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domestic shareholder for the year as a dividend under section 78. Amounts included in gross income under section 78 shall, for purposes of section 904, be deemed to be derived from sources within the United States to the extent the earnings and profits on which the taxes were paid are treated under section 904(g) as United States source earnings and profits. Section 1.9045(m)(6). Amounts included in gross income under section 78 shall be treated for purposes of section 904 as income in a separate category to the extent that the foreign income taxes were allocated and apportioned to income in that separate category. See section 904(d)(3)(G) and §1.904-6(b)(3).

(ii) Foreign income taxes deemed paid by an upper-tier corporation. Foreign income taxes deemed paid by an uppertier corporation on a distribution from a lower-tier corporation are not included in the earnings and profits of the upper-tier corporation. For purposes of section 904, foreign income taxes shall be allocated and apportioned to income in a separate category to the extent those taxes were allocated to the earnings and profits of the lower-tier corporation in that separate category. See section 904(d)(3)(G) and $1.904-6(b)(3). To the extent that section 904(g) treats the earnings of the lower-tier corporation on which those foreign income taxes were paid as United States source earnings and profits, the foreign income taxes deemed paid by the upper-tier corporation on the distribution from the lower-tier corporation shall be treated as attributable to United States source earnings and profits. See section 904(g) and §1.904-5(m)(6).

(iii) Example. The following example illustrates the rules of this paragraph (c)(2):

Example. P, a domestic corporation, owns 100 percent of the voting stock of controlled foreign corporation S. Corporations P and S use the calendar year as their taxable year, and S uses the u as its functional currency. Assume that lu equals $1 at all relevant times. As of January 1, 1992, S has -0- post1986 undistributed earnings and 0 post-1986 foreign income taxes. In 1992, S earns 150u of non-subpart F general limitation income net of foreign taxes and pays 60u of foreign income taxes. As of the end of 1992, but before dividend payments, S has 150u of post-1986

undistributed earnings and $60 of post-1986 foreign income taxes. Assume that 50u of S's earnings for 1992 are from United States sources. S pays P a dividend of 75u which P receives in 1992. Under $1.904-5(m)(4), onethird of the dividend, or 25u (75u×50u/150u), is United States source income to P. P computes foreign taxes deemed paid on the dividend under paragraph (b)(1) of this section of $30 ($60×50%[75u/150u]) and includes that amount in gross income under section 78 as a dividend. Because 25u of the 75u dividend is United States source income to P, $10 ($30×33.33% 25u/75u]) of the section 78 dividend will be treated as United States source income to P under this paragraph (c)(2).

(3) Creditable foreign income taxes. The amount of creditable foreign income taxes under section 901 shall include, subject to the limitations and conditions of sections 902 and 904, foreign income taxes actually paid and deemed paid by a domestic shareholder that receives a dividend from a first-tier corporation. Foreign income taxes deemed paid by a domestic shareholder under paragraph (b) of this section shall be deemed paid by the domestic shareholder only for purposes of computing the foreign tax credit allowed under section 901.

(4) Foreign mineral income. Certain foreign income, war profits and excess profits taxes paid or accrued with respect to foreign mineral income will not be considered foreign income taxes for purposes of section 902. See section 901(e) and § 1.901-3.

(5) Foreign taxes paid or accrued in connection with the purchase or sale of certain oil and gas. Certain income, war profits, or excess profits taxes paid or accrued to a foreign country in connection with the purchase and sale of oil or gas extracted in that country will not be considered foreign income taxes for purposes of section 902. See section 901(f).

(6) Foreign oil and gas extraction income. For rules relating to reduction of the amount of foreign income taxes deemed paid with respect to foreign oil and gas extraction income, see section 907(a) and the regulations under that section.

(7) United States shareholders of controlled foreign corporations. See paragraph (d) of this section and sections 960 and 962 and the regulations under those sections for special rules relating to the application of section 902 in

computing

foreign income taxes deemed paid by United States shareholders of controlled foreign corporations.

(8) Credit for foreign taxes deemed paid in a section 304 transaction. [Reserved].

(9) Effect of section 482 adjustments on post-1986 foreign income taxes and post1986 undistributed earnings. [Reserved].

(d) Dividends from controlled foreign corporations (1) General rule. Except as provided in paragraph (d)(3) of this section, if a dividend is received by a domestic shareholder that is a United States shareholder (as defined in section 951(b) or section 953(c)(1)(A)) from a first-tier corporation that is a controlled foreign corporation (as defined in section 957(a) or section 953(c)(1)(B)), or by an upper-tier corporation from a lower-tier corporation if the corporations are related look-through entities within the meaning of §1.904-5(i), the following rule applies. If a dividend is paid out of post-1986 undistributed earnings or pre-1987 accumulated profits of the upper- or lower-tier controlled foreign corporation attributable to more than one separate category under section 904(d), the amount

of foreign income taxes deemed paid by the domestic shareholder or the uppertier corporation under section 902 and paragraph (b) of this section shall be computed separately with respect to the post-1986 undistributed earnings or pre-1987 accumulated profits in each separate category out of which the dividend is paid. See §1.904-5(c)(4) and paragraph (d)(2) of this section. The separately computed deemed paid taxes shall be added to other taxes paid by the U.S. shareholder or upper-tier corporation with respect to income in the appropriate separate category.

(2) Look-through-(i) Dividends. Except as otherwise provided in paragraph (d)(3) of this section, any dividend distribution out of post-1986 undistributed earnings of a look-through entity to a related look-through entity shall be deemed to be paid pro rata out of each separate category of income. See §§1.904-5(c)(4) and 1.904-7. The portion of the foreign income taxes attributable to a particular separate category that shall be deemed paid by the domestic shareholder or upper-tier corporation must be computed under the following formula:

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(e) Information to be furnished. If the credit for foreign income taxes claimed under section 901 includes foreign income taxes deemed paid under section 902 and paragraph (b) of this section, the domestic shareholder must furnish the same information with respect to the foreign income taxes deemed paid as it is required to furnish with respect to the foreign income taxes it directly paid or accrued and for which the credit is claimed. See §1.905-2. For other information required to be furnished by the domestic shareholder for the annual accounting period of certain foreign corporations ending with or within the shareholder's taxable year, and for reduction in the amount of foreign income taxes paid, accrued, or deemed paid for failure to furnish the required information, see section 6038 and the regulations under that section.

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

Example 1. Since 1987, domestic corporation M has owned 10 percent of the one class of stock of foreign corporation A. The remaining 90 percent of Corporation A's stock is owned by Z, a foreign corporation. Corpora

tion A is not a controlled foreign corporation. Corporation A uses the u as its functional currency, and lu equals $1 at all relevant times. Both Corporation A and Corporation M use the calendar year as the taxable year. In 1992, Corporation A pays a 30u dividend out of post-1986 undistributed earnings, 3u to Corporation M and 27u to Corporation Z. Corporation M is deemed, under paragraph (b) of this section. to have paid a portion of the post-1986 foreign income taxes paid by Corporation A and includes the amount of foreign taxes deemed paid in gross income under section 78 as a dividend. Both the foreign taxes deemed paid and the dividend would be subject to a separate limitation for dividends from Corporation A, a noncontrolled section 902 corporation. Under paragraph (a)(9)i) of this section. Corporation A must reduce its post-1986 undistributed earnings as of January 1, 1993, by the total amount of dividends paid to Corporation M and Corporation Z in 1992. Under paragraph (a)(8)(i) of this section, Corporation A must reduce its post-1986 foreign income taxes as of January 1, 1993, by the amount of foreign income taxes that were deemed paid by Corporation M and by the amount of foreign income taxes that would have been deemed paid by Corporation Z had Corporation Z been eligible to compute an amount of foreign income taxes deemed paid with respect to the dividend received from Corporation A. Foreign income taxes deemed paid by Corporation M and Corporation A's opening balances in post-1986 undistributed earnings and post-1986 foreign income taxes for 1993 are computed as follows:

1. Assumed post-1986 undistributed earnings of Corporation A at start 25u of 1992.

2. Assumed post-1986 foreign income taxes of Corporation A at start of $25 1992.

3. Assumed pre-tax earnings and profits of Corporation A for 1992

50u 4. Assumed foreign income taxes paid or accrued by Corporation A in 15u 1992.

5. Post-1986 undistributed earnings in Corporation A for 1992 (pre-divi- 60u dend) (Line 1 plus Line 3 minus Line 4).

6. Post-1986 foreign income taxes in Corporation A for 1992 (pre-divi- $40 dend) (Line 2 plus Line 4 translated at the appropriate exchange rates).

7. Dividends paid out of post-1986 undistributed earnings of Corpora- 3u tion A to Corporation M in 1992.

8. Percentage of Corporation A's post-1986 undistributed earnings paid 5% to Corporation M (Line 7 divided by Line 5).

9. Foreign income taxes of Corporation A deemed paid by Corporation $2 M under section 902(a) (Line 6 multiplied by Line 8).

10. Total dividends paid out of post-1986 undistributed earnings of Cor- 30u poration A to all shareholders in 1992.

11. Percentage of Corporation A's post-1986 undistributed earnings 50% paid to all shareholders in 1992 (Line 10 divided by Line 5).

12. Post-1986 foreign income taxes paid with respect to post-1986 undis- $20 tributed earnings distributed to all shareholders in 1992 (Line 6 multiplied by Line 11).

13. Corporation A's post-1986 undistributed earnings at the start of 30u 1993 (Line 5 minus Line 10).

14. Corporation A's post-1986 foreign income taxes at the start of 1993 $20 (Line 6 minus Line 12).

Example 2. (i) The facts are the same as in Example 1, except that Corporation M has also owned 10 percent of the one class of stock of foreign corporation B since 1987. Corporation B uses the calendar year as the taxable year. The remaining 90 percent of Corporation B's stock is owned by Corporation Z. Corporation B is not a controlled foreign corporation. Corporation B uses the u as its functional currency, and lu equals $1 at all relevant times. In 1992, Corporation B has earnings and profits and pays foreign income taxes, a portion of which are attributable to high withholding tax interest, as defined in section 904(d)(2)(B)(i). Corporation B must reduce its pool of post-1986 foreign income taxes by the amount of tax imposed on high

withholding tax interest in excess of 5 percent because that amount is not treated as a tax for purposes of section 902. See section 904(d)(2)(E)(ii) and paragraph (a)(8)(iii) of this section. Corporation B pays 50u in dividends in 1992, 5u to Corporation M and 45u to Corporation Z. Corporation M must compute its section 902(a) deemed paid taxes separately for the dividends it receives in 1992 from Corporation A (as computed in Example 1) and from Corporation B. Foreign income taxes of Corporation B deemed paid by Corporation M. and Corporation B's opening balances in post-1986 undistributed earnings and post1986 foreign income taxes for 1993 are computed as follows:

1. Assumed post-1986 undistributed earnings of Corporation B at start (100u) of 1992.

2. Assumed post-1986 foreign income taxes of Corporation B at start of $0 1992.

3. Assumed pre-tax earnings and profits of Corporation B for 1992 (in- 302.50u cluding 50u of high withholding tax interest on which 5u of tax is withheld).

4. Assumed foreign income taxes paid or accrued by Corporation B in 102.50u 1992.

5. Post-1986 undistributed earnings in Corporation B for 1992 (pre-divi- 100u
dend) (Line 1 plus Line 3 minus Line 4).

6. Amount of foreign income tax of Corporation B imposed on high 2.50u
withholding tax interest in excess of 5% (5u withholding tax-
[5%×50u high withholding tax interest]).

7. Post-1986 foreign income taxes in Corporation B for 1992 (pre-divi- $100
dend) (Line 2 plus [Line 4 minus Line 6 translated at the appropriate
exchange rate]).

8. Dividends paid out of post-1986 undistributed earnings to Corpora- 5u tion M in 1992.

9. Percentage of Corporation B's post-1986 undistributed earnings paid 5% to Corporation M (Line 8 divided by Line 5).

10. Foreign income taxes of Corporation B deemed paid by Corporation $5 M under section 902(a) (Line 7 multiplied by Line 9).

11. Total dividends paid out of post-1986 undistributed earnings of Cor- 50u poration B to all shareholders in 1992.

12. Percentage of Corporation B's post-1986 undistributed earnings 50% paid to all shareholders in 1992 (Line 11 divided by Line 5).

13. Post-1986 foreign income taxes of Corporation B paid on or with respect to post-1986 undistributed earnings distributed to all shareholders in 1992 (Line 7 multiplied by Line 12).

$50

14. Corporation B's post-1986 undistributed earnings at start of 1993 50u (Line 5 minus Line 11).

15. Corporation B's post-1986 foreign income taxes at start of 1993 $50 (Line 7 minus Line 13).

(ii) For 1992, as computed in Example 1, Corporation M is deemed to have paid $2 of the post-1986 foreign income taxes paid by Corporation A and includes $2 in gross income as a dividend under section 78. Both the income inclusion and the credit are subject to a separate limitation for dividends from Corporation A, a noncontrolled section 902 corporation. Corporation M also is deemed to have paid $5 of the post-1986 foreign income taxes paid by Corporation B and includes $5 in gross income as a deemed dividend under section 78. Both the income inclusion and the foreign taxes deemed paid are subject to a separate limitation for dividends from Corporation B, a noncontrolled section 902 corporation.

Example 3. (1) Since 1987, domestic corporation M has owned 50 percent of the one class of stock of foreign corporation A. The remaining 50 percent of Corporation A is owned by foreign corporation Z. For the same time period, Corporation A has owned 40 percent of the one class of stock of foreign corporation B, and Corporation B has owned 30 percent of the one class of stock of foreign corporation C. The remaining 60 percent of Corporation B is owned by foreign corporation Y, and the remaining 70 percent of Corporation C is owned by foreign corporation X. Corporations A, B, and C are not con

A. Corporation C (third-tier corporation):

trolled foreign corporations. Corporations A, B, and C use the u as their functional currency, and lu equals $1 at all relevant times. Corporation B uses a fiscal year ending June 30 as its taxable year; all other corporations use the calendar year as the taxable year. On February 1, 1992, Corporation C pays a 500u dividend out of post-1986 undistributed earnings, 150u to Corporation B and 350u to Corporation X. On February 15, 1992, Corporation B pays a 300u dividend out of post-1986 undistributed earnings computed as of the close of Corporation B's fiscal year ended June 30, 1992, 120u to Corporation A and 180u to Corporation Y. On August 15, 1992, Corporation A pays a 200u dividend out of post1986 undistributed earnings. 100u to Corporation M and 100u to Corporation Z. In computing foreign taxes deemed paid by Corporations B and A. section 78 does not apply and Corporations B and A thus do not have to include the foreign taxes deemed paid in earnings and profits. See paragraph (c)(2)(ii) of this section. Foreign income taxes deemed paid by Corporations B, A and M, and the foreign corporations' opening balances in post-1986 undistributed earnings and post1986 foreign income taxes for Corporation B's fiscal year beginning July 1, 1992, and Corporation C's and Corporation A's 1993 calendar years are computed as follows:

1. Assumed post-1986 undistributed earnings in Corporation C at 1300u start of 1992.

2. Assumed post-1986 foreign income taxes in Corporation C at $500 start of 1992.

3. Assumed pre-tax earnings and profits of Corporation C for 1992 4. Assumed foreign income taxes paid or accrued in 1992

500u 300u

5. Post-1986 undistributed earnings in Corporation C for 1992 (pre- 1500u dividend) (Line 1 plus Line 3 minus Line 4).

6. Post-1986 foreign income taxes in Corporation C for 1992 (pre- $800 dividend) (Line 2 plus Line 4 translated at the appropriate exchange rates).

7. Dividends paid out of post-1986 undistributed earnings of Cor- 150u poration C to Corporation B in 1992.

8. Percentage of Corporation C's post-1986 undistributed earnings 10% paid to Corporation B (Line 7 divided by Line 5).

9. Foreign income taxes of Corporation C deemed paid by Corpora- $80 tion B under section 902(b)(2) (Line 6 multiplied by Line 8).

10. Total dividends paid out of post-1986 undistributed earnings of 500u Corporation C to all shareholders in 1992.

11. Percentage of Corporation C's post-1986 undistributed earnings 33.33% paid to all shareholders in 1992 (Line 10 divided by Line 5).

12. Post-1986 foreign income taxes paid with respect to post-1986 $266.66 undistributed earnings distributed to all shareholders in 1992

(Line 6 multiplied by Line 11).

13. Post-1986 undistributed earnings in Corporation C at start of 1000u 1993 (Line 5 minus Line 10).

14. Post-1986 foreign income taxes in Corporation C at start of 1993 $533.34 (Line 6 minus Line 12).

B. Corporation B (second-tier corporation):

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