(a) through (c)(1) [Reserved] For further guidance, see Sec. 1.861-12T(a) through (c)(1).
(2) Basis adjustment for stock in nonaffiliated 10 percent owned corporations--(i) Taxpayers using the tax book value method--(A) General rule. For purposes of apportioning expenses on the basis of the tax book value of assets, the adjusted basis of any stock in a 10 percent owned corporation owned by the taxpayer either directly or, for taxable years beginning after April 25, 2006, indirectly through a partnership or other pass-through entity shall be--
(i) Taxpayers using the tax book value method--(A) General rule. For purposes of apportioning expenses on the basis of the tax book value of assets, the adjusted basis of any stock in a 10 percent owned corporation owned by the taxpayer either directly or, for taxable years beginning after April 25, 2006, indirectly through a partnership or other pass-through entity shall be--
(1) Increased by the amount of the earnings and profits of such corporation (and of lower-tier 10 percent owned corporations) attributable to such stock and accumulated during the period the taxpayer or other members of its affiliated group held 10 percent or more of such stock; or
(2) Reduced (but not below zero) by any deficit in earnings and profits of such corporation (and of lower-tier 10 percent owned corporations) attributable to such stock for such period.
(c)(2)(i)(B) through (c)(3) [Reserved] For further guidance, see Sec. 1.861-12T(c)(2)(i)(B) through (c)(3).
(2)(i)(B) through (c)(3) [Reserved] For further guidance, see Sec. 1.861-12T(c)(2)(i)(B) through (c)(3).
(i)(B) through (c)(3) [Reserved] For further guidance, see Sec. 1.861-12T(c)(2)(i)(B) through (c)(3).
(B) through (c)(3) [Reserved] For further guidance, see Sec. 1.861-12T(c)(2)(i)(B) through (c)(3).
(4) Characterization of stock of noncontrolled section 902 corporations--(i) General rule. The principles of Sec. 1.861-12T(c)(3) shall apply to stock in a noncontrolled section 902 corporation (as defined in section 904(d)(2)(E)). Accordingly, stock in a noncontrolled section 902 corporation shall be characterized as an asset in the various separate limitation categories on the basis of either the asset method described in Sec. 1.861-12T(c)(3)(ii) or the modified gross income method described in Sec. 1.861-12T(c)(3)(iii). Stock in a noncontrolled section 902 corporation the interest expense of which is apportioned on the basis of assets shall be characterized in the hands of its domestic shareholders (as defined in Sec. 1.902-1(a)(1)) under the asset method described in Sec. 1.861-12T(c)(3)(ii). Stock in a noncontrolled section 902 corporation the interest expense of which is apportioned on the basis of gross income shall be characterized in the hands of its domestic shareholders under the gross income method described in Sec. 1.861-12T(c)(3)(iii).
(i) General rule. The principles of Sec. 1.861-12T(c)(3) shall apply to stock in a noncontrolled section 902 corporation (as defined in section 904(d)(2)(E)). Accordingly, stock in a noncontrolled section 902 corporation shall be characterized as an asset in the various separate limitation categories on the basis of either the asset method described in Sec. 1.861-12T(c)(3)(ii) or the modified gross income method described in Sec. 1.861-12T(c)(3)(iii). Stock in a noncontrolled section 902 corporation the interest expense of which is apportioned on the basis of assets shall be characterized in the hands of its domestic shareholders (as defined in Sec. 1.902-1(a)(1)) under the asset method described in Sec. 1.861-12T(c)(3)(ii). Stock in a noncontrolled section 902 corporation the interest expense of which is apportioned on the basis of gross income shall be characterized in the hands of its domestic shareholders under the gross income method described in Sec. 1.861-12T(c)(3)(iii).
(ii) Nonqualifying shareholders. Stock in a noncontrolled section 902 corporation shall be characterized as a passive category asset in the hands of a shareholder that is not eligible to compute an amount of foreign taxes deemed paid with respect to a dividend from the noncontrolled section 902 corporation for the taxable year, and in the hands of any shareholder with respect to whom look-through treatment is not substantiated. See Sec. 1.904-5(c)(4)(iii).
(5) Effective/applicability date. Paragraphs (c)(2)(i)(A) and (4) of this section apply to taxable years of shareholders ending on or after April 20, 2009. See 26 CFR Sec. 1.861-12T(c)(2)(i) introductory text, (2)(i)(A), (2)(i)(B), and (4) (revised as of April 1, 2009) for rules applicable to taxable years of shareholders ending after the first day of the first taxable year of the noncontrolled section 902 corporation beginning after December 31, 2002, and ending before April 20, 2009.
(d) through (j) [Reserved] For further guidance, see Sec. 1.861-12T(d) through (j). [T.D. 9452, 74 FR 27874, June 11, 2009] Sec. 1.861-12T Characterization rules and adjustments for certainassets (temporary).
(a) In general. These rules are applicable to taxpayers in apportioning expenses under an asset method to income in various separate limitation categories under section 904(d), and supplement other rules provided in Sec. Sec. 1.861-9T, 1.861-10T, and 1.861-11T. The rules of this section apply to taxable years beginning after December 31, 1986, except as otherwise provided in Sec. 1.861-13T. Paragraph (b) of this section describes the treatment of inventories. Paragraph (c)(1) of this section concerns the treatment of various stock assets. Paragraph (c)(2) of this section describes a basis adjustment for stock in nonaffiliated 10 percent owned corporations. Paragraph (c)(3) of this section sets forth rules for characterizing the stock in controlled foreign corporations. Paragraph (c)(4) of this section describes the treatment of stock of noncontrolled section 902 corporations. Paragraph (d)(1) of this section concerns the treatment of notes. Paragraph (d)(2) of this section concerns the treatment of the notes of controlled foreign corporations. Paragraph (e) of this section describes the treatment of certain portfolio securities that constitute inventory or generate income primarily in the form of gains. Paragraph (f) of this section describes the treatment of assets that are subject to the capitalization rules of section 263A. Paragraph (g) of this section concerns the treatment of FSC stock and of assets of the related supplier generating foreign trade income. Paragraph (h) of this section concerns the treatment of DISC stock and of assets of the related supplier generating qualified export receipts. Paragraph (i) of this section is reserved. Paragraph (j) of this section sets forth an example illustrating the rules of this section, as well as the rules of Sec. 1.861-9T(g).
(b) Inventories. Inventory must be characterized by reference to the source and character of sales income, or sales receipts in the case of LIFO inventory, from that inventory during the taxable year. If a taxpayer maintains separate inventories for any federal tax purpose, including the rules for establishing pools of inventory items under sections 472 and 474 of the Code, each separate inventory shall be separately characterized in accordance with the previous sentence.
(c) Treatment of stock--(1) In general. Subject to the adjustment and special rules of paragraphs (c) and (e) of this section, stock in a corporation is taken into account in the application of the asset method described in Sec. 1.861-9T(g). However, an affiliated group (as defined in Sec. 1.861-11T(d)) does not take into account the stock of any member in the application of the asset method.
(1) In general. Subject to the adjustment and special rules of paragraphs (c) and (e) of this section, stock in a corporation is taken into account in the application of the asset method described in Sec. 1.861-9T(g). However, an affiliated group (as defined in Sec. 1.861-11T(d)) does not take into account the stock of any member in the application of the asset method.
(2) Basis adjustment for stock in nonaffiliated 10 percent owned corporations--
(i)(A) [Reserved] For further guidance, see Sec. 1.861-12(c)(2)(i)(A).
(A) [Reserved] For further guidance, see Sec. 1.861-12(c)(2)(i)(A).
(B) Computational rules.Solely for purposes of this section, a taxpayer's basis in the stock of a controlled foreign corporation shall not include any amount included in basis under section 961 or 1293(d) of the Code. For purposes of this paragraph (c)(2), earnings and profits and deficits are computed under the rules of section 312 and, in the case of a foreign corporation, section 902 and the regulations thereunder for taxable years of the 10 percent owned corporation ending on or before the close of the taxable year of the taxpayer. The rules of section 1248 and the regulations thereunder shall apply to determine the amount of earnings and profits that is attributable to stock without regard to whether earned and profits (or deficits) were derived (or incurred) during taxable years beginning before or after December 31, 1962. This adjustment is to be made annually and is noncumulative. Thus, the adjusted basis of the stock (determined without prior years' adjustments under this section) is to be adjusted annually by the amount of accumulated earnings and profits (or any deficit) attributable to such stock as of the end of each year. Earnings and profits or deficits of a qualified business unit that has a functional currency other than the dollar must be computed under this paragraph (c)(2) in functional currency and translated into dollars using the exchange rate at the end of the taxpayer's current taxable year with respect to which interest is being allocated (and not the exchange rates for the years in which the earnings and profits or deficits were derived or incurred).
(ii) 10 percent owned corporation defined--(A) In general. The term ``10 percent owned corporation'' means any corporation (domestic or foreign)--
(1) Which is not included within the taxpayer's affiliated group as defined in Sec. 1.861-11T(d) (1) or (6).
(2) In which the members of the taxpayer's affiliated group own directly or indirectly 10 percent or more of the total combined voting power of all classes of the stock entitled to vote, and
(3) Which is taken into account for purposes of apportionment.
(B) Rule of attribution. Stock that is owned by a corporation, partnership, or trust shall be treated as being indirectly owned proportionately by its shareholders, partners, or beneficiaries. For this purpose, a partner's interest in stock held by a partnership shall be determined by reference to the partner's distributive share of partnership income.
(iii) Earnings and profits of lower-tier corporations taken into account. For purposes of the adjustment to the basis of the stock of the 10 percent owned corporation owned by the taxpayer under paragraph (c)(2)(i) of this section, the earnings and profits of that corporation shall include its pro rata share of the earnings and profits (or any deficit therein) of each succeeding lower-tier 10 percent owned corporation. Thus, a first-tier 10 percent owned corporation shall combine with its own earnings and profits its pro rata share of the earnings and profits of all such lower-tier corporations. The affiliated group shall then adjust its basis in the stock of the first-tier corporation by its pro rata share of the total combined earnings and profits of the first-tier and the lower-tier corporations. In the case of a 10 percent owned corporation whose tax year does not conform to that of the taxpayer, the taxpayer shall include the annual earnings and profits of such 10 percent owned corporation for the tax year ending within the tax year of the taxpayer, whether or not such 10 percent owned corporation is owned directly by the taxpayer.
(iv) Special rules for foreign corporations in pre-effective date tax years. Solely for purposes of determining the adjustment required under paragraph (c)(2)(i) of this section, for tax years beginning after 1912 and before 1987, financial earnings (or losses) of a foreign corporation computed using United States generally accepted accounting principles may be substituted for earnings and profits in making the adjustment required by paragraph (c)(2)(i) of this section. A taxpayer is not required to isolate the financial earnings of a foreign corporation derived or incurred during its period of 10 percent ownership or during the post-1912 taxable years and determine earnings and profits (or deficits) attributable under section 1248 principles to the taxpayer's stock in a 10 percent owned corporation. Instead, the taxpayer may include all historic financial earnings for purposes of this adjustment. If the affiliated group elects to use financial earnings with respect to any foreign corporation, financial earnings must be used by that group with respect to all foreign corporations, except that earnings and profits may in any event be used for controlled foreign corporations for taxable years beginning after 1962 and before 1987. However, if the affiliated group elects to use earnings and profits with respect to any single controlled foreign corporation for the 1963 through 1986 period, such election shall apply with respect to all its controlled foreign corporations.
(v) Taxpayers using the fair market value method. Because the fair market value of any asset which is stock will reflect retained earnings and profits, taxpayers who use the fair market value method shall not adjust stock basis by the amount of retained earnings and profits, as otherwise required by paragraph (c)(2)(i) of this section.
(vi) Examples. Certain of the rules of this paragraph (c)(2) may be illustrated by the following examples.
Example 1. X, an affiliated group that uses the tax book value method of apportionment, owns 20 percent of the stock of Y, which owns 50 percent of the stock of Z. X's basis in the Y stock is $1,000. X, Y, and Z have calendar taxable years. The undistributed earnings and profits of Y and Z at year-end attributable to X's period of ownership are $80 and $40, respectively. Because Y owns half of the Z stock, X's pro rata share of Z's earnings and profits attributable to X's Y stock is $4. X's pro rata share of Y's earnings attributable to X's Y stock is $16. For purposes of apportionment, the tax book value of the Y stock is, therefore, considered to be $1,020.
Example 2. X, an unaffiliated domestic corporation that was organized on January 1, 1987, has owned all the stock of Y, a foreign corporation with a functional currency other than the U.S. dollar, since January 1, 1987. Both X and Y have calendar taxable years. All of Y's assets generate general limitation income. X has a deductible interest expense incurred in 1987 of $160,000. X apportions its interest expense using the tax book value method. The adjusted basis of its assets that generate domestic income is $7,500,000. The adjusted basis of its assets that generate foreign source general limitation income (other than the stock of Y) is $400,000. X's adjusted basis in the Y stock is $2,000,000. Y has undistributed earnings and profits for 1987 of $100,000, translated into dollars from Y's functional currency at the exchange rate on the last day of X's taxable year. Because X is required under paragraph (b)(1) of this Sec. 1.861-10T to increase its basis in the Y stock by the computed amount of earnings and profits, X's adjusted basis in the Y stock is considered to be $2,100,000, and its adjusted basis of assets that generate foreign source general limitation income is, thus, considered to be $2,500,000. X would apportion its interest expense as follows:
To foreign source general limitation income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.009
To domestic source income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.010
(3) Characterization of stock of controlled foreign corporations--(i) In general. Stock in a controlled foreign corporation (as defined in section 957) shall be characterized as an asset in the various separate limitation categories either on the basis of:
(i) In general. Stock in a controlled foreign corporation (as defined in section 957) shall be characterized as an asset in the various separate limitation categories either on the basis of:
(A) The asset method described in paragraph (c)(3)(ii) of this section, or
(B) The modified gross income method described in paragraph (c)(3)(iii) of this section. Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of assets shall be characterized in the hands of its United States shareholders under the asset method described in paragraph (c)(3)(ii). Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of gross income shall be characterized in the hands of its United States shareholders under the gross income method described in paragraph (c)(3)(iii).
(ii) Asset method. Under the asset method, the taxpayer characterizes the tax book value or fair market value of the stock of a controlled foreign corporation based on an analysis of the assets owned by the controlled foreign corporation during the foreign corporation's taxable year that ends with or within the taxpayer's taxable year. This process is based on the application of Sec. 1.861-9T(g) at the level of the controlled foreign corporation. In the case of a controlled foreign corporation that owns stock in one or more lower-tier controlled foreign corporations in which the United States taxpayer is a United States shareholder, the characterization of the tax book value of the fair market value of the stock of the first-tier controlled foreign corporation to the various separate limitation categories of the affiliated group must take into account the stock in lower-tier corporations. For this purpose, the stock of each such lower-tier corporation shall be characterized by reference to the assets owned during the lower-tier corporation's taxable year that ends during the taxpayer's taxable year. The analysis of assets within a chain of controlled foreign corporations must begin at the lowest-tier controlled foreign corporation and proceed up the chain to the first-tier controlled foreign corporation. For purposes of this paragraph (c), the value of any passive asset to which related person interest is allocated under Sec. 1.904-5(c)(2)(ii) must be reduced by the principal amount of indebtedness on which such interest is incurred. Furthermore, the value of any asset to which interest expense is directly allocated under Sec. 1.861-10T must be reduced as provided in Sec. 1.861-9T(g)(2)(iii). See Sec. 1.861-9T(h)(5) for further guidance concerning characterization of stock in a related person under the fair market value method.
(iii) Modified gross income method. Under the gross income method, the taxpayer characterizes the tax book value of the stock of the first-tier controlled foreign corporation based on the gross income net of interest expense of the controlled foreign corporation (as computed under Sec. 1.861-9T(j)) within each relevant category for the taxable year of the controlled foreign corporation ending with or within the taxable year of the taxpayer. For this purpose, however, the gross income of the first-tier controlled foreign corporation shall include the total amount of net subpart F income of any lower-tier controlled foreign corporation that was excluded under the rules of Sec. 1.861-9T(j)(2)(ii)(B).
(4) [Reserved] For further guidance, see Sec. 1.861-12(c)(4).
(5) [Reserved] For further guidance, see Sec. 1.861-12(c)(5).
(d) Treatment of notes--(1) General rule. Subject to the adjustments and special rules of this paragraph (d) and paragraph (e) of this section, all notes held by a taxpayer are taken into account in the application of the asset method described in Sec. 1.861-9T(g). However, the notes of an affiliated corporation are subject to special rules set forth in Sec. 1.861-11T(e). For purposes of this section, the term ``notes'' means all interest bearing debt, including debt bearing original issue discount.
(1) General rule. Subject to the adjustments and special rules of this paragraph (d) and paragraph (e) of this section, all notes held by a taxpayer are taken into account in the application of the asset method described in Sec. 1.861-9T(g). However, the notes of an affiliated corporation are subject to special rules set forth in Sec. 1.861-11T(e). For purposes of this section, the term ``notes'' means all interest bearing debt, including debt bearing original issue discount.
(2) Characterization of related controlled foreign corporation notes. The debt of a controlled foreign corporation shall be characterized according to the taxpayer's treatment of the interest income derived from that debt obligation after application of the look-through rule of section 904(d)(3)(C). Thus, a United States shareholder includes interest income from a controlled foreign corporation in the same category of income as the category of income from which the controlled foreign corporation deducts the interest expense. See section 954(b)(5) and Sec. 1.904-5(c)(2) for rules concerning the allocation of related person interest payments to the foreign personal holding company income of a controlled foreign corporation.
(e) Portfolio securities that constitute inventory or generate primarily gains. Because gain on the sale of securities is sourced by reference to the residence of the seller, a resident of the United States will generally receive domestic source income (and a foreign resident will generally receive foreign source income) upon sale or disposition of securities that otherwise generate foreign source dividends and interest (or domestic source dividends and interest in the case of a foreign resident). Although under paragraphs (c) and (d) of this section securities are characterized by reference to the source and character of dividends and interest, the source and character of income on gain or disposition must also be taken into account for purposes of characterizing portfolio securities if:
(1) The securities constitute inventory in the hands of the holder, or
(2) 80 percent or more of the gross income generated by a taxpayer's entire portfolio of such securities during a taxable year consists of gains. For this purpose, a portfolio security is a security in any entity other than a controlled foreign corporation with respect to which the taxpayer is a United States shareholder under section 957, a noncontrolled section 902 corporation with respect to the taxpayer, or a 10 percent owned corporation as defined in Sec. 1.861-12(c)(2)(ii). In taking gains into account, a taxpayer must treat all portfolio securities generating foreign source dividends and interest as a single asset and all portfolio securities generating domestic source dividends as a single asset and shall characterize the total value of that asset based on the source of all income and gain generated by those securities in the taxable year.
(f) Assets funded by disallowed interest--(1) Rule. In the case of any asset in connection with which interest expense accruing at the end of the taxable year is capitalized, deferred, or disallowed under any provision of the Code, the adjusted basis or fair market value (depending on the taxpayer's choice of apportionment methods) of such an asset shall be reduced by the principal amount of indebtedness the interest on which is so capitalized, deferred, or disallowed.
(1) Rule. In the case of any asset in connection with which interest expense accruing at the end of the taxable year is capitalized, deferred, or disallowed under any provision of the Code, the adjusted basis or fair market value (depending on the taxpayer's choice of apportionment methods) of such an asset shall be reduced by the principal amount of indebtedness the interest on which is so capitalized, deferred, or disallowed.
(2) Example. The rules of this paragraph (f) may be illustrated by the following example.
Example. X is a domestic corporation which uses the tax book value method of apportionment. X has $1000 of indebtedness and $100 of interest expense. X constructs an asset with an adjusted basis of $800 before interest capitalization and is required under the rules of section 263A to capitalize $80 in interest expense. Because interest on $800 of debt is capitalized and because the production period is in progress at the end of X's taxable year, $800 of the principal amount of X's debt is allocable to the building. The $800 of debt allocable to the building reduces its adjusted basis for purposes of apportioning the balance of X's interest expense ($20).
(g) Special rules for FSCs--(1) Treatment of FSC stock. No interest expense shall be allocated or apportioned to stock of a foreign sales corporation (``FSC'') to the extent that the FSC stock is attributable to the separate limitation for certain FSC distributions described in section 904(d)(1)(H). FSC stock is considered to be attributable solely to the separate limitation category described in section 904(d)(1)(H) unless the taxpayer can demonstrate that more than 20 percent of the FSC's gross income for the taxable year consists of income other than foreign trading income.
(1) Treatment of FSC stock. No interest expense shall be allocated or apportioned to stock of a foreign sales corporation (``FSC'') to the extent that the FSC stock is attributable to the separate limitation for certain FSC distributions described in section 904(d)(1)(H). FSC stock is considered to be attributable solely to the separate limitation category described in section 904(d)(1)(H) unless the taxpayer can demonstrate that more than 20 percent of the FSC's gross income for the taxable year consists of income other than foreign trading income.
(2) Treatment of assets that generate foreign trade income. Assets of the related supplier that generate foreign trade income must be prorated between assets attributable to foreign source general limitation income and assets attributable to domestic source income in proportion to foreign source general limitation income and domestic source income derived from transactions generating foreign trade income.
(i) Value of assets attributable to foreign source income. The value of assets attributable to foreign source general limitation income is computed by multiplying the value of assets for the taxable year generating foreign trading gross receipts by a fraction:
(A) The numerator of which is foreign source general limitation income for the taxable year derived from transactions giving rise to foreign trading gross receipts, after the application of the limitation provided in section 927(e)(1), and
(B) The denominator of which is total income for the taxable year derived from the transaction giving rise to foreign trading gross receipts.
(ii) Value of assets attributable to domestic source income. The value of assets attributable to domestic source income is computed by subtracting from the total value of assets for the taxable year generating foreign trading gross receipts the value of assets attributable to foreign source general limitation income as computed under paragraph (g)(2)(i) of this section.
(h) Special rules for DISCs--(1) Treatment of DISC stock. No interest shall be allocated or apportioned to stock in a DISC (or stock in a former DISC to the extent that the stock in the former DISC is attributable to the separate limitation category described in section 904(d)(1)(F)).
(1) Treatment of DISC stock. No interest shall be allocated or apportioned to stock in a DISC (or stock in a former DISC to the extent that the stock in the former DISC is attributable to the separate limitation category described in section 904(d)(1)(F)).
(2) Treatment of assets that generate qualified export receipts. Assets of the related supplier that generate qualified export receipts must be prorated between assets attributable to foreign source general limitation income and assets attributable to domestic source income in proportion to foreign source general limitation income and domestic source income derived from transactions during the taxable year from transactions generating qualified export receipts.
(i) [Reserved]
(j) Examples. Certain of the rules in this section and Sec. Sec. 1.861-9T(g) and 1.861-10(e) are illustrated by the following example.
(1) Facts. X, a domestic corporation organized on January 1, 1987, has a calendar taxable year and apportions its interest expense on the basis of the tax book value of its assets. In 1987, X incurred a deductible third-party interest expense of $100,000 on an average month-end debt amount of $1 million. The total tax book value of X's assets (adjusted as required under paragraph (b) of this section for retained earnings and profits) is $2 million. X manufactures widgets. One-half of the widgets are sold in the United States and one-half are exported and sold through a foreign branch with title passing outside the United States.
X owns all the stock of Y, a controlled foreign corporation that also has a calendar taxable year and is also engaged in the manufacture and sale of widgets. Y has no earnings and profits or deficits in earnings and profits prior to 1987. For 1987, Y has taxable income and earnings and profits of $50,000 before the deductible for related person interest expense. Half of the $50,000 is foreign source personal holding company income and the other half is derived from widget sales and constitutes foreign source general limitation income. Assume that Y has no deductibles from gross income other than interest expense. Y's foreign personal holding company taxable income is included in X's gross income under section 951. Y paid no dividends in 1987. Prior to 1987, Y did not borrow any funds from X. The average month-end level of borrowings by Y from X in 1987 is $100,000, on which Y paid a total of $10,000 in interest. The total tax book value of Y's assets in 1987 is $500,000. Y has no liabilities to third parties. X elects pursuant to Sec. 1.861-9T for Y to apportion Y's interest expense under the gross income method prescribed in Sec. 1.861-9T(g).
In addition to its stock in Y, X owns 20 percent of the stock of Z, a noncontrolled section 902 corporation. X's total assets and their tax book values are: ------------------------------------------------------------------------
Tax book
Asset value------------------------------------------------------------------------Plant & equipment........................................... $1,000,000Corporate headquarters...................................... 500,000Inventory................................................... 200,000Automobiles................................................. 20,000Patents..................................................... 50,000Trademarks.................................................. 10,000Y stock (including paragraph (c)(2) adjustment)............. 80,000Y note...................................................... 100,000Z stock..................................................... 40,000------------------------------------------------------------------------
(2) Categorization of Assets.
Single Category Assets
1. Automobiles: X's automobiles are used exclusively by its domestic sales force in the generation of United States source income. Thus, these assets are attributable solely to the grouping of domestic income.
2. Y Note: Under paragraph (d)(2) of this section, the Y note in the hands of X is characterized according to X's treatment of the interest income received on the Y note. In determining the source and character of the interest income on the Y note, the look-through rules of sections 904(d)(3)(C) and 904(g) apply. Under section 954(b)(5) and Sec. 1.904-5(c)(2)(ii), Y's $10,000 interest payment to X is allocated directly to, and thus reduces, Y's foreign personal holding company income of $25,000 (yielding foregin personal holding company taxable income of $15,000). Therefore, the Y note is attributable solely to the statutory grouping of foreign source passive income.
3. Z stock: Because Z is a noncontrolled section 902 corporation, the dividends paid by Z are subject to a separate limitation under section 904(d)(1)(E). Thus, this asset is attributable solely to the statutory grouping consisting of Z dividends.
Multiple Category Assets
1. Plant & equipment, inventory, patents, and trademarks: In 1987, X sold half its widgets in the United States and exported half outside the United States. A portion of the taxable income from export sales will be foreign source income, since the export sales were accomplished through a foreign branch and title passed outside the United States. Thus, these assets are attributable both to the statutory grouping of foreign general limitation and the grouping of domestic income.
2. Y Stock: Since Y's interest expense is apportioned under the gross income method prescribed in Sec. 1.861-9T(j), the Y stock must be characterized under the gross income method described in paragraph (c)(3)(iii) of this section.
Assets without Directly Identifiable Yield
1. Corporate headquarters: This asset generates no directly identifiable income yield. The value of the asset is disregarded.
(3) Analysis of Income Yield for Multiple Category Assets.
1. Plant & Equipment, inventory, patents, and trademarks: As noted above, X's 1987 widget sales were half domestic and half foreign. Assume that Example 2 of Sec. 1.863-3(b)(2) applies in sourcing the export income from the export sales. Under Example 2, the income generated by the export sales is sourced half domestic and half foreign. The income gnerated by the domestic sales is entirely domestic source. Accordingly, three-quarters of the income generated on all sales is domestic source and one-quarter of the income is foreign source. Thus, three-quarters of the fair market value of these assets are attributed to the grouping of domestic source income and one-quarter of the fair market value of these assets is attributed to the statutory grouping of foreign source general limitation income.
2. Y Stock: Under the gross income method described in paragraph (c)(3)(iii) of this section, Y's gross income net of interest expenses in each limitation category must be determined--$25,000 foreign source general limitation income and $15,000 of foreign source passive income. Of X's adjusted basis of $80,000 in Y stock, $50,000 is attributable to foreign source general limitation income and $30,000 is attributable to foreign source passive income.
(4) Application of the Special Allocation Rule of Sec. 1.861-10T(e). Assume that the taxable year in question is 1990 and that the appliable percentage prescribed by Sec. 1.861-10T(e)(1)(iv)(A) is 80 percent. Assume that X has elected to use the quadratic formula provided in Sec. 1.861-10T(e)(1)(iv)(B).
Step 1. X's average month-end level of debt owning to unrelated persons is $1 million. The tax book value of X's assets is $2 million. Thus, X's debt-to-asset ratio computed under Sec. 1.861-10T(e)(1)(i) is 1 to 2.
Step 2. The tax book value of Y's assets is $500,000. Because Y has no debt to persons other than X, Y's debt-to-asset ratio computed under Sec. 1.861-10T(e)(1)(ii) is $0 to $500,000.
Step 3. Y's average month-end liabilities to X, as computed under Sec. 1.861-10T(e)(1)(iii) for 1987 are $100,000.
Step 4. Adding the $100,000 of Y's liabilities owed to X as computed under Step 3 to Y's third party liabilities ($0) would be insufficient to make Y's debt-to-asset ratio computed in Step 2 ($100,000-to-$500,000, or 1:5) equal to at least 80 percent of X's debt-to-asset ratio computed under Step 1, as adjusted to reflect a reduction in X's debt and assets by the $100,000 of excess related person indebtedness (.80x$900,000/$1,900,000 or 1:2.6). Therefore, the entire amount of Y's liabilities to X ($100,000) constitute excess related person indebtedness under Sec. 1.861-10T(e)(1)(ii). Thus, the entire $10,000 of interest received by X from Y during 1987 constitutes interest received on excess related person indebtedness.
Step 5. The Y note held by X has a tax book value of $100,000. Solely for purposes of Sec. 1.861-10(e)(1)(v), the Y note is attributed to separate limitation categories in the same manner as the Y stock. Under paragraph (c)(3)(iii) of this section, of the $80,000 of Y stock held by X, $50,000 is attributable to foreign source general limitation income, and $30,000 is attributable to foreign source passive income. Thus, for purposes of $1.861-10T(e)(1)(v), $62,500 of the $100,000 Y note is considered to be a foreign source general limitation asset and $37,500 of the $100,000 Y note is considered to be a foreign source passive asset.
Step 6. Since $8,000 of the $10,000 in related person interest income received by Y constitutes interest received on excessive related person indebtedness, $10,000 of X's third party interest expense is allocated to X's debt investment in Y. Under Sec. 1.861-10T(e)(1)(vi), 62.5 percent of the $10,000 of X's third party interest expense ($6,250) is allocated to foreign source general limitation income and 37.5 percent of the $10,000 of X's third party interest expense ($3,750) is allocated to foreign source passive income. As a result of this direct allocation, the value of X's assets generating foreign source general limitation income shall be reduced by the principal amount of indebtedness the interest on which is directly allocated to foreign source general limitation income ($62,500), and X's assets generating foreign general limitation income shall be reduced by the principal amount of indebtedness the interest on which is directly allocated to foreign passive income ($37,500).
(5) Totals.
Having allocated $10,000 of its third party interest expense to its debt investment in Y, X would apportion the $90,000 balance of its interest according to the following apportionment fractions: ----------------------------------------------------------------------------------------------------------------
Domestic Foreign Foreign Noncontrolled
Asset source general passive section 902----------------------------------------------------------------------------------------------------------------Plant and equipment...................................... $750,000 $250,000 ........... ..............Inventory................................................ $150,000 $50,000 ........... ..............Automobiles.............................................. $20,000 ........... ........... ..............Patents.................................................. $37,500 $12,500 ........... ..............Trademarks............................................... $7,500 $2,500 ........... ..............Y stock.................................................. ........... $50,000 $30,000 ..............Y note................................................... ........... ........... $100,000 ..............
Z stock.................................................. ........... ........... ........... $40,000
------------------------------------------------------
Totals............................................. $965,000 $365,000 $130,000 $40,000
======================================================
Adjustments for directly allocable interest........ ........... ($62,250) ($37,750) ..............
------------------------------------------------------
Adjusted totals.................................... $965,000 $302,750 $92,250 $40,000
======================================================Percentage............................................... 69 22 6 3----------------------------------------------------------------------------------------------------------------
Example 2. Assume the same facts as in Example 1, except that Y has $100,000 of third party indebtedness. Further, assume for purposes of the application of the special allocation rule of Sec. 1.861-10T(e) that the taxable year is 1990 and that the applicable percentage prescribed by Sec. 1.861-10T(e)(1)(iv)(A) is 80 percent. The application of the Sec. 1.861-10(e) would be modified as follows.
Step 1. X's debt-to-asset ratio computed under Sec. 1.861-10T(e)(1)(i) remains 1 to 2 (or 0.5).
Step 2. The tax book value of Y's assets is $500,000. Y has $100,000 of indebtedness to third parties. Y's debt-to-asset ratio computed under Sec. 1.861-10T(e)(1)(ii) is $100,000 to $500,000 (1:5 or 0.2).
Step 3. Y's average month-end liabilities to X, as computed under Sec. 1.861-10T(e)(1)(iii) remain $100,000.
Step 4. X's debt-to-asset ratio is 0.5 and 80 percent of 0.5 is 0.4. Because Y's debt-to-asset ratio is 0.2, there is excess related person indebtedness, the amount of which can be computed based on the following formula:[GRAPHIC] [TIFF OMITTED] TC07OC91.011
Supplying the facts as given, this equation is as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.012
Multiply both sides by 500,000 and (2,000,000-X), yielding:
[GRAPHIC] [TIFF OMITTED] TC07OC91.013
Since there is an X\2\ in this equation, a quadratic formula must be utilized to solve for X. Group the components in this equation, segregating the X and the X\2\:[GRAPHIC] [TIFF OMITTED] TC07OC91.014
Apply the quadratic formula:
[GRAPHIC] [TIFF OMITTED] TC07OC91.015
a=1 (coefficient of X\2\)b=-2,300,000 (coefficient of X)c=2x10\11\ (remaining element of equation) Therefore, X equals either 90,519 or (2.21x10\11\). for purposes of computing excess related person indebtedness, X is the lowest positive amount derived from this equation, which is 90,519.
Steps 5 and 6 are unchanged from Example 1, except that the total amount of interest on excess related party indebtedness is $9,051.
(k) Effective/applicability date. The rules of this section apply for taxable years beginning after December 31, 1986. [T.D. 8228, 53 FR 35495, Sept. 14, 1988, as amended by T.D. 9260, 71 FR 24526, Apr. 25, 2006, T.D. 9452, 74 FR 27875, June 11, 2009; T.D. 9456, 74 FR 38875, Aug. 4, 2009] Sec. 1.861-13T Transition rules for interest expenses(temporary regulations).
(a) In general--(1) Optional application. The rules of this section may be applied at the choice of a corporate taxpayer. In the case of an affiliated group, however, the choice must be made on a consistent basis for all members. Therefore, a corporate taxpayer (or affiliated group) may allocate and apportion its interest expense entirely on the basis of the rules contained in Sec. Sec. 1.861-8T through 1.861-12T and without regard to the rules of this section. The choice is made on an annual basis and, thus, is not binding with respect to subsequent tax years.
(1) Optional application. The rules of this section may be applied at the choice of a corporate taxpayer. In the case of an affiliated group, however, the choice must be made on a consistent basis for all members. Therefore, a corporate taxpayer (or affiliated group) may allocate and apportion its interest expense entirely on the basis of the rules contained in Sec. Sec. 1.861-8T through 1.861-12T and without regard to the rules of this section. The choice is made on an annual basis and, thus, is not binding with respect to subsequent tax years.
(2) Transition relief. This section contains transitional rules that limit the application of the rules for allocating and apportioning interest expense of corporate taxpayers contained in Sec. Sec. 1.861-8T through 1.861-12T, which are applicable in allocating and apportioning the interest expense of corporate taxpayers generally for taxable years beginning after 1986. Sections 1.861-9(d) (relating to individuals, estates, and certain trusts) and 1.861-9(e) (relating to partnerships) are effective for taxable years beginning after 1986. Thus, the taxpayers to whom those sections apply do not qualify for transition relief under this section.
(3) Indebtedness defined. For purposes of this section, the term ``indebtedness'' means any obligation or other evidence of indebtedness that qenerates an expense that constitutes interest expense within the meaning of Sec. 1.861-9T(a). In the case of an obligation that does not bear interest initially, but becomes interest bearing with the lapse of time or upon the occurrence of an event, such obligation shall only be considered to constitute indebtedness when it first bears interest. Obligations that are outstanding as of November 16, 1985 shall only qualify for transition relief under this section if they bear interest-bearing as of that date. For this purpose, any obligation that has original issue discount within the meaning of section 1273(a)(1) of the Code shall be considered to be interest-bearing.
(4) Exceptions. The term ``indebtedness'' shall not include any obligation existing between affiliated corporations, as defined in Sec. 1.861-llT(d). Moreover, the term ``indebtedness'' shall not include any obligation the interest on which is directly allocable under Sec. Sec. 1.861-10T(b) and 1.861-10T(c). Under Sec. 1.861-9T(b)(6)(iv)(B), certain interest expense is directly allocated to the gain derived from an appropriately identified financial product. When interest expense on a liability is reduced by such gain, the principal amount of such liability shall be reduced pro rata by the relative amount of interest expense that is directly allocated.
(b) General phase-in--(1) In general. In the case of each of the first three taxable years of the taxpayer beginning after December 31, 1986, the rules of Sec. Sec. 1.861-8T through 1.861-12T shall not apply to interest expenses paid or accrued by the taxpayer during the taxable year with respect to an aggregate amount of indebtedness which does not exceed the general phase-in amount, as defined in paragraph (b)(2) of this section.
(1) In general. In the case of each of the first three taxable years of the taxpayer beginning after December 31, 1986, the rules of Sec. Sec. 1.861-8T through 1.861-12T shall not apply to interest expenses paid or accrued by the taxpayer during the taxable year with respect to an aggregate amount of indebtedness which does not exceed the general phase-in amount, as defined in paragraph (b)(2) of this section.
(2) General phase-in amount defined. Subject to the limitation imposed by paragraph (b)(3) of this section, the general phase-in amount means the amount which is the applicable percentage (determined under the following table) of the aggregate amount of indebtedness of the taxpayer outstanding on November 16, 1985:
Taxable year beginning after December 31, 1986 Percentage
First...................................................... 75Second..................................................... 50Third...................................................... 25
(3) Reductions in indebtedness. The general phase-in amount shall not exceed the taxpayer's historic lowest month-end debt level taking into account all months after October 1985. However, for the taxable year ln which a taxpayer attains a new historic lowest month-end debt level (but not for subsequent taxable years), the general phase-in amount shall not exceed the average of month-end debt levels within that taxable year (without taking into account any increase in month-end debt levels occurring in such taxable Year after the new historic lowest month-end debt level is attained).
Example. X is a calendar year taxpayer that had $100 of indebtedness outstanding on November 16, 1985. X's month-end debt level remained $100 for all subsequent months until July 1987, when X's month-end debt level fell to $50. In computing transition relief for 1987, X's general phase-in amount cannot exceed $75 (900 divided by 12), which is the average of month-end debt levels in 1987. Assuming that X's month-end debt level for any subsequent month does not fall below $50, the limitation on its general phase-in amount for all taxable years after 1987 will be $50, its historic lowest month-end debt level after October 1985.
(c) Nonapplication of the consolidation rule--(1) General rule. In the case of each of the first five taxable years of the taxpayer beginning after December 31, 1986, the consolidation rule contained in Sec. 1.861-11T(c) shall not apply to interest expenses paid or accrued by the taxpayer during the taxable year with respect to an aggregate amount of indebtedness which does not exceed the special phase-in amount, as defined in paragraph (c)(2) of this section.
(1) General rule. In the case of each of the first five taxable years of the taxpayer beginning after December 31, 1986, the consolidation rule contained in Sec. 1.861-11T(c) shall not apply to interest expenses paid or accrued by the taxpayer during the taxable year with respect to an aggregate amount of indebtedness which does not exceed the special phase-in amount, as defined in paragraph (c)(2) of this section.
(2) Special phase-in amount. The special phase-in amount is the sum of--
(i) The general phase-in amount,
(ii) The five-year phase-in amount, and
(iii) The four-year phase-in amount.
(3) Five-year phase-in amount. The five-year phase-in amount is the lesser of--
(i) The applicable percentage (the ``unreduced percentage'' in the following table) of the five-year debt amount, or
(ii) The applicable percentage (the ``reduced percentage'' in the following table) of the five-year debt amount reduced by paydowns (if any): ------------------------------------------------------------------------
Unreduced Reduced
Transition year percentage percentage------------------------------------------------------------------------Year 1........................................ 8\1/3\ 10Year 2........................................ 16\2/3\ 25Year 3........................................ 25 50Year 4........................................ 33\1/3\ 100Year 5........................................ 16\2/3\ 100------------------------------------------------------------------------
(4) Four-year phase-in amount. The four-year phase-in amount is the lesser of--
(i) The applicable percentage (the ``unreduced percentage'' in the following table) of the four-year debt amount, or
(ii) The applicable percentage (the ``reduced percentage'' in the following table) of the four-year debt amount reduced by paydowns (if any) to the extent that such paydowns exceed the five-year debt amount: ------------------------------------------------------------------------
Unreduced Reduced
Transition year percentage percentage------------------------------------------------------------------------Year 1........................................ 5 6\1/4\Year 2........................................ 10 16\2/3\Year 3........................................ 15 37\1/2\Year 4........................................ 20 100------------------------------------------------------------------------
(5) Five-year debt amount. The ``five-year debt amount'' means the excess (if any) of--
(i) The amount of the outstanding indebtedness of the taxpayer on May 29, 1985, over
(ii) The amount of the outstanding indebtedness of the taxpayer on December 31, 1983. The five-year debt amount shall not exceed the aggregate amount of indebtedness of the taxpayer outstanding on November 16, 1985.
(6) Four-year debt amount. The ``four-year debt amount'' means the excess (if any) of--
(i) The amount of the outstanding indebtedness of the taxpayer on December 31, 1983, over
(ii) The amount of the outstanding indebtedness of the taxpayer on December 31, 1982. The four-year debt amount shall not exceed the aggregate amount of indebtedness of the taxpayer outstanding on November 16, 1985, reduced by the five-year debt amount.
(7) Paydowns. The term ``paydowns'' means the excess (if any) of--
(i) The aggregate amount of indebtedness of the taxpayer outstanding on November 16, 1985, over
(ii) The limitation on the general phase-in amount described in paragraph (b)(3) of this section.
Paydowns are first applied to the five-year debt amount to the extent thereof and then to the four-year debt amount for purposes of computing the five-year and the four-year phase-in amounts.
(d) Treatment of affiliated group. For purposes of this section, all members of the same affiliated group of corporations (as defined in Sec. 1.861-11(d)) shall be treated as one taxpayer whether or not such members filed a consolidated return. Interaffiliate debt is not taken into account in computing transition relief. Moreover, any reduction in the amount of interaffiliate debt is not taken into account in determining the amount of paydowns.
(e) Mechanics of computation--(1) Step 1: Determination of the amounts within the various categories of debt. Each separate member of an affiliated group must determine each of its following amounts:
(1) Step 1: Determination of the amounts within the various categories of debt. Each separate member of an affiliated group must determine each of its following amounts:
(i) November 16, 1985 amount. The amount of its debt outstanding on November 16, 1985 (after the elimination of interaffiliate indebtedness),
(ii) Unreduced five-year debt. The amount of any net increase in the amount of its indebtedness on May 29, 1985 (after elimination of interaffiliate indebtedness) over the amount of its indebtedness on December 31, 1983 (after elimination of interaffiliate indebtedness),
(iii) Unreduced four-year debt. The amount of any net increase in the amount of its indebtedness on December 31, 1983 (after elimination of interaffiliate indebtedness) over the amount of its indebtedness on December 31, 1982 (after elimination of interaffiliate indebtedness), and
(iv) Month-end debt. The amount of its month-end debt level for all months after October 1985 (after elimination of interaffiliate indebtedness).
(2) Step 2: Aggregation of the separate company amounts. Each of the designated amounts for the separate companies identified in Step 1 must be aggregated in order to compute consolidated transition relief. Paragraph (e)(10)(iv) of this section (Step 10) requires the use of the taxpayer's current year average debt level for the purpose of computing the percentages of debt that are subject to the three sets of rules that are identified in Step 10. For use in that computation, the taxpayer should compute the current year average debt level by aggregating separate company month-end debt levels and then by averaging those aggregate amounts.
(3) Step 3: Calculation of the lowest historic month-end debt level of the taxpayer. In order to calculate the lowest historic month-end debt level of the taxpayer, determine the month-end debt level of each separate company for each month ending after October 1985 and aggregate these amounts on a month-by-month basis. On such aggregate basis, in any taxable year in which the taxpayer attains an aggregate new lowest historic month-end debt level, add together all the aggregate month-end debt levels within the taxable year (without taking into account any increase in aggregate debt level subsequent to the attainment of such lowest historic month-end debt level) and divide by the number of months in that taxable year, yielding the average of month-end debt levels for such year. Such average shall constitute the taxpayer's lowest historic month-end debt level for that taxable year in which the aggregate new lowest historic month-end debt level was attained. Unless otherwise specified, all subsequent references to any amount refer to the aggregate amount for all members of the same affiliated group of corporations.
(4) Step 4: Computation of paydowns. Paydowns equal the amount by which the November 16, 1985 amount exceeds the taxpayer's lowest historic month-end debt level, determined under Step 3.
(5) Step 5: Computation of limitations on unreduced five-year debt and unreduced four-year debt. (i) The unreduced five-year debt cannot exceed the November 16, 1985 amount.
(i) The unreduced five-year debt cannot exceed the November 16, 1985 amount.
(ii) The unreduced four-year debt cannot exceed the November 16, 1985 amount less the unreduced five-year debt.
(6) Step 6: Computation of reduced five-year and reduced four-year debt--(i) Reduced five-year debt. Compute the amount of reduced five-year debt by subtracting from the unreduced five-year debt (see Step 5) the amount of paydowns (see Step 4).
(i) Reduced five-year debt. Compute the amount of reduced five-year debt by subtracting from the unreduced five-year debt (see Step 5) the amount of paydowns (see Step 4).
(ii) Reduced four-year debt. To the extent that the amount of paydowns (see step 4) exceeds the amount of unreduced five-year debt (see Step 5), compute the amount of reduced four-year debt by subtracting such excess from the unreduced four-year debt (see Step 1).
(iii) To the extent that paydowns do not offset either the unreduced five-year amount or the unreduced four-year amount, the reduced and the unreduced amounts are the same.
(7) Step 7: Computation of the general phase-in amount. The general phase-in amount is the lesser of--
(i) The percentage of the November 16, 1985 amount designated for the relevant transition year in the table below, or
(ii) The lowest group month-end debt level (see Step 3).
General Phase-in Table------------------------------------------------------------------------
Transition year Percentage------------------------------------------------------------------------Year 1..................................................... 75Year 2..................................................... 50Year 3..................................................... 25------------------------------------------------------------------------
(8) Step 8: Computation of Five-Year Phase-in Amount. The five-year phase-in amount is the lesser of--
(i) The percentage of the unreduced five-year debt designated for the relevant transition year in the table below, or
(ii) The percentage of the reduced five-year debt designated for the relevant transition year in the table below.
Five-Year Phase-In Table------------------------------------------------------------------------
Unreduced Reduced
Transition year percentage percentage------------------------------------------------------------------------Year 1........................................ 8\1/3\ 10Year 2........................................ 16\2/3\ 25Year 3........................................ 25 50Year 4........................................ 33\1/3\ 100Year 5........................................ 16\2/3\ 100------------------------------------------------------------------------
(9) Step 9: Computation of Four-year Phase-in Amount. The four-year phase-in amount is the lesser of--
(i) The percentage of the unreduced four-year debt designated for the relevant transition year in the table below, or
(ii) The percentage of the reduced four-year debt designated for the relevant transition year in the table below.
Four-Year Phase-In Table------------------------------------------------------------------------
Unreduced Reduced
Transition year percentage percentage------------------------------------------------------------------------Year 1........................................ 5 6\1/4\Year 2........................................ 10 16\2/3\Year 3........................................ 15 37\1/2\Year 4........................................ 20 100------------------------------------------------------------------------
(10) Step 10: Determination of group debt ratio and application of transition relief to separate company interest expense. (i) The general phase-in amount consists of the amount computed under Step 7. Interest expense on this amount is subject to pre-1987 rules of allocation and apportionment.
(i) The general phase-in amount consists of the amount computed under Step 7. Interest expense on this amount is subject to pre-1987 rules of allocation and apportionment.
(ii) The post-1986 separate company amount consists of the sum of the amounts determined under Steps 8 and 9. Interest expense on this amount is subject to post-1986 rules of allocation and apportionment as applied on a separate company basis. Thus, Sec. 1.861-11T(c) does not apply with respect to this amount of indebtedness. Because the consolidation rule does not apply, stock in affiliated corporations shall be taken into account in computing the apportionment fractions for each separate company in the same manner as under pre-1987 rules.
(iii) The post-1986 one-taxpayer amount consists of any indebtedness that does not qualify for transition relief under Steps 7, 8, and 9. Interest expense on this amount is subject to post-1986 rules as applied on a consolidated basis.
(iv) To determine the extent to which the interest expense of each separate company is subject to any of these sets of allocation and apportionment rules, each company shall prorate its own interest expense using two fractions. The general phase-in fraction is the general phase-in amount over the current year average debt level of the affiliated group (see Step 2). The post-1986 separate company fraction is the post-1986 separate company amount over the current year average debt level of the affiliated group. The balance of each separate company's interest expense is subject to post-1986 one-taxpayer rules.
(f) Example. XYZ form an affiliate group.
(1) Step 1: Determination of the amounts within the various debt categories. ------------------------------------------------------------------------
Historic
3rd party Increase
debt------------------------------------------------------------------------Company X:
Nov. 16, 1985............................. $100,000 ...........
May 29, 1983 (5-year)..................... 90,000 $10,000
Dec. 31, 1983 (4-year).................... 80,000 10,000
Dec. 31, 1982............................. 70,000 ...........
Current Interest Expense.................. 10,000 ...........Company Y:
Nov. 16, 1985............................. 200,000 ...........
May 29, 1985 (5-year)..................... 170,000 120,000
Dec. 31, 1983 (4-year).................... 50,000 10,000
Dec. 31, 1982............................. 40,000 ...........
Current Interest Expense.................. 30,000 ...........Company Z:
Nov. 16, 1985............................. 300,000 ...........
May 29, 1985 (5-year)..................... 300,000 50,000
Dec. 31, 1983 (4-year).................... 250,000 100,000
Dec. 31, 1982............................. 150,000 ...........
Current Interest Expense.................. 30,000 ...........------------------------------------------------------------------------
(2) Step 2: Aggregation of the separate company amounts. Aggregate Nov. 16, 1985...................................... $600,000Aggregate 5-year debt........................................ 180,000Aggregate 4-year debt........................................ 120,000Current year average debt level.............................. 700,000
(3) Step 3: Calculation of lowest historic month-end debt level.
An analysis of historic month-end debt levels indicates that in 1986, XYZ's aggregate month-end debt level fell to $500,000, which represents the lowest sum for all years under consideration. Because this historic low occurred in a prior tax year, there is no averaging of month-end debt levels in the current taxable year.
(4) Step 4: Computation of paydowns.
The aggregate November 16, 1985 amount ($600,000), less the lowest historic month-end debt level ($500,000), yields a total paydown in the amount of $100,000.
(5) Step 5: Computation of limitations on aggregate unreduced five-year debt and aggregate unreduced four-year debt. Aggregate Nov. 16, 1985 amount............................... $600,000Aggregate unreduced 5-year debt.............................. 180,000Aggregate unreduced 4-year debt.............................. 120,000
Because the November 16, 1985 amount exceeds the unreduced 4- and 5-year debt, the full amount of the 4- and 5-year debt qualify for transition relief. In cases where the November 16, 1985 amount is less than the 4- or 5-year debt (or the sum of both), the latter amounts are limited to the November 16, 1985 amount. See the limitations on the 4-year and 5-year debt amounts in paragraphs (c)(6) and (c)(5), respectively, of this section.
(6) Step 6: Computation of reduced five-year and four-year debt. The paydowns computed under Step 4 are deemed to first offset the aggregate unreduced five-year debt. Accordingly, the reduced amount of five-year debt is $80,000. Since the paydowns are less than the aggregate unreduced five-year debt, there is no paydown in connection with aggregate unreduced four-year debt. Accordingly, the unreduced four-year debt and the reduced four-year debt are both considered to be $120,000.
(7) Step 7: Computation of the general phase-in amount. In transition year 1, the general transition amount is the lesser of:
(i) 75 percent of the aggregate November 16, 1985 amount (75% of $600,000 = $450,000); or
(ii) the lowest month-end debt level since November 16, 1985 ($500,000).
Therefore, the general transition amount is $450,000.
(8) Step 8: Computation of the five-year phase-in amount. In transition year 1, the five-year phase-in amount is the lesser of:
(i) 8\1/3\ percent of the unreduced five-year amount (8\1/3\% of $180,000=$15,000); or
(ii) 10 percent of the reduced five-year amount (10% of $80,000=$8,000).
Therefore, the five-year phase-in amount is $8,000.
(9) Step 9: Computation of the four-year phase-in amount. In transition year 1, the four-year phase-in amount is the lesser of:
(i) 5 percent of the unreduced four-year amount (5% of $120,000=$6,000); or
(ii) 6\1/4\ percent of the reduced four-year amount (6\1/4\% of $120,000=$7,500).
Therefore, the four-year phase-in amount is $6,000.
(10) Step 10: Determination of group debt ratio and application of relief to separate company interest expense.
(i) As determined under Step 7, interest expense on a total of $450,000 of the XYZ debt in the first transition year is computed under pre-1987 rules of allocation and apportionment.
(ii) The sum of Steps 8 ($8,000) and 9 ($6,000) is $14,000. Interest expense on a total of $14,000 of XYZ debt is computed under post-1986 rules of allocation and apportionment as applied on a separate company basis.
(iii) The balance of XYZ's current year interest expense is computed under post-1986 rules of allocation and apportionment as applied on a consolidated basis. X, Y, and Z, respectively, have current interest expense of $10,000, $30,000, and $30,000. Thus, 64.3 percent (450,000/700,000) of the interest expense of each separate company is subject to pre-1987 rules. Two percent (14,000/700,000) of the interest expense of each separate company is subject to post-1986 rules applied on a separate company basis. Finally, the balance of each separate company's current year interest expense (33.7 percent) is subject to post-1986 rules applied on a consolidated basis.
(g) Corporate transfers--(1) Effect on transferee--(i) General rule. Except as provided in paragraph (g)(1)(ii) of this section, if a domestic corporation or an affiliated group acquires stock in a domestic corporation that was not a member of the transferee's affiliated group before the acquisition, but becomes a member of the transferee's affiliated group after the acquisition, the transferee group shall take into account the following transition attributes of the acquired corporation in computing its transition relief:
(1) Effect on transferee--(i) General rule. Except as provided in paragraph (g)(1)(ii) of this section, if a domestic corporation or an affiliated group acquires stock in a domestic corporation that was not a member of the transferee's affiliated group before the acquisition, but becomes a member of the transferee's affiliated group after the acquisition, the transferee group shall take into account the following transition attributes of the acquired corporation in computing its transition relief:
(i) General rule. Except as provided in paragraph (g)(1)(ii) of this section, if a domestic corporation or an affiliated group acquires stock in a domestic corporation that was not a member of the transferee's affiliated group before the acquisition, but becomes a member of the transferee's affiliated group after the acquisition, the transferee group shall take into account the following transition attributes of the acquired corporation in computing its transition relief:
(A) November 16, 1985 amount;
(B) Unreduced five-year amount;
(C) Unreduced four-year amount; and
(D) The amount of any transferor paydowns attributed to the acquired corporation under the rules of paragraph (h)(1) of this section.
(ii) Special rule for year of acquisition. To compute the amount of the transition attributes described in paragraph (g)(1)(i) of this section that a transferee takes into account in the transferee's taxable year of the acquisition, such transition attributes shall be multiplied by a fraction, the numerator of which is the number of months within the taxable year that the transferee held the acquired corporation and the denominator of which is the number of months in such taxable year. In order for the transferee to assert ownership of a subsidiary for a given month, the transferee and the acquired corporation must be affiliated corporations as of the last day of the month. In addition, the transferor and the transferee shall take account of the month-end debt level of the transferred corporation only for those months at the end of which the transferred corporation was a member of the transferor's or the transferee's respective affiliated group.
(iii) Aggregation of transition attributes. The transition attributes of the acquired corporation shall be aggregated with the respective amounts of the transferee group.
(iv) Conveyance of transferor paydowns. The total paydowns of the transferee group shall include the amount of any paydown of the transferor group that was attributed to the acquired corporation under the rules of paragraph (h)(1) of this section.
(v) Effect of certain elections. If an election--
(A) Is made under section 338(g) (whether or not an election under 338(h)(10) is made),
(B) Is deemed to be made under section 338(e) (other than (e)(2)), or section 338(f), or,
(C) Is made under section 336(e), no indebtedness of the acquired corporation shall qualify for transition relief for the year such election first becomes effective and for subsequent taxable years, and no other transition attributes of the acquired corporation shall be taken into account by the transferee group.
(2) Effect on transferor--(i) General rule. Except as provided in paragraph (g)(2)(ii) of this section, in the case of an acquisition of a member of an affiliated group by a nonmember of the group, the transferor shall not take into account the transition attributes of the acquired corporation in computing the transition relief of the transferor group in subsequent taxable years. Thus, the November 16, 1985 amount, the unreduced five-year and four-year debt amounts, and the end-of-month debt levels of the transferor group shall be computed without regard to the acquired corporation's respective amounts for purposes of computing transition relief of the tranferor group for years thereafter.
(i) General rule. Except as provided in paragraph (g)(2)(ii) of this section, in the case of an acquisition of a member of an affiliated group by a nonmember of the group, the transferor shall not take into account the transition attributes of the acquired corporation in computing the transition relief of the transferor group in subsequent taxable years. Thus, the November 16, 1985 amount, the unreduced five-year and four-year debt amounts, and the end-of-month debt levels of the transferor group shall be computed without regard to the acquired corporation's respective amounts for purposes of computing transition relief of the tranferor group for years thereafter.
(ii) Special rule for the year of disposition. To compute the amount of the transition attributes described in paragraph (g)(2)(i) of this section that a transferor shall take into account in the transferor's taxable year of the disposition, such transition attributes shall be multiplied by a fraction, the numerator of which is the number of months within the taxable year that the transferor held the acquired corporation and the denominator of which is the number of months in such taxable year. In order for the transferor to assert ownership of a subsidiary for a given month, the transferor and the acquired corporation must be affiliated corporations as of the last day of the month.
(iii) Effect of prior paydowns. Any paydowns of the acquired corporation that are considered to reduce the debt of other members of the transferor group under the rules of paragraph (h)(1) of this section (whether incurred in a prior taxable year or in that portion of a year of disposition that is taken into account by the transferor) shall continue to be taken into account by the transferor group after the disposition.
(3) Special rule for assumptions of indebtedness. In connection with the transfer of a corporation, if the indebtedness of an acquired corporation is assumed by any party other than the transferee or another member of the transferee's affiliated group, the transition attributes of the acquired corporation shall not be taken into account in computing the transition relief of the transferee group. See paragraph (g)(2) of this section concerning the treatment of the transferor group. Also in connection with the transfer of a corporation, if the transferee or another member of the transferee's affiliated group assumes the indebtedness of an acquired corporation, such assumed indebtedness shall only qualify for transition relief during the period in which the acquired corporation remains a member of the transferee group. Further, if the transferee group subsequently disposes of the acquired corporation, the indebtedness of the acquired corporation will continue to qualify for transition relief only if the indebtedness is assumed by the new purchaser as of the time such corporation is acquired.
(4) Effect of asset sales. If substantially all of the assets of a corporation are sold, the indebtedness of such corporation shall cease to be qualified for transition relief. Thus, the transition attributes of such corporation shall not be taken into account in computing transition relief.
(h) Rules for attributing paydowns among separate companies--(1) General rule. In the case of a corporate transfer under paragraph (g) of this section, it is necessary to determine the amount of paydowns attributable to the acquired corporation. Under paragraph (c)(7) of this section, paydowns are deemed to reduce first the five-year phase-in amount, then the four-year phase-in amount, and then the general phase-in amount. Thus, for example, a reduction in indebtedness of the group caused by a reduction in the debt of a group member that has no five-year debt will nevertheless be deemed under this ordering rule to reduce the indebtedness of those group members that do have five-year debt. In order to preserve the effect of paydowns caused by a reduction, each member must determine on a separate company basis at the time of any transfer of any member of the affiliated group the impact of paydowns (including those paydowns occurring in the year of transfer prior to the time of the transfer) on the various categories of indebtedness.
(1) General rule. In the case of a corporate transfer under paragraph (g) of this section, it is necessary to determine the amount of paydowns attributable to the acquired corporation. Under paragraph (c)(7) of this section, paydowns are deemed to reduce first the five-year phase-in amount, then the four-year phase-in amount, and then the general phase-in amount. Thus, for example, a reduction in indebtedness of the group caused by a reduction in the debt of a group member that has no five-year debt will nevertheless be deemed under this ordering rule to reduce the indebtedness of those group members that do have five-year debt. In order to preserve the effect of paydowns caused by a reduction, each member must determine on a separate company basis at the time of any transfer of any member of the affiliated group the impact of paydowns (including those paydowns occurring in the year of transfer prior to the time of the transfer) on the various categories of indebtedness.
(2) Mechanics of computation. Separate company accounts of paydowns are determined by prorating any paydown among all group members with five-year debt to the extent thereof on the basis of the relative amounts of five-year debt. Paydowns in excess of five-year debt are prorated on a similar basis among all group members with four-year debt to the extent thereof on the basis of the relative amounts of four-year debt. Paydowns in excess of four-year and five-year debt are prorated among all group members with general phase-in debt to the extent thereof on the basis of the relative amounts of general phase-in debt. After an initial paydown has been prorated among the members of an affiliated group, any further reduction in the amount of aggregate month-end debt level as compared to the November 16, 1985 amount is prorated among all members of the affiliated group based on the remaining net amounts of four-year and five-year debt.
(3) Examples. The rules of paragraphs (g) and (h) of this section may be illustrated by the following examples.
(i) Facts. XYZ constitutes an affiliated group of corporations that has a calendar taxable year and the following transition attributes: ------------------------------------------------------------------------
Historic
3rd party Increase
debt------------------------------------------------------------------------Company X:
Nov. 16, 1985............................. $100,000 ...........
May 29, 1985 (5-year)..................... 80,000 $0
Dec. 31, 1983 (4-year).................... 80,000 10,000
Dec. 31, 1982............................. 70,000 ...........Company Y:
Nov. 16, 1985............................. 200,000 ...........
May 29, 1985 (5-year)..................... 170,000 120,000
Dec. 31, 1983 (4-year).................... 50,000 10,000
Dec. 31, 1982............................. 40,000 ...........Company Z:
Nov. 16, 1985............................. 300,000 ...........
May 29, 1985 (5-year)..................... 290,000 40,000
Dec. 31, 1983 (4-year).................... 250,000 100,000
Dec. 31, 1982............................. 150,000 ...........------------------------------------------------------------------------ In 1986, the XYZ group attained its lowest historic month-end debt level of $500,000. Because the November 16, 1985 amount is $600,000 the XYZ group therefore has a paydown in the amount of $100,000. This paydown partially offsets the $160,000 of five-year debt in the XYZ group.
(ii) Analysis. Applying the rule of paragraph (h)(1) of this section, separate company accounts of paydowns are computed by prorating the $100,000 paydown among those members of the group that have five-year debt. Accordingly, the paydown is prorated between Y and Z as follows:
To Y:
[GRAPHIC] [TIFF OMITTED] TC07OC91.016
To Z:
[GRAPHIC] [TIFF OMITTED] TC07OC91.017
(i) Facts. The facts are the same as in example 1. On July 15, 1987, the XYZ group sells all the stock of Y to A. Having held the stock of Y for six months in 1987, the XZ group computes its transition relief for that year taking into account half of the transition attributes of Y. AY constitutes an affiliated group of corporations after the acquisition. Having held the stock of Y for six months in 1987, the AY group computes its transition relief for that year taking into account half of the transition attributes of Y. In 1987, the AY group attained a new lowest month-end debt level that yields an average lowest month-end debt level for 1987 of $150,000.
(ii) Transferee group. The following analysis applies in determining transition relief for purposes of apportioning the interest expense of the transferee group for 1987. The AY group has the following transition attributes for 1987: ------------------------------------------------------------------------
Historic
3rd party Increase
debt------------------------------------------------------------------------Company A:
Nov. 16, 1985............................. $100,000 ...........
May 29, 1985 (5-year)..................... 250,000 $5,000
Dec. 31, 1983 (4-year).................... 245,000 10,000
Dec. 31, 1982............................. 235,000 ...........Company Y (half-year amounts):
Nov. 16, 1985............................. 100,000 ...........
May 29, 1985 (5-year)..................... 85,000 60,000
Dec. 31, 1983 (4-year).................... 25,000 5,000
Dec. 31, 1982............................. 20,000 ...........
Pre-acquisition year paydown by another 37,500 ...........
member of the transferor group that
reduced Y's five-year debt (one half of
$75,000).................................------------------------------------------------------------------------ Because the November 16, 1985 amount of the AY group in 1987 is $200,000 and because the 1987 average of historic month-end debt levels was $150,000, the AY group has a paydown in the amount of $50,000. In addition, the 1986 paydown by the XYZ group that was deemed to reduce Y debt is added to the paydown computed above, yielding a total paydown of $87,500. This amount is prorated between members, eliminating the four and five year debt of the AY group. Note that Y is only a member of the AY group for half of the 1987 taxable year. In 1988, Y's entire transition indebtedness and a $75,000 paydown must be taken into account in computing the amount of interest expense eligible for transition relief.
(iii) Transferor group. The following analysis applies in determining transition relief for purposes of apportioning the interest expense of the transferor group for 1987. The XZ group has the transition attributes stated below for 1987. In 1987, the XZ group attained a new lowest month-end debt level that yields an average lowest month-end debt level for 1987 of $250,000. ------------------------------------------------------------------------
Historic
3rd party Increase
debt------------------------------------------------------------------------Company X:
Nov. 16, 1985............................. $100,000 ...........
May 29, 1985 (5-year)..................... 80,000 $0
Dec. 31, 1983 (4-year).................... 80,000 10,000
Dec. 31, 1982............................. 70,000 ...........
Pre-disposition paydown that reduced X's 0 ...........
debt.....................................Company Y (half-year amounts):
Nov. 16, 1985............................. 100,000 ...........
May 29, 1985 (5-year)..................... 85,000 60,000
Dec. 31, 1983 (4-year).................... 25,000 5,000
Dec. 31, 1982............................. 20,000 ...........
Pre-disposition paydown that reduced Y's 37,500 ...........
debt.....................................Company Z:
Nov. 16, 1985............................. 300,000 ...........
May 29, 1985 (5-year)..................... 290,000 40,000
Dec. 31, 1983 (4-year).................... 250,000 100,000
Dec. 31, 1982............................. 150,000 ...........
Pre-disposition paydown that reduced Z's 25,000 ...........
debt.....................................------------------------------------------------------------------------ Because the revised November 16, 1985 amount of the XZ group is $500,000 and because the 1987 average of lowest historic month-end debt levels of the XZ group was $250,000, the XZ group has a paydown in the amount of $250,000. This paydown offsets the total five and four year debt of the XZ group. Had the 1987 paydown of the XZ group been an amount less than the five-year amount, the paydown would have been prorated based on Y's adjusted 5-year amount of $22,500 and Z's adjusted 5-year amount of $15,000. [T.D. 8257, 54 FR 31820, Aug. 2, 1989]