# 26 CFR § 1.904-5 - Look-through rules as applied to controlled foreign corporations and other entities.

(a) Scope and definitions -

(1) Look-through rules under section 904(d)(3) to passive category income. Paragraph (c) of this section provides rules for determining the extent to which dividends, interest, rents, and royalties received or accrued by certain eligible persons, and inclusions under sections 951(a)(1) and 951A(a), are treated as passive category income. Paragraph (g) of this section provides rules applying the principles of paragraph (c) of this section to foreign source interest, rents, and royalties paid by a domestic corporation to a related corporation. Paragraph (h) of this section provides rules for assigning a partnership payment to a partner described in section 707 to the passive category. Paragraph (i) of this section provides rules applying the principles of this section to assign distributions and payments from certain related entities to the passive category or to treat the distributions and payments as not in the passive category.

(2) Other look-through rules under section 904(d). Under section 904(d)(4) and paragraph (c)(4)(iii) of this section, certain dividends from noncontrolled 10-percent owned foreign corporations are treated as income in a separate category. Under section 904(d)(3)(H) and paragraph (j) of this section, certain inclusions under section 1293 are treated as income in a separate category. Paragraph (i) of this section provides rules applying the principles of this section to assign distributions from certain related entities to separate categories.

(3) Other rules provided in this section. Paragraph (b) of this section provides operative rules for this section. Paragraph (d) of this section provides rules addressing exceptions to passive category income for certain purposes in the case of controlled foreign corporations that meet the requirements of section 954(b)(3)(A) (de minimis rule) or section 954(b)(4) (high-tax exception). Paragraph (e) of this section provides rules for characterizing a controlled foreign corporation's foreign base company income and gross insurance income when section 954(b)(3)(B) (full inclusion rule) applies. Paragraph (f) of this section modifies the look-through rules for certain types of income. Paragraph (k) of this section provides ordering rules for applying the look-through rules. Paragraph (l) of this section provides examples illustrating the application of certain rules in this section. Paragraphs (m) and (n) of this section provide rules related to the resourcing rules described in section 904(h).

(4) Definitions. For purposes of this section, the following definitions apply:

(i) The term controlled foreign corporation has the meaning given such term by section 957 (taking into account the special rule for certain captive insurance companies contained in section 953(c)), determined without applying section 318(a)(3)(A), (B), and (C) so as to consider a United States person as owning stock which is owned by a person who is not a United States person.

(ii) The term look-through rules means the rules described in this section that assign income to a separate category based on the separate category of the income to which it is allocable.

(iii) The term noncontrolled 10-percent owned foreign corporation has the meaning provided in section 904(d)(2)(E)(i).

(iv) The term pass-through entity means a partnership, S corporation, or any other person (whether domestic or foreign) other than a corporation to the extent that the income or deductions of the person are included in the income of one or more direct or indirect owners or beneficiaries of the person. For example, if a domestic trust is subject to Federal income tax on a portion of its income and its owners are subject to tax on the remaining portion, the domestic trust is treated as a domestic pass-through entity with respect to such remaining portion.

(v) The term separate category means, as the context requires, any category of income described in section 904(d)(1)(A), (B), (C), or (D), any specified separate category of income as defined in § 1.904-4(m), or any category of earnings and profits to which income described in such provisions is attributable.

(vi) The term United States shareholder has the meaning given such term by section 951(b) (taking into account the special rule for certain captive insurance companies contained in section 953(c)), determined without applying section 318(a)(3)(A), (B), and (C) so as to consider a United States person as owning stock which is owned by a person who is not a United States person, except that for purposes of this section, a United States shareholder includes any member of the controlled group of the United States shareholder. For purposes of this paragraph (a)(4)(vi), the controlled group is any member of the affiliated group within the meaning of section 1504(a)(1) except that “more than 50 percent” is substituted for “at least 80 percent” wherever it appears in section 1504(a)(2). When used in reference to a noncontrolled 10-percent owned foreign corporation described in section 904(d)(2)(E)(i)(II), the term United States shareholder also means a taxpayer that meets the stock ownership requirements described in section 904(d)(2)(E)(i)(II).

(b) Operative rules -

(1) Assignment of income not assigned under the look-through rules. Except as provided by the look-through rules, dividends, interest, rents, and royalties received or accrued by a taxpayer from a controlled foreign corporation in which the taxpayer is a United States shareholder are excluded from passive category income. Income excluded from the passive category under this paragraph (b)(1) is assigned to another separate category (other than the passive category) under the rules in § 1.904-4.

(2) Priority and ordering of look-through rules. Except as provided in this paragraph (b)(2), to the extent the look-through rules assign income to a separate category, the income is assigned to that separate category rather than the separate category to which the income would have been assigned under § 1.904-4 (not taking into account § 1.904-4(l)). See paragraph (k) of this section for ordering rules for applying the look-through rules. However, passive income that is financial services income is assigned to a separate category under the rules in § 1.904-4(e)(1), (f)(1), and (l), regardless of whether the look-through rules otherwise would have assigned such income to the passive category.

(c) Rules for specific types of inclusions and payments -

(1) Scope. Subject to the exceptions in paragraph (f) of this section, paragraphs (c)(2) through (6) (other than paragraph (c)(4)(iii) of this section) of this section provide look-through rules with respect to interest, rents, royalties, dividends, and inclusions under sections 951(a)(1) and 951A(a) that are received or accrued from a controlled foreign corporation in which the taxpayer is a United States shareholder. Paragraph (c)(4)(iii) of this section provides a look-through rule for dividends received from a noncontrolled 10-percent owned foreign corporation by a domestic corporation that is a United States shareholder in the foreign corporation.

(2) Interest -

(i) In general. For purposes of this paragraph, related person interest is any interest paid or accrued by a controlled foreign corporation to any United States shareholder in that corporation (or to any other related person) to which the look-through rules of section 904(d)(3) and this section apply. Unrelated person interest is all interest other than related person interest. Related person interest is treated as passive category income to the extent it is allocable to passive category income of the controlled foreign corporation. If related person interest is received or accrued from a controlled foreign corporation by two or more persons, the amount of interest received or accrued by each person that is allocable to passive category income is determined by multiplying the amount of related person interest allocable to passive category income by a fraction. The numerator of the fraction is the amount of related person interest received or accrued by that person and the denominator is the total amount of related person interest paid or accrued by the controlled foreign corporation. Solely for purposes of assigning interest income to a separate category under section 904(d)(3) and the look-through rule in this paragraph (c)(2), the rules in paragraph (c)(2)(ii) of this section for allocating and apportioning interest expense of a controlled foreign corporation apply for purposes of characterizing interest income in the hands of the recipient, even if a deduction for the interest expense is deferred or disallowed to the controlled foreign corporation.

(ii) Allocating and apportioning expenses of a controlled foreign corporation including interest paid to a related person. Related person interest and other expenses of a controlled foreign corporation shall be allocated and apportioned in the following manner:

(A) Gross income in each separate category shall be determined;

(B) Any expenses that are definitely related to less than all of gross income as a class, including unrelated person interest that is directly allocated to income from a specific property, shall be allocated and apportioned under the principles of §§ 1.861-8 or 1.861-10T, as applicable, to income in each separate category;

(C) Related person interest shall be allocated to and shall reduce (but not below zero) the amount of passive foreign personal holding company income as determined after the application of paragraph (c)(2)(ii)(B) of this section;

(D) To the extent that related person interest exceeds passive foreign personal holding company income as determined after the application of paragraphs (c)(2)(ii) (B) and (C) of this section, the related person interest shall be apportioned under the rules of this paragraph to separate categories other than passive income.

(1) If under § 1.861-9T, the modified gross income method of apportioning interest expense is elected, related person interest shall be apportioned as follows:

$\begin{array}{c}\text{Related person interest minus Related}\\ \text{person interest allocated under}\\ \text{paragraph}\phantom{\rule{0ex}{0ex}}\text{(}\text{c}\text{)(}\text{2}\text{)(}\text{ii}\text{)(}\text{C}\text{)}\phantom{\rule{0ex}{0ex}}\text{of this section}\end{array}×\phantom{\rule{0ex}{0ex}}\frac{\begin{array}{c}\text{Gross income in a separate category}\\ \text{(other than passive)}\end{array}}{\text{Total gross income (other than passive)}}$

(2) If under § 1.861-9T, the asset method of apportioning interest expense is elected, related person interest shall be apportioned according to the following formula:

(E) Any other expenses (including unrelated person interest that is not directly allocated to income from a specific property) that are not definitely related expenses or that are definitely related to all of gross income as a class shall be apportioned under the rules of this paragraph to reduce income in each separate category.

(1) If under § 1.861-9T, the modified gross income method of apportioning interest expense is elected, the interest expense shall be apportioned as follows:

$\begin{array}{c}\text{Expense apportionable}\\ \text{to a separate category}\end{array}\phantom{\rule{0ex}{0ex}}\text{=}\phantom{\rule{0ex}{0ex}}\text{Expense}\phantom{\rule{0ex}{0ex}}×\phantom{\rule{0ex}{0ex}}\frac{\begin{array}{c}\text{Gross income in a separate category (minus}\\ \text{related person interest allocated under}\\ \text{paragraph}\phantom{\rule{0ex}{0ex}}\text{(}\text{c}\text{)(}\text{2}\text{)(}\text{ii}\text{)(}\text{C}\text{)}\phantom{\rule{0ex}{0ex}}\text{of this section if}\\ \text{the category is passive)}\end{array}}{\begin{array}{c}\text{Total gross income minus relatedperson}\\ \text{interest allocated to passive income}\\ \text{under paragraph}\phantom{\rule{0ex}{0ex}}\text{(}\text{c}\text{)(}\text{2}\text{)(}\text{ii}\text{)(}\text{C}\text{)}\phantom{\rule{0ex}{0ex}}\text{of}\\ \text{this section}\end{array}}$

(2) If under § 1.861-9T, the asset method of apportioning interest expense is elected, then the expense shall be apportioned as follows:

$\begin{array}{c}\text{Expense apportionable}\\ \text{to a separate category}\end{array}\phantom{\rule{0ex}{0ex}}\text{=}\phantom{\rule{0ex}{0ex}}\text{Expense}\phantom{\rule{0ex}{0ex}}×\phantom{\rule{0ex}{0ex}}\frac{\begin{array}{c}\text{Value of assets in a separatecategory}\\ \text{(minus related person debt}\\ \text{allocated to passive assets if}\\ \text{the category is passive)}\end{array}}{\begin{array}{c}\text{Value of total assets minus}\\ \text{related person debt allocated}\\ \text{to passive assets}\end{array}}$

(3) Expenses other than interest shall be apportioned in a similar manner depending on the apportionment method used. See § 1.861-8T(c)(1) (i)-(vi).

(iii) Allocating and apportioning expenses of a noncontrolled 10-percent owned foreign corporation. Expenses of a noncontrolled 10-percent owned foreign corporation shall be allocated and apportioned in the same manner as expenses of a controlled foreign corporation under paragraph (c)(2)(ii) of this section, except that the related person interest rule of paragraphs (c)(2)(ii)(C) and (D) of this section shall not apply.

(iv) Definitions -

(A) Value of assets and reduction in value of assets and gross income. For purposes of paragraph (c)(2)(ii) (D) and (E) of this section, the value of total assets is the value of assets in all categories (determined under the principles of § 1.861-9T(g)). See § 1.861-10T(d)(2) to determine the reduction in value of assets and gross income for purposes of apportioning additional third person interest expense that is not directly allocated when some interest expense has been directly allocated. For purposes of this paragraph and paragraph (c)(2)(ii)(E) of this section, any reduction in the value of assets for indebtedness that relates to interest allocated under paragraph (c)(2)(ii)(C) of this section is made before determining the average of asset values. For rules relating to the averaging of reduced asset values see § 1.861-9T(g)(2).

(B) Related person debt allocated to passive assets. For purposes of paragraph (c)(2)(ii)(E) of this section, related person debt allocated to passive assets is determined as follows:

$\begin{array}{c}\\ \end{array}\begin{array}{c}\text{Related person debt}\\ \text{allocated to the}\\ \text{passive category}\end{array}\phantom{\rule{0ex}{0ex}}\text{=}\phantom{\rule{0ex}{0ex}}\begin{array}{c}\text{Total related}\\ \text{person debt}\end{array}\text{}\phantom{\rule{0ex}{0ex}}×\phantom{\rule{0ex}{0ex}}\frac{\begin{array}{c}\text{Related person interest}\phantom{\rule{0ex}{0ex}}\text{allocable}\\ \text{to passive income under}\\ \text{paragraph}\phantom{\rule{0ex}{0ex}}\phantom{\rule{0ex}{0ex}}\text{(}\text{c}\text{)(}\text{2}\text{)(}\text{ii}\text{)(}\text{C}\text{)}\phantom{\rule{0ex}{0ex}}\end{array}}{\begin{array}{c}\text{All related person interest}\end{array}}$
For this purpose, the term total related person debt means the sum of the principal amounts of obligations of a controlled foreign corporation owed to any United States shareholder of such corporation or to any related entity (within the meaning of paragraph (g) of this section) determined at the end of the taxable year.

(v) Examples. The following examples illustrate the application of this paragraph (c)(2).

(A) Example 1 -

(1) CFC, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns $200x of foreign personal holding company income that is passive category income. CFC also earns$100x of foreign base company sales income that is general category income. CFC has $2,000x of passive category assets and$2,000x of general category assets. In Year 1, CFC makes a $150x interest payment to USP with respect to a$1,500x loan from USP. CFC also pays $100x of interest to an unrelated person on a$1,000x loan from that person. CFC has no other expenses. CFC uses the asset method to apportion interest expense.

(2) Under paragraph (c)(2)(ii)(C) of this section, the $150x related person interest payment is allocable to CFC's passive category foreign personal holding company income. Therefore, the$150x interest payment is passive category income to USP. Because the entire related person interest payment is allocated to passive category income under paragraph (c)(2)(ii)(C) of this section, none of the related person interest payment is apportioned to general category income under paragraph (c)(2)(ii)(D) of this section. Under paragraph (c)(2)(iv)(B) of this section, the entire amount of the related person debt is allocable to passive category assets ($1,500x =$1,500x × $150x/$150x). Under paragraph (c)(2)(ii)(E) of this section, $20x of the interest expense paid to an unrelated person is apportioned to passive category income ($20x = $100x × ($2,000x − $1,500x)/($4,000x − $1,500x)), and$80x of the interest expense paid to an unrelated person is apportioned to general category income ($80x =$100x × $2,000x/($4,000x − $1,500x)). (B) Example 2. The facts are the same as in paragraph (c)(2)(v)(A) of this section (the facts in Example 1), except that CFC uses the modified gross income method to apportion interest expense. Under paragraph (c)(2)(ii)(E) of this section, the unrelated person interest expense is apportioned based on gross income. Therefore,$33x of interest expense paid to an unrelated person is apportioned to CFC's passive category income ($33x =$100x × ($200x −$150x)/($300x −$150x)) and $67x of interest expense paid to an unrelated person is apportioned to CFC's general category income ($67x = $100x ×$100x/($300x −$150x)).

(C) Example 3 -

(1) The facts are the same as in paragraph (c)(2)(v)(A) of this section (the facts in Example 1), except that CFC has an additional $50x of third person interest expense that is directly allocated to income from a specific property that produces only passive category income. The principal amount of indebtedness to which the interest relates is$500x. CFC also has $50x of additional non-interest expenses that are not definitely related expenses and that are apportioned on an asset basis. (2) Under paragraph (c)(2)(ii)(B) of this section, the$50x of directly allocated third person interest is first allocated to reduce the passive category income of CFC. Under paragraph (c)(2)(ii)(C) of this section, the $150x of related person interest is allocated to the remaining$150x of passive category income. Under paragraph (c)(2)(iv)(B) of this section, all of the related person debt is allocated to passive category assets ($1,500x =$1,500x × $150x/$150x).

(3) Under paragraph (c)(2)(ii)(E) of this section, the non-interest expenses that are not definitely related are apportioned on the basis of the asset values reduced by the allocated related person debt. Therefore, $10x of these expenses are apportioned to the passive category ($50x × ($2,000x −$1,500x)/($4,000x −$1,500x)) and $40x are apportioned to the general category ($50x × $2,000x/($4,000x − $1,500x)). (4) In order to apportion third person interest (that was not directly allocated third person interest) between the categories of assets, the value of assets in a separate category must also be reduced under the principles of § 1.861-8 by the indebtedness relating to the specifically allocated interest. Therefore, under paragraph (c)(2)(iv)(B) of this section, the value of assets in the passive category for purposes of apportioning the additional third person interest = 0 ($2,000x minus $500x (the principal amount of the debt, the interest payment on which is directly allocated to specific interest-producing properties) minus$1,500x (the related person debt allocated to passive category assets)). Under paragraph (c)(2)(ii)(E) of this section, all $100x of the non-definitely related third person interest expense is apportioned to the general category ($100x = $100x ×$2,000x/($4,000x −$500x − $1,500x)). (D) Example 4 - (1) CFC, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns$100x of foreign personal holding company income that is passive category income. CFC also earns $100x of foreign base company sales income that is general category income. CFC has$1,000x of general category assets and $1,000x of passive category assets. In Year 1, CFC makes a$150x interest payment to USP on a $1,500x loan from USP and has$20x of general and administrative expenses (G & A) that under the principles of §§ 1.861-8 through 1.861-14T is treated as directly allocable to all of CFC's gross income. CFC also makes a $25x interest payment to an unrelated person on a$250x loan from the unrelated person. CFC has no other expenses. CFC uses the asset method to apportion interest expense. CFC uses the modified gross income method to apportion G & A.

(2) Under paragraph (c)(2)(iv)(B) of this section, related person debt allocated to passive category assets equals $1,000x ($1,000x = $1,500x ×$100x/$150x).Under paragraph (c)(2)(ii)(C) of this section,$100x of the interest payment to USP is allocable to CFC's passive category foreign personal holding company income. Under paragraph (c)(2)(ii)(D) of this section, the additional $50x of related person interest expense is apportioned to CFC's general category income ($50x = $50x ×$1,000x/$1,000x). (3) Under paragraph (c)(2)(ii)(E) of this section, none of the$25x of interest expense paid to an unrelated person is apportioned to passive category income ($0 =$25x × ($1,000x −$1,000x)/($2,000x −$1,000x)). All $25x of the interest expense paid to an unrelated person is apportioned to general category income ($25x = $25x ×$1,000x/($2,000x −$1,000x)). Under paragraph (c)(2)(ii)(E) of this section, none of the G & A is allocable to CFC's passive category foreign personal holding company income ($0 =$20x × ($100x −$100x)/($200x −$100x)). All $20x of the G & A is apportioned to CFC's general category income ($20x = $20x ×$100x/($200x −$100x)).

(E) Example 5. The facts are the same as in paragraph (c)(2)(v)(D) of this section (the facts in Example 4), except that CFC uses the modified gross income method to apportion interest expense. As in paragraph (c)(2)(v)(D) of this section (Example 4), $100x of the interest payment to USP is allocated to passive category income under paragraph (c)(2)(ii)(C) of this section. Under paragraph (c)(2)(ii)(D) of this section, the additional$50x of related person interest expense is apportioned to general category income ($150x - 100x ×$100x/$100x). Under paragraph (c)(2)(ii)(E) of this section, none of the unrelated person interest expense and none of the G & A is apportioned to passive category income, because after the application of paragraph (c)(2)(ii)(C) of this section, no income remains in the passive category. (F) Example 6. CFC2, a controlled foreign corporation, is a wholly-owned subsidiary of CFC1, a controlled foreign corporation. CFC1 is a wholly-owned subsidiary of USP, a domestic corporation. CFC1 and CFC2 are incorporated in the same country. In Year 1, USP sells tractors to CFC2, which CFC2 sells to X, a foreign corporation that is related to both CFC1 and CFC2 and is organized in the same country as CFC1 and CFC2. CFC1 makes a loan to × to finance the tractor sales. Assume that the interest earned by CFC1 from financing the sales is export financing interest that is neither related person factoring income nor foreign personal holding company income. Under § 1.904-4(h), the export financing interest earned by CFC1 is, therefore, general category income. CFC1 earns no other income. CFC1 makes a$100x interest payment to USP. The $100x of interest paid is not allocable under the look-through rules and paragraph (c)(2)(ii) of this section to passive category income of CFC1. The income is general category income to USP. (3) Rents and royalties. Any rents or royalties received or accrued from a controlled foreign corporation in which the taxpayer is a United States shareholder are treated as passive category income to the extent they are allocable to passive category income of the controlled foreign corporation under the principles of §§ 1.861-8 through 1.861-14T. (4) Dividends - (i) Look-through rule for controlled foreign corporations. Except as provided in paragraph (d)(2) of this section, any dividend paid or accrued out of the earnings and profits of any controlled foreign corporation is treated as passive category income in proportion to the ratio of the portion of earnings and profits attributable to passive category income to the total amount of earnings and profits of the controlled foreign corporation. For purposes of this paragraph (c)(4), the term “dividend” includes any amount included in gross income under section 951(a)(1)(B) as a pro rata share of a controlled foreign corporation's increase in earnings invested in United States property. (ii) Special rule for dividends attributable to certain loans. If a dividend is distributed to a taxpayer by a controlled foreign corporation, that controlled foreign corporation is the recipient of loan proceeds from a related look-through entity (within the meaning of § 1.904-5(i)), and the purpose of such loan is to alter the characterization of the dividend for purposes of this section, then, to the extent of the principal amount of the loan, the dividend shall be characterized with respect to the earnings and profits of the related person lender rather than with respect to the earnings and profits of the dividend payor. A loan will not be considered made for the purpose of altering the characterization of a dividend if the loan would have been made or maintained on substantially the same terms irrespective of the dividend. The determination of whether a loan would have been made or maintained on substantially the same terms irrespective of the dividend will be made taking into account all the facts and circumstances of the relationship between the lender and the borrower. Thus, for example, a loan by a related party lender to a controlled foreign corporation that arises from the sale of inventory in the ordinary course of business will not be considered a loan made for the purpose of altering the character of any dividend paid by the borrower. (iii) Look-through rule for dividends from noncontrolled 10-percent owned foreign corporations - (A) In general. Except as provided in paragraph (c)(4)(iii)(B) of this section, any dividend that is distributed by a noncontrolled 10-percent owned foreign corporation and received or accrued by a domestic corporation that is a United States shareholder of such foreign corporation is treated as income in a separate category in proportion to the ratio of the portion of earnings and profits attributable to income in such category to the total amount of earnings and profits of the noncontrolled 10-percent owned foreign corporation. (B) Inadequate substantiation. A dividend distributed by a noncontrolled 10-percent owned foreign corporation is treated as income in the separate category described in section 904(d)(4)(C)(ii) if the Commissioner determines that the look-through characterization of the dividend cannot reasonably be determined based on the available information. (5) Inclusions under section 951(a)(1)(A). Any amount included in gross income under section 951(a)(1)(A) is treated as passive category income to the extent the amount included is attributable to income received or accrued by the controlled foreign corporation that is passive category income. All other amounts included in gross income under section 951(a)(1)(A) are treated as general category income or income in a specified separate category under the rules in § 1.904-4. For rules concerning a distributive share of partnership income, see § 1.904-4(n). For rules concerning the gross up under section 78, see § 1.904-4(o). For rules concerning inclusions under section 951(a)(1)(B), see paragraph (c)(4)(i) of this section. (6) Inclusions under section 951A(a). Any amount included in gross income under section 951A(a) is treated as passive category income to the extent the amount included is attributable to income received or accrued by the controlled foreign corporation that is passive category income. All other amounts included in gross income under section 951A(a) are treated as section 951A category income or income in a specified separate category under the rules in § 1.904-4. For rules concerning a distributive share of partnership income, see § 1.904-4(n). For rules concerning the gross up under section 78, see § 1.904-4(o). (7) Examples. The following examples illustrate the application of paragraph (c) of this section. (i) Example 1 - (A) Facts. CFC, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns$100x of net income, $85x of which is general category foreign base company sales income and$15x of which is passive category foreign personal holding company income. No foreign tax is imposed on the income. CFC's income of $100x is subpart F income taxed currently to USP under section 951(a)(1)(A). (B) Analysis. Because$15x of the subpart F inclusion is attributable to passive category income of CFC, under section 904(d)(3)(B) and paragraph (c)(5) of this section $15x of the subpart F inclusion is passive category income to USP. The remaining$85x subpart F inclusion is general category income to USP.

(ii) Example 2 -

(A) Facts. CFC1, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. CFC2 is a controlled foreign corporation wholly owned by CFC1 and is incorporated and operates all of its business in the same country as CFC1. All of CFC2's earnings and profits are attributable to passive category foreign personal holding company income. USP elects to exclude CFC2's income from subpart F income under section 954(b)(4). In Year 1, CFC2 makes a distribution to CFC1 and CFC1 makes a distribution to USP, all of which is attributable to Year 1 earnings and profits. CFC1 has no earnings and profits in Year 1 other than those received from CFC2.

(B) Analysis -

(1) With respect to the dividend from CFC2 to CFC1, such amount is not subpart F income. See section 954(c)(3). Under section 904(d)(3)(D) and (E) and paragraphs (c)(4) and (d)(2) of this section the dividend income is not passive category income and therefore under § 1.904-4 it is general category income to CFC1. Under section 951A(c)(2)(A)(i)(IV), such dividend income is not tested income.

(2) With respect to the dividend from CFC1 to USP, under section 904(d)(3)(D) and (E) and paragraphs (c)(4) and (d)(2) of this section, such dividend income is not passive category income and therefore under § 1.904-4 is general category income to USP.

(iii) Example 3 -

(A) Facts. The facts are the same as in paragraph (c)(7)(ii)(A) of this section (the facts in Example 2), except that CFC1 receives interest income from CFC2 instead of dividend income.

(B) Analysis. Under section 904(d)(3)(C) and paragraph (c)(2)(i) of this section, the interest income is passive category income to CFC1 because such interest is properly allocable to the passive category income of CFC2. The interest income from CFC2 is subpart F income of CFC1 taxable to USP because such income reduces the subpart F income of CFC2 or such interest is properly allocable to the subpart F income of CFC2. See section 954(c)(3) and (6). Under section 904(d)(3)(B) and paragraph (c)(5) of this section, the subpart F inclusion is passive category income to USP. Under section 959(a), the distribution from CFC1 to USP is excluded from USP's gross income.

(iv) Example 4 -

(A) Facts. The facts are the same as in paragraph (c)(7)(iii)(A) of this section (the facts in Example 3), except that USP elects to exclude CFC1's interest income from subpart F income under section 954(b)(4).

(B) Analysis. Under section 904(d)(3)(D) and (E) and paragraphs (c)(4) and (d)(2) of this section, the distribution from CFC1 to USP is not a passive category dividend and therefore under § 1.904-4 is general category income to USP.

(v) Example 5 -

(A) Facts. The facts are the same as in paragraph (c)(7)(iv)(A) of this section (the facts in Example 4), except that USP receives interest income from CFC1 instead of dividend income.

(B) Analysis. Under section 904(d)(3)(C) and paragraph (c)(2)(i) of this section, the interest income is passive category income to USP because such interest is properly allocable to passive category income of CFC1.

(d) Effect of exclusions from subpart F income -

(1) De minimis amount of subpart F income. If the sum of a controlled foreign corporation's gross foreign base company income (determined under section 954(a) without regard to section 954(b)(5)) and gross insurance income (determined under section 953(a)) for the taxable year is less than the lesser of 5 percent of gross income or $1,000,000, then none of that income is treated as passive category income. In addition, if the test in the first sentence of this paragraph (d)(1) is satisfied, for purposes of paragraphs (c)(2)(ii)(D) and (E) of this section (apportionment of interest expense to passive income using the asset method), any passive assets are not treated as passive category assets but are treated as assets in the general category or a specified separate category. The determination in the first sentence of this paragraph (d)(1) is made before the application of the exception for certain income subject to a high rate of foreign tax described in paragraph (d)(2) of this section. (2) Exception for certain income subject to high foreign tax. Except as provided in § 1.904-4(c)(7)(iii) (relating to reductions in tax upon distribution), for purposes of the dividend look-through rule of paragraph (c)(4)(i) of this section, an item of net income that would otherwise be passive category income (after application of the priority rules of § 1.904-4(l)) and that is received or accrued by a controlled foreign corporation is not treated as passive category income, and the earnings and profits attributable to such income is not treated as passive category earnings and profits, if the taxpayer establishes to the satisfaction of the Secretary under section 954(b)(4) that the income was subject to an effective rate of income tax imposed by a foreign country greater than 90 percent of the maximum rate of tax specified in section 11 (with reference to section 15, if applicable). Such income is treated as general category income or income in a specified separate category under the rules in § 1.904-4. The first sentence of this paragraph (d)(2) has no effect on amounts (other than dividends) paid or accrued by a controlled foreign corporation to a United States shareholder of such controlled foreign corporation to the extent those amounts are allocable to passive category income of the controlled foreign corporation. (3) Example. The following example illustrates the application of this paragraph (d). (i) Facts. CFC, a controlled foreign corporation, is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns$100x of gross income, $4x of which is interest that is foreign personal holding company income and$96x of which is gross manufacturing income that is not subpart F income. CFC has no other earnings for Year 1. CFC has no expenses and pays no foreign taxes.

(ii) Analysis. Under the de minimis rule of section 954(b)(3)(A) and § 1.954-1(b)(1)(i), none of CFC's income is treated as foreign base company income. All of CFC's income, therefore, is treated as general category income and tested income. In Year 1, USP has a GILTI inclusion amount with respect to CFC. Such amount is section 951A category income to USP.

(e) Treatment of subpart F income in excess of 70 percent of gross income -

(1) Rule. If the sum of a controlled foreign corporation's gross foreign base company income (determined without regard to section 954(b)(5)) and gross insurance income for the taxable year exceeds 70 percent of the gross income, then all of the controlled foreign corporation's gross income shall be treated as foreign base company income (whichever is appropriate) and, thus, included in a United States shareholder's gross income. However, the inclusion in gross income of an amount that would not otherwise be subpart F income does not affect its character for purposes of determining whether the income is within a separate category. The determination of whether the controlled foreign corporation's gross foreign base company income and gross insurance income exceeds 70 percent of gross income is made before the exception for certain income subject to a high rate of foreign tax.

(2) Example. The following example illustrates the application of this paragraph (e).

(i) Facts. Controlled foreign corporation CFC is a wholly-owned subsidiary of USP, a domestic corporation. CFC earns $100x,$75x of which is foreign personal holding company income and $25x of which is non-subpart F services income. CFC's gross and net income are equal. (ii) Analysis. Under the 70 percent full inclusion rule of section 954(b)(3)(B), the entire$100x is foreign base company income currently taxable to USP under section 951. Because $75x of the$100x section 951 inclusion is attributable to CFC's passive category income, $75x of the inclusion is passive category income to USP. The remaining$25x of the inclusion is treated as general category income to USP.

(f) Modification of look-through rules for certain income.

(1) [Reserved]

(2) Distributions from a FSC. Income received or accrued by a taxpayer that, under the rules of paragraph (c)(4) of this section (look-through rules for dividends), would be treated as foreign trade income or as passive income that is interest and carrying charges (as defined in section 927(d)(1)), and that is also a distribution from a FSC (or a former FSC), shall be treated as a distribution from a FSC (or a former FSC).

(g) Application of look-through rules to certain domestic corporations. The principles of paragraph (c) of this section shall apply to any foreign source interest, rents and royalties paid by a domestic corporation to a related corporation. For this purpose, a domestic corporation and another corporation are considered to be related if one owns, directly or indirectly, stock possessing more than 50 percent of the total voting power of all classes of stock of the other corporation or more than 50 percent of the total value of the other corporation. In addition, a domestic corporation and another corporation shall be considered to be related if the same United States shareholders own, directly or indirectly, stock possessing more than 50 percent of the total voting power of all classes of stock or more than 50 percent of the total value of each corporation. For purposes of this paragraph, the constructive stock ownership rules of section 318 and the regulations under that section apply.

(h) Application of look-through rules to payments from a partnership or other pass-through entity. Payments to a partner described in section 707 (e.g., payments to a partner not acting in capacity as a partner) are characterized as passive category income to the extent that the payment is attributable under the principles of § 1.861-8 and this section to passive category income of the partnership, if the payments are interest, rents, or royalties that would be characterized under the controlled foreign corporation look-through rules of paragraph (c) of this section if the partnership were a foreign corporation, and the partner who receives the payment owns 10 percent or more of the value of the partnership (as determined under § 1.904-4(n)(3)). A payment by a partnership to a member of the controlled group (as defined in paragraph (a)(4)(vi) of this section) of the partner is characterized under the look-through rules of this paragraph (h) if the payment would be a section 707 payment entitled to look-through treatment if it were made to the partner. The rules in this paragraph (h) do not apply with respect to interest to the extent the interest income is assigned to a separate category under the downstream partnership loan rules described in § 1.861-9(e)(8). The principles of the rules in this paragraph (h) apply to characterize a payment from any other pass-through entity.

(i) Application of look-through rules to related entities -

(1) In general. Except as provided in paragraphs (i)(2) and (3) of this section, the principles of this section shall apply to distributions and payments that are subject to the look-through rules of section 904(d)(3) and this section from a controlled foreign corporation or other entity otherwise entitled to look-through treatment (a “look-through entity”) under this section to a related look-through entity. A noncontrolled 10-percent owned foreign corporation shall be considered a look-through entity only to the extent provided in paragraph (i)(3) of this section. Two look-through entities shall be considered to be related to each other if one owns, directly or indirectly, stock possessing more than 50 percent of the total voting power of all classes of voting stock of the other entity or more than 50 percent of the total value of such entity. In addition, two look-through entities are related if the same United States shareholders own, directly or indirectly, stock possessing more than 50 percent of the total voting power of all voting classes of stock (in the case of a corporation) or more than 50 percent of the total value of each look-through entity. In the case of a corporation, value shall be determined by taking into account all classes of stock. For purposes of this paragraph (i)(1), indirect ownership of stock is determined under section 318. In the case of a partnership or other pass-through entity, indirect ownership and value is determined under the rules in paragraph (i)(2) of this section.

(2) Indirect ownership and value of a partnership interest. A person is considered as owning, directly or indirectly, more than 50 percent of the value of a partnership if the person, together with any other person that bears a relationship to the first person that is described in section 267(b) or 707, owns more than 50 percent of the capital and profits interests of the partnership. For purposes of this paragraph (i)(2), value will be determined at the end of the partnership's taxable year. The principles of this paragraph (i)(2) apply with respect to a person that owns a pass-through entity other than a partnership.

(3) Special rule for dividends between certain foreign corporations. Solely for purposes of dividend payments between controlled foreign corporations, noncontrolled 10-percent owned foreign corporations, or a controlled foreign corporation and a noncontrolled 10-percent owned foreign corporation, the two foreign corporations are considered related look-through entities if the same person is a United States shareholder of both foreign corporations.

(4) [Reserved]

(5) Examples. The following examples illustrate the application of this paragraph (i):

(i) Example 1. USP, a domestic corporation, owns all of the stock of CFC1, a controlled foreign corporation. CFC1 owns 40% of the stock of CFC2, a Country X corporation that is a controlled foreign corporation. The remaining 60% of the stock of CFC2 is owned by V, a domestic corporation, unrelated to USP. The percentages of value and voting power of CFC2 owned by CFC1 and V correspond to their percentages of stock ownership. CFC2 owns 40% (by vote and value) of the stock of CFC3, a Country Z corporation that is a controlled foreign corporation. The remaining 60% of CFC3 is owned by unrelated United States persons. CFC3 earns exclusively general category income that is neither subpart F income nor tested income. In Year 1, CFC3 makes an interest payment of $100x to CFC2. Look-through principles do not apply because CFC2 and CFC3 are not related look-through entities under paragraph (i)(1) of this section (because CFC2 does not own more than 50% of the voting power or value of CFC3). The interest is passive category income to CFC2 and is subpart F income of CFC2 that is taxable to USP and V. Under paragraph (c)(5) of this section, USP and V's subpart F inclusion with respect to CFC2 is passive category income. (ii) Example 2. The facts are the same as in paragraph (i)(5)(i) of this section (the facts in Example 1), except that instead of a$100x interest payment, CFC3 pays a $50x dividend to CFC2 in Year 1. USP and V each own, directly or indirectly, more than 10% of the voting power of all classes of stock of both CFC2 and CFC3, and, therefore, CFC2 and CFC3 have the same United States shareholders. Pursuant to paragraph (i)(3) of this section, because CFC2 and CFC3 have a common United States shareholder, for purposes of applying this section to the dividend from CFC2 to CFC3, CFC2 and CFC3 are treated as related look-through entities. Therefore, look-through principles apply. Because CFC3 has no passive category income or earnings and profits, the dividend income is characterized as general category income to CFC2. The dividend is subpart F income of CFC2 that is taxable to USP and V. Under paragraph (c)(5) of this section, the subpart F inclusions of USP and V are not passive category income to USP and V and therefore under § 1.904-4 the subpart F inclusions are general category income to USP and V. (iii) Example 3. The facts are the same as in paragraph (i)(5)(i) of this section (the facts in Example 1), except that CFC3 pays both a$100x interest payment and a $50x dividend to CFC2, and CFC2 owns 80% (by vote and value) of CFC3. Under paragraph (i)(1) of this section, CFC2 and CFC3 are related look-through entities, because CFC2 owns more than 50% (by vote and value) of CFC3. Therefore, look-through principles apply to both the interest and dividend income paid or accrued by CFC3 to CFC2, and CFC2 treats both types of income as general category income because CFC3 does not have any passive category earnings. Under paragraph (c)(5) of this section and § 1.904-4, the resulting subpart F inclusions are general category income to USP and V. (iv) Example 4. USP, a domestic corporation, owns 50% of the voting stock of CFC1, a controlled foreign corporation. CFC1 owns 10% of the voting stock of CFC2, a controlled foreign corporation. The remaining 50% of the stock of CFC1 is owned by X. The remaining 90% of the stock of CFC2 is owned by Y. X and Y are each United States shareholders of CFC2 but are not related to USP, CFC1, or each other. In Year 1, CFC2 pays a$100x dividend to CFC1. Under paragraph (i)(3) of this section because no person is a United States shareholder of both CFC1 and CFC2 (USP and X each own only 5% of CFC2), CFC1 and CFC2 are not related look-through entities. Because CFC2 is not a related person to CFC1 within the meaning of section 954(d)(3), section 954(c)(3) and (c)(6) are inapplicable, and the dividend is subpart F income of CFC1 that is taxable to USP and X. Therefore, under section 904(d)(2)(B)(i) and § 1.904-4(b)(2)(i)(A), because the dividend income is foreign personal holding company income, it is passive category income to CFC1.

(v) Example 5. The facts are the same as in paragraph (i)(5)(iv) of this section (the facts in Example 4), except that X owns 10% of the voting stock of CFC2 and Y owns only 80% of the voting stock of CFC2. Because CFC2 is not a related person to CFC1 within the meaning of section 954(d)(3), the dividend is subpart F income of CFC1 that is taxable to USP and X. In addition, because X is a United States shareholder of both CFC1 and CFC2, CFC2 and CFC1 are related look-through entities under paragraph (i)(3) of this section, the dividend income is general category income to CFC1 and the subpart F inclusion is general category income to USP and X.

(j) Look-through rules applied to passive foreign investment company inclusions. If a passive foreign investment company is a controlled foreign corporation and the taxpayer is a United States shareholder in that passive foreign investment company, any amount included in gross income under section 1293 shall be treated as income in a separate category to the extent the amount so included is attributable to income received or accrued by that controlled foreign corporation that is described as income in the separate category.

(k) Ordering rules -

(1) In general. Income received or accrued by a related person to which the look-through rules apply is characterized under § 1.904-4 before amounts included from, or paid or distributed by that person and received or accrued by a related person. For purposes of determining the character of income received or accrued by a person from a related person if the payor or another related person also receives or accrues income from the recipient and the look-through rules apply to the income in all cases, the rules of paragraph (k)(2) of this section apply.

(2) Specific rules. For purposes of characterizing income under this paragraph, the following types of income are characterized in the order stated:

(i) Rents and royalties;

(ii) Interest;

(iii) Inclusions under sections 951(a)(1)(A) and 951A(a) and distributive shares of partnership income;

(iv) Dividend distributions.

If an entity is both a recipient and a payor of income described in any one of the categories described in (k)(2) (i) through (iv) of this section, the income received will be characterized before the income that is paid. In addition, the amount of interest paid or accrued, directly or indirectly, by a person to a related person shall be offset against and eliminate any interest received or accrued, directly or indirectly, by a person from that related person before application of the ordering rules of this paragraph. In a case in which a person pays or accrues interest to a related person, and also receives or accrues interest indirectly from the related person, the smallest interest payment is eliminated and the amount of all other interest payments are reduced by the amount of the smallest interest payment.

(l) Examples. The following examples illustrate the application of this section.

(1) Example 1 -

(i) Facts. CFC1 and CFC2, controlled foreign corporations, are wholly-owned subsidiaries of USP, a domestic corporation. CFC1 and CFC2 are incorporated in two different foreign countries and CFC2 is a financial services entity. In Year 1, CFC1 earns $100x of gross income that is passive category foreign personal holding company income. CFC1's only expense is a$50x interest payment to CFC2. CFC1's $50x of pre-tax income is subject to$20x of foreign income tax, and USP elects to exclude CFC1's $30x of net income from subpart F income under section 954(b)(4). (ii) Analysis. The$50x of interest is foreign personal holding company income in CFC2's hands because section 954(c)(3)(A)(i) (same country exception for interest payments) and section 954(c)(6) do not apply, because the interest payment is allocable to and reduces CFC1's subpart F income. The $50x of interest income is also passive category income to CFC2 because CFC1 and CFC2 are related look-through entities within the meaning of paragraph (i)(1) of this section and, therefore the look-through rules of paragraph (c)(2)(i) of this section apply to characterize the interest payment. However, because CFC2 is a financial services entity, under § 1.904-4(e)(1) and paragraph (b)(2) of this section, the income is treated as financial services income and therefore as general category income in CFC2's hands. Thus, with respect to CFC2, under § 1.904-4(d) and paragraph (c)(5) of this section, USP includes in its gross income a$50x general category inclusion under section 951(a)(1)(A) attributable to the general category foreign personal holding company income.

(2) Example 2 -

(i) Facts. USP, a domestic corporation, owns 75% of USS, a domestic corporation. USP and USS are not financial services entities. In Year 1, USS's earnings consist of $100x of foreign source passive income. USS makes a$100x foreign source royalty payment to USP.

(ii) Analysis. Under paragraph (g) of this section, the royalty payment to USP is subject to the look-through rules of paragraph (c)(3) of this section and is characterized as passive category income the extent that it is allocable to such income in USS's hands.

(3) Example 3 -

(i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% of the stock of CFC2, a controlled foreign corporation. CFC1 has $100x of passive foreign personal holding company income from unrelated persons and$100x of general category income. CFC1 also has $50x of interest income from CFC2. CFC1 pays CFC2$100x of interest.

(ii) Analysis. Under paragraph (k)(2) of this section, the $100x interest payment from CFC1 to CFC2 is reduced for limitation purposes to the extent of the$50x interest payment from CFC2 to CFC1 before application of the rules in paragraph (c)(2)(ii) of this section. Therefore, the interest payment from CFC2 to CFC1 is disregarded. CFC1 is treated as if it paid $50x of interest to CFC2, all of which is allocable to CFC1's passive category foreign personal holding company income under paragraph (c)(2)(ii)(C) of this section. Therefore, under paragraph (c)(2)(i) of this section, the$50x interest payment from CFC1 to CFC2 is passive category income.

(4) Example 4 -

(i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, a controlled foreign corporation. CFC1 owns 100% of the stock of CFC2, a controlled foreign corporation, and 100% of the stock of CFC3, a controlled foreign corporation. In Year 1, CFC2 pays CFC1 $5x of interest, CFC1 pays CFC3$10x of interest, and CFC3 pays CFC2 $20x of interest. (ii) Analysis. Under paragraph (k)(2) of this section, the interest payments from CFC1 to CFC3 must be offset by the amount of interest that CFC1 is considered as receiving indirectly from CFC3 and the interest payment from CFC3 to CFC2 is offset by the amount of the interest payment that CFC3 is considered as receiving indirectly from CFC2. The$10x payment by CFC1 to CFC3 is reduced by $5x, the amount of the interest payment from CFC2 to CFC1 that is treated as being paid indirectly by CFC3 to CFC1. Similarly, the$20x interest payment from CFC3 to CFC2 is reduced by $5x, the amount of the interest payment from CFC1 to CFC3 that is treated as being paid indirectly by CFC2 to CFC3. Therefore, under paragraph (k)(2) of this section, CFC2 is treated as having made no interest payment to CFC1, CFC1 is treated as having paid$5x of interest to CFC3, and CFC3 is treated as having paid $15x to CFC2. (5) Example 5 - (i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% of the stock of CFC2, a controlled foreign corporation. In Year 1, CFC1 earns$100x of passive category foreign personal holding company income and $100x of general category non-subpart F sales income from unrelated persons and$100x of general category non-subpart F interest income from a related person. CFC1 pays $150x of interest to CFC2. CFC2 earns$200x of general category sales income from unrelated persons and the $150x interest payment from CFC1. CFC2 pays CFC1$100x of interest. USP does not have an inclusion under section 951A.

(ii) Analysis - (A) Under paragraph (k)(2) of this section, the $100x interest payment from CFC2 to CFC1 reduces the$150x interest payment from CFC1 to CFC2. CFC1 is treated as though it paid $50x of interest to CFC2. CFC2 is treated as though it made no interest payment to CFC1. (B) Under paragraph (k)(2)(ii) of this section, the remaining$50x interest payment from CFC1 to CFC2 is then characterized. The interest payment is first allocable under the rules of paragraph (c)(2)(ii)(C) of this section to CFC1's passive category income. Therefore, under paragraph (c)(2)(i) of this section, the $50x interest payment to CFC2 is passive category income. The interest income is foreign personal holding company income in CFC2's hands. CFC2, therefore, has$50x of passive category subpart F income and $200x of general category non-subpart F income. (C) Under paragraph (k)(2)(iii) of this section, inclusions under section 951(a)(1)(A) are characterized next. USP has an inclusion under section 951(a)(1)(A) with respect to CFC1 of$50x that is attributable to passive category income of CFC1 and is treated as passive category income to USP. USP has an inclusion under section 951(a)(1)(A) with respect to CFC2 of $50x that is attributable to passive category income of CFC2 and is treated as passive category income to USP. (6) Example 6 - (i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% of the stock of CFC2, a controlled foreign corporation. USP also owns 100% of the stock of CFC3, a controlled foreign corporation. CFC1, CFC2, and CFC3 are all incorporated in different foreign countries. In Year 1, CFC1 earns$100x of passive category foreign personal holding company income and $200x of general category non-subpart F income from unrelated persons. CFC1 also receives a$150x distribution from CFC2. CFC1 pays $100x of interest to CFC2 and$100x of interest to CFC3. CFC3 earns $300x of general category non-subpart F income and the$100x of interest received from CFC1. CFC3 pays a $100x royalty to CFC2. The royalty is directly allocable to CFC3's general category income and the royalty is not subpart F income to CFC2. CFC2 earns the$100x interest payment received from CFC1 and the $100x royalty received from CFC3. USP does not have an inclusion under section 951A. (ii) Analysis - (A) Under paragraph (k)(2)(i) of this section, the royalty paid by CFC3 to CFC2 is characterized first. With respect to CFC2, the royalty is general category non-subpart F income. (B) Under paragraph (k)(2)(ii) of this section, the interest payments from CFC1 to CFC2 and CFC3 are characterized next. Under paragraph (c)(2)(ii)(C) of this section, the interest payments are first allocable to CFC1's passive category income. Therefore, under paragraph (c)(2)(i) of this section,$50x of the interest payment to CFC2 is passive category income and $50x of the interest payment to CFC3 is passive category income. The remaining$50x paid to CFC2 is general category income and the remaining $50x paid to CFC3 is general category income. Because$100x of the interest income received or accrued from CFC1 is properly allocable to income of CFC1 which is not subpart F income, under section 954(c)(6) the general category interest income is not treated as foreign personal holding company income to CFC2 and CFC3. The remaining $100x of interest income received or accrued from CFC1 is passive category subpart F foreign personal holding company income to both recipients. Therefore, CFC3 and CFC2 each have$50x of passive category subpart F foreign personal holding company income related to the interest received from CFC1.

(C) Under paragraph (k)(2)(iii) of this section, USP's $50x inclusion under section 951(a)(1)(A) with respect to CFC2 is characterized next. Under paragraph (c)(5) of this section, USP's inclusion under section 951(a)(1)(A) is attributable to the passive category portion of the interest income received by CFC2 from CFC1 and is passive category income to USP. Under paragraph (k)(2)(iii) of this section, USP's$50x inclusion under section 951(a)(1)(A) with respect to CFC3 is also characterized next. Under paragraph (c)(5) of this section, USP's inclusion under section 951(a)(1)(A) is attributable to the passive category portion of the interest income received by CFC3 from CFC2 and is passive category income to USP.

(D) Under paragraph (k)(2)(iv) of this section, the $150x distribution from CFC2 to CFC1 is characterized next. The first$50x of the distribution is out of passive category earnings and profits described in section 959(c)(2). The remaining $100x of the distribution is a dividend that is not attributable to CFC2's passive category income, so under paragraph (c)(4)(i) of this section it is general category income to CFC1 in its entirety. Because$100x of the dividend received or accrued from CFC2 is attributable to income of CFC2 which is not subpart F income, under section 954(c)(6) such dividend income is not treated as foreign personal holding company income of CFC1.

(7) Example 7 -

(i) Facts. USP, a domestic corporation, owns 100% of the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% of the stock of CFC2, a controlled foreign corporation. USP also owns 100% of the stock of CFC3, a controlled foreign corporation. CFC1, CFC2, and CFC3 are all incorporated in different foreign countries. In Year 1, CFC2 earns $100x of general category income that is not subpart F income and distributes the entire amount to CFC1 as a dividend. CFC1 earns$100x of passive category foreign personal holding company income and the $100x dividend from CFC2. CFC1 pays$100x of interest to CFC3. CFC3 earns $200x of general category income that is foreign base company income and the$100x of interest income from CFC1. USP does not have an inclusion under section 951A.

(ii) Analysis. This transaction does not involve circular payments and, therefore, the ordering rules of paragraph (k)(2) of this section do not apply. Instead, pursuant to paragraph (k)(1) of this section, income received is characterized first. CFC2's earnings and, thus, the dividend from CFC2 to CFC1 are characterized first. Under paragraph (c)(4)(i) of this section, CFC1 includes the $100x dividend from CFC2 in gross income as general category income because none of CFC2's earnings are passive category income. CFC1 thus has$100x of passive category foreign personal holding company income and $100x of general category income that is excluded from subpart F income under section 954(c)(6)(A). The interest payment from CFC1 to CFC3 is then characterized as$100x passive category income under paragraph (c)(2)(ii)(C) of this section because it is allocable to passive foreign personal holding company income of CFC1. For Year 1, CFC3 thus has $200x of general category income that is subpart F income, and$100x of passive category foreign personal holding company income. For Year 1, under § 1.904-4(d) and paragraph (c)(5) of this section, USP includes in its gross income an inclusion under section 951(a)(1)(A) with respect to CFC3, $200x of which is general category income and$100x of which is passive category income.

(m) Application of section 904(h) -

(1) In general. This paragraph (m) applies to certain amounts derived from controlled foreign corporations and noncontrolled 10-percent owned foreign corporations that are treated as United States-owned foreign corporations as defined in section 904(h)(6). For purposes of determining the portion of an interest payment that is allocable to income earned or accrued by a controlled foreign corporation or noncontrolled 10-percent owned foreign corporations from sources within the United States under section 904(h)(3), the rules in paragraph (m)(2) of this section apply. For purposes of determining the portion of a dividend (which, for purposes of this paragraph (m), includes amounts described in section 951(a)(1)(B)) paid or accrued by a controlled foreign corporation or noncontrolled 10-percent owned foreign corporations that is treated as from sources within the United States under section 904(h)(4), the rules in paragraph (m)(4) of this section apply. For purposes of determining the portion of an amount included in gross income under section 951(a)(1)(A), 951A(a), or 1293 that is attributable to income of the controlled foreign corporation or noncontrolled 10-percent owned foreign corporations from sources within the United States under section 904(h)(2), the rules in paragraph (m)(5) of this section apply. In order to determine whether section 904(h) applies, section 904(h)(5) (exception if a United States-owned foreign corporation has a de minimis amount of United States source income) shall be applied to the total amount of earnings and profits of a controlled foreign corporation or noncontrolled 10-percent owned foreign corporations for a taxable year without regard to the characterization of those earnings under section 904(d).

(2) Treatment of interest payments -

(i) Interest payments from controlled foreign corporations. If interest is received or accrued by a United States shareholder or a person related to a United States shareholder (within the meaning of paragraph (c)(2)(ii) of this section) from a controlled foreign corporation, the interest shall be considered to be allocable to income of the controlled foreign corporation from sources within the United States for purposes of section 904(d) to the extent that the interest is allocable under paragraph (c)(2)(ii)(C) of this section to passive income that is from sources within the United States. If related person interest is less than or equal to passive income, the related person interest will be allocable to United States source passive income based on the ratio of United States source passive income to total passive income. To the extent that related person interest exceeds passive income, and, therefore, is allocated under paragraph (c)(2)(ii)(D) of this section to income in a separate category other than passive, the following formulas apply in determining the portion of the interest payment that is from sources within the United States. If the taxpayer uses the gross income method to allocate interest, the portion of the interest payment from sources within the United States is determined as follows:

$\begin{array}{c}\text{The amount of the interest payment}\\ \text{allocated to the separate category under}\\ \text{paragraph (c) (2) (ii) (D) of this section}\end{array}×\frac{\begin{array}{c}\text{Gross income from United States sources}\\ \text{in that category}\end{array}}{\begin{array}{c}\text{Gross income from all sources}\\ \text{in that category}\end{array}}$

(ii) Interest payments from noncontrolled 10-percent owned foreign corporations. If interest is received or accrued by a shareholder from a noncontrolled 10-percent owned foreign corporation (where the shareholder is a domestic corporation that is a United States shareholder of such noncontrolled 10-percent owned foreign corporation), the rules of paragraph (m)(2)(i) of this section apply in determining the portion of the interest payment that is from sources within the United States, except that the related party interest rules of paragraph (c)(2)(ii)(C) of this section do not apply.

(3) Examples. The following examples illustrate the application of this paragraph (m).

(i) Example 1 -

(A) Facts. Controlled foreign corporation CFC is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC pays USP $300x of interest. CFC has no other expenses. In Year 1, CFC has$3,000x of assets that generate $650x of foreign source general category income and a$1,000x loan to an unrelated foreign person that generates $20x of foreign source passive category interest income. CFC also has a$4,000x loan to an unrelated United States person that generates $70x of U.S. source passive category interest income and$4,000x of assets that generate $100x of U.S. source general category income. CFC uses the asset method to allocate interest expense. The following chart summarizes CFC's assets and income: Table 1 to Paragraph (m)(3)(i)(A) Foreign U.S. Totals 1,000x 4,000x 5,000x 3,000x 4,000x 7,000x 4,000x 8,000x 12,000x 20x 70x 90x 650x 100x 750x 670x 170x 840x (B) Analysis. Under paragraph (c)(2)(ii)(C) of this section,$90x of the related person interest payment is allocable to CFC's passive category income. Under paragraph (m)(2) of this section, $70x of USP's$90x of passive category interest income is from sources within the United States and $20x is from foreign sources. Under paragraph (c)(2)(ii)(D) of this section, the remaining$210x of the related person interest payment is allocated to general category income. Under paragraph (m)(2) of this section, $120x of the remaining$210x of USP's interest income is treated as general category income from sources within the United States ($120x =$210x × $4,000x/$7,000x) and $90x is treated as general category income from foreign sources ($90x = $210x ×$3,000x/$7,000x). (ii) Example 2. The facts are the same as in paragraph (m)(3)(i) of this section (the facts in Example 1), except that CFC uses the modified gross income method to allocate interest expense. The first$90x of related person interest expense is allocated to passive category income in the same manner as in paragraph (m)(3)(i) of this section (Example 1), $70x to U.S. sources and$20x to foreign sources. Under paragraph (c)(2)(ii)(D) of this section, the remaining $210x of the related person interest expense is allocated to CFC's general category income. Under paragraph (m)(2) of this section,$28x of the remaining $210x of USP's interest income is treated as general category income from U.S. sources ($28x = $210x ×$100x/$750x) and$182x is treated as general category income from foreign sources ($182x =$210x × $650x/$750x).

(4) Treatment of dividend payments -

(i) Rule. Any dividend or distribution treated as a dividend under this paragraph (m) (including an amount included in gross income under section 951(a)(1)(B)) that is received or accrued by a United States shareholder from a controlled foreign corporation, or any dividend that is received or accrued by a domestic corporation from a noncontrolled 10-percent owned foreign corporation with respect to which the shareholder is a United States shareholder, are treated as income in a separate category derived from sources within the United States in proportion to the ratio of the portion of the earnings and profits of the controlled foreign corporation or noncontrolled 10-percent owned foreign corporation in the corresponding separate category from U.S. sources to the total amount of earnings and profits of the controlled foreign corporation or noncontrolled 10-percent owned foreign corporation in that separate category.

(ii) Determination of earnings and profits from United States sources. In order to determine the portions of earnings and profits from United States sources and from foreign sources within each separate category, related person interest shall be allocated to the United States source portion of income in a separate category by applying the rules of paragraph (m)(2) of this section. Other expenses shall be allocated by applying the rules of paragraph (c)(2)(ii) of this section separately to the United States source income and the foreign source income in each category. For example, unrelated person interest expense that is allocated among categories of income based upon the relative amounts of assets in a category must be allocated between United States and foreign source income within each category by applying the rules of paragraph (c)(2)(ii)(E) of this section separately to United States source and foreign source assets in the separate category

(5) Treatment of inclusions under sections 951(a)(1)(A), 951A and 1293 -

(i) Rule. Any amount included in the gross income of a United States shareholder of a controlled foreign corporation under section 951(a)(1)(A), 951A, or in the gross income of a domestic corporation that is a United States shareholder of a noncontrolled 10-percent owned foreign corporation described in section 904(d)(2)(E)(i)(II) that is a qualified electing fund under section 1293 is treated as income subject to a separate category that is derived from sources within the United States to the extent the amount is attributable to income of the controlled foreign corporation or qualified electing fund, respectively, in the corresponding category of income from sources within the United States. In order to determine a controlled foreign corporation's taxable income and earnings and profits from sources within the United States in each separate category, the principles of paragraph (m)(4)(ii) of this section shall apply. In order to determine a qualified electing fund's earnings and profits from sources within the United States in each separate category, the principles of paragraph (m)(4)(ii) of this section shall apply, except that the related person interest rule of paragraph (m)(2) of this section shall not apply.

(ii) Example. The following example illustrates the application of this paragraph (m)(5).

(A) Facts. Controlled foreign corporation CFC is a wholly-owned subsidiary of domestic corporation, USP. In Year 1, CFC earns $100x of subpart F foreign personal holding company income that is passive category income. Of this amount,$40x is derived from sources within the United States. CFC also earns $50x of subpart F general category income. None of this income is from sources within the United States. Assume that CFC pays no foreign taxes and has no expenses. (B) Analysis. USP must include$150x in gross income under section 951(a). Of this amount, $60x is foreign source passive category income to USP,$40x is U.S. source passive category income to USP, and $50x is foreign source general category income to USP. (6) Treatment of section 78 amount. For purposes of treating taxes deemed paid by a taxpayer under section 960 as a dividend under section 78, taxes that are paid or accrued with respect to United States source income in a separate category shall be treated as United States source income in that separate category. (7) Coordination with treaties - (i) Rule. If any amount of income derived from a United States-owned foreign corporation, as defined in section 904(h)(6), would be treated as derived from sources within the United States under section 904(h) and this paragraph (m) and, pursuant to an income tax convention with the United States, the taxpayer chooses to avail itself of benefits of the convention that treat that amount as arising from sources outside the United States under a rule explicitly treating the income as foreign source, then that amount will be treated as foreign source income. However, sections 904 (a), (b), (c), (d), (f), and (g), 907, and 960 shall be applied separately to amounts described in the preceding sentence with respect to each treaty under which the taxpayer has claimed benefits and, within each treaty, to each separate category of income. (ii) Example. The following example illustrates the application of this paragraph (m)(7). (A) Facts. Controlled foreign corporation CFC is incorporated in Country A and is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC earns$80x of general category foreign base company sales income in Country A and $40x of passive category U.S. source interest income. CFC incurs$20x of expenses attributable to its sales business. CFC pays USP $40x of interest that is allocated to CFC's U.S. source passive category income under paragraph (c)(2)(ii)(C) of this section and so is U.S. source passive category income to USP under paragraphs (c)(2)(i) and (m)(2) of this section. Assume that earnings and profits equal net income. All of CFC's net income of$60x is subpart F income includible in USP's gross income under section 951(a)(1). For Year 1, USP also has $100x of foreign source passive category income derived from investments in Country B. Pursuant to section 904(h)(3) and paragraph (m)(2) of this section, the$40x interest payment from CFC is U.S. source income to USP because it is attributable to U.S. source interest income of CFC. The United States-Country A income tax treaty, however, treats all interest payments by residents of Country A as Country A sourced and USP elects to apply the treaty.

(B) Analysis. Pursuant to section 904(h)(10) and this paragraph (m)(7), the entire interest payment will be treated as foreign source income to USP. USP thus has $60x of foreign source general category income,$40x of foreign source Country A treaty category passive income from CFC, and \$100x of foreign source passive category income.

(n) Order of application of section 904(d) and (h). In order to apply the rules of this section, § 1.904-4 shall first be applied to the controlled foreign corporation or noncontrolled 10-percent owned foreign corporation to determine the amount of income and earnings and profits derived by the controlled foreign corporation or noncontrolled 10-percent owned foreign corporation in each separate category. The income and earnings and profits in each separate category that are from United States sources shall then be determined. Section 904(d)(3), (d)(4), and (h) and this section are then applied for purposes of characterizing and sourcing income received, accrued, or included by a United States shareholder of the foreign corporation that is attributable or allocable to income or earnings and profits of the foreign corporation.

(o) Applicability dates. Except as otherwise provided in this paragraph (o), this section is applicable for taxable years that both begin after December 31, 2017, and end on or after December 4, 2018. Paragraphs (a)(4)(i) and (vi) of this section are applicable for taxable years of foreign corporations ending on or after October 1, 2019, and taxable years of United States persons ending on or after October 1, 2019. For taxable years of foreign corporations ending before October 1, 2019, and taxable years of United States persons ending before October 1, 2019, a taxpayer may apply such provisions to the last taxable year of a foreign corporation beginning before January 1, 2018, and each subsequent taxable year of the foreign corporation, and to taxable years of United States shareholders in which or with which such taxable years of the foreign corporation end, provided that the taxpayer and United States persons that are related (within the meaning of section 267 or 707) to the taxpayer consistently apply such provisions with respect to all foreign corporations. For taxable years of foreign corporations ending before October 1, 2019, and taxable years of United States persons ending before October 1, 2019, where the taxpayer does not apply the provisions of paragraphs (a)(4)(i) and (vi) of this section, see paragraphs (a)(4)(i) and (vi) of this section as in effect and contained in 26 CFR part 1, as revised April 1, 2020.

[T.D. 8214, 53 FR 27020, July 18, 1988]
Editorial Note:
For Federal Register citations affecting § 1.904-5, see the List of CFR Sections Affected, which appears in the Finding Aids section of the printed volume and at www.govinfo.gov.