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 ------------------------------------------------------------------------                                        Classification of earnings and                                        profits for purposes of section                Year                                  959                                     -----------------------------------                                        (c)(1)      (c)(2)      (c)(3)------------------------------------------------------------------------1963................................        $100  ..........  ..........1964................................         100         $75  ..........1965................................  ..........          75         $501966................................  ..........  ..........          50------------------------------------------------------------------------
  (b) During 1966, M Corporation makes three separate distributions to A of $150 each, and the source of such distributions under section 959(c) is as follows:
 ------------------------------------------------------------------------                                                           Allocation of                                                           distributions                                         Amount     Year   under section                                                                959------------------------------------------------------------------------Distribution No. 1...................       $100     1964        (c)(1)                                              50     1963        (c)(1)                                      -----------                                             150                                      ===========Distribution No. 2...................         50     1963        (c)(1)                                              75     1965        (c)(2)                                              25     1964        (c)(2)                                      -----------                                             150                                      ===========Distribution No. 3...................         50     1964        (c)(2)                                              50     1966        (c)(3)                                              50     1965        (c)(3)                                      -----------                                             150  .......  .............------------------------------------------------------------------------
  (c) If, in addition to the above facts—

(1) M Corporation owns throughout the period here involved 100 percent of the only class of stock of N Corporation, a controlled foreign corporation which uses the calendar year as a taxable year,

(2) Corporation N derives $60 of subpart F income for 1963 which A includes in his gross income for such year under section 951(a)(1)(A)(i),

(3) Corporation N has earnings and profits for 1963 of $60 but has neither earnings or profits nor a deficit in earnings and profits for 1964, 1965, or 1966, and

(4) During 1966, N Corporation invests $20 in tangible property (not described in section 956(b)(2)) located in the United States and distributes $45 to M Corporation,

the $20 investment of earnings in United States property is excludable from A's gross income for 1966, under section 959(a)(2) and paragraph (c) of §1.959–1, with respect to N Corporation and the $45 dividend received by M Corporation does not, under section 959(b) and §1.959–2, constitute gross income of M Corporation for 1966 for purposes of determining amounts includible in A's gross income under section 951(a)(1)(A)(i) with respect to M Corporation. However, the $45 dividend paid by N Corporation to M Corporation is allocated under section 959(c) and this paragraph to the earnings and profits of N Corporation as follows: $20 to 1963 earnings described in section 959(c)(1) and $25 to 1963 earnings described in section 959(c)(2). In such case, M Corporation's earnings and profits of $495 (before taking into account distributions made in 1966) would be classified as follows for purposes of section 959(c):

 ------------------------------------------------------------------------                                        Classification of earnings and                                        profits for purposes of section                Year                                  959                                     -----------------------------------                                        (c)(1)      (c)(2)      (c)(3)------------------------------------------------------------------------1963................................        $120         $25  ..........1964................................         100          75  ..........1965................................  ..........          75         $501966................................  ..........  ..........          50------------------------------------------------------------------------
  (d) The three distributions to A in 1966 of $150 each would then have the following source under section 959(c):
 ------------------------------------------------------------------------                                                           Allocation of                                                           distributions                                         Amount     Year   under section                                                                959------------------------------------------------------------------------Distribution No. 1...................       $100     1964        (c)(1)                                              50     1963        (c)(1)                                      -----------                                             150  .......  .............                                      ===========Distribution No. 2...................         70     1963        (c)(1)                                              75     1965        (c)(2)                                               5     1964        (c)(2)                                      -----------                                             150  .......  .............                                      ===========Distribution No. 3...................         70     1964        (c)(2)                                              25     1963        (c)(2)                                              50     1966        (c)(3)                                               5     1965        (c)(3)                                       -----------                                             150  .......  .............------------------------------------------------------------------------

(c) Treatment of deficits in earnings and profits. For purposes of this section, a United States shareholder's pro rata share (determined in accordance with the principles of paragraph (e) of §1.951–1) of a foreign corporation's deficit in earnings and profits, determined under section 964(a) and §1.964–1, for any taxable year shall be applied only to earnings and profits described in paragraph (b)(3) of this section.

(d) Treatment of certain foreign taxes. For purposes of this section, any amount described in subparagraph (1), (2), or (3) of paragraph (b) of this section which is distributed by a foreign corporation through a chain of ownership described in section 958(a)(2) shall be reduced by any income, war profits, or excess profits taxes imposed on or with respect to such distribution by any foreign country or possession of the United States.

Example.  (a) Domestic corporation M owns 100 percent of the only class of stock of foreign corporation A, which is incorporated under the laws of foreign country X and which, in turn, owns 100 percent of the only class of stock of foreign corporation B, which is incorporated under the laws of foreign country Y. All corporations use the calendar year as a taxable year and corporations A and B are controlled foreign corporations throughout the period here involved.

(b) During 1963, B Corporation (a less developed country corporation for 1963 within the meaning of §1.955–5) derives $90 of subpart F income, after incurring $10 of foreign income tax allocable to such income under paragraph (c) of §1.954–1, has earnings and profits in excess of $90, and makes no distributions. Corporation M must include $90 in its gross income for 1963 under section 951(a)(1)(A)(i). As of December 31, 1963, with respect to M Corporation, B Corporation has earnings and profits for 1963 described in section 959(c)(2) of $90.

(c) During 1964, B Corporation has neither earnings and profits nor a deficit in earnings and profits but distributes $90 to A Corporation, and, by reason of section 959(b) and §1.959–2, such amount is not includible in the gross income of M Corporation for 1964 under section 951(a) with respect to A Corporation. Corporation A incurs a withholding tax of $13.50 on the $90 dividend distributed from B Corporation (15 percent of $90) and an additional foreign income tax of 10 percent or $7.65 by reason of the inclusion of the net distribution of $76.50 ($90 minus $13.50) in its taxable income for 1964. As of December 31, 1964, with respect to M Corporation, B Corporation's earnings and profits for 1963 described in section 959(c)(2) amount to zero ($90 minus $90); and A Corporation's earnings and profits for 1963 described in section 959(c)(2) amount to $68.85 ($90 minus $13.50 minus $7.65).

(e) Determination of foreign tax credit. For purposes of applying section 902 and section 960 in determining the foreign tax credit allowable under section 901 in a case in which distributions are made by a second-tier corporation or a first-tier corporation, as the case may be, from its earnings and profits for a taxable year which are attributable to an amount included in the gross income of a U.S. shareholder under section 951(a) or which are attributable to amounts excluded from the gross income of such foreign corporation under section 959(b) and §1.959–2 with respect to a U.S. shareholder, the rules of paragraph (b) of this section shall apply except that in applying subparagraph (1) or (2) of such paragraph—

(1) Distributions from the earnings and profits for such taxable year of the second-tier corporation shall be considered first attributable to its earnings and profits attributable to distributions from the earnings and profits of the foreign corporation, if any, next lower in the chain of ownership described in section 958(a), to the extent of such earnings and profits of the second-tier corporation, and then to the other earnings and profits of such second-tier corporation, and

(2) Distributions from the earnings and profits for such taxable year of the first-tier corporation shall be considered first attributable to its earnings and profits attributable to distributions from the earnings and profits of the second-tier corporation, to the extent of such earnings and profits of the first-tier corporation, and then to the other earnings and profits of such first-tier corporation. For purposes of this paragraph, a second-tier corporation is a foreign corporation referred to in section 960(a)(1)(B), and a first-tier corporation is a foreign corporation referred to in section 960 (a)(1)(A). The application of this paragraph may be illustrated by the following examples:

Example 1.  (a) Domestic corporation A, a United States shareholder, owns 100 percent of the only class of stock of foreign corporation R which, in turn, owns 100 percent of the only class of stock of foreign corporation S. All corporations use the calendar year as a taxable year, and corporations R and S are controlled foreign corporations throughout the period here involved.

(b) Neither R Corporation nor S Corporation has subpart F income for 1963. During 1963, S Corporation increases by $100 its investment in tangible property (not described in section 956(b)(2)) located in the United States, makes no distributions, and has earnings and profits of $100. Corporation A must include $100 in its gross income for 1963 under section 951(a)(1)(B) with respect to S Corporation. During 1963, R Corporation also increases by $100 its investment in tangible property (not described in section 956(b)(2)) located in the United States, makes no distributions, and has earnings and profits of $100. Corporation A must include $100 in its gross income for 1963 under section 951(a)(1)(B) with respect to R Corporation.

(c) During 1964, S Corporation distributes $100 to R Corporation, and R Corporation distributes $100 to A Corporation. Neither corporation has any earnings or profits or deficit in earnings and profits for such year. On December 31, 1964, R Corporation has earnings and profits (computed before distributions to A Corporation made for the year) of $200, consisting of $100 of section 959(c)(1) amounts of R Corporation for 1963 and of $100 of section 959(c)(1) amounts of S Corporation for 1963. For purposes of determining the foreign tax credit under section 960 and the regulations thereunder, the $100 distribution by R Corporation shall be considered attributable to S Corporation's earnings and profits for 1963 described in section 959(c)(1).

Example 2.  (a) Domestic corporation A, a United States shareholder, owns 100 percent of the only class of stock of foreign corporation T which, in turn, owns 100 percent of the only class of stock of foreign corporation U. All corporations use the calendar year as a taxable year, and corporations T and U are controlled foreign corporations throughout the period here involved.

(b) During 1964, T Corporation invests $100 in tangible property (not described in section 956(b)(2)) located in the United States. For 1964, T Corporation has no subpart F income and makes no distributions; A must include $100 in its gross income for 1964 under section 951(a)(1)(B) with respect to T Corporation. For 1964, U Corporation has no subpart F income or investment of earnings in United States property but U Corporation has $100 of earnings and profits which it distributes to T Corporation. At December 31, 1964, T Corporation has earnings and profits of $300, consisting of operating income of $100 for each of the years 1963 and 1964 and $100 in dividends received from the earnings and profits of U Corporation for 1964. These earnings and profits are classified as follows under section 959(c): $100 of section 959(c)(1) amounts of T Corporation for 1964, $100 of section 959(c)(3) amounts of U Corporation for 1964, and $100 of section 959(c)(3) amounts of T Corporation for 1963.

(c) During 1965 neither T Corporation nor U Corporation has any earnings and profits or deficit in earnings and profits or investment of earnings in U.S. property, but T Corporation distributes $100 to A Corporation. For purposes of determining the foreign tax credit under section 960 and the regulations thereunder, the $100 distribution of T Corporation shall be considered attributable to T Corporation's earnings and profits for 1964 described in section 959(c)(1).

(f) Illustration. The application of this section may be illustrated by the following example:

Example.  (a) M, a controlled foreign corporation is organized on January 1, 1963, and is wholly owned by A, a United States shareholder. Both A and Corporation M use the calendar year as a taxable year.

(b) Corporation M's earnings and profits (before distributions) for 1963 are $200, $100, of which is attributable to subpart F income. Corporation M's earnings and profits for such year also include $25 attributable to subpart F income which is excluded from M Corporation's foreign base company income under section 954(b)(1) as dividends, interest, and gains invested in qualified investments in less developed countries. Corporation M's increase in earnings invested in tangible property (not described in section 956(b)(2)) located in the United States for 1963, is $50, and M Corporation makes a distribution of such property during such year of $20. For purposes of section 959, A's interest in M Corporation's earnings and profits as of December 31, 1963, determined after the distributions of $20, is classified as follows:

   Section 959(c)(1) amounts:  Earnings for 1963 attributable to increased      $50   investment in U.S. property which would   have been included in A's gross income but   for application of section 959(a)(2) and   § 1.959-1(c).........................  Less: Distribution for 1963 allocated under       20      $30   section 959(c)(1) and paragraph (b)(1) of   this section to such amounts..............                                              ---------Section 959(c)(2) amounts:  Earnings for 1963 attributable to subpart F      100   income included in A's gross income under   section 951(a)(1)(A)(i)...................  Less: Earnings for 1963 attributable to           50       50   increased investment in U.S. property   which would have been included in A's   gross income but for application of   section 959(a)(2) and § 1.959-1(c)...                                              ---------Section 959(c)(3) amounts:  Predistribution earnings for 1963..........      200  Less: Earnings for 1963 classified as:    Section 959(c)(1) amounts................      $50    Section 959(c)(2) amounts................       50      100      100                                              --------------------------A's total interest in M Corporation's          .......  .......      180 earnings and profits........................------------------------------------------------------------------------ 

For 1963, A is required to include $100 of subpart F income in his gross income under section 951(a)(1)(A)(i). He would have been required to include $50 in his gross income under section 951(a)(1)(B) as M Corporation's increase in earnings invested in United States property, except that section 959(a)(2) and paragraph (c) of §1.959–1 provide in effect that earnings and profits taxed to A under section 951(a)(1)(A) with respect to M Corporation (whether in the current taxable year or in prior years) may be invested in United States property without again being included in gross income under section 951(a). The $20 dividend from M Corporation is excluded from A's gross income under section 959(a)(1) and paragraph (b) of §1.959–1, since such distribution is allocated under section 959(c)(1) and paragraph (b)(1) of this section to amounts described in section 959(c)(1).

  (c) During 1964, M Corporation's earnings and profits (before distributions) are $300, $75 of which is attributable to subpart F income. Corporation M has no change in investments in United States property during such year and withdraws $15 of previously excluded subpart F income from investment in less developed countries. Corporation M makes a cash distribution of $250 to A during 1964. For purposes of section 959, A's interest in M Corporation's earnings and profits as of December 31, 1964, determined after the distribution of $250, is classified as follows:
   Section 959 (c)(1) amounts:  Section 959(c)(1) net amount for        $30   1963 (as determined under   paragraph (b) of this example)...  Less: Distribution for 1964              30   allocated under section 959(c)(1)   and paragraph (b)(1) of this   section to such amount...........                                     =========Section 959(c)(2) amounts:  Section 959(c)(2) net amount for         50   1963 (as determined under   paragraph (b) of this example)...  Plus: Earnings for 1964   attributable to:    Subpart F income for 1964              75     included in A's gross income     under section 951(a)(1)(A)(i)..    Previously excluded subpart F          15     income withdrawn in 1964 from     investment in less developed     countries and included in A's     gross income under section     951(a)(1)(A)(ii)...............                                     ---------                                          140  Less: Distribution for 1964             140   allocated under section 959(c)(2)   and paragraph (b)(2) of this   section to such amounts..........                                     =========Section 959(c)(3) amounts:  Section 959(c)(3) net amount for        100   1963 (as determined under   paragraph (b) of this example)...  Plus: Section 959(c)(3) net amount   for 1964:    Predistribution earnings for      .......     $300     1964...........................    Less:      Earnings for 1964 classified        $90       as section 959(c)(1) amounts       ($0) and as section 959(c)(2)       amounts ($75+$15)............      Distributions for 1964               80      170      130     $230       allocated under section       959(c)(3) and paragraph       (b)(3) of this section.......                                     -----------------------------------A's total interest in M               .......  .......  .......      230 Corporation's earnings and profits.------------------------------------------------------------------------ 

For 1964, A is required to include in his gross income under section 951(a)(1)(A)(i) $75 of subpart F income, and under section 951 (a)(1)(A)(ii) $15 of previously excluded subpart F income withdrawn from investment in less developed countries. Of the $250 cash distribution, A may exclude $170 from his gross income under section 959(a)(1) and paragraph (b) of §1.959–1 and $80 is includible in his gross income as a dividend.

  (d) The source under section 959(c) of the 1964 distribution of $250 to A is as follows:
 ------------------------------------------------------------------------                                                           Allocation of                                                           distribution                  Year                        Amount       under section                                                                959------------------------------------------------------------------------1963....................................             $30         (c)(1).1964....................................              90         (c)(2).1963....................................              50         (c)(2).1964....................................              80         (c)(3).                                         ----------------                                                     250  ..............------------------------------------------------------------------------

[T.D. 6795, 30 FR 945, Jan. 29, 1965, as amended by T.D. 7334, 39 FR 44211, Dec. 23, 1974; T. D. 7545, 43 FR 19652, May 8, 1978; T.D. 7893, 48 FR 22510, May 19, 1983]

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