraph (a)(1) of this section, N must reduce the $300 capital gain in the passive category by $50. N has $250 of capital gain remaining in the passive category.

(iii) Because N has a net long-term capital loss from sources within the United States ($100) and also has a short-term capital gain from U.S. sources ($50), N must apply the provisions of paragraph (c)(1)(ii) of this section to determine the amount of the $250 of capital gain in the passive category that is subject to a rate differential adjustment. Under Step 1, the U.S. long-term capital loss adjustment amount is $50 ($100 - $50). Under Step 2, the applicable rate differential amount is $200 ($250 - $50). Thus, $200 of the capital gain in the passive category is subject to a rate differential adjustment under paragraph (c)(1) of this section. The remaining $50 is not subject to a rate differential adjustment.

Example 3. (i) O, an individual, has a $100 short-term capital gain from foreign sources in the passive category. O has $300 of long-term capital gain from foreign sources in the passive category, all of which is subject to tax at a rate of 15 percent under section 1(h). O has a $100 long-term capital loss from sources within the United States.

(ii) O’s capital gain net income from sources outside the United States ($400) exceeds O’s capital gain net income from all sources ($300). Pursuant to paragraph (a)(1) of this section, O must reduce the $400 capital gain net income in the passive category by $100. Because C has capital gain net income in two or more rate groups in the passive category, O must apportion such amount, as a reduction, to each rate group on a pro rata basis pursuant to paragraph (a)(1)(ii)(B) of this section. Thus, $25 ($100/$400 of $100) is apportioned to the short-term capital gain and $75 ($300/$400 of $100) is apportioned to the long-term capital gain in the 15 percent rate group. After application of paragraph (a)(1) of this section, O has $75 of short-term capital gain in the passive category and $225 of long-term capital gain in the 15 percent rate group in the passive category.

(iii) Because O has a net long-term capital loss from sources within the United States ($100) and also has a short-term capital gain from foreign sources ($100), O must apply the provisions of paragraph (c)(1)(ii) of this section to determine the amount of the $225 of long-term capital gain in the 15 percent rate group that is subject to a rate differential adjustment. Under Step 1, the U.S. long-term capital loss adjustment amount is $25 ($100 - $75). Under Step 2, the applicable rate differential amount is $200 ($225 - $25). Thus, $200 of the long-term capital gain is subject to a rate differential adjustment under paragraph (c)(1) of this section. The remaining $25 of long-term capital gain is not subject to a rate differential adjustment.

(2) Rate differential adjustment of capital gains in entire taxable income. For purposes of section 904 and this section, entire taxable income shall include gains from the sale or exchange of capital assets only to the extent of capital gain net income reduced by the sum of the rate differential portions of each rate group of net capital gain.

(d) Rate differential adjustment of capital losses from sources outside the United States—(1) In general. In determining taxable income from sources outside the United States for purposes of section 904 and this section, a taxpayer with a net capital loss in a separate category rate group shall reduce such net capital loss by the sum of the rate differential portions of the capital gain net income in each long-term rate group offset by such net capital loss. A net capital loss in a separate category rate group is the amount, if any, by which capital losses in a rate group from sources outside the United States included in a separate category exceed capital gains from sources outside the United States in the same rate group and the same separate category.

(2) Determination of which capital gains are offset by net capital losses from sources outside the United States. For purposes of paragraph (d)(1) of this section, in order to determine the capital gain net income offset by net capital losses from sources outside the United States, the following rules shall apply in the following order:

(i) Net capital losses from sources outside the United States in each separate category rate group shall be netted against capital gain net income from sources outside the United States from the same rate group in other separate categories.

(ii) Capital losses from sources within the United States shall be netted against capital gains from sources within the United States in the same rate group.

(iii) Net capital losses from sources outside the United States in excess of the amounts netted against capital gains under paragraph (d)(2)(i) of this section shall be netted against the taxpayer’s remaining capital gains from sources within and outside the United States in the following order, and without regard to any net capital losses, from any rate group, from sources within the United States—

(A) First against capital gain net income from sources within the United States in the same rate group;

(B) Next, against capital gain net income in other rate groups, in the order in which capital losses offset capital gains for purposes of determining the taxpayer’s taxable income and without regard to whether such capital gain net income derives from sources within or outside the United States, as follows:

(1) A net capital loss in the short-term rate group is used first to offset any capital gain net income in the 28 percent rate group, then to offset capital gain net income in the 25 percent rate group, then to offset capital gain net income in the 15 percent rate group, and finally to offset capital gain net income in the 5 percent rate group.

(2) A net capital loss in the 28 percent rate group is used first to offset capital gain net income in the 25 percent rate group, then to offset capital gain net income in the 15 percent rate group, and finally to offset capital gain net income in the 5 percent rate group.

(3) A net capital loss in the 15 percent rate group is used first to offset capital gain net income in the 5 percent rate group, and then to offset capital gain net income in the 28 percent rate group, and finally to offset capital gain net income in the 25 percent rate group.

(iv) Net capital losses from sources outside the United States in any rate group, to the extent netted against capital gains in any other separate category under paragraph (d)(2)(i) of this section or against capital gains in the same or any other rate group under paragraph (d)(2)(iii) of this section, shall be treated as coming pro rata from each separate category that contains a net capital loss from sources outside the United States in that rate group. For example, assume that the taxpayer has $20 of net capital losses in the 15 percent rate group in the passive category and $40 of net capital losses in the 15 percent rate group in the general limitation category, both from sources outside the United States. Further assume that $50 of the total $60 net capital losses from sources outside the United States are netted against capital gain net income in the 28 percent rate group (from other separate categories or from sources within the United States). One-third of the $50 of such capital losses would be treated as coming from the passive category, and two-thirds of such $50 would be treated as coming from the general limitation category.

(v) In determining the capital gain net income offset by a net capital loss from sources outside the United States pursuant to this paragraph (d)(2), a taxpayer shall take into account any reduction to capital gain net income from sources outside the United States pursuant to paragraph (a) of this section and shall disregard any adjustments to such capital gain net income pursuant to paragraph (c)(1) of this section.

(vi) If at any time during a taxable year, tax is imposed under section 1(h) at a rate other than a rate of tax specified in this paragraph (d)(2), the principles of this paragraph (d)(2) shall apply to determine the capital gain net income offset by any net capital loss in a separate category rate group.

(vii) The determination of which capital gains are offset by capital losses from sources outside the United States under this paragraph (d)(2) is made solely in order to determine the appropriate rate-differential-based adjustments to such capital losses under this section and section 904(b), and does not change the source, allocation, or separate category of any such capital gain or loss for purposes of computing taxable income from sources within or outside the United States or for any other purpose.

(e) Qualified dividend income—(1) In general. A taxpayer that has taxable income (excluding net capital gain and qualified dividend income) for the taxable year and that qualifies for a reduced rate of tax under section 1(h) on its qualified dividend income (as defined in section 1(h)(11)) for the taxable year shall adjust the amount of such qualified dividend income in a manner consistent with the rules of paragraphs (c)(1)(i) (first sentence) and (c)(2) of this section irrespective of whether such taxpayer has a net capital gain for the taxable year. For purposes of making adjustments pursuant to this paragraph (e), the special rule in paragraph (c)(1)(ii) of this section for taxpayers with a net long-term capital loss from sources within the United States shall be disregarded.

(2) Exception. A taxpayer that makes the election provided for in paragraph (b)(3) of this section shall not make adjustments pursuant to paragraph (e)(1) of this section. Additionally, a taxpayer other than a corporation that does not have a capital gain rate differential for the taxable year within the meaning of paragraph (b)(2) of this section may elect not to apply paragraph (e)(1) of this section if such taxpayer would have qualified for the election provided for in paragraph (b)(3) of this section had such taxpayer had a capital gain rate differential for the taxable year. Such a taxpayer shall be presumed to make the election provided for in the preceding sentence unless such taxpayer applies the rate differential adjustments provided for in paragraph (e)(1) of this section to the qualified dividend income in determining its foreign tax credit limitation for the taxable year.

(f) Definitions. For purposes of section 904(b) and this section, the following definitions apply:

(1) Alternative tax rate. The term alternative tax rate means, with respect to any rate group, the rate applicable to that rate group under section 1(h) (for taxpayers other than corporations) or section 1201(a) (for corporations). For example, the alternative tax rate for unrecaptured section 1250 gain is 25 percent.

(2) Net capital gain. For purposes of this section, net capital gain shall not include any qualified dividend income (as defined in section 1(h)(11)). See paragraph (e) of this section for rules relating to qualified dividend income.

(3) Rate differential portion. The term rate differential portion with respect to capital gain net income from sources outside the United States in a separate category long-term rate group (or the applicable portion of such amount), net capital gain in a rate group, or capital gain net income in a long-term rate group, as the case may be, means the same proportion of such amount as—

(i) The excess of the highest applicable tax rate (as defined in section 904(b)(3)(E)(ii)) over the alternative tax rate; bears to

(ii) the highest applicable tax rate (as defined in section 904(b)(3)(E)(ii)).

(4) Rate group. For purposes of this section, the term rate group means:

(i) Short-term capital gains or losses. With respect to a short-term capital gain or loss, the rate group is the short-term rate group.

(ii) Long-term capital gains. With respect to a long-term capital gain, the rate group is the particular rate of tax to which such gain is subject under section 1(h). Such a rate group is a long-term rate group. For example, the 28 percent rate group of capital gain net income from sources outside the United States consists of the capital gain net income from sources outside the United States that is subject to tax at a rate of 28 percent under section 1(h). Such 28 percent rate group is a long-term rate group. If a taxpayer has long-term capital gains that may be subject to tax at more than one rate under section 1(h) and the taxpayer’s net capital gain attributable to such long-term capital gains and any qualified dividend income are taxed at one rate of tax under section 1(h), then all of such long-term capital gains shall be treated as long-term capital gains in that one rate group. If a taxpayer has long-term capital gains that may be subject to tax at more than one rate of tax under section 1(h) and the taxpayer’s net capital gain attributable to such long-term capital gains and any qualified dividend income are taxed at more than one rate pursuant to section 1(h), the taxpayer shall determine the rate group for such long-term capital gains from sources within or outside the United States (and, to the extent from sources outside the United States, from each separate category) ratably based on the proportions of net capital gain and any qualified dividend income taxed at each applicable rate. For example, under the section 1(h) rates in effect for tax years beginning in 2004, a long-term capital gain (other than a long-term capital gain described in section 1(h)(4)(A) or (h)(6)) may be subject to tax at 5 percent or 15 percent.

(iii) Long-term capital losses. With respect to a long-term capital loss, a loss described in section 1(h)(4)(B)(i) (collectibles loss) or (iii) (long-term capital loss carryover) is a loss in the 28 percent rate group. All other long-term capital losses shall be treated as losses in the highest rate group in effect under section 1(h) for the tax year with respect to long-term capital gains other than long-term capital gains described in section 1(h)(4)(A) or (h)(6).For example, under the section 1(h) rates in effect for tax years beginning in 2004, a long-term capital loss not described in section 1(h)(4)(B)(i) or (iii) shall be treated as a loss in the 15 percent rate group.

(5) Terms used in sections 1(h), 904(b) or 1222. For purposes of this section, any term used in this section and also used in section 1(h), section 904(b) or section 1222 shall have the same meaning given such term by section 1(h), 904(b) or 1222, respectively, except as otherwise provided in this section.

(g) Examples. The following examples illustrate the provisions of this section. In these examples, the rate differential adjustment is shown as a fraction, the numerator of which is the alternative tax rate percentage and the denominator of which is 35 percent (assumed to be the highest applicable tax rate for individuals under section 1). Finally, all dollar amounts in the examples are abbreviated from amounts in the thousands (for example, $50 represents $50,000). The examples are as follows:

Example 1. (i) AA, an individual, has items from sources outside the United States only in the passive category for the taxable year. AA has $1000 of long-term capital gains from sources outside the United States that are subject to tax at a rate of 15 percent under section 1(h). AA has $700 of long-term capital losses from sources outside the United States, which are not described in section 1(h)(4)(B)(i) or (iii). For the same taxable year, AA has $800 of long-term capital gains from sources within the United States that are taxed at a rate of 28 percent under section 1(h). AA also has $100 of long-term capital losses from sources within the United States, which are not described in section 1(h)(4)(B)(i) or (iii). AA also has $500 of ordinary income from sources within the United States. The highest tax rate in effect under section 1(h) for the taxable year with respect to long-term capital gains other than long-term capital gains described in section 1(h)(4)(A) or (h)(6) is 15 percent. Accordingly, AA’s long-term capital losses are in the 15 percent rate group.

(ii) AA’s items of ordinary income, capital gain and capital loss for the taxable year are summarized in the following table:

(iii) AA’s capital gain net income from sources outside the United States ($300) does not exceed AA’s capital gain net income from all sources ($1,000). Therefore, paragraph (a)(1) of this section does not require any reduction of AA’s capital gain net income in the passive category.

(iv) In computing AA’s taxable income from sources outside the United States in the numerator of the section 904(a) foreign tax credit limitation fraction for the passive category, AA’s $300 of capital gain net income in the 15 rate group in the passive category must be adjusted as required under paragraph (c)(1) of this section. AA adjusts the $300 of capital gain net income using 15 percent as the alternative tax rate, as follows: $300(15%/35%).

(v) In computing AA’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fraction, AA combines the $300 of capital gain net income from sources outside the United States and the $100 net capital loss from sources within the United States in the same rate group (15 percent). AA must adjust the resulting $200 ($300 - $100) of net capital gain in the 15 percent rate group as required under paragraph (c)(2) of this section, using 15 percent as the alternative tax rate, as follows: $200(15%/35%). AA must also adjust the $800 of net capital gain in the 28 percent rate group, using 28 percent as the alternative tax rate, as follows: $800(28%/35%). AA must also include ordinary income from sources outside the United States in the numerator, and ordinary income from all sources in the denominator, of the foreign tax credit limitation fraction.

(vi) AA’s passive category foreign tax credit limitation fraction is $128.58/$1225.72, computed as follows:

Example 2. (i) BB, an individual, has the following items of ordinary income, capital gain, and capital loss for the taxable year:

(ii) BB’s capital gain net income from sources outside the United States in the aggregate (zero, since losses exceed gains) does not exceed BB’s capital gain net income from all sources ($300). Therefore, paragraph (a)(1) of this section does not require any reduction of BB’s capital gain net income in the passive category.

(iii) In computing BB’s taxable income from sources outside the United States in the numerators of the section 904(a) foreign tax credit limitation fractions for the passive and general limitation categories, BB must adjust capital gain net income from sources outside the United States in each separate category long-tem rate group and net capital losses from sources outside the United States in each separate category rate group as provided in paragraphs (c)(1) and (d) of this section.

(A) The $100 of capital gain net income in the 15 percent rate group in the passive category is adjusted under paragraph (c)(1) of this section as follows: $100(15%/35%).

(B) BB must adjust the net capital losses in the 15 percent and 28 percent rate groups in the general limitation category in accordance with the ordering rules contained in paragraph (d)(2) of this section. Under paragraph (d)(2)(i) of this section, BB’s net capital loss in the 15 percent rate group is netted against capital gain net income from sources outside the United States in other separate categories in the same rate group. Thus, $100 of the $500 net capital loss in the 15 percent rate group in the general limitation category offsets $100 of capital gain net income in the 15 percent rate group in the passive category. Accordingly, $100 of the $500 net capital loss is adjusted under paragraph (d)(1) of this section as follows: $100(15%/35%).

(C) Next, under paragraph (d)(2)(iii)(A) of this section, BB’s net capital losses from sources outside the United States in any separate category rate group are netted against capital gain net income in the same rate group from sources within the United States. Thus, $300 of the $500 net capital loss in the 15 percent rate group in the general limitation category offsets $300 of capital gain net income in the 15 percent rate group from sources within the United States. Accordingly, $300 of the $500 net capital loss is adjusted under paragraph (d)(1) of this section as follows: $300(15%/35%). Similarly, the $300 of net capital loss in the 28 percent rate group in the general limitation category offsets $300 of capital gain net income in the 28 percent rate group from sources within the United States. The $300 net capital loss is adjusted under paragraph (d)(1) of this section as follows: $300(28%/35%).

(D) Finally, under paragraph (d)(2)(iii)(B) of this section, the remaining net capital losses in a separate category rate group are netted against capital gain net income from other rate groups from sources within and outside the United States. Thus, the remaining $100 of the $500 net capital loss in the 15 percent rate group in the general limitation category offsets $100 of the remaining capital gain net income in the 28 percent rate group from sources within the United States. Accordingly, the remaining $100 of net capital loss is adjusted under paragraph (d)(1) of this section as follows: $100(28%/35%).

(iv) In computing BB’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fractions, BB must adjust net capital gain by netting all of BB’s capital gains and losses, from sources within and outside the United States, and adjusting any remaining net capital gains, based on rate group, under paragraph (c)(2) of this section. BB must also include foreign source ordinary income in the numerators, and ordinary income from all sources in the denominator, of the foreign tax credit limitation fractions. The denominator of BB’s foreign tax credit limitation fractions reflects $2,000 of ordinary income from all sources, $100 of net capital gain taxed at the 28% rate and adjusted as follows: $100(28%/35%), and $200 of net capital gain taxed at the 25% rate and adjusted as follows: $200(25%/35%).

(v) BB’s foreign tax credit limitation fraction for the general limitation category is $8.56/$2222.86, computed as follows:

(vi) BB’s foreign tax credit limitation fraction for the passive category is $542.86/$2222.86, computed as follows:

Example 3. (i) CC, an individual, has the following items of ordinary income, capital gain, and capital loss for the taxable year:

(ii) CC’s capital gain net income from sources outside the United States (zero, since losses exceed gains) does not exceed CC’s capital gain net income from all sources ($100). Therefore, paragraph (a)(1) of this section does not require any adjustment.

(iii) In computing CC’s taxable income from sources outside the United States in the numerators of the section 904(a) foreign tax credit limitation fractions for the passive and general limitation categories, CC must adjust capital gain net income from sources outside the United States in each separate category long-tem rate group and net capital losses from sources outside the United States in each separate category rate group as provided in paragraphs (c)(1) and (d) of this section.

(A) CC must adjust the $50 of capital gain net income in the 28 percent rate group in the passive category pursuant to paragraph (c)(1) of this section as follows: $50(28%/35%).

(B) Under paragraph (d)(2)(i) of this section, $50 of CC’s $150 net capital loss in the 28 percent rate group in the general limitation category offsets $50 of capital gain net income in the 28 percent rate group in the passive category. Thus, $50 of the $150 net capital loss is adjusted as follows: $50(28%/35%). Next, under paragraph (d)(2)(iii)(A) of this section, the remaining $100 of net capital loss in the 28 percent rate group in the general limitation category offsets $100 of capital gain net income in the 28 percent rate group from sources within the United States. Thus, the remaining $100 of net capital loss is adjusted as follows: $100(28%/35%).

(C) Under paragraphs (d)(2)(iii)(A) and (d)(2)(iv) of this section, the net capital losses in the 15 percent rate group in the passive and general limitation categories offset on a pro rata basis the $300 of capital gain net income in the 15 percent rate group from sources within the United States. The proportionate amount of the $720 net capital loss ($720/$800 of $300, or $270) is adjusted as follows: $270(15%/35%). The proportionate amount of the $80 net capital loss ($80/$800 of $300, or $30) is adjusted as follows $30(15%/35%).

(D) Of the remaining $500 of net capital loss in the 15 percent rate group in the general limitation and passive categories, $400 offsets the remaining $400 of capital gain net income in the 28 percent rate group from sources within the United States under paragraph (d)(2)(iii)(B)(3) of this section. The proportionate amount of the $720 net capital loss ($720/$800 of $400, or $360) is adjusted as follows: $360(28%/35%). The proportionate amount of the $80 net capital loss ($80/$800 of $400, or $40) is adjusted as follows: $40(28%/35%).

(E) Under paragraph (d)(2)(iii)(B)(3) of this section, the remaining $100 of net capital loss in the 15 percent rate group in the general limitation and passive limitation categories offsets $100 of capital gain net income in the 25 percent rate group from sources within the United States. The proportionate amount of the $720 net capital loss ($720/$800 of $100, or $90) is adjusted as follows: $90(25%/35%). The proportionate amount of the $80 net capital loss ($80/$800 of $100 of $10) is adjusted as follows: $10(25%/35%).

(iv) In computing CC’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fractions, CC must adjust capital gain net income by netting all of CC’s capital gains and losses, from sources within and outside the United States, and adjusting any remaining net capital gains, based on rate group, under paragraph (c)(2) of this section. The denominator of CC’s foreign tax credit limitation fractions reflects $2,500 of ordinary income from all sources and $100 of net capital gain taxed at the 25% rate and adjusted as follows: $100(25%/35%).

(v) CC’s foreign tax credit limitation fraction for the general limitation category is $424.87/$2571.42, computed as follows:

(vi) CC’s foreign tax credit limitation fraction for the passive category is $488.00/$2571.42, computed as follows:

Example 4. (i) DD, an individual, has the following items of ordinary income, capital gain and capital loss for the taxable year:

(ii) DD’s capital gain net income from outside the United States ($800) exceeds DD’s capital gain net income from all sources ($720). Pursuant to paragraph (a)(1)(ii)(A) of this section, DD must apportion the $80 of excess of capital gain net income from sources outside the United States between the general limitation and passive categories based on the amount of capital gain net income in each separate category. Thus, one-half ($400/$800 of $100, or $40) is apportioned to the general limitation category and one-half ($400/$800 of $80, or $40) is apportioned to the passive category. The $40 apportioned to the general limitation category reduces DD’s $500 short-term capital gain in the general limitation category to $460. Pursuant to paragraph (a)(1)(ii)(B) of this section, the $40 apportioned to the passive category must be apportioned further between the capital gain net income in the short-term rate group and the 15 percent rate group based on the relative amounts of capital gain net income in each rate group. Thus, one-fourth ($100/$400 of $40 or $10) is apportioned to the short-term rate group and three-fourths ($300/$400 of $40 or $30) is apportioned to the 15 percent rate group. DD’s passive category includes $90 of short-term capital gain and $270 of capital gain net income in the 15% rate group.

(iii) Because DD has a net long-term capital loss from sources within the United States ($80) and also has short-term capital gains, DD must apply the provisions of paragraph (c)(1)(ii) of this section to determine the amount of DD’s $270 of capital gain net income in the 15% rate group that is subject to a rate differential adjustment under paragraph (c)(1) of this section. Under Step 1, the U.S. long-term capital loss adjustment amount is $50 ($80 - $30). Under Step 2, the applicable rate differential amount is the excess of the remaining capital gain net income over the U.S. long-term adjustment amount. Thus, the applicable rate differential amount is $220 ($270 - $50). In computing DD’s taxable income from sources outside the United States in the numerator of the section 904(a) foreign tax credit limitation fraction for the passive category, DD must adjust this amount as follows: $220(15%/35). DD does not adjust the remaining $50 of capital gain net income in the 15% rate group.

(iv) The amount of capital gain net income in the 15% rate group in the passive category, taking into account the adjustment pursuant to paragraph (a)(1) of this section and disregarding the adjustment pursuant to paragraph (c)(1) of this section, is $270. Under paragraphs (d)(2)(i) and (d)(2)(v) of this section, DD’s $100 net capital loss in the 15% rate group in the general limitation category offsets capital gain net income in the 15% rate group in the passive category. Accordingly, the $100 of net capital loss is adjusted as follows: $100(15%/35%).

(v) In computing DD’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fractions, DD must adjust capital gain net income by netting all of DD’s capital gains and losses from sources within and outside the United States, and adjusting the remaining net capital gain in each rate group pursuant to paragraph (c)(2) of this section. The denominator of DD’s foreign tax credit limitation fraction reflects $500 of ordinary income from all sources, $600 of short-term capital gain and $120 of net capital gain in the 15 percent rate group adjusted as follows: $120(15%/35%).

(vi) DD’s foreign tax credit limitation fraction for the general limitation category is $417.14/$1151.43, computed as follows:

(vii) DD’s foreign tax credit limitation fraction for the passive category is $234.29/$1151.43, computed as follows:

Example 5. (i) EE, an individual, has the following items of ordinary income, capital gain and capital loss for the taxable year:

(ii) EE’s capital gain net income from sources outside the United States ($600) exceeds EE’s capital gain net income from all sources ($480). Pursuant to paragraph (a)(1)(ii) of this section, the $120 of excess capital gain net income from sources outside the United States is allocated as a reduction to the passive category and must be apportioned pro rata to each rate group within the passive category with capital gain net income. Thus, $20 ($100/$600 of $120) is apportioned to the short-term rate group, $60 ($300/$600 of $120) is apportioned to the 15 percent rate group and $40($200/$600 of $120) is apportioned to the 28 percent rate group. After application of paragraph (a)(1) of this section, EE has $80 of capital gain net income in the short-term rate group, $240 of capital gain net income in the 15 percent rate group and $160 of capital gain net income in the 28 percent rate group.

(iii) Because EE has a net long-term capital loss from sources within the United States ($150) and also has short-term capital gains, EE must apply the provisions of paragraph (c)(1)(ii) of this section to determine the amount of EE’s remaining $400 ($240 + $160) of capital gain net income in long-term rate groups in the passive category that is subject to a rate differential adjustment. Under Step 1, the U.S. long-term capital loss adjustment amount is $50 ($150 - $100). Under Step 2, EE must apportion this amount pro rata to each long-tem rate group within the passive category with capital gain net income. Thus, $30 ($240/$400 of $50) is apportioned to the 15 percent rate group and $20 ($160/$400 of $50) is apportioned to the 28 percent rate group. The applicable rate differential amount for the 15 percent rate group is $210 ($240 - $30). The applicable rate differential amount for the 28 percent rate group is $140 ($160 - $20).

(iv) Pursuant to paragraph (c)(1)(ii) of this section, EE must adjust $210 of the $240 capital gain in the 15 percent rate group as follows: $210 (15%/35%). EE does not adjust the remaining $30. Pursuant to paragraph (c)(1)(ii) of this section, EE must adjust $140 of the $160 capital gain in the 28 percent rate group as follows: $140 (28%/35%). EE does not adjust the remaining $20.

(v) In computing EE’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fractions, EE must adjust capital gain net income by netting all of EE’s capital gains and losses from sources within and outside the United States, and adjusting the remaining net capital gain in each rate group pursuant to paragraph (c)(2) of this section. The denominator of EE’s foreign tax credit limitation fraction reflects $500 of ordinary income from all sources, $130 of short-term capital gain, $150 of net capital gain in the 15 percent rate group adjusted as follows: $150(15%/35%), and $200 of net capital gain in the 28 percent rate group adjusted as follows: $200(28%/35%).

(vi) EE’s foreign tax credit limitation fraction for the passive category is $332/$854.29, computed as follows:

(h) Coordination with section 904(f)—(1) In general. Section 904(b) and this section shall apply before the provisions of section 904(f) as follows:

(i) The amount of a taxpayer’s separate limitation income or loss in each separate category, the amount of overall foreign loss, and the amount of any additions to or recapture of separate limitation loss or overall foreign loss accounts pursuant to section 904(f) shall be determined after applying paragraphs (a), (c)(1), (d) and (e) of this section to adjust capital gains and losses and qualified dividend income from sources outside the United States in each separate category.

(ii) To the extent a capital loss from sources within the United States reduces a taxpayer’s foreign source taxable income under paragraph (a)(1) of this section, such capital loss shall be disregarded in determining the amount of a taxpayer’s taxable income from sources within the United States for purposes of computing the amount of any additions to the taxpayer’s overall foreign loss accounts.

(iii) In determining the amount of a taxpayer’s loss from sources in the United States under section 904(f)(5)(D) (section 904(f)(5)(D) amount), the taxpayer shall make appropriate adjustments to capital gains and losses from sources within the United States to reflect adjustments pursuant to section 904(b)(2) and this section. Therefore, for purposes of section 904, a taxpayer’s section 904(f)(5)(D) amount shall be equal to the excess of the taxpayer’s foreign source taxable income in all separate categories in the aggregate for the taxable year (taking into account any adjustments pursuant to paragraphs (a)(1), (c)(1), (d) and (e) of this section) over the taxpayer’s entire taxable income for the taxable year (taking into account any adjustments pursuant to paragraphs (c)(2) and (e) of this section).

(2) Examples. The following examples illustrate the application of paragraph (h) of this section:

Example 1. (i) W, an individual, has the following items of ordinary income, capital gain, and capital loss for the taxable year:

(ii) In computing W’s taxable income from sources outside the United States for purposes of section 904 and this section, W must adjust the capital gain net income and net capital loss in each separate category as provided in paragraphs (c)(1) and (d) of this section. Thus, W must adjust the $100 of capital gain net income in the general limitation category and the $400 of net capital loss in the passive category as follows: $100(15%/35%) and $400(15%/35%).

(iii) After the adjustment to W’s net capital loss in the passive category, W has a $171.43 separate limitation loss in the passive category. After the adjustment to W’s capital gain in the general limitation category, W has $142.86 of foreign source taxable income in the general limitation category. Thus, $142.86 of the separate limitation loss reduces foreign source taxable income in the general limitation category. See section 904(f)(5)(B). W adds $142.86 to the separate limitation loss account for the passive category. The remaining $28.57 of the separate limitation loss reduces income from sources within the United States. See section 904(f)(5)(A).Thus, W adds $28.57 to the overall foreign loss account for the passive category.

Example 2. (i) X, a corporation, has the following items of ordinary income, ordinary loss, capital gain and capital loss for the taxable year:

(ii) X’s capital gain net income from sources outside the United States ($700) exceeds X’s capital gain net income from all sources ($200). Pursuant to paragraph (a)(1) of this section, X must reduce the $700 capital gain in the general limitation category by $500. After the adjustment, X has $200 of capital gain net income remaining in the general limitation category. Thus, X has an overall foreign loss attributable to the general limitation category of $800.

(iii) For purposes of computing the amount of the addition to X’s overall foreign loss account for the general limitation category, the $500 capital loss from sources within the United States is disregarded and X’s taxable income from sources within the United States is $1100. Accordingly, X must increase its overall foreign loss account for the general limitation category by $800.

Example 3. (i) Y, a corporation, has the following items of ordinary income, ordinary loss, capital gain and capital loss for the taxable year:

(ii) Y’s capital gain net income from sources outside the United States ($200) exceeds Y’s capital gain net income from all sources ($100). Pursuant to paragraph (a)(1) of this section, Y must reduce the $200 capital gain in the passive category by $100. Y has $100 of capital gain net income remaining in the passive category.

(iii) Y is not required to make adjustments pursuant to paragraph (c), (d) or (e) of this section. See paragraphs (b) and (e) of this section. Y’s foreign source taxable income in the passive category after the adjustment pursuant to paragraph (a)(1) of this section is $600. Y’s entire taxable income for the taxable year is $400.

(iv) Y’s section 904(f)(5)(D) amount is the excess of Y’s foreign source taxable income in all separate categories in the aggregate for the taxable year after taking into account the adjustment pursuant to paragraph (a)(1) of this section ($600) over Y’s entire taxable income for the taxable year ($400). Therefore, Y’s section 904(f)(5)(D) amount is $200 and Y’s foreign source taxable income in the passive category is reduced to $400. See section 904(f)(5)(D).

Example 4. (i) Z, an individual, has the following items of ordinary income, ordinary loss and capital gain for the taxable year:

(ii) Z’s foreign source taxable income in all of Z’s separate categories in the aggregate for the taxable year is $600. (There are no adjustments to Z’s foreign source taxable income pursuant to paragraph (a)(1), (c)(1), (d) or (e) of this section.)

(iii) In computing Z’s entire taxable income in the denominator of the section 904(d) foreign tax credit limitation fractions, Z must adjust the $100 of net capital gain in the 15 percent rate group pursuant to paragraph (c)(2) of this section as follows: $100(15%/35%). Thus, Z’s entire taxable income for the taxable year, taking into account the adjustment pursuant to paragraph (c)(2) of this section, is $442.86.

(iv) Z’s section 904(f)(5)(D) amount is the excess of Z’s foreign source taxable income in all separate categories in the aggregate for the taxable year ($600) over Z’s entire taxable income for the taxable year after the adjustment pursuant to paragraph (c)(2) of this section ($442.86). Therefore, Z’s section 904(f)(5)(D) amount is $157.32. This amount must be allocated pro rata to the passive and general limitation categories in accordance with section 904(f)(5)(D).

Example 5. (i) O, an individual, has the following items of ordinary income, ordinary loss and capital gain for the taxable year:

(ii) In determining O’s taxable income from sources outside the United States, O must reduce the $500 capital loss in the general limitation category to $214.29 ($500 x 15%/35%) pursuant to paragraph (d) of this section. Taking this adjustment into account, O’s foreign source taxable income in all of O’s separate categories in the aggregate is $1285.71 ($1000 - $214.29 + $500).

(iii) In computing O’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fraction, O must reduce the $600 of net capital gain for the year to $257.14 ($600 x 15%/35%) pursuant to paragraph (c)(2) of this section. Taking this adjustment into account, O’s entire taxable income for the year is $757.14 ($500 + $257.14).

(iv) Therefore, O’s section 904(f)(5)(D) amount is $528.57 ($1285.71 - $757.14). This amount must be allocated pro rata to O’s $500 of income in the passive category and O’s $785.71 of adjusted income in the general limitation category in accordance with section 904(f)(5)(D).

(i) Effective date. This section shall apply to taxable years beginning after July 20, 2004. Taxpayers may choose to apply this section and §1.904(b)-2 to taxable years ending after July 20, 2004.

Par. 7. Section 1.904(b)-2 is revised to read as follows:

(a) Application of section 904(b)(2)(B) adjustments. Section 904(b)(2)(B) shall apply for purposes of determining the alternative minimum tax foreign tax credit under section 59 (regardless of whether or not the taxpayer has made an election under section 59(a)(4)).

(b) Use of alternative minimum tax rates—(1) Taxpayers other than corporations. In the case of a taxpayer other than a corporation, for purposes of determining the alternative minimum tax foreign tax credit under section 59—

(i) Section 904(b)(3)(D)(i) shall be applied by using the language “section 55(b)(3)” instead of “subsection (h) of section 1”;

(ii) Section 904(b)(3)(E)(ii)(I) shall be applied by using the language “section 55(b)(1)(A)(i)” instead of “subsection (a), (b), (c), (d), or (e) of section 1 (whichever applies)”; and

(iii) Section 904(b)(3)(E)(iii)(I) shall be applied by using the language “the alternative rate of tax determined under section 55(b)(3)” instead of “the alternative rate of tax determined under section 1(h)”.

(2) Corporate taxpayers. In the case of a corporation, for purposes of determining the alternative minimum tax foreign tax credit under section 59, section 904(b)(3)(E)(ii)(II) shall be applied by using the language “section 55(b)(1)(B)” instead of “section 11(b)”.

(c) Effective date. This section shall apply to taxable years beginning after July 20, 2004. See §1.904(b)-1(i) for a rule permitting taxpayers to choose to apply §1.904(b)-1(i) and this §1.904(b)-2 to taxable years ending after July 20, 2004.

Par. 8. Sections 1.904(b)-3 and 1.904(b)-4 are removed.

Par. 9. Section 1.904(j)-1 is added to read as follows:

(a) Election available only if all foreign taxes are creditable foreign taxes. A taxpayer may elect to apply section 904(j) for a taxable year only if all of the taxes for which a credit is allowable to the taxpayer under section 901 for the taxable year (without regard to carryovers) are creditable foreign taxes (as defined in section 904(j)(3)(B)).

(b) Coordination with carryover rules—(1) No carryovers to or from election year. If the taxpayer elects to apply section 904(j) for any taxable year, then no taxes paid or accrued by the taxpayer during such taxable year may be deemed paid or accrued under section 904(c) in any other taxable year, and no taxes paid or accrued in any other taxable year may be deemed paid or accrued under section 904(c) in such taxable year.

(2) Carryovers to and from other years determined without regard to election years. The amount of the foreign taxes paid or accrued, and the amount of the foreign source taxable income, in any year for which the taxpayer elects to apply section 904(j) shall not be taken into account in determining the amount of any carryover to or from any other taxable year. However, an election to apply section 904(j) to any year does not extend the number of taxable years to which unused foreign taxes may be carried under section 904(c) and §1.904-2(b). Therefore, in determining the number of such carryover years, the taxpayer must take into account years to which a section 904(j) election applies.

(3) Determination of amount of creditable foreign taxes. Otherwise allowable carryovers of foreign tax credits from other taxable years shall not be taken into account in determining whether the amount of creditable foreign taxes paid or accrued by an individual during a taxable year exceeds $300 ($600 in the case of a joint return) for purposes of section 904(j)(2)(B).

(c) Examples. The following examples illustrate the provisions of this section:

Example 1. In 2006, X, a single individual using the cash basis method of accounting for income and foreign tax credits, pays $100 of foreign taxes with respect to general limitation income that was earned and included in income for United States tax purposes in 2005. The foreign taxes would be creditable under section 901 but are not shown on a payee statement furnished to X. X’s only income for 2006 from sources outside the United States is qualified passive income, with respect to which X pays $200 of creditable foreign taxes shown on a payee statement. X may not elect to apply section 904(j) for 2006 because some of X’s foreign taxes are not creditable foreign taxes within the meaning of section 904(j)(3)(B).

Example 2. (i) In 2009, A, a single individual using the cash basis method of accounting for income and foreign tax credits, pays creditable foreign taxes of $250 attributable to passive income. Under section 904(c), A may also carry forward to 2009 $100 of unused foreign taxes paid in 2005 with respect to passive income, $300 of unused foreign taxes paid in 2005 with respect to general limitation income, $400 of unused foreign taxes paid in 2006 with respect to passive income, and $200 of unused foreign taxes paid in 2006 with respect to general limitation income. In 2009, A’s only foreign source income is passive income described in section 904(j)(3)(A)(i), and this income is reported to A on a payee statement (within the meaning of section 6724(d)(2)). If A elects to apply section 904(j) for the 2009 taxable year, the unused foreign taxes paid in 2005 and 2006 are not deemed paid in 2009, and A therefore cannot claim a foreign tax credit for those taxes in 2009.

(ii) In 2010, A again is eligible for and elects the application of section 904(j). The carryforwards from 2005 expire in 2010. The carryforward period established under section 904(c) is not extended by A’s election under section 904(j). In 2011, A does not elect the application of section 904(j). The $600 of unused foreign taxes paid in 2006 on passive and general limitation income are deemed paid in 2011, under section 904(c), without any adjustment for any portion of those taxes that might have been used as a foreign tax credit in 2009 or 2010 if A had not elected to apply section 904(j) to those years.

(d) Effective date. Section 1.904(j)-1 applies to taxable years beginning after July 20, 2004.

Par. 10. Section 1.954-2 is amended by:

1. Revising paragraph (b)(2)(iv), Example 2.

2. Removing paragraph (b)(2)(iv), Example 3.

The revision reads as follows:

* * * * *

(b) * * *

(2) * * *

(iv) * * *

Example 2. (i) DS, a domestic corporation, wholly owns two controlled foreign corporations organized in Country A, CFC1 and CFC2. CFC1 purchases from DS property that DS manufactures in the United States. CFC1 uses the purchased property as a component part of property that CFC1 manufactures in Country A within the meaning of §1.954-3(a)(4). CFC2 provides loans described in section 864(d)(6) to unrelated persons in Country A for the purchase of the property that CFC1 manufactures in Country A.

(ii) The interest accrued from the loans by CFC2 is not export financing interest as defined in section 904(d)(2)(G) because the property sold by CFC1 is not manufactured in the United States under §1.927(a)-1T(c). No portion of the interest is export financing interest as defined in this paragraph (b)(2). The full amount of the interest is, therefore, included in foreign personal holding company income under paragraph (b)(1)(ii) of this section.

* * * * *

Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.

Approved June 16, 2004.

Gregory F. Jenner,
Acting Assistant Secretary for Tax Policy.

In Walton v. Commissioner, 115 T.C. 589 (2000), the Tax Court considered a situation similar to that presented in Example 5 of §25.2702-3(e). In this example, A transfers property to an irrevocable trust, retaining the right to receive a unitrust amount for 10 years. If A dies within the 10-year term, the unitrust amount is to be paid to A’s estate for the balance of the term. The example concludes that A’s interest is a qualified unitrust interest to the extent of the right to receive the unitrust amount for 10 years or until A’s prior death. The example also concludes, however, that the unitrust amount payable to A’s estate if A dies within the term of the trust is not a qualified interest.

In Example 6 of §25.2702-3(e), the facts are the same as in Example 5, except that, if A dies within the 10-year term, the unitrust amount will be paid to A’s estate for an additional 35 years. The example concludes that the result is the same as in Example 5; that is, A’s interest is a qualified unitrust interest to the extent of the right to receive the unitrust amount for 10 years or until A’s prior death.

In Walton, the grantor established a grantor retained annuity trust (GRAT), pursuant to which the grantor was to receive an annuity for a term of 2 years. If the grantor died before the expiration of the 2-year term, the annuity was to be paid to the grantor’s estate for the balance of the term. Upon expiration of the 2-year term, the trust corpus was to be distributed to a designated remainder beneficiary. After considering the legislative history and purpose of section 2702, the court held that Example 5 is an unreasonable interpretation and invalid extension of section 2702. The court concluded that a retained annuity payable for a specified term of years to the grantor, or to the grantor’s estate if the grantor dies prior to expiration of the term, is a qualified interest under section 2702 for the specified term of years.

As noted above, §25.2702-2(a)(5) provides that the retention of a power to revoke a qualified annuity interest (or unitrust interest) of the transferor’s spouse is treated as the retention by the transferor of a qualified annuity interest (or unitrust interest). Section 25.2702-2(d)(1), Examples 6 and 7 illustrate the application of this rule.

In Example 6 of §25.2702-2(d)(1), A transfers property to an irrevocable trust, retaining the right to receive the income for 10 years. Upon the expiration of 10 years, the income of the trust is payable to A’s spouse for 10 years, if living. Upon expiration of the spouse’s interest, the trust terminates and the trust corpus is payable to A’s child. A retains the right to revoke the spouse’s interest. Because A has made a completed gift of the remainder interest, the transfer of property to the trust is not incomplete as to all interests in the property and section 2702 applies. A’s power to revoke the spouse’s term interest is treated as a retained interest for purposes of section 2702. The example concludes that, because neither one of the interests retained by A (that is, A’s income interest and the spouse’s revocable income interest) is a qualified interest, the amount of the gift is the fair market value of the property transferred to the trust.

In Example 7 of §25.2702-2(d)(1), the facts are the same as in Example 6, except that both the term interest retained by A and the interest transferred to A’s spouse (subject to A’s right of revocation) are qualified annuity or unitrust interests. The example concludes that the amount of the gift is the fair market value of the property transferred to the trust reduced by the value of both A’s qualified interest and the qualified interest transferred to A’s spouse (subject to A’s power to revoke).

In Schott v. Commissioner, T.C.M. 2001-110, rev’d and remanded 319 F.3d 1203 (9^th Cir. 2003), the GRAT at issue provided for fixed annuity payments to the grantor for a 15-year term, or until the grantor’s prior death. If the grantor died prior to the end of the 15-year term and the grantor’s spouse survived the grantor, then the annuity was to be paid to the spouse for the balance of the 15-year term. The grantor retained the right to revoke the spouse’s interest. The Tax Court, relying on its earlier opinion in Cook v. Commissioner, 115 T.C. 15 (2000), aff’d 269 F.3d 854 (7^th Cir. 2001), concluded that the successor spousal interest was not a qualified interest, and thus, that the successor spousal interest must be valued at zero. The court noted that the term of the revocable spousal interest was contingent upon the death of the grantor and thus was not fixed and ascertainable under the governing instrument as required by §25.2702-3(d)(3). Further, because the revocable spousal interest was deemed to be an interest retained by the grantor, the possibility existed that the retained annuity interest could extend beyond the life of the term holder (the grantor) but for less than the specified 15-year term, which is not consistent with the requirement in §25.2702-3(d)(3) that the qualified annuity or unitrust interest be payable “for the life of the term holder, for a specified term of years, or for the shorter (but not longer) of those periods.” The Tax Court, following its opinion in Cook, distinguished the Schott GRAT from §25.2702-2(d)(1), Example 7, because, in the Court’s view, in Example 7, the spouse or the estate of the spouse would receive the annuity regardless of whether the spouse was living at the end of the grantor’s initial 10-year term. Thus, the court viewed the spouse’s interest in Example 7 as a noncontingent interest for a fixed term of years. In contrast, the Schott spousal interest would pass to the spouse only if the grantor died within the term of the trust and the spouse was living when the grantor died.

However, on appeal, the Ninth Circuit concluded that the Schott spousal interest was a qualified interest. The Ninth Circuit distinguished Cook because the revocable spousal interest in Cook was also contingent upon the grantor and the spouse being married to each other at the grantor’s death, which could not be accounted for by an annuity table. Further, the Ninth Circuit rejected the Commissioner’s contention that a spousal interest contingent on the death of the grantor lacks the fixed term required by the regulations. Rather, the court stated that every annuity given to a person, if living, is contingent on that person’s survival. The court also stated that the present value of the spouse’s interest (even if dependent on the grantor’s death prior to expiration of the specified term) can be ascertained using the actuarial tables.

In Notice 2003-72, 2003-44 I.R.B. 964 (released October 15, 2003), the IRS announced that it will follow the Walton decision. Consistent with Notice 2003-72, the proposed regulations revise Example 5 and Example 6 of §25.2702-3(e) to conform to the Walton decision. Under the examples as revised, a unitrust amount payable for a specified term of years to the grantor, or to the grantor’s estate if the grantor dies prior to the expiration of the term, is a qualified interest for the specified term. Thus, in Example 5, the interest of A (and A’s estate) to receive the unitrust amount for a specified term of 10 years in all events is a qualified interest. Similarly, in Example 6, the unitrust interest, to the extent payable to either A or A’s estate for a 10-year period in all events, is a qualified interest for a 10-year term. However, in Example 6, the interest of A’s estate to receive the unitrust amount after the 10-year period for the remaining balance of the additional 35-year term if A dies within the 10-year period, is a contingent interest that is not fixed or ascertainable at the creation of the interest and, therefore, is not a qualified interest.

The result in Example 6, in which only a discrete portion of the grantor’s retained 35-year unitrust interest (specifically, that portion payable in all events for a 10-year term) is a qualified interest, does not change the result in Example 1 of §25.2702-3(e). In Example 1, A retains the right to receive an annuity for a 10-year term, or until A’s prior death. If A dies prior to the expiration of the 10-year term, the entire trust corpus reverts to A’s estate. The example concludes that the estate’s contingent reversion is valued at zero, notwithstanding that, economically, this reversion of the entire trust corpus includes the equivalent value of the annuity that would be payable for the balance of the 10-year term. The Tax Court in Walton addressed Example 1, noting that, in the case of a reversion, even though the equivalent of the term annuity’s value would be payable to the grantor or the grantor’s estate in all events, Congress was entitled to require that interests be cast in one of three specified forms to receive the favorable treatment afforded qualified interests. The Court stated “. . . the Commissioner is equally justified in assigning a zero value to reversionary interests outside the scope of the statutory definition and refusing to consider whether such interests can have the practical effect of a different form of interest not chosen by the grantor. See §25.2702-3(e), Example (1), Gift Tax Regs.” Walton, 115 T.C. at 602. Thus, in Example 1, the reversion, even though including the equivalent value of an annuity payable for the balance of the 10-year term, is not in a qualified form prescribed by the statute and is, therefore, not a qualified interest to any extent. On the other hand, in Example 6 of §25.2702-3(e), the retained interest is in the form of a unitrust interest and, therefore, is a qualified interest to the extent payable to A or A’s estate for a 10-year period in all events.

The proposed regulations also clarify when a revocable spousal interest is a qualified interest.

Sections 2702(a)(3)(A)(i) and (B) confirm that the valuation rules of section 2702 do not apply to a gift that is incomplete. Section 25.2702-2(a)(5) provides a regulatory exception to this statutory rule by providing that the retention of a power to revoke a qualified annuity or unitrust interest of the transferor’s spouse is a qualified interest. The annuity or unitrust interest payable to the transferor’s spouse must be a qualified interest to meet this exception. Thus, the regulatory exception focuses on the spouse’s annuity or unitrust interest and applies only if that interest is a qualified interest as described in §25.2702-3(d).

The references to “term holder” in §25.2702-3(d)(3) or “holder of the qualified ... interest” in §25.2702-3(b) and (c) refer to the person to whom the annuity or unitrust interest is payable during the fixed term. In the case of a revocable successor interest held by the transferor’s spouse, although the spouse’s interest (if qualified) is valued as a retained qualified interest of the transferor and may thus be deducted from the total value of the assets transferred in computing the taxable gift under section 2702, the spouse is the holder during the period when an interest is payable to the spouse. Thus, each qualified interest must meet the fixed duration requirements of §25.2702-3(d)(3), and each holder’s separate interest must be valued as a single life annuity or unitrust interest.

In addition to the requirement that a qualified interest be for a fixed term, payment of the interest cannot be contingent on any event other than the survival of the term holder (subject to the transferor’s retained right of revocation). A revocable spousal interest is contingent, and therefore not a qualified interest, if the spouse will not receive any payments if the transferor survives the fixed term during which the transferor is the holder.

Section 25.2702-2(d)(1), Example 7, illustrates the revocable spousal interest exception. In Example 7, beginning at the expiration of a 10-year term, the spouse’s annuity is payable to the spouse for 10 years or until the spouse’s prior death. Thus, the spouse’s annuity in the example meets the requirements of §25.2702-3(d)(3), that the term of the annuity must be for either the life of the holder (the spouse), for a specified term of years, or for the shorter but not the longer of these two periods and, assuming the spouse survives until the commencement of his or her interest, the spouse will receive that interest in all events (subject to the transferor’s retained right of revocation). In contrast, in Schott, the spouse’s annuity does not meet the requirements of §25.2702-3(d)(3) because the spousal annuity is payable, if at all, only if the grantor dies prior to the termination of the term of the trust and, if payable at all, is payable for a period that depends on the length of the unexpired portion of the trust’s term when the grantor dies.

The proposed regulations clarify that the revocable spousal interest exception applies only if the spouse’s interest, standing alone, would constitute a qualified interest that meets the requirements of §25.2702-3(d)(3), but for the grantor’s revocation power.

* * * * *

(a) * * *

(5) Holder.

* * * * *

* * * * *

(d) * * *

(2) Contingencies.

* * * * *

(6) Use of debt obligations to satisfy the annuity or unitrust payment obligation.

Par. 3. Section 25.2702-2 is amended as follows:

1. Paragraphs (a)(5) through (a)(9) are redesignated as paragraphs (a)(6) through (a)(10), respectively.

2. A new paragraph (a)(5) is added.

3. In redesignated paragraph (a)(6), the second sentence is removed and two sentences are added in its place.

4. In paragraph (d)(1), Example 6 and Example 7 are removed.

5. In paragraph (d)(2), introducing text, the phrase “Examples 8-10” is revised to read “Examples 6 through 8”.

6. In paragraph (d)(2), Examples 8, 9 and 10 are redesignated Examples 6, 7 and 8, respectively.

The additions read as follows:

(a) * * *

(5) Holder. The holder is the person to whom the annuity or unitrust interest is payable during the fixed term of that interest. References to holder shall also include the estate of that person.

(6) * * * If a transferor retains a power to revoke a qualified annuity interest or qualified unitrust interest of the transferor’s spouse, then the revocable qualified annuity or unitrust interest of the transferor’s spouse is treated as a retained qualified interest of the transferor. In order for the transferor to be treated as having retained a qualified interest under the preceding sentence, the interest of the transferor’s spouse (the successor holder) must be an interest that meets the requirements of a qualified annuity interest in accordance with §25.2702-3(b) and (d), or a qualified unitrust interest in accordance with §25.2702-3(c) and (d), but for the transferor’s retained power to revoke the interest.

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Par. 4. Section 25.2702-3 is amended as follows:

1. Paragraphs (d)(2) through (d)(5) are redesignated as paragraphs (d)(3) through (d)(6), respectively.

2. A new paragraph (d)(2) is added.

3. In redesignated paragraph (d)(4), the first two sentences are revised.

4. Redesignated paragraph (d)(5) is revised.

5. In paragraph (e), Example 5, the last sentence is revised.

6. In paragraph (e), Example 6, the last sentence is removed and two new sentences are added in its place.

7. In paragraph (e), new Example 8 and new Example 9 are added.

The revisions and additions read as follows:

* * * * *

(d) * * *

(2) Contingencies. A holder’s qualified interest must be payable in any event to or for the benefit of the holder for the fixed term of that interest. Thus, payment of the interest cannot be subject to any contingency other than either the survival of the holder until the commencement, or throughout the term, of that holder’s interest, or, in the case of a revocable interest described in §25.2702-2(a)(6), the transferor’s right to revoke the qualified interest of that transferor’s spouse.

* * * * *

(4) Term of the annuity or unitrust interest. The governing instrument must fix the term of the annuity or unitrust and the term of the interest must be fixed and ascertainable at the creation of the trust. The term must be for the life of the holder, for a specified term of years, or for the shorter (but not the longer) of those periods. * * *

(5) Commutation. The governing instrument must prohibit commutation (prepayment) of the interest of the holder. * * *

* * * * *

(e) * * *

Example 5. * * * The interest of A (and A’s estate) to receive the unitrust amount for the specified term of 10 years in all events is a qualified unitrust interest for a term of 10 years.

Example 6. * * * As in Example 5, the interest of A (and A’s estate) to receive the unitrust amount for a specified term of 10 years in all events is a qualified unitrust interest for a term of 10 years. However, the right of A’s estate to continue to receive the unitrust amount after the expiration of the 10-year term if A dies within that 10-year period is not fixed and ascertainable at the creation of the interest and is not a qualified unitrust interest.

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Example 8. A transfers property to an irrevocable trust, retaining the right to receive an annuity equal to 6 percent of the initial net fair market value of the trust property for 10 years, or until A’s prior death. At the expiration of the 10-year term, or on A’s death prior to the expiration of the 10-year term, the annuity is to be paid to B, A’s spouse, if then living, for 10 years or until B’s prior death. A retains the right to revoke B’s interest. Upon expiration of B’s interest (or if A revokes B’s interest, or if B predeceases A, then on the expiration of A’s interest), the trust terminates and the trust corpus is payable to A’s child. Because A has made a completed gift of the remainder interest, the transfer of property to the trust is not incomplete as to all interests in the property and section 2702 applies. A’s annuity interest (A’s right to receive the annuity for 10 years, or until A’s prior death) is a retained interest that is a qualified annuity interest under paragraphs (b) and (d) of this section. In addition, because A has retained the power to revoke B’s interest, B’s interest is treated as an interest retained by A for purposes of section 2702. B’s successive annuity interest otherwise satisfies the requirements for a qualified interest contained in paragraph (d) of this section, but for A’s power to revoke. The term of B’s interest is specified in the governing instrument and is fixed and ascertainable at the creation of the trust, and B’s right to receive the annuity is contingent only on B’s survival, and A’s power to revoke. Following the expiration of A’s interest, the annuity is to be paid for a 10-year term or for B’s (the successor holder’s) life, whichever is shorter. Accordingly, A is treated as retaining B’s revocable qualified annuity interest pursuant to §25.2702-2(a)(6). Because both A’s interest and B’s interest are treated as qualified interests retained by A, the value of the gift is the value of the property transferred to the trust less the value of both A’s qualified interest and B’s qualified interest (subject to A’s power to revoke), each valued as a single-life annuity. Further, if A revokes B’s interest prior to the commencement of that interest, A is treated as making a completed gift at that time to A’s child. The amount of the gift would be the present value of B’s interest determined under section 7520 and the applicable regulations, as of the date the interest is revoked. See §25.2511-2(b) and (f).

Example 9. (i) A transfers property to an irrevocable trust, retaining the right to receive 6 percent of the initial net fair market value of the trust property for 10 years, or until A’s prior death. If A survives the 10-year term, the trust terminates and the trust corpus is payable to A’s child. If A dies prior to the expiration of the 10-year term, the annuity is payable to B, A’s spouse, if then living, for the balance of the 10-year term, or until B’s prior death. A retains the right to revoke B’s interest. Upon expiration of B’s interest (or upon A’s death if A revokes B’s interest), the trust terminates and the trust corpus is payable to A’s child. As is the case in Example 8, A’s retained annuity interest (A’s right to receive the annuity for 10 years, or until A’s prior death) is a qualified annuity interest under paragraphs (b) and (d) of this section. However, B’s interest does not meet the requirements of paragraph (d) of this section. The term of B’s annuity is not fixed and ascertainable at the creation of the trust, because it is not payable for the life of B, a specified term of years, or for the shorter of those periods. Rather, B’s annuity is payable for an unspecified period that will depend upon the number of years left in the original term after A’s death. Further, B’s annuity is payable only if A dies prior to the expiration of the 10-year term. Thus, payment of B’s annuity is not dependent solely on B’s survival, but rather is dependent on A’s failure to survive.

(ii) Accordingly, the amount of the gift is the fair market value of the property transferred to the trust reduced by the value of A’s qualified interest (A’s right to receive the stated annuity for 10 years or until A’s prior death). B’s interest is not a qualified interest and is thus valued at zero under section 2702.

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Par. 5. Section 25.2702-7 is amended to add two new sentences at the end of that section. The addition reads as follows:

***Section 25.2702-2(a)(5), the second and third sentences of §25.2702-2(a)(6), §25.2702-3(d)(2), the first two sentences of §25.2702-3(d)(4), the last sentence of §25.2702-3(e), Example 5, the last two sentences of §25.2702-3(e), Example 6, and §25.2702-3(e), Examples 8 and 9, are effective for trusts created on or after July 26, 2004. However, the Internal Revenue Service will not challenge any prior application of the changes to Examples 5 and 6 in §25.2702-3(e).

Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.