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Federal Register / Vol. 72, No. 245 / Friday, December 21, 2007 / Rules and RegulationsFOR FURTHER INFORMATION CONTACT:sroberts on PROD1PC70 with RULESJeffrey L. Parry, (202) 622–3850 (not atoll-free number).SUPPLEMENTARY INFORMATION:BackgroundSection 402 of the AJCA enacted newsection 904(g) of the Code to provide forthe recharacterization of U.S. sourceincome as foreign source income wherea taxpayer’s foreign tax credit limitationhas been reduced as a result of anoverall domestic loss. See Public Law108–357, 118 Stat. 1418 (October 22,2004), as corrected by the GulfOpportunity Zone Act of 2005, PublicLaw 109–135, 119 Stat. 2577 (December22, 2005). The primary reason forenacting these provisions was ‘‘to createparity in the treatment of overalldomestic losses and overall foreignlosses in order to prevent the doubletaxation of income.’’ H.R. Rep. No. 108–548, at 187 (June 16, 2004); see also S.Rep. No. 108–192, at 19–20 (November7, 2003).When a U.S. source loss is allocatedto reduce foreign source income, theforeign tax credit limitation is reducedfor the taxable year, which may result inexcess foreign tax credits. Any suchexcess foreign taxes may be credited, ifat all, in a subsequent (or the preceding)taxable year. In addition, U.S. sourcetaxable income in a subsequent taxableyear is not offset by the U.S. source lossallocated to foreign source income inthe prior taxable year, and U.S. tax onsuch U.S. source taxable income cannotbe offset by the foreign tax creditcarryforward. This may lead to thedouble taxation of foreign sourceincome over time. The overall domesticloss recapture provisions amend thisresult.Section 904(g)(1) generally providesthat a portion of a taxpayer’s U.S. sourceincome is recharacterized as foreignsource income in an amount equal tothe lesser of (1) the amount of theoverall domestic loss for years prior tosuch taxable year and (2) fifty percent ofthe taxpayer’s U.S. source income forsuch taxable year. Section 904(g)(2)generally defines an overall domesticloss for this purpose as any domesticloss to the extent it offsets foreignsource taxable income for the currentyear or any preceding taxable year byreason of a carryback. Section 904(g)(4)provides that the Secretary of theTreasury shall prescribe suchregulations as may be necessary tocoordinate the overall domestic lossprovisions with the overall foreign lossprovisions.Similar rules were first enacted as apart of the Tax Reform Act of 1976,Public Law 94–455, 90 Stat. 1531VerDate Aug 31 200518:20 Dec 20, 2007Jkt 214001(1976), in section 904(f) to deal withoverall foreign losses. Under the overallforeign loss provisions, a portion offoreign source taxable income earnedafter an overall foreign loss year isrecharacterized as U.S. source taxableincome for foreign tax credit purposes.Unless a taxpayer elects a higherpercentage, generally no more than 50percent of the foreign source taxableincome earned in any particular taxableyear is recharacterized as U.S. sourcetaxable income. Recapturing the overallforeign loss reduces the foreign taxcredit limitation in one or more yearsfollowing an overall foreign loss.The separate limitation lossprovisions of section 904(f)(5) wereadded by the Tax Reform Act of 1986,Public Law 99–514, 100 Stat. 2085(1986) (the 1986 Act) and amended bythe Technical and MiscellaneousRevenue Act of 1988, Public Law 100–647, 102 Stat. 3342 (1988). Otheramendments to the overall foreign lossprovisions were made by the AJCA aswell.Regulations addressing overall foreignlosses under section 904(f) werepublished in the Federal Register (52FR 31992) on August 25, 1987 (the 1987regulations) and updated by regulationspublished in the Federal Register (71FR 24516) on April 25, 2006 (the 2006regulations). Additional guidance wasprovided in Notice 89–3, 1989–1 CB623, regarding ordering rules for theallocation of net operating losses,overall foreign losses, and separatelimitation losses; the recapture ofoverall foreign losses and separatelimitation losses; and the allocation ofU.S. source losses. The section 904(f)regulations have not been amended toreflect changes to the Code since theTax Reform Act of 1976 or toincorporate the rules of Notice 89–3. See§ 601.601(d)(2)(ii)(b).These temporary regulations provideguidance needed to comply withenactment of the overall domestic lossregime, as well as provide updatedguidance with respect to overall foreignlosses and separate limitation losses.Explanation of ProvisionsI. Overall Domestic LossesThe temporary regulations includerules in §§ 1.904(g)–1T and 1.904(g)–2Twhich address the establishment,maintenance, and recapture of overalldomestic loss accounts.A. Overall Domestic Loss AccountsSection 1.904(g)–1T(b)(1) providesthat taxpayers must establish overalldomestic loss accounts for an overalldomestic loss. It further provides that aPO 00000Frm 00031Fmt 4700Sfmt 470072593separate overall domestic loss accountmust be maintained for each separatecategory of foreign source income that isoffset by a domestic loss.Section 1.904(g)–1T(b)(2) explainswhen an overall domestic loss issustained. Generally, an overalldomestic loss is treated as sustained inthe later of the taxable years in whichthe domestic loss is incurred or theforeign source income offset by thedomestic loss is earned. Accordingly, inthe case of a domestic loss that iscarried back to offset foreign sourceincome in a prior taxable year in whichthe taxpayer elects to credit foreigntaxes, the resulting overall domestic lossis treated as sustained in the taxableyear the domestic loss is incurred, notin the prior taxable year in which thedomestic loss offsets foreign sourceincome. In the case of a domestic lossthat is carried forward to offset foreignsource income in a later taxable year,however, the overall domestic loss istreated as sustained in the year in whichthe domestic loss offsets foreign sourceincome, not the earlier year in whichthe domestic loss is incurred.Accordingly, if a taxpayer incurs adomestic loss in a pre-2007 taxable year,and the loss is carried forward as partof a net operating loss and applied tooffset foreign source income in a post2006 taxable year, the resulting overalldomestic loss is treated as sustained inthe post-2006 taxable year.Section 1.904(g)–1T(c) provides thatan overall domestic loss is sustainedwhen a domestic loss offsets foreignsource taxable income in the sametaxable year or a preceding taxable yearby reason of a carryback, provided thetaxpayer has elected to take a credit forits foreign taxes in the year of the offset.A domestic loss is the amount by whichU.S. source gross income is exceeded bydeductions properly allocated andapportioned thereto. See § 1.904(g)–1T(c).Section 1.904(g)–1T(d) describesadditions to overall domestic lossaccounts. This includes any overalldomestic losses of the taxpayer, asdetermined above, as well as anyallocation from another taxpayer of anoverall domestic loss account under§ 1.1502–9T, described in Part V of thispreamble, and certain adjustments forcapital gains and losses. Section1.904(g)–1T(e) describes reductions tooverall domestic loss accounts,including reductions for recapturedamounts and any allocation to anothertaxpayer of an overall domestic lossaccount under § 1.1502–9T.E:\FR\FM\21DER1.SGM21DER1

72594Federal Register / Vol. 72, No. 245 / Friday, December 21, 2007 / Rules and RegulationsB. Recapture of Overall Domestic LossesSection 1.904(g)–2T provides thatoverall domestic losses are recapturedby treating a portion of a taxpayer’s U.S.source taxable income as foreign sourceincome. If the taxpayer has overalldomestic loss accounts attributable tomore than one separate category, therecharacterized income will be allocatedamong those categories on a pro ratabasis. The amount of U.S. sourceincome subject to recapture is the lesserof the aggregate balance in the overalldomestic loss account, or fifty percent ofthe taxpayer’s U.S. source taxableincome. Unlike the overall foreign lossrecapture provisions in section 904(f),section 904(g) does not permit ataxpayer to elect to recharacterize morethan fifty percent of its U.S. sourcetaxable income. Recapture continuesuntil the balance in the overall domesticloss account has been reduced to zero.sroberts on PROD1PC70 with RULESII. Separate Limitation LossesAs discussed below, the 1987regulations do not reflect the enactmentof the separate limitation loss provisionsof section 904(f)(5) as part of the 1986Act. These temporary regulationsinclude new provisions regarding theestablishment and recapture of separatelimitation loss accounts. Section1.904(f)–7T provides that taxpayersmust establish a separate limitation lossaccount with respect to a separatecategory to the extent a foreign sourceloss in that category offsets foreignsource income in another separatecategory. This section also providesdefinitions and rules relating to themaintenance of these accounts.Section 1.904(f)–8T provides rules forthe recapture of separate limitation lossaccounts. Separate limitation lossaccounts are recaptured byrecharacterizing a portion of the foreignsource income in the separate categorywith the loss account as income in theseparate category in which foreignsource income of a prior year was offsetto create the loss account. The amountof foreign source income subject torecharacterization is the lesser of thebalance in a separate limitation lossaccount or the amount of foreign sourceincome for the taxable year in that sameseparate category. There is no fiftypercent limitation with respect toseparate limitation loss accountrecapture. If there is more than oneseparate limitation loss account in asingle separate category and theaggregate balance in all those lossaccounts exceeds the income in theseparate category, income isrecharacterized in proportion to thebalance in each account. Recapture withVerDate Aug 31 200518:20 Dec 20, 2007Jkt 214001respect to a particular separatelimitation loss account continues untilthe balance in the separate limitationloss account has been reduced to zero.III. Overall Foreign LossThe 1987 regulations set forth rulesgoverning the determination andmaintenance of overall foreign lossaccounts, as well as the recapture ofoverall foreign losses and the allocationof net operating losses and net capitallosses. The regulations do not reflectchanges made to the overall foreign lossrules of section 904(f) as part of the 1986Act and certain subsequent changes tosection 904(f), such as the enactment inthe AJCA of section 904(f)(3)(D),addressing dispositions of stock incontrolled foreign corporations. Thesetemporary regulations update theexisting regulations to take into accountcertain changes made to the overallforeign loss rules since the 1987regulations were promulgated.Section 1.904(f)–1(a) states that the1987 regulations apply to taxpayers thatsustain overall foreign losses (as definedin paragraph (c) of that section) intaxable years beginning after December31, 1975. However, paragraph (c) of thatsection only defines overall foreignlosses for taxable years beginning afterDecember 31, 1982, and before January1, 1987.While it is beyond the scope of thisproject to undertake a full revision ofthe 1987 regulations to reflect allintervening statutory changes made tosection 904(f), the Treasury Departmentand the IRS believe that as part of thisregulations project the principles of the1987 regulations should be extended toapply to overall foreign losses sustainedin taxable years beginning afterDecember 31, 1986, modified so as totake into account statutory amendments.New § 1.904(f)–1T(a)(2) adopts such arule.The Treasury Department and the IRSbelieve the application of the fiftypercent limitation on the amount offoreign source income subject torecapture in a taxable year under theoverall foreign loss recapture provisionsalso needs to be clarified as part of thisregulations project. Section 1.904(f)–2(c)(1) provides that the amount offoreign source taxable income subject torecapture in a taxable year is the lesserof the balance in the applicable overallforeign loss account in a given separatecategory or fifty percent of thetaxpayer’s foreign source taxable incomein that same separate category. Forexample, recapture of a general categoryoverall foreign loss would be limited tothe lesser of the balance in the generalcategory overall foreign loss account orPO 00000Frm 00032Fmt 4700Sfmt 4700fifty percent of the general categorytaxable income for the taxable year.The legislative history to the 1986 Actclarifies that the fifty-percent limitationis to be applied to the full amount of thetaxpayer’s foreign source income, not ona separate-category-by-separate-categorybasis. See H.R. Conf. Rep. No. 99–841 atII–590 (1986). This clarification wasincorporated by reference into Notice89–3, paragraph 3(b), and reflected ininstructions to Form 1118 (Foreign TaxCredit—Corporations). The temporaryregulations modify the fifty-percentlimitation to reflect this clarification.Section 1.904(f)–2T(c)(1) providesthat the foreign source taxable incomesubject to recharacterization is the lesserof the aggregate amount of maximumpotential recapture in all overall foreignloss accounts or fifty percent of thetaxpayer’s total foreign source income. Ifthe aggregate amount of maximumpotential recapture in all overall foreignloss accounts exceeds fifty percent ofthe taxpayer’s total foreign sourcetaxable income, foreign source taxableincome in each separate category withan overall foreign loss account isrecharacterized in an amount equal tothe separate category’s allocable portionof the section 904(f)(1) recaptureamount. The maximum potentialrecapture from any separate category isthe lesser of the balance in the overallforeign loss account or the foreignsource taxable income for the currentyear in the same separate category.Other revisions to the 1987regulations include updating provisionsto reflect statutory and regulatorychanges affecting capital gains andlosses, in particular those provisionsthat were superseded by the regulationspromulgated under section 904(b) in TD9141 (July 20, 2004). In addition,§ 1.904(f)–3 is made obsolete by theordering rules added in § 1.904(g)–3Tand is removed accordingly.IV. Coordination of Overall ForeignLosses, Separate Limitation Losses, andOverall Domestic LossesUnder the specific grant of regulatoryauthority in section 904(g)(4), thesetemporary regulations provide orderingrules for coordinating the section 904(f)overall foreign loss and separatelimitation loss provisions and thesection 904(g) overall domestic lossprovisions.Section 1.904(g)–3T provides orderingrules for the allocation of net operatinglosses, net capital losses, U.S. sourcelosses, and separate limitation losses,and the recapture of separate limitationlosses, overall foreign losses, and overalldomestic losses. While these rulesgenerally follow the ordering rules setE:\FR\FM\21DER1.SGM21DER1

Federal Register / Vol. 72, No. 245 / Friday, December 21, 2007 / Rules and Regulationssroberts on PROD1PC70 with RULESforth in Notice 89–3, some changes wereappropriate to take into account theenactment of the overall domestic lossprovisions.A. Step One: Allocation of NetOperating Loss and Net Capital LossCarryoversThese temporary regulations generallyfollow the rules of Notice 89–3 for thecarryover and carryback of net operatinglosses. Under § 1.904(g)–3T(b)(1), netoperating losses that are carried back toa prior year are allocated to income inthe carryback year in accordance withthe allocation rules for absorbing andallocating net operating loss carryovers.However, the income against which thenet operating loss is allocated is theincome after application of the overallforeign loss, separate limitation loss andoverall domestic loss allocation andrecapture rules for the carryback year.The rules for net operating losscarryforwards vary for full and partialcarryovers of the net operating loss. Inthe case of a full net operating losscarryover, the U.S. source losses andforeign losses in separate categories thatare part of the net operating loss arecarried forward and combined with U.S.source income or loss and foreignsource income or loss in the samecategories as the respective portions ofthe net operating loss.In the case of a partial net operatingloss carryover, several steps apply. Inapplying these steps it is important todistinguish the net operating loss,which is the total net operating loss, andthe net operating loss carryover, whichis the portion of the net operating lossthat is absorbed in the carryover year.First, the U.S. source portion of the netoperating loss (but not in excess of thenet operating loss carryover) is carriedover to the extent of U.S. source incomein the carryover year. Second, theseparate limitation losses that are part ofthe net operating loss are tentativelycarried to the extent of taxable incomein the same separate category. Thisamount is tentative because the totalamount of matching net operating lossesand separate limitation income mayexceed the net operating loss carryoveramount remaining after the first step. Tothe extent the total amount of thesetentative loss carryovers is in factlimited by the amount of the remainingnet operating loss carryover, then thetentative carryovers in each separatecategory are reduced on a pro rata basisso that their sum equals the amount ofthe remaining net operating losscarryover amount.Third, any net operating losscarryover remaining after the first andsecond steps is carried overVerDate Aug 31 200518:20 Dec 20, 2007Jkt 214001proportionately from any remaining lossin each separate category and combinedwith foreign source loss, if any, in thesame separate categories in thecarryover year. Finally, any remainingU.S. source loss is carried over to theextent of the net operating losscarryover remaining after the third step,if any, and combined with U.S. sourceloss, if any, in the carryover year.The temporary regulations deviatefrom the net operating loss rules ofNotice 89–3 in the final two steps. Thetemporary regulations require the U.S.source loss and foreign source losses inthe separate categories that are carriedover to be combined with U.S. sourceincome or loss and foreign sourceincome or loss in the same categories asthe respective portions of the netoperating loss. Then, the temporaryregulations provide these losses areallocated against other income as part ofthe general loss allocation rules forcurrent year losses. Notice 89–3,however, requires the allocation of thenet operating loss against income inother separate categories beforeallocation of current year losses. TheTreasury Department and the IRSbelieve there is no difference in resultwhether the net operating losses carriedinto a taxable year are allocated beforeor at the same time as current yearlosses, given the treatment of U.S. lossesin § 1.904(g)–3T. However, the approachof the temporary regulations providesadded simplicity in application of theordering rules as well as greaterconsistency with the rules for full netoperating loss carryovers.The rules for the allocation of netoperating losses apply similarly to netcapital loss carryovers.B. Step Two: Allocation of SeparateLimitation LossesSeparate limitation losses are firstallocated to separate limitation incomefor the taxable year in other separatecategories on a proportionate basis.Separate limitation loss accounts areincreased as a result of any suchallocations. To the extent the separatelimitation losses exceed separatelimitation income for the year, thoselosses are allocated against U.S. income,if any, for the taxable year and overallforeign loss accounts are increased.Unlike Notice 89–3, the temporaryregulations also provide that offsettingseparate limitation loss accounts arenetted against one another. For example,if a taxpayer has a separate limitationloss account in the general categorywith respect to passive category income,and in the next year incurs a passivecategory separate limitation loss thatoffsets general category income, the twoPO 00000Frm 00033Fmt 4700Sfmt 470072595accounts will be netted against eachother, rather than both being carriedforward until each one is recaptured.C. Step Three: Allocation of U.S. SourceLossU.S. source losses are allocatedagainst separate limitation income on aproportionate basis, and overalldomestic loss accounts are increasedappropriately. Under the ordering rulesin Notice 89–3, U.S. losses sustained inthe current taxable year are allocatedafter all other losses are allocated andafter separate limitation losses andoverall foreign losses are recaptured.With the addition of section 904(g),Congress expressed that domestic lossesand foreign source losses should betreated with greater parity. To that end,the Treasury Department and the IRSbelieve the ordering rules of Notice 89–3 should be amended. Accordingly, thetemporary regulations provide that U.S.losses are allocated in the same manneras foreign losses, before any income isrecharacterized.D. Step Four: Recapture of OverallForeign Loss AccountsTo the extent a taxpayer has anyseparate limitation income for thetaxable year after losses are allocated insteps one through three, a portion ofsuch income will be subject torecharacterization in order to recaptureprior year overall foreign losses, if any.E. Step Five: Recapture of SeparateLimitation Loss AccountsTo the extent a taxpayer has anyseparate limitation income for thetaxable year after overall foreign lossesare recaptured in step four, then suchincome will be subject torecharacterization in order to recaptureprior year separate limitation losses, ifany.F. Step Six: Recapture of OverallDomestic Loss AccountsTo the extent a taxpayer has any U.S.source income after losses are allocatedin steps one through three, but nottaking into account any foreign sourceincome that is recharacterized as U.S.source income under step four, then aportion of such income will be subjectto recharacterization in order torecapture prior year overall domesticlosses, if any.The temporary regulations coordinatethe overall foreign loss and overalldomestic loss regimes by providing thatthe recapture of overall foreign anddomestic loss accounts is doneindependently. Accordingly, incomerecharacterized under one recaptureprovision is not taken into account inE:\FR\FM\21DER1.SGM21DER1

72596Federal Register / Vol. 72, No. 245 / Friday, December 21, 2007 / Rules and Regulationsdetermining the amount of incomesubject to recharacterization under theother recapture provision. For example,foreign source income that isrecharacterized as U.S. source income inorder to recapture an overall foreign lossaccount will not then be included in thedetermination of U.S. source incomesubject to recharacterization as foreignsource income in order to recapture anoverall domestic loss account.V. Conso

to reduce the general category and passive category income. Accordingly, 30 ( 90 100/ 300) of the U.S. loss is allocated to general category income and 60 ( 90 200/ 300) of the U.S. loss is allocated to passive category income, with a corresponding creation or increase to Z's overall domestic loss accounts. Example 2. (i) Facts. (A .